LEGAL ISSUES

Account-Ability

How one company's problems with accounts payable and the IRS jeopardized its future.
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Danny Sullivan learned the hard way how problems with accounts payable can jeopardize the future of an otherwise solid business

June 5, 1990. It was just about 9:00 in the morning when Danny Sullivan, the 34-year-old owner of Village Shoes, an upscale retailer in the wealthy Detroit suburb of Grosse Pointe, pulled his '87 Mustang into the parking lot behind his store. He was somewhat distracted, thinking about a meeting he had scheduled for that morning with his financial advisers and an Internal Revenue Service official to try to resolve a tax dispute that had dragged on for nearly five years.

When he rounded the corner of Kercheval Street, the main shopping drag in town and home for 14 years to his $750,000 shoe store, his hopes were dashed with a vengeance. The locks on Village Shoes' front door had been changed. Large pieces of masking tape framed a notice that proclaimed the store and its property had been seized by the state of Michigan. Two of the store's saleswomen paced the sidewalk uncertainly. Several armed policemen waited by the front door, as Sullivan recalls, "so that they could slap me with a warrant and stop me in case I went crazy and tried to break into my own store."

The day marked an end to Sullivan's 18-month struggle to find a way to withstand Michigan's economic slowdown and the resultant collapse in his customers' purchases of luxury shoes. He had been negotiating with his suppliers about ways to reorganize his accounts-payable obligations into smaller, more manageable levels and longer payment schedules. He also had been battling the IRS and the state over failure to pay taxes.

But when he saw the policemen and the new locks, Sullivan realized there was no room left for negotiation. After obtaining permission to enter his office through the store's unlocked back door, he started making phone calls. Within hours he had retained a bankruptcy lawyer, who filed a petition on Village Shoes' behalf for Chapter 11 protection from its creditors, including state and federal tax authorities. The following Monday Village Shoes reopened for business, while Sullivan's bankruptcy lawyer and financial advisers began the painstaking process of evaluating whether his company stood a chance of financially reorganizing under a bankruptcy-court-approved scheme.

Saddest of all about Danny Sullivan's experience is that so much of it stemmed from his own misguided business decisions -- decisions that placed growth ahead of profitability, customers ahead of creditors. As a result, he lacked the kind of accounts-payable controls that could have helped Village Shoes creatively respond to its sales slump. Michigan's economic recession was beyond Sullivan's control. But it took years for him to realize that his accounts-payable problems were not.

Unfortunately, Danny Sullivan's story is far from unique. When the economy is weak, as it has become throughout the country over the past two years, growing companies face twin pressures from sales slowdowns and the buildup of accounts-receivable problems. When credit and other sources of financing also dry up, as is the case today, cash-strapped managers must struggle to find ways to meet their financial obligations. All too often, what seems to be a solution is to stretch out, or occasionally even skip, their company's payments to suppliers, service vendors, bankers, or the tax man. "You keep telling yourself you'll be able to catch up and straighten it all out as soon as business picks up," Sullivan comments. "But pretty soon I began to feel as though I'd never get out from under it all."

Accounts-payable crises can snowball faster than almost any other financial problem -- to the point where they can jeopardize the future of businesses with otherwise strong growth potential. Yet few entrepreneurs view their bill-payment operations as worthy of the same attention they'd pay to sales or marketing activities. All too often they delegate the responsibility to overloaded bookkeepers who are already preoccupied with data processing or their own bill collecting. Danny Sullivan never realized how big a payables problem he had, until it was too late. "I kept thinking that if I could just figure out a way to raise some money, I could restock my most popular shoe lines and boost sales, and then everything would be all right again."

* * *

At first it did seem as though sales -- and sales alone -- were Village Shoes' problem. Sullivan had begun to notice a drop-off in customer activity as far back as January 1989. "There were little signs, but they kept on building," he recalls. "First, I noticed that men, particularly fathers, had stopped buying luxury shoes and were only spending money on items that they really needed. Then women started curtailing their purchases. Children's shoes were the last to be hit, but then we started to see a drop-off there as well."

Sullivan's inventory kept expanding during those slow winter months. "As a specialty retailer, I've normally got to place my orders with manufacturers and designers as much as a year in advance," he explains. "So there was no way to cut back on inventory buildup that winter and spring, even though I could watch my sales shrinking. Shoes just kept on coming." He had to find a way to pay manufacturers for the upscale shoes and boots he had long ago ordered, even if his customers were no longer buying them.

If some of Sullivan's accounts-payable problems stemmed from forces beyond his control, others were clearly of his own making. About five years earlier he had made a fairly common -- and in the end, very costly -- mistake. In the midst of an intensive growth period, he succumbed to the temptation to build inventory -- and thus push for sales growth -- at the expense of other financial priorities, including his tax liabilities. His accountant had presented him with a $12,000 federal tax bill that Sullivan thought was too hefty for him to be able to pay just then. "We had just invested $40,000 in building up our inventory, and I didn't have enough cash left over to pay the tax bill," he acknowledges. "So I went in to my local IRS office and asked for tax relief through some kind of payment-work-out plan."

He hired a law firm to work out a payment plan, which he followed for a couple of years. "As time went on," Sullivan says, "penalties and interest kept accruing at a phenomenal rate until -- in what seemed like no time at all -- I owed $30,000, not $12,000." Then the state, he says, began dunning him for back taxes as well. That, too, is fairly common since state liabilities are pegged to federal liabilities. So when an IRS bill is in dispute, red flags go up at the state level as well.

"I couldn't understand why I kept paying money but the problems never seemed to go away," Sullivan says. "I wanted to get bottom-line documentation from the IRS about where my tax payments had gone and how much I still owed, and I couldn't even seem to get that." Finally, he decided to draw attention to his case by stopping his tax payments entirely. Although he may have thought of his gesture as an act of well-justified anger or frustration, he was breaking the law in a way guaranteed to eventually earn the wrath of both federal and state tax authorities.

Sullivan was surprised that the tax collectors ignored him, at least at first. Since the U.S. tax system relies initially on voluntary compliance and the information that companies themselves report, often it takes a fair amount of time for the authorities to catch on. In this case, that only made it easier for Sullivan to put his tax problems out of his mind, especially as sales kept dropping and his financial obligations to suppliers continued to mount. "I started calling my suppliers to tell them I needed more time to pay my bills. At first, most of them were pretty understanding," he recalls.

But Sullivan wound up just postponing his problems. "Eventually, I got to the point where some of my payments to suppliers were 90 days overdue. After that they'd turn me over to collection agencies. The agencies would be happy at first if I said I would pay them anything. But after a while, they turned me over to the collection lawyers." Meanwhile, some of his suppliers put him on a cash-only delivery basis. "That was the worst, since it meant I'd have to pay cash for items that were just building up in inventory, sometimes with seasons to go until they stood a chance of being sold."

As a supersalesman with unstinting confidence in the basic strength of his store and sales base, Sullivan was slow to realize that the situation with his suppliers was becoming as insoluble as his tax problems. But before long, he recalls simply, "I began to feel as if I were drowning."

* * *

By April 1990, with no bottom in sight for Michigan's economic downturn, Sullivan concluded that the only way out of his own financial troubles would be an infusion of new capital, either a bank loan or a private investment. So he contacted James Greenfield, a longtime customer of Sullivan's who is a consultant with The Wharton Resource Group Inc., based in Shaumburg, Ill., a nationwide firm that specializes in advising small, growing companies. "Danny approached me about the idea of raising capital so that he could refinance his business," Greenfield recalls. "But once I started analyzing his financial operations, I realized that his immediate problem wasn't the need to build sales. He had to take care of his payables problems and do it fast."

It was a crisis situation. Greenfield and Sullivan figured that Village Shoes' outstanding obligations amounted to nearly $130,000, and most were way overdue. It was time to set some priorities for payables.

"Danny Sullivan had made the same mistake that probably 70% of businesspeople with payables problems make," says Greenfield. "He had focused his attention on whichever suppliers called him and yelled 'pay me, pay me' the loudest -- while, at a dire risk to his company, he had ignored his tax obligations to the government. Of all the people a business owner can owe money to, the ones that are least likely to be willing to negotiate with you and most likely to step in there and shut down your business are the federal and state tax departments."

His top priority was to resolve Village Shoes' tax problems. But what he learned, as he began to research the case, was that the IRS had never approved the payment scheme. As a result, Greenfield explains, "the IRS didn't care if he had been making regular payments in good faith for a good part of the time that was in dispute. As far as the IRS was concerned, he hadn't paid the money he owed when he owed it, and he hadn't paid the interest and penalties that the IRS said he owed, either. And the IRS couldn't care less about the payment plan because it had never approved it." As for the problems with the state, Sullivan's own tax records were so confused, he possessed little evidence that could back up his claims.

Despite the tax fiasco, Greenfield was convinced that Village Shoes' overall business prospects would be quite strong if he and Sullivan could just straighten out the store's financial operations. So while attempting to resolve the tax problems, Greenfield began contacting every one of Village Shoes' creditors to try to informally negotiate extended payment plans. His goal was to help the company adjust and upgrade inventory whenever necessary to keep the 2,000-square-foot store and its product line contemporary and attractive to Sullivan's customers.

Although the store's financial difficulties were dragging into their 18th month, most of Sullivan's creditors were willing to negotiate. "Most of them had already stood behind me once before, during the recession of 1981, and they'd seen me come out of a sales slump with stronger growth than I'd ever had before. It was in their interest to help me work out my problems," says Sullivan.

Greenfield, too, was optimistic. "The only stumbling block seemed to be the IRS," he says. "But we finally succeeded, with some help from our senator, in scheduling a meeting with an IRS supervisor for the morning of June 5."

* * *

That meeting never took place. Instead, Danny Sullivan telephoned Greenfield from Village Shoes' back office to tell him the store had been seized by the state of Michigan. "We had no choice but to file for Chapter 11 protection," says Greenfield. For Sullivan it was "a bitter pill at first." When the court unraveled his tax problems, what it found was unbelievable to him. "Between the state and federal tax authorities, I had owed a total of $68,000 in taxes. But by the time I got through with all the interest charges and penalties, I had paid $137,000 and it still hadn't been enough," he says.

Greenfield was disappointed in having to file for Chapter 11. He believes Village Shoes could have reimbursed its creditors in full, over a protracted payment schedule, if it had been allowed to continue negotiations in an informal way outside bankruptcy court.

The filing has definitely taken its toll. "Of the 32 suppliers I deal with, the vast majority have put me on a cash-in-advance payment basis," Sullivan says. Still, he sees some positive signs: "Only one of my old suppliers has decided to stop doing business with me. And recently, about 6 agreed to put me back on a credit basis again." With tighter financial systems in place, Village Shoes will certainly be better positioned to withstand its region's continued economic downturn.

But the best thing Danny Sullivan may have going for him is what he's learned from his accounts-payable crisis. "If you find you've got problems paying your bills -- above all else, keep an open line of communication with all your suppliers," he says. He hadn't always done that in the past, in part because he was confused about the true nature of his financial problems. A chastened man, Sullivan adds, "Never be afraid to tell your creditors what's happening, where you see problems, and what you're planning to do about them."

After a moment's thought, he goes on. "Always, always, always send your creditors money when you tell them you're going to send them money. Even if you owe them a lot and can only afford to send a small sum, send it, because it shows your good faith."

And that's what a well-run accounts-payable system is all about.



RESOURCES

All-purpose financial-management software packages

The quickest way to upgrade your accounts payable is to switch to a computerized system that is integrated with all your other financial operations. A good program should automatically age your company's outstanding obligations, generate weekly analytic updates along with other cash-flow reports, and provide precautionary double checks, such as matching payments and invoices against original order forms. Chances are, your company can manage quite nicely with a general, all-purpose software package. Here are two systems that management consultant Paul Parish of the accounting firm Grant Thornton recommends:

* CYMA offers three packages of differing complexity targeted at small companies and start-ups. The software helps companies handle accounts payable, accounts receivable, and most other financial operations. Available through a network of certified dealers and consultants, the software operates on virtually all corporate computer systems. (Prices range from $49 to $995, depending on the software's complexity.) For a list of nearby dealers, call (800) 292-2962.

* Accounts Payable 2000, by Software 2000, is for companies with sales greater than $20 million. This is a pricey system that could pay off if you have a large and complicated set of creditors. It offers useful features such as duplicate-invoice validation, an on-line audit capacity to track individual payments, and, best of all, something called "interactive vendor analysis," to help companies figure out the most profitable date to pay each bill, given early-payment discounts and late fees. But it is targeted for IBM AS/400 systems and won't work on your PC. The accounts-payable module can be purchased separately for prices that range from $38,000 to $70,000, which means it's worth consulting with your accountant to see if you need anything that sophisticated. For the location of the sales office closest to you, call (800) 525-0490; in Massachusetts, call (508) 778-2000.


STRATEGIES THAT PAY OFF

How five small businesses are managing payables -- even when their own customers are taking longer to pay

* Prioritize: For Bill Rizzo, whose $7-million environmental-engineering firm, Rizzo Associates Inc., is located in Natick, Mass., financial obligations fall into three categories: the bills he pays as soon as they're due (personnel costs, bank loans, and taxes), bills he pays within 10 days (to professional contractors whose services he's already been reimbursed for by clients), and bills he tries to pay within 30 days (all others). As his company has begun to feel the recessionary pinch, he's "made a conscious decision," he says, "to stretch that third category out to 45 days. It's the only strategy that makes sense for us," he emphasizes. "When you look at our cash flow, accounts payable are the only factor that we ourselves have got some control over -- and we'll play with them if and when we have to."

* Negotiate: John Roberts, chief executive of $10-million Roberts Welding Contractors Inc., in Winterville, N.C., agrees -- but he prefers to negotiate longer payment terms in advance, although he says the process can be time-consuming. "We've got 1,500 different vendors that we deal with, and what we do is telephone every single major vendor, maybe a couple hundred of them, to ask when they absolutely have to have their money." Roberts's suppliers don't try to take advantage: "Some tell us 45 days is all right. One of our biggest steel suppliers said, 'Fifty-four days is OK -- just don't try to pay on the 55th day.' " That information then gets recorded in each vendors' accounts-payable file and sets the guidelines for payment of all major outstanding obligations. With smaller suppliers, where there's not much potential payoff from stretching out payments, Roberts aims for a 30-day turnaround of bills.

* Monitor payables closely: Each week Bill Senecal, chief financial officer of $2.8-million TMA Technologies Inc., in Bozeman, Mont., analyzes an accounts-payable aging schedule he gets from the accounting department along with other cash-flow documents. "It's always been our goal to pay our service professionals -- the lawyer, accountants, and so on -- within 20 days because they're with smaller firms, and other vendors at 30 days. But with the economic downturn, I've watched us push that closer to 40 days, which I see as our outside limit of what's acceptable," he says. Since Senecal tracks the numbers weekly, he's in a good position to stop the erosion fast: "At 40 days, I'll use our credit line to make payments if we can't bring the money in fast enough from our accounts-receivable operation."

* Demonstrate good faith: "There's no doubt about it. When your money doesn't come in, you're in a jam," confesses Jimmy McAndrew, CEO of $9.4-million Matthew Outdoor Advertising Inc., in Parsippany, N.J. His solution: "We pay our staff, our tax bill, our bank, and our priority leases for billboards whatever we owe them when we owe it." Then he divides whatever cash is left over among all his remaining vendors. "It shows we're trying, even if we can't swing the whole bill payment at that time. And we don't just send the money -- we get on the phone and explain what's happening and why and set up an informal workout plan on the spot."

* Protect credit ratings: Since she knows that smaller companies are the ones hardest hit by the credit crunches that accompany recessions, Linda Miles, CEO of Linda L. Miles & Associates, a $1.5-million consulting firm in Virginia Beach, Va., has made it her top priority to pay all bills on time despite what she sees as a temporary slump in sales. "If I have to go to the bank tomorrow to borrow $40,000 to print a marketing catalog, I want to be able to do it. So I'm still paying all our bills at the 30-day point, even though I've had to cut our monthly expenses by $15,000 and put my staff on a four-day workweek." She stopped drawing her own salary a few months ago but is confident she's made the right decision. "In a recession it's more important than ever not to spend what you don't have. We're forecasting a turnaround by midyear 1991, and our company is going to be around to enjoy it."


NINE CARDINAL RULES

How to take control of your payables

A well-managed accounts payable system is, quite simply, managed. It should be given the same attention as the other key systems that constitute your company's cash-flow base: bill collection, inventory management, money management, credit, and other banking systems. Controlling the cash that leaves your company is every bit as important as controlling the cash that comes in through sales, marketing, and collection efforts.

To achieve control, payables must be aggressively supervised by a top manager who knows the company's financial status and goals. That means the chief executive or controller, not an overloaded accounting clerk. Bill payments must be not simply made but planned. Above all, payables must be viewed as a flexible system that you can manipulate in response to other factors such as sales decreases or slowdowns in your own bill collecting.

While there is no such thing as a single accounts-payable system that will work for every company, here are nine rules that well-managed systems should adhere to:

1. Evaluate cash flow. Every accounts-payable strategy should be rooted in a company's current cash-flow realities. To some degree, that's common sense: if it takes 90 days to collect accounts receivable, it's financially self-destructive for you to pay your own bills within 15 days.

That said, few chief executives devote enough attention to analyzing exactly how long it takes dollars spent to be replaced. Ron Weiner, a CPA whose New York City-based firm, Weiner Associates, specializes in working with owner-managed companies, recommends that you monitor your cash-to-cash cycle. This is the length of time that elapses from your expenditure of dollars on raw materials, labor, warehousing, and so on, through the sales and marketing process, until the date you receive payments from your customers.

"That statistic should then become a management tool," advises Weiner. Take a hypothetical case of a distributor who buys a widget on January 1 and pays for that widget on January 30; it takes him 60 days from that point to sell that widget (which brings him to March 31) and 45 days after that to collect his cash (May 15). His cash-to-cash cycle adds up to 105 days, which Weiner describes as "the length of time he's in the hole" after expending his company's cash. "Anything a business owner can do to reduce that number will help his business: collect money from customers faster, sell and distribute faster, or lengthen the number of days that he takes to pay his own bills."


2. Set goals.
Once you've evaluated your cash flow, establish written payment goals so there can be no confusion among your bill payers. Avoid a situation in which accounting clerks make the decisions about which bills are to be paid and when -- usually, suppliers who yell loudest are paid the fastest, regardless of the overall benefit to the company.

Bill payments should be timed to coordinate exactly with your company's formal disbursement goals. That means you should date checks no earlier than the dates upon which payments are due (and suppliers should receive checks no more than a day or two earlier than the due date). "At all times," says Paul Parish, a management consultant at the accounting firm of Grant Thornton, in Denver, "a company's goal should be to hold its cash within its own investment accounts until the last possible minute in which payments must be made so as to maintain good relations with its suppliers."


3. Establish payment priorities.
Every CEO should be able to set up his or her own two-tiered list of payment priorities, which then becomes part of the company's formal disbursement strategy. Tier one, the group that should be paid at all costs and at whatever terms have been agreed upon, should include major vendors and service suppliers, bankers, and most important, the state and federal tax authorities. Tier two, which offers more room for short-term maneuvering during cash-flow crunches, should consist of minor suppliers whose goodwill is less vital to the company's overall well-being. To avoid confusion, inform your accounting clerks of those payment priorities, by supplier, in writing.


4. Aggressively negotiate payment terms.
Granted, there's not much room for negotiation with bankers or tax collectors, but once they're taken care of, everything else on the payables front should be open for discussion. You have leverage to negotiate better-than-usual terms from your major suppliers, especially during recessionary times, when everyone is afraid of losing business. Figure out your optimal payment terms (using the cash-to-cash or other cash-flow statistics as a guide); then -- when orders are placed, not when bills become due or overdue -- negotiate to achieve those terms.


5. Forecast cash needs.
A company's CEO or controller should be able to predict exactly how much cash the company will need -- and when -- to fulfill its payables obligations. That forecast then becomes an important tool in averting cash-flow problems. Managers should be able to tell if funds will be available at the right time from money-management accounts or bank credit lines. And if funds won't be available, you can take precautionary measures, such as stepping up the company's own bill-collecting efforts.


6. Keep good payables records.
They should include weekly updates about the aging of every outstanding bill; documentation that matches each bill paid with its original sales order, delivery records, and payment invoice; and total cost records, including interest penalties paid on each bill. The last is important because, as James Greenfield, management consultant with The Wharton Resource Group, emphasizes, "most businesspeople don't realize how much it adds to their cost of doing business when they wind up having to pay interest charges to finance late payables."


7. Review payables records regularly.
Payables reports are every bit as important as other cash-flow documents and need to be evaluated by all relevant personnel. (Depending upon a company's structure, that may include the CEO or controller, sales managers, and, if they exist, accounts-payable and accounts-receivable supervisors.) Generally speaking, you should review payables-aging schedules weekly; cost records can be evaluated monthly.


8. Recognize warnings signs.
Since cash-flow cycles vary even in the best of times, there may be times when your payables get stretched without any long-term risk. But it's essential for someone in top management to keep an eye out for indications of more serious problems. (See "Warning Signs," next page.) One approach is to draw up a "payables problems" checklist, which breaks down average bill age, promptness of tax payments, any interest charges, and other warning factors you come up with for your company. To keep everyone informed, circulate the list each month to all managers, including your sales manager.


9. Fraud-proof the payables operation.
"CEOs should never underestimate the importance of installing safeguards to prevent people within the organization from looting payables," says Paul Parish. "Fraud can be one of the most common problems growing companies encounter in their accounts-payable operations."

To minimize the risks, you should formalize payment procedures that should include double checks at each step of the process: bills should be paid only when they can be matched against purchase orders and delivery confirmations; one person should write or authorize checks while another signs them; computerized bill-payment systems should be ac-cessed only by computer code. If you rely on manual check-writing systems, keep blank checks under lock and key and track all numbers, including voided checks. If you make payments by wire transfer, establish bank procedures that ensure proper control over such transfers. "The best defense of all against fraud -- and it's one that an amazing number of smaller companies overlook -- is to make certain the checkbook balances each month," Parish advises.


WARNING SIGNS

Heading for accounts-payable problems? Here are five typical symptoms

* Aged payables: Most financial experts agree that companies are heading for trouble when their bills start becoming, on average, 45 to 60 days overdue. (The only exception: bills whose issuers have approved late-payment terms without interest penalties, in advance at order time.) "At 60 days, you've got to sit down and figure out which vendors you absolutely, positively must stay current with and start paying them anyway you can," emphasizes management consultant James Greenfield of The Wharton Resource Group.

* Interest penalties: Cash-savvy chief executives never box themselves in to paying interest charges on overdue bills -- unless they've already calculated clear financial benefits from using their funds elsewhere. Once you're paying penalties to even one or two vendors on a regular monthly basis, you're in trouble. Instead, you should approach your creditors about a workout plan that will reduce or perhaps eliminate hefty interest charges.

* Disorganization: "You know your whole system is heading for disaster when unpaid bills get thrown into someone's desk instead of entered into a record-keeping system that will keep aging bills so that management can track their payment," says CPA Ron Weiner of Weiner Associates. (For tips on software products that will correct this problem, see "Resources," page 3.)

* Overdue taxes: As Danny Sullivan of Village Shoes learned the hard way, skipping tax payments -- even with the best of intentions -- is a sure road to disaster. If your payroll, corporate federal, or state taxes are late, pay them immediately, even if it means keeping vendors waiting. If you dispute your tax bill, pay it anyway and then fight for a refund; that's the only way to eliminate the risk of costly penalties and interest charges.

* Hassles from creditors: If your only form of communication with vendors is being on the receiving end of hot-tempered telephone calls, chances are, you're suffering from problems of your own creation. Instead, "make it a habit to communicate informally with your creditors whenever you think a cash-flow crunch might be developing," urges Greenfield. "If you tell them, 'Yes, we've got a problem, we recognize it, here's what we think we can do about it, and we think we need your help,' it's pretty likely you'll get it."

Last updated: Mar 1, 1991




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