Accounting Matters and So Does the Balance Sheet

I keep seeing agencies that need dramatic improvements to their accounting practices. Many such agencies are small, but not all. Many are new agencies, although some larger agencies have had shoddy accounting practices for 50 years.

Most of the time the accounting problems are unknown to the owners. In other words, the owners do not know their agency’s accounting is poor, and in many cases the situation is so obvious their accountants should be fired. The owners are relying on their accountants and the accountants are failing. I

n other cases, the situation is more complex or the owners are ignoring their accountant(s). Sometimes, the owners know their agency has accounting problems or deficiencies, but do not know what to do and no one is pressing them to fix the issues.

Whatever the situation and reason, listed below are absolute accounting requirements that are applicable to all agencies. What follows are not suggestions, these are contractual and legal requirements and sometimes, just harsh realities.

No Difference Exists

Large agency accounting rules and small agency accounting rules are the same. Absolutely no difference exists. The rules are the same for every size agency. Many small agency owners find it hard to believe, sometimes they are literally beyond belief, that only one set of accounting rules exists. The playing field is level and only one set of rules applies to agencies of all sizes.

In Trust

Contractually, agencies of all sizes and types must be able to show they are in trust and maintain proper records. Many agency owners feel this point is moot because carriers never check. Carriers may not always check, but whether or not the agency is in trust, is checked when an agency is valued, sold, or applies for a loan (provided the bank knows what they are looking for).

Rules Apply

Trust rules apply equally to all agencies. Every single state and territory always require that agents be in trust. The federal government even regulates this aspect of insurance agency behavior. For too long agents have confused the right to comingle money with the requirement to be in trust. Being in trust is completely different from comingling money.

Trust Law

Few general accountants know anything about insurance agency trust law and contractual trust requirements. You will be doing yourself and your accountant a favor if you explain this to them and ask them to consider these requirements when providing tax advice so that too much money is not withdrawn at year-end.

Balance Sheets

To prove you are in trust, you must have a correct balance sheet. I have had too many small agency owners tell me they do not maintain, understand, or even have a balance sheet because only larger agencies need balance sheets. Every agency needs a quality balance sheet. I empathize, particularly with small agencies, on this point because:

• They don’t always have the accounting background;
• They are more susceptible to hiring lesser quality accountants; and
• Many of their agency management systems have subpar accounting systems.

Good Balance Sheets Matter

For many agencies, balance sheets do not really matter in good times. I can make the point that balance sheets matter all the time and an agency can make more money and grow faster with good balance sheet management. However, many agency owners will never be interested in using a balance sheet that way, so their balance sheets will only matter when they have a serious problem. A weak plumbing pipe does not matter until it breaks. When things go wrong, particularly at valuation time, or loan time, or working capital shortage time, the balance sheet can make or break an agency. One does not need a heart surgeon often, but when you need one, you want the best one on speed dial. The difference is you can always have a good balance sheet if you manage it correctly.

When Is a Good Balance Sheet Needed?

Whenever the agency is valued. The balance sheet matters a great deal in agency valuations. All good valuations consider the balance sheet. I have had owners who told me they acquired X agencies without ever considering the balance sheets. Many were nearly broke from buying agencies with bad balance sheets they had ignored. Nonetheless, they were still adamant that balance sheets do not matter. To accept that balance sheets matter would be to accept responsibility for their financial problems and that was not going to happen.

Bank loans. Many banks do not have a clue how to assess an agency’s balance sheet. A few years ago, I had one banker tell me that his brother-in-law’s agency was worth just as much as the agency down the road because their books of business were the same size. The differences between the agencies were long and large, but the main difference was that one agency was in trust and the other was not. An agency out of trust does not usually have clear title to their expirations per their carrier contracts. Banks that do not specialize in insurance agency loans almost never understand how to read an insurance agency’s balance sheet. In my experience, the banks that do, do not make loans to agencies that are out of trust or have bad balance sheets.

Every agency will be sold. If an agency owner with a bad balance sheet dies before the valuation, they have arguably sinned against their family and employees. Your family and employees will all be going through a tough time and to then subject them to the discovery that the agency is of low value or worthless because the balance sheet is so poor may be unforgivable. Yet I see this scenario happen at least once per year.

Clusters

If you are a cluster member, understand the cluster agreement likely requires the agency to be in trust, too. Some such contracts have special assessment potential, are not written well and the trust money situation is joint and several. In other words, you become responsible for the other members’ trust monies — without limit!

Proper Accounting Methods

To have a proper balance sheet, one must use proper insurance agency accounting methods. Insurance agency accounting is not “normal” relative to other business accounting primarily because of how premiums are billed.

With direct bill, excluding audit potential, accounting is fairly straightforward provided one does not ever book premiums as revenues (which I still see happening). The major issues revolve around agency billing policies. The agency is accepting and billing money from a fiduciary trust position. The money is not the agency’s, but they are responsible for it. This is why, historically (though not possible under the new accounting rules applicable to agencies), agencies could use cash accounting and still have bad debt. In most businesses one cannot have bad debt with cash accounting, but in agencies the bad debt exists because it is related to the money that has to be forwarded to the carrier versus revenue to the agency.

Fix your accounting and balance sheets when times are good, before that heart attack.

Similarly, this is why an agency’s trust ratio is so important as those monies are premiums, not revenues, which some accountants and some agency management systems do not tie together well.

One point of this article is purely selfish. I am tired of being the first person to tell an agency owner or a prospective client they have an accounting problem. No one ever likes the first consultant who serves up such bad news. It is preferable to be the third such consultant. I am tired of showing agency owners their agencies are worth far less than they thought or have been told by people who do not understand or neglect agency balance sheets. In reality, the value of the agency is materially less than the owner was hoping.

I am tired of being thought of as an idiot and I must be an idiot because I am the only one giving them bad news. I am also tired of so many agency owners getting bad advice when they hire someone who tells them what they want to hear, no matter how wrong it is. Finally, I just like delivering good news more than bad news.

Fix your accounting and balance sheets when times are good, before that heart attack. No agencies are ever exceptions to this advice. Yes, I acknowledge accounting can be a boring process, but it is the scorecard of your success. Sooner or later you will need that balance sheet and it will need to be proper and sensical. It is your choice, your livelihood.