Dumb Accounting Mistakes You'll See in Seller Financials

1.) The Numbers Don't Actually Add Up in the Total Column

I have seen 4 deals now where the sum of the last 12 months did not match the total column. This could be a catastrophic mistake if a buyer does not catch this. Ultimately due diligence is the responsibility of the buyer.

Possible reason's this occurred.

• At some point the excel documents were converted to a PDF and then converted back. The formulas got messed up and never were corrected.

• Incompetence in excel, accounting and in general.

• The totals were manually input for some reason which deleted the SUM formulas. The financials stayed like that for an extended period of time where the totals always stayed the same even with the monthly entries were the same.

• **In excel, if you copy a cell with the formula you want and then try to paste it multiple times in different cells, sometimes the formula won't transfer but the hard coded number will. This makes it easy to miss the error.

Solutions:

Always add up the numbers yourself in the excel sheet instead of relying on the seller formulas.

2.) Check if the Trailing 12 Month Financial Statement is Actually 12 Months.

I’ve seen 4 deals where the total months shows on the T12 were less than the full 12 months. The total was used as if it were the 12 month financials.

Possible reason's this occurred.

• The financials you were given were year to date and not the actual T12. You may have gotten the financials from Jan-Oct for instance.

• The seller isn't up to date on the financials and so they just deleted the last months they're behind on.

• Incompetence, especially if they are using the NOI of less than a year to base their sale price on.

Solutions:

1.) On every deal, highlight the columns in excel and when you drag it across, it will tell you how many columns are selected. Make sure this is 12 columns. If it's not, you will have to divded their totals by the number of months shown, then multiply it by 12. The thing to watch out for in doing this is on the expenses. Property taxes and insurance can sometimes be an annual payment in the shorter than 12 month time frame. If you divide by the number of months and then multiply by 12, you just increased the one time annual expenses when they should stay the same. You'd leave those one time annual expenses the same.

2.) Ask the broker for the T12 instead of the partial T12.

3.) Putting a Negative Number Instead of a Positive Number

The most common place this occurs that I've seen is on the loss and gain to lease line item. Instead of a (-) loss per month it will show a positive. This is twice as big of a mistake as purely omitting it altogether because you're both subtracting a negative from NOI and adding a positive number to NOI.

How to catch this:

• having a loss to lease is more common than having a gain to lease, especially if the gross potential rents are rising across the year. If there is a significant gain to lease and rents have consistently risen, there could be an error.

Possible reasons for this:

• items in the expense category are typically labeled as a positive number. When there is a loss in the income section, it is a (-) negative number. The person may not know how accounting works

• They may have the (- or +) labeled incorrectly, but they have the formula right in the total equation. If you do your own calculations, make sure to compare your totals compared to theirs and see if they prove out and why.

4.) Lumping Utility Income and Utility Expenses All Into the Expense Category

As a general rule of thumb, the smaller the deals, the more common this mistake is made. Utility income, reimbursements, collections, etc. need to be in the income category.

When lenders underwrite your deal to determine the loan terms to give you, they will take your income items from the last 3 months and multiply it by 4 to create T3 annualized income. Then they'll use the T12 for the expenses.

Solution:

• Recategorize the utility income items using the last 3 months of income and multiply it by 4 to get the T3 annualized. Add this to the other income category.

  
  

  • Note: You should be using the T3 annualized for all your income items and the T12 for all your expenses. This is because income is more consistent than expenses. T3 annualized income shows what the most current income achieved is. You have to use the T12 for the expenses because many expenses like taxes and insurance are paid in a lump sum. If they are or are not in the last 3 months, the numbers will be skewed.

5.) Wrong Accounting of Interest Income

Cash flow that isn't yet distributed will likely be placed in an interest bearing bank account. Security deposits will likely be held in an interest bearing bank account as well. This is where your "Interest Income" comes from. It is accounted for in the other income category.

There is also interest income below the NOI line as non-operating income. This comes from reserves from the capital raise being placed in an interest bearing bank account. This is usually a much larger number than the other income interest income.

The mistake is when the seller accounts for the non-operating interest income as operating income. I've seen this around half a dozen times.

Possible reason's this occurs:

• They both have the same label and so it's though to be the same

• They want to show a boosted NOI of the property through placing a non-operating income source into the operating income.

6.) Capitalizing Repair and Maintenance Items

Capitalizing expenses means putting them below the NOI line. This matters because the NOI divided by the market cap rate is what determines the purchase price.

What sellers sometimes do is categorize the repairs and maintenance items as a capex expenses below the line.

How to tell if expenses have been capitalized based on financials

Usually it will be noticing that the repairs and maintenance and turnover costs are drastically low. Being able to notice this is can come down to area knowledge of assets of a similar quality.

How to solve this:

• Talk with multiple property managers in the area. Have them help you determine realistic expenses. Create the proforma that your offer is based on off of the expense estimations from the property manager, not the reported seller financials

Possible reasons this occurs:

• The person doing the books isn't skilled in accounting.

• reporting repairs and maintenance items as capex raises the advertised NOI. This could get a higher sale price if the buyer is inexperienced.

7.) Delinquency Left Out

Delinquency is defined as unpaid income balances that still have a chance of being collected upon. It's when tenants are late on their rent and / or other income balances.

What you'll surprisingly find is that delinquency is commonly left out of the financials completely and not accounted for until classified as bad debt.

Possible reasons for this.

• it's a lot of bookkeeping work to stay current on this, especially if they think they'll collect on it anyway

• it can artificially boost NOI by not including it. This omission could be overlooked by someone less experienced

• lack of accounting knowledge and how accrual accounting works