Author: C.O.R.E. Beliefs

Auditing investments

~ C.O.R.E. Beliefs ~ Leave a comment

It is always refreshing to see associations which take responsibility for their future replacements by trying to find investments which can actually grow beyond the rate of inflation.  A solid investment plan can help them ease the burden of reserve assessments by using collected funds to grow at an accelerated, but reasonably safe, rate of return.

Auditing these investments is challenging though.

Conceptually, auditing investments is not any harder than auditing cash.  Except that investments carry certain additional disclosure requirements and the treasurer typically has little to no exposure on how to record the transactions let alone report them to be audited.  Which means that our work as the auditor grows significantly.

You see, Generally Accepted Accounting Principles (GAAP) requires that the investments be reported as either trading, available for sale or held to maturity.  How many investment advisors even understand what can be assigned to these categories?  And our role, as auditor, is to make sure that the investments are properly categorized and that the related gains, losses, and earnings is properly reported in the statement of activity; i.e. the profit and loss statement.  To ensure that they are properly recorded in the period, the accounting department has to know the difference between realized and recognized gains and losses, temporary impairment, other than temporary impairment and put those in the right reporting areas.

Which of course leads to another big accounting issue, accumulated other comprehensive income.  This is the series of holding accounts for the unrealized gains.  You have to know how to close out the transaction to recognize the ultimate sale of the investment.

Did I mention that you have to also track bond premiums and discounts and do some accounting work to get the amortization right?  Again, all this has to be tracked correctly to report in accordance with GAAP.

The rub is that treasurers and boards don’t really understand the complexity of this and often don’t really care.  Their issue is the investment and the return, not its reporting.  Which brings us to our dilemma.

Trying to account for, and then audit, investments can add a substantial cost to the engagement.  It is a cost that probably won’t be valuable to the board and owners in the association.  So, do we allow for a GAAP departure on the investments and simply say they are recorded at cost and have associations report gains and losses at the time of sale?

It is a difficult position.  On the one hand we want the statements to fairly represent the financial activity of the association but on the other hand we don’t want to drive up the cost of the engagement to the point where they find another auditor.  One who perhaps will take huge shortcuts on the reporting and auditing side.  Yes, we see that far too often as well.

So, putting your reserve fund to work by investing it strategically and at reasonable risk is a fair approach to managing the money.  But there are other things to consider besides the actual investing and you, as a board, need to be aware of these issues and take a position on how to report this to the owners in your association financial statement.

Have a great day and an awesome weekend.  And, if you are looking for an experienced audit team to help you maintain effective controls over your association’s finances, feel free to contact us anytime.  We look forward to the opportunity to be of service to you.

You, Your Business and Internal Controls

~ C.O.R.E. Beliefs ~ Leave a comment

Some of the most exciting people to have as clients are driven small business owners.  Some of the most exacerbating people to have as clients are driven small business owners.  While they want to make their first billion in sales, they also don’t want anything to stand in the way of them making those sales; even if it keeps them out of hot water.

Invariably, the entrepreneur comes to a decision point; start putting others in charge of areas of the business or shrink the business back to a manageable level.  The really driven, focused owner starts hiring managers.  The rest, well they ignore the advice.

The excuse for not hiring managers is mostly permutations of the, “It is my company, I made it so therefore only I can control it.”  Really?  Look at your balance sheet:

  • You have uncollected receivables from 9 months ago
  • You have nothing recorded for inventory but your shop is stuffed to the rafters with stuff
  • You barely have enough cash on hand to make next weeks payroll
  • You have loaned the company $250,000
  • The bank loaned you $500,000

I can go on but I think you get the picture.  You are not in control.  Because you are the only person who makes decisions, you are merely at fault for what is happening.  Being “in control” in business doesn’t mean making all the decisions, it means that there are natural checks and balances which make sure that one person can start a transaction and someone else verifies it.

So, what should you do as a first step to start building a solid internal control structure?

Start acting ethically and responsibly.

I have worked with small business owners who don’t like safety rules.  I have walked into shops where employees are grinding metal and are not wearing goggles.  Guess what?  I carry a set of goggles in my backpack.  I have walked onto job sites where employees are not wearing hardhats.  Yes, I carry my own hardhat in the car.  The point to make is that you need to set the tone that safety matters.  And it is not just about safety, it is about acting ethically and responsibly at every moment.

Set the example: Be the example.  This one little rule applies to every small business and starts everyone on the path towards better decision making.

Reward good behavior when you see it.  I worked with a contractor who sat back and watched an employee help a subcontractor who dropped a bucket of nails off the back of a truck.  Nails scattered everywhere.  The employee stopped what he was doing and helped shovel up the mess.  It was the right thing for the employee to do.  The owner missed a great opportunity to teach his employees how to act responsibly and reinforce actions that benefit everyone.

Don’t be arbitrary as you teach employees to be arbitrary.  A business owner employed his daughter to work reception.  She would on occasion come back a few minutes late from lunch.  The owner berated her out in the open about setting a poor example.  Another employee came back over an hour late from lunch and he joked with him.  You might think it is not showing favoritism by abusing your receptionist/daughter but it is in fact an arbitrary enforcement pattern.  If the rule is “In your seat at 1pm” then make sure you enforce the rule on everyone, not just the convenient target who won’t fight back.

Strong controls begin with the tone at the top.  If you take shortcuts, your employees will take shortcuts.  If you pad your expense account, your employees will add time to their work week.  You cannot grow and be successful if everyone is always looking for the easiest route.  Believe it or not, your success as an entrepreneur is totally based on the success of the people you hire.  Act accordingly.

Have a great day.  If you would like to learn more about how to start implementing effective internal controls that won’t break the bank, feel free to write me anytime for a free consultation.  I can help you understand how to grow your business while also keeping it under control.  If you would like to learn more about C.O.R.E. and how our services can help your business and association, check out our website.

New Rules for Leases

~ C.O.R.E. Beliefs ~ Leave a comment

For decades now, businesses have been able to treat certain capital transactions as “off-the-books”, meaning that they didn’t have to record the debt and capitalize the asset. This method of treating leases was codified in ASC 840.   This is all about to change for leases beginning in the year 2020 for small businesses.  Beginning in 2020, (2019 for publicly traded companies) lease transactions will follow ASC 842.

The new lease rules will hit lessee’s hardest.  Lessor’s will see some new disclosure requirements but their accounting treatment will remain similar to what they do now.

The biggest change?  Beginning in 2020, you will be required to show a debt for the lease commitment and related asset for the “Right of Use” of the leased asset.  This means all that equipment you have been leasing will now show up on the balance sheet and run up the amount of debt you have on the books.

This may well have a major impact on businesses with loan covenants which restrict the amount of debt that the Company can incur.  If you are a business, such as a highway contractor, who leases equipment, you will want to start talking with your lender and bonding agent about the potential impact of this new accounting standard.

As for the technical details of the new standard, one thing that changes is in the definitions.  Property and buildings are now the only things considered operating leases.  Almost every other asset lease will be considered a financing lease.  The split is based on the “Consumption (usage and wear) of the underlying lease asset”.  If the lessee “consumes” a significant portion of the asset, it is considered a financing lease.  If it doesn’t, it is a capital lease.

An example might help.

You need warehouse space.  You find 5,000 square feet of warehouse space and lease it for $12.00/sf for a 5 year term.  At the end of the lease you will turn it back to the lessor in the same condition you originally found it.

Since the land will last indefinitely and the structure 50 or more years, you are considered to not put significant wear and use (i.e. consume) on the leased asset.  Accordingly, you enter into a capital lease.

In comparison, you are going to lease 3 trucks for your business to deliver goods to customers.  These are 60 month leases for $1,000 each truck.  You could purchase the trucks new for $70,000 each.  Since the trucks have a typical economic life of 7 years and the lease payment represents a substantial portion of the asset’s value, these would be considered financing leases.

Why does it matter?  Well, as you might infer from the name, financing leases will report financing costs – interest expense.  Capital leases will only report lease expense.  However, both do require recording the lease asset – the Right of Use (RoU) and the corresponding liability at the present value of the lease payments.

To calculate the present value, you need to know 3 things: 1)The number of periods to make the payment;  2) the payment amount; and 3) the interest or discount rate.  Guess what, 2 of the 3 are provided but the interest rate? Typically not.

The interest rate to use will either need to be stated by the lessor or you as the lessee will need to impute your rate.  So, for the truck lease above, the capitalized value with an interest rate of 4.5% is $53,000; but if the interest rate is 9.0%, then the amount capitalized is only $47,000.  And if your only source of additional capital is your credit card at 18% interest, well, your capitalized value will be much lower but your interest cost will skyrocket.

Why does all this matter?  Because there is far too much debt off balance sheet and note disclosure, especially for small business, was typically weak on the subject of the lease contingency.  Although there is some additional work, it doesn’t take a huge amount of skill to set up a PV formula in Excel.  Obviously, the hard part will be in identifying the interest rate to use and also to account for step increases and other lease costs but it is not terribly complex.

As you approach 2020, make sure your accountant is up-to-speed on the new lease rules.  You as the business owner or bookkeeper will need to provide more information to the accountant so it is set up correctly and the asset and debt recorded.  And you will want to make sure you have a conversation with your lender well in advance of that financial statement as you do not want underwriting surprised by the sudden increase of debt that shows up on your financial statements.

Have a great day.  If you would like to know more about the details of the upcoming changes to the lease rules, you should discuss with your accountant or feel free to write me anytime.  And if you are looking for a more proactive accountant, feel free to contact me anytime for a free consultation.

 

The Possible

~ C.O.R.E. Beliefs ~ Leave a comment

There are times when I think we do not spend enough time thinking about the possible.  What I mean to say is, we are almost always fixated on the probable, or most likely to happen, outcome.  This is as true in accounting and auditing as it is in life itself.

One important aspect of our role as auditor though, is to consider the possible.  For instance, theft of company assets.  When we look at how assets are controlled, from their purchase to their ultimate disposal, we are looking for possible holes in that system.  Who approves a bad debt write-off, who can set the selling price of a piece of equipment that is no longer in use; the issues which concern is are possibilities.

If we focused solely on the probable, we would potentially miss a warning sign.  Is it probable that the purchasing agent is receiving a kick-back from a vendor for steering business their way?  Maybe not.  But what controls, what business process reduces the possibility?

It is one of the things that concerns us regarding condo and HOA audits.  As the association’s independent auditor, we are first and foremost concerned with the financial statement and the fact that it is materially correct.  But when you think about what provides a materially correct financial statement, it is all the controls and safeguards of the manager – who is charged with the board with carrying out the daily activity of the association.

This is the main reason we spend so much energy on understanding how the community manager does the job.  Who has access to a checking account, who initiates the transaction, who approves it?  These points reduce or increase the risk of misuse of the association’s assets. There are far too many stories about trusting a system that really did not provide any safeguards and addressing that possibility is the responsibility of the auditor.

For instance, what if employee A of the community manager could initiate a transaction for say, yard maintenance.  Employee A contacts the maintenance company, negotiates the price and sets the contract.  Employee A then reviews their work and approves payment.  Finally Employee A can write the check and have someone else sign.

This seems harmless doesn’t it?  After all, employee A can’t sign the check so the asset is safeguarded right?  Not at all.  Employee A could have created a fact maintenance transaction, set up a fake company, approved the work and, because everything was signed off on, the check is cut.  To employee A.

Is it probably this happens in any particular association?  No.  But this scenario could result in this possible outcome.  And the auditor should know that and make appropriate comment.

Community Managers will argue that this couldn’t happen.  They are, however, arguing that it is not probable because they believe they know their employees.  The fact that it could happen though is what we are concerned with when we try to determine the risks of weak internal controls.  Boards need to be made aware that the risk exists so they can take steps, if they feel it necessary, to eliminate, or at least reduce, the risk of it happening.

As a director, make sure your auditor works to understand how the community manager is operating and how it impacts your association.  Press them on their thoughts on what risks might exist to the assets of your association.  Your auditor should have a good grasp of the fundamentals of the control system and can give you some good points to consider.  And if they can’t, it may be time to switch auditors.  C.O.R.E. is here to help you, the board, rely upon your manager.  We do this by looking at the managers controls and how they impact your association.  Feel free to contact us to schedule a conversation about how we can be of service to your association.

Have a great weekend.