Category: Accounting

Understanding Why Financial Reporting Exists

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I was asked to answer a question on financial accounting concepts on Quora.   I felt that it is an issue worthy of sharing on my blog as well as we don’t often discuss why we have expectations when we prepare and audit financial statements – other than to say GAAP requires it.

The most basic concept underlying financial reporting (and the accounting procedures used to accumulate the data) is investment decision-making.  Everything Mahesh spoke to, and what I am going to elaborate on, is premised on the need for some information for investment decisions.

FASB and IASB have concept statements.  I am most familiar with US GAAP which is put out by FASB.  But I believe both standards setters agree overall on the concept of information necessary for decision making.

Ask yourself, if you were ready to make a decision to invest in a company, what information would you like to know?  Conceptually, the argument goes, you would like to know the business’ financial position – its balance sheet; its operations – profit and loss statement; and its cash flows.  These collectively make up the general purpose financial statements.
Oftentimes, the information presented on the face of one of those statements does not tell the whole story.  Take inventory as an example.  Lets say the statement of financial position says only that inventory is $1.0 Million.  As an investor, your decision to invest might change if you knew that the inventory was all finished goods: Or perhaps it is all work-in-process.  Knowing additional details which can impact an investment decision might still be necessary, the standards require additional disclosure – footnotes – to help investors put those statements into context and provide details that otherwise do not exist.
These statements do not exist in a vacuum.  They are the accumulation and summarization of thousands and millions of transactions.  And to ensure the necessary information is presented timely, is a faithful representation of what actually happened, and is relevant, the standard setters created accounting principles.

And to ensure that investors receive accurate information based on these guiding concepts, it is important that reported information be verifiable (can be audited successful) and comparable to others in similar situations.  This is why there are industry-specific principles and there is a focus on establishing an effective audit trail.  Investors should be wary where there is first, not an independent examination of the statements and second, where the underlying accounting is totally dissimilar to everyone else in the industry.  Sadly, it happens all too often.

If you are a small business and your bank requires you to prepare GAAP financial statements, it is important to understand that this is what they are looking for: Investment Decision information.  It doesn’t matter if the financial statements are prepared by your bookkeeper or audited by an independent CPA.  Your business is responsible for sharing financial information that the bank can use to make an investment (loan) decision.  You have an obligation to ensure it is accurate, tells the whole story, can be compared to other businesses that are in the same industry as you, and ensure that whatever is recorded can be independently verified.

You, management, are responsible for the accumulation, summarization and reporting of the information.  Management decides when to recognize revenues; or to have it be reported as unearned because the job isn’t done; Management decides if a product was actually sold; or was actually shipped to another warehouse across the country.  There is an undeniable tension between management sharing accurate accounting information and investors receivable actionable investment information.  You see this played out frequently in the press when you see a stock slide because a company missed its revenue target.

Accounting principles exist to put the concept into context.  Accounting principles are not complex or difficult to employ, business is moving farther and farther away from simple transactions of shifting values from producer to consumer.  Complex transactions make for challenging financial statements as investors cannot see where value begins and ends.  So ask yourself, do you really want to invest in a company where you can’t tell who owns what and who is owed what?  If not, demand that GAAP be followed; otherwise:

Caveat Emptor baby.

 

 

How Small Business Can Apply GAAP Successfully

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There are two big GAAP changes coming up that could have a major impact on small business if decision makers do not start thinking about the issues.  These are changes to lease accounting and the new revenue recognition standards.  The lease accounting is probably the more challenging of the two, as I will hopefully explain below.

New Lease Standards

The new lease standards will challenge every small business who needs access to capital and where the money people want GAAP financial statements.  So, if you are even thinking of going public or taking on substantial bank debt, you need to think about implementing the new lease standards.

The new lease standards now require you to record an asset and a liability as though you bought the asset on a contract.  You then amortize (depreciate) the new asset over the lease term.  This is substantially different from old GAAP which handled leases off balance sheet – meaning payments were treated as an expense in the period incurred.  The commitment for the lease was then reported in the disclosures.

Obviously, the kicker here is that you will now have additional debt on your books which did not exist before.  And like all debt, the current portion, that amount due in the next twelve months, is considered a current liability.  So businesses with tight current ratios (say 1.1:1.0) and an affirmative covenant to maintain a current ratio of 1.0:1.0 may find themselves out of compliance.  Noncompliance is a default condition.

So, if you are thinking about leasing equipment you may want to reconsider this approach IF GAAP statements are a business requirement.

Recognizing Revenue from Service Contracts

This is a major rewrite for GAAP but is probably will not have a huge impact on most small businesses.  Yes, conceptually the issue exists, but most small businesses do not have agreements with customers which extend for long periods of time.  But, where your business does have an ongoing customer relationship where money is changed hands intermittently and service is on-going, then you will want to start looking at this ASC.

The biggest change is realizing that billing a customer no longer drives revenue.  For QuickBooks users, this could cause problems.  As an example, lets say your business enters into a maintenance contract which runs for twelve months.  You agree that the client gets up to 20 hours of on-call service plus a 5 hour preventative maintenance visit monthly.  The on-call hours do not roll-over and you charge $100 per hour for any hours over 20.

Historically, you know that your clients use about 300 hours additional during the year and you anticipate that this new client will be the same.  The new ASC, ASC 606, would require you to anticipate this when you recognize revenues.

What is happening is that we are separating out the revenues from what customers are going to pay.  This separation is a good thing, even though it may not seem like it.  But anyone who has ever worked with contractors and percentage of completion will understand this concept.  Billings are the offset to the accounts receivable and costs and gross profit on contracts is the offset to revenues.  The separation will make almost all businesses with contractual relationships with customers record revenues similar to contractors.

This is because we are moving into a transfer of control (knowledge, ability, compute cycles, etc.) instead of transfers of products.  Stores will likely continue their accounting the way they used to; unless they have after-sale service offerings.  Then, this will become a little more complex but still somewhat like what you are already doing.  But you need to start analyzing your processes now to see what can remain the same and what you need to change – assuming GAAP is required.

If you have questions or would like to discuss how the new accounting standards might impact your business, make sure you talk with your CPA.  Or, if you would like some help understanding what is about to happen, feel free to contact me with your questions.  We are here to help.

Have a great day.

When Assessments become loans

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We had an interesting one come up last week.  A 100 unit condo Association passed the following in a resolution:

  • Monthly payments of $200 per month
  • Term of the assessment is for 10 years
  • The assessment is transferred to the buyer at time of sale unless the buyer demands it to be paid in full at time of sale

This passed in February of 2016.  The association waived the 2016 audit (not wise) and then contacted us for a 2017 audit.  The dilemma?  How should this transaction be recorded?

The board and management argued that it is a monthly, on-going assessment.  But we are not so certain that is the correct way to handle it.  As we dug deeper we discovered:

  • Bank loan with a principal balance of about $1.8 Million dollars at 4.0% interest
  • Monthly payments on the loan of $20,000
  • Can pay any amount of principal after year 3 of the loan

We believed their assertion was incorrect and requested they capitalize the full receivable as a loan.  Our reasoning?

  • The present value of the payment stream could be calculated using the interest rate provided by the bank as the minimum interest charged
  • The assessment was directly tied to the repayment of the bank loan
  • The assessment was assumable but only if the buyer accepted it, otherwise it had to be paid in full at time of settlement

It is important because most state laws require disclosure of outstanding balances due from owners.  There is a huge difference between stating that the amount in arrears on an assessment is $0 and there is a $20,000 special assessment balance outstanding.  In some instances, the amount disclosed on the resale certificate is the maximum amount of liability that the buyer can assume at closing.  Management disclosed the seller’s maximum amount due on the disclosure.

Finally, since the buyer could assume, but didn’t have to, all the available evidence indicated that it should be treated as a loan to the owners.

Now there is a 10 year receivable to record.  There is interest to charge to the owner which splits their payment into two parts – principal and interest.  And because they didn’t adjust it correctly for 2016, the Association’s cost for the financial statement is going to almost double to correct for the prior year.

All of this could be avoided by consulting with a CPA firm which specializes in association (CIRA) accounting and auditing.  If you are a board that is looking at doing something that hadn’t been done before, it will be well worth the few hundred dollars you will be charged to get an idea of the complexity involved in accounting for the activity.  Can your management handle this type of transaction?  Will their software perform the calculations correctly?  How will our reports change?  All of this is as important as making sure you legally dot your “I’s” and cross your “T’s”.  Otherwise, don’t be surprised when your auditor says, “No, sorry it can’t work that way.”

Ask your accountant or feel free to reach out to us.  We are happy to assist you in any way we can as a little work up front can stop a landslide later.

At C.O.R.E. Services, we focus on being a strong independent check on management and their assertions. Which is why we enjoy working with Property Owner Associations. The boards are dedicated but typically outsource the management who record the transactions and prepare financial statements for the board to review. Our audits are designed to help the board and owners rely upon those statements. You can find more information about us on our website.

Complexity

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The past 10 days has seen us dealing with a lot of challenges which come about through complex entities trying to be simple.  Most of the challenges come from participants claiming they don’t understand but in reality it is they don’t want to pay the underlying cost of their organization structure.

The condominium association where the board didn’t want to address the interest charges to owners for financing a special assessment over 10 years.  Their stated argument was that they were trying to keep it simple.  The real issue was that they didn’t want to pay a manager or accountant money to track the owner accounts.  Eight years later, they need to perform a new special assessment to come up with the shortfall that is owed the bank.  This is going to be complex.

The investment partnership which wants to shift income between partners.  They crafted a simple partnership agreement and right from the beginning started doing this.  In the beginning they had lots of equity so the tax preparer was not worried about the unequal distributions.  Five years later six of eight members have negative capital accounts and it needs to be fixed.  They created a complex structure and thought a simple partnership agreement would allow them to do what they wanted.  They didn’t understand.   The truth is they didn’t want to pay someone to manage the complex modeling of the cash flow reallocation to ensure it was done correctly.  It is their profit after all.

The Corporation who borrows money from the bank and then retires their majority shareholder.  They write an agreement which says that the Company will repurchase 1/10th of the shares every year for the next 10 years.  At a stated price.  And then they fire the accountant who tells them they need to record a $5.0 Million debt – which of course puts them out of compliance with the bank.  They find a more accommodating CPA to prepare the financial statement.  Bank still finds out and calls the bank loans.  They didn’t understand GAAP.  No, the didn’t want to pay for effective advice.

Complexity has a price.  If you don’t want to pay higher prices, keep it simple.  There are no rules which say that profit can’t be distributed equally amongst all partners.  Shockingly  simple.  There is no rule which says you can’t buy back the owners shares.  But you should probably discuss that with the bank before you borrow money.  And then talk with someone who knows what GAAP might have to say about that kind of transaction.

The old adage is very true: Pay me now or pay me more later.  Alright I confess I added the more but it should have always been there.  It is never cheaper to fix the problem later.  NEVER.

There is another old saying: Accountants have the magic wand and attorneys have the way back machine.  Notice though that you have to go to the true wizards of Oz to fix the problem.  Accountant’s to create the numbers to correct the problem you created and the attorney to create the right paperwork at the right time.  In hindsight.

Today is about clichés apparently.  I believe it was Einstein who said, “A problem can never be solved by the same intellect which created it.” or something to that effect.  What this means, in my world, is that the client goes to one accountant and lawyer to “be simple” and then fires them to find someone to fix the “complexity”.  That means coming up to speed, understanding what you originally did, and then trying brainstorming for hours trying to come up with a plausible solution.

Yes, there is a better way.  Plan for complexity.  Accept that some modes of transacting business require new, or at least different, processes.  Maybe new software; perhaps a new department; perhaps a new legal structure.

The entities above each spent under $2,500 to create the original simple way they wanted.  Each has to be in excess of $20,000 to fix the problem.  I don’t think planning to deal with complexity right up front would have cost anywhere near the cost to fix it.

Complexity.  You will pay for it.  The smarter play is to accept it upfront and make it a cost of being in business.  Or don’t.  You simply pay more to fix it.

Have a great weekend.