Category: Accounting

What did I say?

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

I guess I stepped in it today.

On my other blog for CORE, I wrote today about independence, you know that little section of rules which constrain the CPA from essentially reporting on their own work.

  • Yes, I know that it is done;
  • Yes, I know it is done all the time;
  • Yes, it is a literal interpretation;
  • No, I don’t think you should try and paper it over.

Two reports require the CPA to be independent of the client and management: Audit and Review.  No one is forcing the CPA firm to perform an audit or a review.  If you want to be part of management, I say GO FOR IT!  Help management get their act together.  Help them adjust their books and, more importantly, know when they need to debit this and credit that.  Help them, but don’t come back and then claim your independence isn’t impaired.

Impairment of independence isn’t just a factual matter.  Yes, you can create lots of paper which says that Ms. Whatshername, the a/p clerk, understands what you are doing on her behalf and she is ok with you making that journal entry for her.  But when you are brought in to re-enter the entire accounts payable because Ms. Whatshername didn’t enter anything and the controller was fired so there is no one to check your work… don’t push your luck.

The appearance of impairment is even more important for those reviews and audits.  You are dealing with the integrity of the profession when you ignore what some other person might think about your independence, or lack of it.  If it looks to an innocent person that you are doing the work of management, well, guess what?  You are.

To paraphrase a letter which went from an association to the owners of a condominium:

  • Management way back when got it wrong
  • New management starting in 20XX got it even more wrong
  • New management denied their work was wrong consistently from then until now
  • New management denied it was wrong even after being beat over the head with it
  • Board hired independent CPA to redo management’s work
  • Independent CPA recalculated the numbers, resulting in a major change
  • The CPA says their work is correct
  • And, you can rely upon the CPA for this because they are trustworthy

Sorry, but that wonderful letter praising the CPA now means the CPA probably is no longer independent as to the financial statement audit.

Their work was awesome.  Totally correct.  Nailed it to within $0.02 for every owner.  Told the attorney and the board they were right and said so in a letter to the owners.  they were worth every dime they were paid to fix the mess.

But their independence is now impaired.  There is no one, not management, not the board, definitely not the attorney, who is going to take responsibility for the CPA’s work.  The CPA owns it.  They said so.  Under the rules, both of the AICPA and common sense, they are no longer independent of the client.

No independence no audit.

I get it, it is my interpretation.  Well… Not really.  It is 20 odd years of practicing in this area and reading hundreds of ethics interpretations.  It is having to struggle with deciding when we cross a line and are no longer looked at by Tommy Banker or Amanda Bonding Agent as separate from management.  When the question is, “Are you getting paid to help management or to report on them?”; it does become a little more clear.

Attest firms MUST err on the side of caution.  The big 4 don’t, the next 8 don’t.  Their failures don’t give the rest of us license to slide down that wonderful chute into impairment hell.  Take the road less traveled but best for your client.  Have integrity to admit your lack of independence when it exists.

Make the right call.  Help management or report on them.  If you can’t tell the difference, well, you probably shouldn’t be playing this game.

 

Debit This, Credit That, isn’t that Accounting?

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

Sometimes all you can do is simply stare at a speaker and wonder what is going through his mind.  “Accounting says you have to debit receivables and credit revenues.”

Um, no.

Accounting makes no such claim.  Effective accountants (and auditors) know that often earning revenues is divorced from demands for payment.  Demanding payment is a contract right – your attorney might require a retainer, your roofer wants a deposit, you want to be paid for the feet of pipe laid; but none of these are revenues. Yet.

Accounting is about reporting the economic substance of a transaction.  Accounting has to look for features which support the premise that the efforts necessary have been expended and accepted by the buyer in order to record revenue.  It doesn’t have to be hard, but it does have to be consistently applied.

Take for example, that piping contractor.  Let’s say he has a contract to

  • Dig a 1,000 foot ditch for $20/foot
  • Lay 1,000 of 24″ concrete pipe at $18/foot
  • Backfill and compact the trench for a lump sum of $8,000

The contract requires that the contractor submit a schedule of values (work completed) in order to be paid.

On the first billing, the contractor submits the schedule for the 1,000 feet of ditch dug for $20,000.  The effective accountant does not immediately do this for the invoice:

  • Accounts Receivable       $20,000
  •     Contract Revenues                         $20,000

That is because the rules for recognizing revenues is not based upon something as arbitrary as a schedule of values.  The smart accountant understands that the true measure of the revenue for a contractor is based upon an analysis of costs expended to actual anticipated costs.  So the accountant creates a little spreadsheet:

Anticipated Period Actual
Contract Revenue Costs Gross Profit Costs % Complete Revenue Billings Over/Under CIE BIE
ABCD     46,000   35,000          11,000   6,500 18.57%       8,543   20,000          11,457     –   11,457

The Company incurred only $6,500 of costs in the period.  This represents less than 20% of the total anticipated costs for the project.  The reality is, the contractor front-loaded the bid.  This is perfectly acceptable – provided the owner accepts the schedule of values and is a great way to get project funds in early.  But, GAAP says to recognize the contract’s revenue based on the relationship between actual costs incurred and the estimated total costs to complete.

In this case, only 18.6% of the project costs were incurred so really only 18.56% of the contracts revenues are earned.  The remainder is considered unearned revenues or, in construction accounting parlance, Billings in Excess of Costs and Gross Profits.  The accounting principle is called the percentage of completion method of accounting for long-term construction contracts.  The rule says that the form – the schedule of values – is not the appropriate measurement for recording revenues: The comparison of actual to anticipated costs is the appropriate basis for recording revenues.  Economic substance over the form.  $8,500 not $20,000 for revenues.

Accounting is more than debits and credits.  That is, assuming you need to know what is actually happening economically in an enterprise.  Most non-employee investors in a business should be thinking about the true substance of transactions and how they impact today’s profits and tomorrow’s cash flows.  Revenues and profits generate true cash flow, not the other way around.  The effective accountant knows this is far more important than debits and credits.

 

A Focus on Cash Flow

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At a recent board and owner meeting, I was asked about cash basis of accounting being a better reflection of activity than GAAP.  This owner was an observer at a prior board meeting where I discussed this issue with the board so I think she wanted me to go on record in front of others.

GAAP, for all its flaws, is superior to the cash basis of accounting when it comes to reporting outside of management.  While I agree that GAAP can include requirements that are complex and perhaps outside the competency of management, that doesn’t mean that GAAP is inappropriate: It means that management is likely over its head.

Since this was a condominium association, I asked the board if management told them how much money owners had not paid for the reporting period.  The answer – Yes.  But it wasn’t included in the financial statements.  Management prepared a report showing how much money was collected and spent during the month, and then provided a separate statement with

  • How much owners hadn’t paid
  • How much in vendor invoices came in but were not paid yet

Also known as accounts payable and accounts receivable. The concern I have is not that they were doing this on a monthly basis but rather that management decided that this was an appropriate year-end reporting model as well.  This was the mistake.

Management could have made essentially three journal entries to ensure that the books and records accrued non-cash activity:

  • Record the due but unpaid assessments
  • Record the due but unpaid vendor invoices
  • Adjust the insurance for the amount that is considered prepaid

There is absolutely nothing wrong with keeping a set of management books and a set of financial reporting books.  It is, in fact, encouraged since decision-makers have different information needs.  Keeping separate books should not entail a great deal of work either.  Most software today is sophisticated enough to easily track cash in and cash out while at the same time tracking the amounts which have not been converted to cash.  The excuse that it is too much work is just that; an excuse.

But I would go further.  The board should receive a GAAP based balance sheet and statement of operations for each meeting.  But, management should also create special reports, or dashboards, for the various members of the board.  The treasurer is mostly worried about current cash receipts and disbursements.  The president, on the other hand, may be worried about reserve project expenditures in relationship to the reserve study.  It is most appropriate, indeed it should be considered essential, to give the information to decision-makers which is most appropriate for their particular needs.

GAAP fills a need for external reporting.  It is as complicated as the entity makes itself out to be.  Internal management reporting can be as simple and targeted as the user wants it to be and indeed should be.  The point of keeping the books on GAAP basis is to ensure that transactions are not overlooked at year-end; Otherwise both management and the auditor have to put more effort into the accounting than is likely warranted.  But if no one minds paying extra to address the conversion from one accounting basis to another, it is likely fine with the auditor.  I know it is fine with us.

Understanding Overhead

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

When I first start evaluating a financial statement, I try to group costs together logically.  It is far too typical for most businesses to rely upon the canned reports and these are almost always prepared in GL Number order.  But a clearer picture can be developed by grouping the costs of revenues separate from the overhead and the overhead into 4 main groups.

The overhead groups I prefer follow the Throughput model:

  • Labor Overhead
  • Marketing Overhead
  • Facilities Overhead
  • General

A little bit about the groupings:  Labor overhead includes not only those who are on payroll but also consultants and outsourced staffing.  So, for instance, if your company outsources janitorial services, this expense is reported in labor, not facilities.  My approach is to put all labor into labor overhead, including production labor, unless it is truly variable – which most is not these days.

General is the catch-all classification.  There are two services I typically would group into general – legal and auditing.  While both are still people performing services, these are services which your business typically cannot provide internally.  Otherwise, if it cannot clearly fit into one of the other three groups, put it in general for now.

Let’s say your business does $1.0 Million in sales monthly.  Your direct material costs are $350K and you have depreciation on equipment which manufactures the products you sell of $50K.  Throughput, which is the measure of how much money you generate to cover overhead and profit, is $600K.

Continuing our analysis:

  • Labor Overhead runs $400K  or 66.7% of throughput
  • Marketing Overhead is $50K  or 8.3% of throughput
  • Facilities Overhead is $50K or 8.3% of throughput
  • General Overhead is $30K or 5.0% of throughput

In total you are spending $530K to generate $600K of throughput.  88.3% of every dollar you bring in is consumed by your overhead, of which most is tied up in labor costs.  You see, when you separate out your labor into different categories, such as production labor, sales commissions, accounting and office staff, you can lose sight of the total amount you are spending to generate throughput.  It isn’t that these separate amounts are not important, but when you are looking at leveraging your business, having expenses scattered everywhere can lead to a misunderstanding.

Properly grouped, we can start analyzing.  There would be two points of reference to the analysis, average and best case.  Both of which can be found in the prior year’s records.  For the average, I would recommend taking the last 5-7 years of information and reformatting to match the groupings above.  You are looking for a trend and what you will likely find is that throughput has remained fairly steady but labor overhead has crept up.  It isn’t necessarily bad, but it does indicate that more money is being paid out for peoples time but the company is not getting much in return.

The comparison to best case can be a real eye opener though.  Here you find the year where there was the most profit and then compare where you are today with the overhead structure in place when the company made vast profits.  In almost all cases, you will find that the company increased spending across the board relative to that maximum profit year.

So, instead of giving a bonus to the employees and management, the company raised base compensation.  The company went from a 50,000 sf facility to 100,000.  When you study this great year you start realizing that perhaps it was luck and you were betting it would continue – only to find out it didn’t.

GAAP statements have their purpose.  But managing to GAAP can be dangerous to the bottom-line.  It is all too easy to want to capitalize everything into your inventory but that means that today’s costs are probably being buried and will be recovered in a later year.  But in the meantime, your costs are possibly growing out of control which is impacting your current cash flow picture and may even hurt you in the future if you have to reduce prices to be competitive.

Consider using the Throughput model for evaluating your internal financial statements.  I think you will be surprised at how much information it can provide you to help you make better business decisions.

If you would like more information or would like to discuss how effective analysis can help you understand your operations and profitability, feel free to contact mecontact me anytime.  I am here to help.