FINANCIAL PLANNING &
STRUCTURING YOUR FINANCES TO SUCCEED
Organizing or structuring the company’s financial resources is one of management’s most important activities. A financial plan or budget sets goals for allocating its resources. We begin by discussing the capital requirements to get a company up and running. Then we develop a general operating budget to forecast income and expenditures, normally for one year. The broker has important decisions to make regarding the way fees or compensation for services and the costs of sales, including compensation of salespeople and mangers, are structured. These issues have a significant impact on the income and expenses of the organization. We also discuss annual, variable expense and monthly budgets as well as sound accounting procedures that management needs for monitoring and controlling the organization’s assets.
Upon completion of this module, students should be able to:
• Identify the capital requirements a company needs to get started and understand the importance of having adequate resources for this venture and how to prepare loan proposals.
• Understand how to develop a general operating budget using realistic projects of income and expenses.
• Understand how to use various types of budgets to monitor a company’s operations.
• Understand the importance of establishing accounting procedures to protect the financial integrity of a company’s operations.
Opening an Office Checklist (Financial Areas)
- Financial Plausibility
• Determine that corporate funds are available
• Determine that proper business and market conditions prevail
• Check company growth statistics
• Check all Multi-list statistics
• Check national and local financial conditions
• Check national and local mortgage money availability
• Order package policy
• Property damage
• Product liability
• Check of lease by insurance company for “hold harmless” clauses
- Financial Arrangements
• Choose bank.
• Open escrow account, if necessary
• Arrival of check ledgers
• Arrival of deposit books
• Arrival of deposit slips
• Arrival of rubber stamps
• Enter account resolutions
• Set up accounting ledgers
- Manager Instructions Re: Financial and Closing Procedures
• Bank deposits
• Bringing deals to closing
• Closing deals
FINANCIAL SYSTEMS AND RECORDS
Even the smallest real estate office needs to have a system of cost control. By establishing a budget and matching system of cost accounting, brokers can know at a glance whether or not they are running a profitable operation.
This module deals with basic accounting methods, guides you through the important business of determining costs accurately, shows you how to analyze your income dollar and how to reflect these last two factors in an operating statement. Included are details on analyzing costs for any size operation and on computing the costs of running a real estate brokerage business.
TWO REASONS FOR A GOOD
New brokers, generally having started their careers in sales, typically have a salesperson’s approach to problems and are often prone to overlook their need for a good accounting system. They may operate with only a checkbook until it comes time to prepare their income tax returns. Their tax service will inform them that their increase or decrease in cash is probably not the same as their taxable income. Because they have purchased equipment, perhaps an office building, they have spent a lot of cash that is not deductible as an expense but must be capitalized and expensed out gradually (depreciated or amortized) as the assets lose their value.
Brokers soon learn they must have an accounting system for two main reasons: various income tax reports and good managerial control. Taking advantage of the different software packages designed specifically for small one-office and large multi-office real estate firms will save time and money in getting records in a timely fashion to make better decisions faster.
While their business is small, owner-managers need only a simple bookkeeping system. They make all of the decisions alone and can adjust rapidly to new conditions. Few, if any, reports are required because they can observe most variable in the making. It often suffices for small brokers to use generalized expense and income accounts, often using as few as ten accounts to trace their income and expense. However, the beginning brokers would be wise to get some help in originating their accounting system so it can expand and become more sophisticated as they grow without starting over on a new system. Aside from the extra cost involved, switching systems sometimes causes brokers to lose the direct comparative value of their past data.
As the business grows, brokers must delegate authority. Now they must be able to control expenses on which they are not making all the decisions. Each link in their chain of command represents a span of control. Having the proper accounting records givens management the tools it needs to evaluate each span of control—such as each branch office, and so forth.
Systems are one of the most important variables because they determine how things actually get done. Financial systems are a key system because they support the company’s business strategy. These systems and records provide the means for management to track its performance in executing its financial strategies directed at achieving the firm’s long-term strategic intent.
The balance sheet is really a report of the financial condition of an enterprise as of a specific date. (See Figure 4.1.) Oversimplified, your financial position is made up of all your possessions (assets) offset by your debts (liabilities). The difference between your assets and your debts is your net worth or owner’s equity. Since assets are generally maintained at net book value (cost less depreciation to date) instead of current market value, the statement of position is accurate for tax reporting purposes but not for an absolutely true financial position. The real value of an operating company is not its net worth but the current value of its probable future earning power (liquidation value sometimes must be considered if the company consistently produces a loss or marginal profit).
FIGURE 4.1 Balance Sheet
BK Realty, Inc.
as of December 31, 200X
Current Assets Current Liabilities
Cash $ 96,555 Deferred
Deferred Payable (closed
Commissions transactions) $ 3,875
(closed Note Payable-
transactions) 6,150 Short-Term 29,950
Total Current Income Taxes
Assets $102,705 Withheld 21,525
Liabilities $ 55,350
Fixed Assets Long-Term Liabilities
Furniture and Note Payable-
Equipment $ 86,100 Long-Term $ 20,910
Less Depreciation 19,065 Total Long-Term
Liabilities $ 20,910
Net Furniture and
Equipment $ 67,035 Total Liabilities $ 76,260
Improvements 32,595 Owner’s Equity
Less: Depreciation 13,530 Common Stock $ 88,560
Net Leasehold Retained Earnings 23,985
Improvements $ 19,065 Owner’s Equity $112,545
Total Fixed Assets $ 86,100
Total Liabilities &
Total Assets $188,805* Owner’s Equity $188,805*
- The balance sheet is called this because total assets and total liabilities plus owner’s equity must balance (be equal).
Balance Sheet Relationships
When financial people look at balance sheets, they often note three common relationships.
The first common relationship is current ratio. This ratio measures the firm’s ability to pay its bills. This is the arithmetic ratio of total current assets to total current liabilities. The formula is CA ÷ CL. For example, if a firm’s net current assets (current assets are assets readily converted to cash, such as marketable securities) are $50,000 and its short-term debts are $25,000, then it has a 2 to 1 current ratio which is considered healthy. As assets decrease and/or liabilities increase, the ratio decreases to less than 2 to 1 which increases risk to solvency. Bankers, who tend to be conservative when lending money to firms, like to see a ratio of at least 2 to 1.
The second common relationship is working capital. In this case, $50,000 less $25,000 equals $25,000, total current assets less total current liabilities. (The formula is CA – CL.) Working capital is additional liquid assets above the amount owed that can be used by the firm to implement its strategies.
The third common relationship is equity ratio. If this company had total assets of $100,000 with total liabilities of $45,000, the equity ratio is $100,000 less $45,000, equaling $55,000 equity or 55 percent equity ratio. The formula is TA – TL = Net Worth ÷ TA = Equity Ratio. As the ratio approaches 100 percent or 1, the firm has less debt, resulting in less financial risk.
The income statement, sometimes called a profit and loss (P&L) statement or operating statement, portrays the ongoing operation of the company in terms of dollars for a specific period. The income statement must reflect total sales commissions and revenue by each principal division of the company.
The expenses should reflect both operating and nonoperating expenses. Operating expenses are those costs necessary for the operation of the business. Nonoperating expenses are costs that are not due to the actual operation of the company (i.e., interest and debt and/or income taxes).
Net income may be defined as the earnings that management has produced during a specified period for all those who have invested capital in the enterprise. It might also be described as being made up of revenues, a positive factor, minus negatives, which are expenses, deductible losses and income taxes. Do not be confused because the word cash has not been used. Cash often has little or nothing to do with the calculation of net income, especially under accrual-based accounting systems or for any enterprise that owns nonliquid assets.
Net income is the income remaining after all expenses have been paid. The income after deducting only operational expenses (does not include interest and taxes) is called Earnings Before Interest and Taxes (EBIT).
Example: Gross Revenue
- Operational Expenses
= Earnings Before Interest & Taxes (EBIT)
= Earnings Before Taxes (EBT)
= Net Income
EBIT measures the business decisions and the efficiency of the company’s operations. If EBIT is a negative number, the operation has produced a loss. If EBIT equals “0,” the company has broken even. If EBIT is a positive number, the company has made a profit from operations.
EXPENSE VERSUS COST
It is typical for business people to misuse the term expense when they talk of the expense of buying equipment or buildings. Buying buildings or equipment is a cost for an asset. The depreciation of those assets is an expense. Costs of making or buying assets are not expenses; they are “costs of” the assets acquired. Expense means that you have given up something of value to obtain revenue.
Gross revenue or gross income is the total dollars that a firm takes in from all available sources. Gross revenue is 100 percent of the income to the company. Expenses will represent a percentage of gross revenue. If gross revenue is $1 million and commissions paid to salespeople is $530,000, then 53 percent of gross revenue is commissions paid to salespeople. If $80,000 is spent on advertising, then advertising expense is 8 percent of gross revenue.
Expenditures from Gross Revenue
Commissions and fees comprise the single largest category of expenditure form gross revenue. These expenses take more than one-half the gross income, regardless of the company’s size or type of operation.
Owner/brokers should distribute listing and sales splits to themselves the same way they do to regular salespeople. Personal income from managerial duties should appear in summary value of the service provided.
ACCRUAL VERSUS CASH BASIS ACCOUNTING
The cash basis of accounting means that revenue is acknowledged when cash (or something of value) is actually received. Expenses are recognized only in amounts for which cash has been paid. The cash basis is normally used for small businesses because the accounting is simple and less costly. Current income taxes can be saved if all expenses are paid as incurred. When large receivable and payable are accumulated, the profit or loss picture can be greatly distorted through cash basis accounting.
The accrual basis of accounting dictates that one accrues revenue when the service is rendered or the sale is made. The time of collecting the cash proceeds or commission from the sale has no direct bearing on the timing or the amount of the revenue. To keep the accrual system as realistic as possible, a reserve could be established for lost sales if past experience warrants it. Expenses are recognized in the same manner, when they are incurred or become payable, and not when cash is paid out. The accrual method allows brokers to match expenses with revenues in the proper period thereby portraying a truer profit or loss position. Be careful of trying to get the best of two worlds by reporting revenue on a cash basis (when the sale is closed) but accruing expenses and charging them out at the end of the accounting period. The Internal Revenue Service will normally demand that you consistently stay on an accrual basis. All external expenses and revenues are funneled through your receivable and payable accounts when you employ pure accrual accounting. However, many firms operate as if on a cash basis until the end of the accounting period, at which time all expenses and revenue are adjusted to the accrual basis. With the proper procedures established, accounting time can be saved through the adjusted accrual methods without distorting the interim statements.
It is best to seek professional tax assistance before deciding which method to follow.
Brokerage owners must always presume that embezzlement could happen to them. Signing all checks can help prevent embezzlement, but the following steps are also recommended.
Full audits with interim unannounced reviews should be conducted by outside sources such as an independent CPA firm.
All bank statements and canceled checks should be returned to the owner, not to the person in control of accounting and not to the person who balances out the checking account each month. Each statement, together with the canceled checks, must be examined monthly when received by the owner and should at least appear as if they have been examined carefully. Occasional calls about checks to the person balancing the books each month helps support the fact that the owner is looking at every check. This simple procedure alone will probably do more than any other to prevent embezzlement.
Different people should handle the deposits and checks with a tie-in between deposits and checks. Checks should not be written to pay out salespeople’s commissions unless there is evidence of a commission deposit having been made for the company on that transaction.
Two people should sign checks and two other people should handle bank deposits.
The ratio of commission payout to gross revenue should be watched. If there is a change in this ratio, the owners may have a problem.
Be sure check protection systems prevent digits being added without it being obvious. For example, leaving space behind the figures and wording on a check could make it easy to change $100.00 to $100,000.
To run a business successfully, management must be able to plan, coordinate and control its business operation. A budget is a financial formula to operate within for a future period. Budgets are usually projected for each expense line item monthly for the next full year. To exercise the proper control, management must make continuous reviews and comparisons to the budget so that undesirable variances can be noted and corrective action taken.
Steps in Preparing a Budget
Budgeting can be done as an “incremental” process—using last year’s budget as a base form which to start. Alternatively, budgeting may be a “zero-based” process—starting from scratch each year to validate every expense in the budget. Or it can be a combination of incremental and zero-based, which is probably the best option.
Assuming top management has decided what must be done to reach their objectives, they should now call in the various people responsible for attaining these objectives and have them work up their own budgets (with a minimum of direction from top management). Often top management can subtly influence middle or lower management to project a budget for both sales and expenses just about in line with what they want. It is important that the budget be set by the chain of command responsible for attaining that performance. People who set their own budgets are much more likely to stick to them than those who have budgets set by someone else.
The budget must be prepared with two considerations in mind:
- It must be broken down to areas of one person’s authority, such as branch offices or departments.
- It must be complied to comply with the established accounting framework to accumulate and measure the data.
In order to control expenses for budgetary purposes, standard expenses must be determined. Therefore, management must not only know how much the actual expenses and revenue are at the present time, it must know through standards what they should be. Expense and revenue standards can provide these measures to gauge present performance. Generally we look to the past for these standards of performance and expense to obtain the desired future performance. Using these past revenue/expense/profit relationships, a realistic budget can be prepared to obtain a planned profit for the future.
Although a target budget will be kept in focus, a flexible budget is more meaningful. This budget will reflect expenses for each level of revenue produced. The flexible budget is far more realistic and usable than a fixed budget because it takes into account both fixed and variable expenses of the operation to be controlled.
Variable expenses are caused by production. No production, no expense. In a real estate operation, the following expenses are variable: commissions, fees, management overrides—all are a percentage of gross revenue.
Fixed expenses, on the other hand, are not caused by production and exist whether one unit has or has not been produced. The following expenses are relatively fixed: sales management salaries and fees, salaries, advertising, communications, occupancy and other operating expenses (property taxes, auto expense, insurance, dues, and so on.).
Knowing how much each of these fixed and variable expenses will be incurred as a standard for the operation of each office or department, we can now measure and gauge each manager’s operation. They not only can be watched to see that they meet or exceed their production quotas but they are also measured to see that they attained these quotas or positions with all costs in proper alignment. All of this data can be set up in the form of a table(s) and/or graph(s) that can also portray very conspicuously the budgeted breakeven point, the point at which revenue equals expenses, for the office or department.
It must be understood that fixed costs do not always remain fixed but must at times be shown as a vertical rise, such as when your business grows to a point where another salaried person must be added. When a firm goes all out for volume and bigness at any cost, it will feel the effects of the limit of its personnel’s capacity or expertise and/or the limit of the market potential. When this happens, the fixed costs such as advertising and selling expense become inefficient and skyrocket upward to the point where profit eventually diminishes rather than increases with more volume. This is the opposite result of the one hoped for.
Rules of Thumb for Breakeven
The broker should know the following by the month, quarter and year:
• Number of exclusive listings
• Number of sales and sales volume in-house (own firm selling own listings)
• Number of co-op sales and sales volume, listings and volume sold by co-op
• Average revenue per unit
• Total expenses
• Number of units produced (sale equals one unit, listing sold equals one unit)
With the proper records on the number of contracts needed on average to get an exclusive listing or make a sale, calculate how many contacts per day are needed by your office to break even per month and how many contacts it would take per day on average to make your budgeted profit.
TYPE OF BUDGETS
AS many budgets can be prepared as there are departments or lines of authority to fix responsibility within the framework of a firm’s accounting capability. They include budgets for sales, listings, advertising, selling and administrative expense, cash, new office development and overhead. Segmented budgets only involve management people who have responsibility and control for a given area.
Upon completion of this chapter, students should be able to:
- Identify the capital requirements a company needs to get started and understand the importance of having adequate resources for this venture and how to prepare loan proposals
- Understand how to develop a general operating budget using realistic projects of income and expenses
- Understand how to develop a general operating budget using realistic projects of income and expenses
- Understand how to use various types of budgets to monitor a company’s operations
- Understand the importance of establishing accounting procedures to protect the financial integrity of a company’s operation
Get An Accountant – It will save you time, money & grief
Why Do You Need A Good Accounting System?
- Income Tax Reports
- Managerial Control
- You can’t run your brokerage the same way you ran your business as an associate
When You’re Small
Software Packages Designed for You
When You’re Large
Software Packages Designed for You
As You Grow So Does “Span of Control”. You Need Information on Other’s Decisions. Get an Accountant.
Current Ratio – Firms ability to pay its bills (CA ¸ CL)
- CA = Current Assets
- CL = Current Liabilities
2 to 1 is Good
- Additional liquid assets above what is owed
- It may be used to implement strategies
- CA – CL
Indicator of the percent of debt to assets.
It shows financial risk:
TA – TL (Total Assets – Total Liabilities) = Net Worth ¸ TA = Equity Ratio
$100,000 – $45,000 = $55,000 ¸ $100,000 = .55%
The closer to 1.00% you get, the less risk you have.
FOR EXAMPLE: $100,000 – $25,000 = $75,000 = .75%
Income Statement (Profit and Loss)
Operation of the brokerage in terms of dollars for a specific period. It reflects:
- Total Revenues
Operating / Non-Operating
Net Income; Income: After all expenses have been paid
– Operational Expenses
= Earnings Before Interest & Taxes (EBIT)
= Earnings Before Taxes (EBT)
= Net Income
EBIT = Earnings Before Interest & Taxes
EBIT measures business decisions and the efficiency of the brokerage.
EBT = Earnings Before Taxes
Expense vs. Cost
Buying equipment or real estate is a cost for an asset
The depreciation is an expense of the asset
Means that you have given up something of value to obtain revenue
Gross Income or Revenue / Expenses
Income; Total dollars taken in from all sources
Accrual vs. Cash Base Accounting
Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy.
You are a calendar year accrual method taxpayer. You sold a computer on December 28, 2015. You billed the customer in the first week of January 2016, but you did not receive payment until February 2016. You must include the amount received for the computer in your 2015 income.
The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services.
Estimated income. If you include a reasonably estimated amount in gross income, and later determine the exact amount is different, take the difference into account in the tax year in which you make the determination.
Change in payment schedule for services. If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a lower rate until you complete the services and then receive the difference.
Advance payments for services. Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can elect to postpone including the advance payment in income until the next tax year. However, you cannot postpone including any payment beyond that tax year.
For more information, see Advance Payment for Services under Accrual Method in Pub. 538. That publication also explains special rules for reporting the following types of income.
- Advance payments for service agreements.
- Prepaid rent.
Advance payments for sales. Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods you hold primarily for sale to your customers in the ordinary course of your business. If the advance payments are for contracts involving both the sale and service of goods, it may be necessary to treat them as two agreements. An agreement includes a gift certificate that can be redeemed for goods. Treat amounts that are due and payable as amounts you received.
You generally include an advance payment in income for the tax year in which you receive it. However, you can use an alternative method. For information about the alternative method, see Pub. 538.
Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.
- The all-events test has been met. The test has been met when:
- All events have occurred that fix the fact of liability, and
- The liability can be determined with reasonable accuracy.
- Economic performance has occurred.
Economic performance. You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or as the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. An exception allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. For more information on economic performance, see Economic Performance under Accrual Method in Pub. 538.
Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. For more information, see Inventories , later.
Under the cash method, include in your gross income all items of income you actually or constructively receive during your tax year. If you receive property or services, you must include their fair market value in income.
On December 30, 2014, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 2015. You must include the amount of the check in income for 2015.
Constructive receipt. You have constructive receipt of income when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it. If you authorize someone to be your agent and receive income for you, you are treated as having received it when your agent received it.
Interest is credited to your bank account in December 2015. You do not withdraw it or enter it into your passbook until 2016. You must include it in your gross income for 2015.
Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.
Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December 2015. She was told in December that her payment was available. At her request, she was not paid until January 2016. She must include this payment in her 2015 income because it was constructively received in 2015.
Checks. Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if you cannot cash or deposit the check until the following year.
Dr. Redd received a check for $500 on December 31, 2015, from a patient. She could not deposit the check in her business account until January 2, 2016. She must include this fee in her income for 2015.
Debts paid by another person or canceled. If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled or paid. For more information, see Canceled Debt under Kinds of Income in chapter 5.
Repayment of income. If you include an amount in income and in a later year you have to repay all or part of it, you can usually deduct the repayment in the year in which you make it. If the amount you repay is over $3,000, a special rule applies. For details about the special rule, see Repayments in chapter 11 of Pub. 535, Business Expenses.
Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules .
Expenses paid in advance. You can deduct an expense you pay in advance only in the year to which it applies.
You are a calendar year taxpayer and you pay $1,000 in 2015 for a business insurance policy effective for one year, beginning July 1. You can deduct $500 in 2015 and $500 in 2016.
*Talk to your accountant
Most consider “cash” best for small business
IRS Small Business:
For the latest information about developments related to Publication 334, such as legislation enacted after it was published, go towww.irs.gov/pub334.
Accounting methods. Certain small business taxpayers may be eligible to adopt or change to the cash method of accounting and may not be required to account for inventories. For more information, see Inventories in chapter 2.
Reportable transactions. You must file Form 8886, Reportable Transaction Disclosure Statement, to report certain transactions. You may have to pay a penalty if you are required to file Form 8886 but do not do so. You may also have to pay interest and penalties on any reportable transaction understatements. Reportable transactions include:
- Transactions the same as or substantially similar to tax avoidance transactions identified by the IRS,
- Transactions offered to you under conditions of confidentiality for which you paid an advisor a minimum fee,
- Transactions for which you have, or a related party has, contractual protection against disallowance of the tax benefits,
- Transactions that result in losses of at least $2 million in any single tax year ($50,000 if from certain foreign currency transactions) or $4 million in any combination of tax years, and
- Transactions the same or substantially similar to one of the types of transactions the IRS has identified as a transaction of interest.
For more information, see the Instructions for Form 8886.
Simplified method for business use of home deduction. . The IRS provides a simplified method to determine your expenses for business use of your home. For more information, see Business Use of Your Home .