Inštitut za ekonomsko demokracijo

Common fallacies of misinterpreting net income and net cashflow

Author: David Ellerman, President of the IED

27 Day Cash Buffer

How to correctly treat cashflow and income

In over 40+ years of working with businesses and businesspeople, I have found much fallacious reasoning based on confusing net income and net cashflow for a business or an individual. Let us begin with the cases of correctly treating income and cashflow.

Partnerships

In a partnership, e.g., law, architectural, or medical, each partner has a certain income for the time period (month or year) and it is normally paid out in cash so the income = cashflow to the partners. But suppose in a particular year, a building is being purchased so the partnership has to put up a large amount of cash to borrow the rest of the purchased price. Hence each partner’s income for the year cannot be paid out entirely in cash. Now there is a difference between the partner’s income and cashflow. What does the partnership do? Does it just forget about the income that could not be paid out in cash? Does it say “Well you will be around to use the services of the building that you paid for with the foregone cash” (even though the older partners may be retiring in a few years)?

No, the solution is that the partnership sets up a liability account to record the income to a partner that was not paid out in cash now but will be paid out at some point in the future. It is as if each partner loaned a portion of their income back to the partnership to make the down payment on the building or to make loan payments. Thus even though the whole income could not be paid out in cash, the partners still received their whole income, partly in cash and partly in debt of the partnership to them.

Cooperatives

In cooperatives, e.g., consumer or agricultural co-ops, each member gets a certain income due to their patronage of the co-op during the time period. It is called their “patronage dividend.” But for the usual reasons (e.g., the co-op making a large purchase of machinery or a building), the patronage dividend for a year cannot be paid out in cash. Does the co-op say “Forget about the rest of your patronage dividend; we don’t have the money”? No, the solution is that there is such a thing as a “Certificate of retained patronage dividends” that is a liability to the member to be paid off in the future. The accumulation of a member’s retained patronage dividends is the equivalent of the partner’s liability account recording the income that could not be currently paid out in cash.

The Mondragon worker cooperatives made a great innovation in setting up such accounts for each worker-member, accounts which are unfortunately lacking in traditional worker cooperatives that just “socialize” any retained earnings.

Individual wage-earners buying an asset

Suppose an individual worker arranges to buy an apartment with a down payment due to the 3Fs (family, friends, and fools) and a bank loan to cover the rest of the purchase price. The wage-earner arranges for the bank payments to be automatically deducted from their wages. Is that a reduction in their income? No, it is a reduction in their take-home cash income but that reduction is counter-balanced by their increase in their equity in the apartment. That “apartment equity” functions like the internal account that records the reduction in their cashflow in another form of wealth so their overall income is the same.

Employees jointly buying a company through an ESOP

The same principle is at work in the Employee Stock Ownership Plan (ESOP) in the American version or in the IED’s Slovene model. The company makes cash contributions to the ESOP to pay off the debt to the old exiting shareholders. That cash has to come from somewhere. It may mean a reduction in current cash outflows (e.g., reductions in cash bonuses, extra cash for holidays, 13th salaries, or dividends to current employee shareholders). Is that a reduction in the income of the employees? No, it is a reduction in the current cash income but that reduction is counter-balanced by their increase in their equity in the company recorded in their internal accounts in the ESOP.

 

How to incorrectly treat cashflow and income

Now we turn to the cases which incorrectly treat the differences in income and cashflow.

Social or common ownership of companies

The Yugoslav socially-owned companies, the common-ownership firms in the UK, and most worker cooperatives, e.g., in Italy, had or have no system of internal accounts for the members. When cash is available, it is paid in current benefits as income to the members, but if there are other demands on cashflow (buying a building or machinery), then the members just sacrifice that income—since those companies do not differentiate between income and current cashflow to members. Somehow, the designers of those legal structures did not have a clear idea of the income earned by the members whether paid out in current cash or not. Moreover, they seem to have had trouble conceptualizing liability accounts for the members recording their rightful income that could not be paid out in current cash.

Employee Ownership Trusts (EOTs) in the UK

ESOPs (in American or in the IED’s Slovene model) have internal accounts that, in effect, record the income of worker-owners that is retained in the company as opposed to being paid out in cash. But the United Kingdom has recently (2014) legalized a “simplified” model of ‘employee ownership,’ the Employee Ownership Trust or EOT, that is based on the common-ownership idea with no internal accounts for the employee-owners. There is ‘so much less bookkeeping’ with no internal accounts for owners.

In addition to their usual wages and salaries, the employees get their “ownership income” only in the form of current cash bonuses—if the cash is available (and otherwise such income is just lost). In an EOT, like in an ESOP, the company (with a certain portion of employee ownership) makes cash contributions that buy out the original shareholders for a certain percentage of the ownership. In the ESOP, each such payment of that acquisition debt to the old shareholders is balanced by shares of equal value being individualized into employee individual accounts. But in the EOT, there are no such accounts (“common ownership”) so what might otherwise be income to the employees who are paying off the acquisition debt is just lost.

In an EOT, we might differentiate the initial cohort of employee-owners who will have little if any cash benefits (due to paying off the acquisition debt) from the second cohort of employee-owners who have no acquisition debt to pay off and can thus get the full cash bonuses as income. During that initial period, the first cohort of employee-owners is just giving up what might otherwise be their income due to the high demands on the cashflow. There are no internal accounts recording that foregone income (“common ownership”). The second cohort of employee-owners gets the full benefit of a company without acquisition debt so they, with their cash bonuses, reap the benefits of the first cohort’s foregone income.

This is not a new or controversial observation. As admitted by a consultant working with EOTs:

The company must still generate sufficient cash flow to pay the bonuses and they may not be paid up to the full level, if at all, for the first several years of EOT ownership, as the company may need to dedicate its excess cash flow to repaying the debt used to finance the transaction. [Source: Karch, Gary R. 2018. The UK Employee Ownership Trust: Shared Ownership for the Twenty-First Century. 2nd Ed. New Malden UK: RM2 Corporate Finance, p. 10]

Housing cooperative

A housing cooperative aims to have tenants pay for the true cost of their use of the housing facilities (which includes depreciation and charges for communal spaces). Hence, in that sense, the income to the co-op from the tenant, e.g., the current cash rent (plus any admission fee not eventually returned) should equal their true cost or expenses of occupancy. That might be the case where there was some municipal or non-profit entity that had already paid for the purchase or construction of the housing facilities. But absent such a benefactor, a beginning housing co-op has to pay off the acquisition or construction costs. That means that the cashflows from the tenants, e.g., their current rents, have to be high enough to cover the loan payments for the acquisition or construction in addition to their true costs of current occupancy.

Unfortunately, housing co-ops typically have no internal liability accounts (common ownership again) to record those excess cash rental payments from the first cohort of tenants. Again, the second cohort of tenants has a housing facility with no purchase or construction loans to pay off so they can enjoy much lower rents. As in the EOTs, it is again the confusion between cashflows and income (true expense in this case) that is at the bottom of the flawed structure that forces the first cohort to pay out far more for which there is no record and no return.

The IED is working with the Zadrugator housing cooperative initiative to develop a model structure with the internal liability accounts for tenants to avoid the typical flawed structure.

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