Key Takeaways
- Investors may compare regular reporting packages to tax forms, such as a K-1. If the comparison shows discrepancies, investors may feel compelled to question the sponsor’s accounting procedures.
- Addressing investor concerns often requires time-consuming ad hoc reporting and explanations, which can divert resources away from higher-value activities.
- Private equity real estate firms can take action to improve reporting protocols and ensure that investor reporting and tax forms tie out appropriately.
Most private equity real estate sponsors issue investor reporting throughout the year, and year-end investor reporting is typically issued early in the following calendar year. This package usually includes financial reports and written commentary to provide insight into the performance of the vehicle over the last year. This is also around the time that tax reporting is completed and returns are filed.
It’s a delicate time of the year because investors may receive year-end reporting from the sponsor around the same time they are issued a Form K-1. An astute investor may take the time to compare the two packages. In the event the financials provided as part of year-end investor reporting show any discrepancies compared to the tax form, investors may feel compelled to dig deeper and raise questions about the reporting process.
What is the Risk in Reporting Figures that Differ from Tax Filings?
While there may be valid reasons for differences in reported figures, discrepancies have the potential to undermine investor confidence. Investors rely on accurate reporting to assess the financial health of their investment, and any mismatch in reported income or expenses can lead to questions about the integrity of the sponsor’s accounting practices. In more extreme cases, we have seen these occurrences strain relationships and even cause reputational damage to the sponsor – whether warranted or not.
In our experience, when an astute investor perceives inconsistencies, they often begin scrutinizing all aspects of financial reporting and are likely to request additional information. This can quickly increase the administrative burden on the sponsor’s team. Resolving concerns often requires time-consuming ad hoc reporting and explanations, diverting resources away from high-value strategic initiatives.
One of the most common causes of inconsistencies between investor reporting and tax filings is the use of cash financials for one reporting workflow and accrual financials for the other.
A Refresher: Cash vs. Accrual Accounting in Private Equity Real Estate
Cash and accrual accounting offer two distinct approaches to tracking the financial performance of a property or portfolio. Cash accounting recognizes revenue when payments are received and records expenses when they are paid. This method provides a clear and immediate picture of cash flow, which can sometimes make it easier to manage liquidity. However, cash accounting may not always present an accurate reflection of the long-term financial health of a property because income and expenses are only recorded when money actually changes hands.
On the other hand, accrual accounting records revenue when it is earned and expenses when they are incurred, regardless of when cash is received or paid. This approach tends to align more closely with economic reality and can offer a more accurate representation of profitability over time. Accrual accounting is widely used by private equity real estate investment firms, fund administrators, and is sometimes preferred by lenders and investors.
How to Ensure Consistency Between Investor Reporting and Tax Filings
There are three areas where private equity real estate firms can focus to improve reporting protocols and ensure that investor reporting and tax forms tie out appropriately.
Accounting Methodology
First, sponsors should work with their accounting team and tax preparation firm to adopt a standardized accounting method—whether cash or accrual. Decisions about accounting methodology should be made in coordination with the individuals or the firm overseeing day-to-day bookkeeping and ongoing controller workflows. Importantly, this decision should be applied to investor reporting and tax reporting processes.
Coordination Among Stakeholders
Agreeing on which accounting methodology to use can be a complex decision, especially when it comes time to move from one methodology to another. The most common reason for a change arises when a firm grows to the point where it makes sense to move from cash to accrual accounting. When this occurs, it is very important that all stakeholders who maintain or use the accounting records are made aware of the change, and all parties should commit to generating reporting in the agreed upon format on an ongoing basis. Care should be taken to only share financials with external stakeholders in this format.
Systems and Processes
Most of the commonly used property accounting software packages include the option to generate cash and accrual financials. Once the sponsors, the accounting team, and the tax preparers agree on which methodology to use, controls should be implemented to ensure that the correct version is generated during each reporting cycle. This typically includes a review and approval workflow prior to the dissemination of reports.
Final Thoughts
Investors rely on accurate and reliable reporting to evaluate their positions, and inconsistent presentation between regular investor reporting and tax forms can raise concerns or even jeopardize relationships. By taking steps to standardize accounting methodologies, foster collaboration among stakeholders, and implement strong reporting controls, private equity real estate firms can mitigate the risks that stem from common reporting discrepancies. If executed well, these activities can greatly reduce the risk of discrepancies in reported figures as well as the reputational harm and cleanup that often follows.
Lexcraft Advisors is a CFO services firm that supports middle market real estate funds and syndications. Our team takes pride in providing sponsors with reliable financial operations solutions that mitigate risk and facilitate growth. To learn more about our services, schedule a complimentary meeting with our Managing Partner.