Understanding Why Financial Reporting Exists

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.

 

 

You take the left, I’ll take the right

I recently finished re-reading Michael Gerber’s “The E-Myth Revisited”.  It is one of my go-to books whenever I find an organization that appears to be dysfunctional.  I find myself using parts of his model on my own organizations – since typically professional firms believe everyone should do everything.  This isn’t to knock professional firms but this approach is the single biggest obstacle to healthy and effective growth that I know.

“You take corporations and I take LLC’s”, seems like a great business model for accountants but it is simply a permutation of the “You take the left and I take the right” approach to management.  It doesn’t address the actual needs of the business and it doesn’t leave room for growth.  How do you hire an employee to fit that sort of arrangement?

It is even worse for other types of businesses.  I have worked hard to try and straighten out small businesses who grew into a disaster.  It is in those instances that I find comfort in the E-Myth; technicians who didn’t want to work for a boss suddenly have the worst boss in the world and so do his 12 employees.  All of whom are stepping on each other, tripping over inventory, losing tools, upsetting customers and generally eating up profits.

And in the meantime the owner is working 14-16 hours a day 7 days a week. Until he collapses.  What was the owner doing in those hours?  Everyone else’s job.

Organization, structure, discipline are tough to live with.  I get it.  As Mr. Gerber implies, you start your business because you want to simply work – you want a job.  You want to do it your way, meeting your customers needs by you always being available.  And, as he points out, it can’t work.  You simply don’t know it yet.

The problem is inertia.  Actually, that isn’t true.  The problem is the owner-technician’s inertia.  Try to take the owner out of the picture and you are accused of planning a mutiny.  Never mind the reality that the owner has already lost control; he talked to a friend who had a buddy who hired a consultant and that consultant ended up buying the company for almost nothing.  Never mind the reality that a company built around the owner is worth almost nothing.

Are you looking at a situation like that?  Are you the sole owner-technician of a small business where it seems that you re-do everything your employees already did?  Do you feel you are the only person qualified to make a sales call?  To build the widget?  To make a collection call?

Perhaps you are in a partnership and hoped that by making your best friend/employee an owner she would work 140 hours a week just like you?  Re-doing everything someone else already did, calling the same customers, shipping extra widgets…

This is where I depart from the E-Myth.  The author makes it sound like you can be down this path and somehow recover.  Sorry, it simply isn’t going to work that way.  Inertia is working against you.

Think about it.  You hired a bookkeeper because you hated doing the books and it ate into the time to make a sales call and build the product.  You still hate doing the books plus you don’t know how.  And if you do the books who will make the sales calls?  And don’t even get you started on sales people:  They make deals that you can’t keep and then they leave and take the customer.  No, it is better if you keep things they way they are and just work harder, right?

No.  It is not better; not for you, not your business, not your employees.  You can make the change but you can’t fight the inertia.  You may, however, be able to start deflecting your path.  The goal is not to slow you down but rather start changing the direction so that you start going in the direction you want.

More on this in my next article.  Have a great day.

Complexity

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.

Cash Flow and Investors

I am occasionally asked to provide guidance to developers on how best to structure cash flows and how to present the information so that their investors can see what is happening.  Unfortunately, GAAP is somewhat weak in this area so we fall back on good old fashioned sources and uses statements.

Of course, these become a little more challenging when the project has multiple classes of ownership, each with their own return on investment (ROI) expectation.  And they become really hard when the cash flows are no where near expectations.

Naturally, developers don’t turn to the accountant when things are going well – invariably we are asked to weigh in when things are not working as expected.  In the most recent case, the investors are bothered by cash being paid to the developer and they think it should be paid to them.  This is a pretty common theme.

Changing the facts and circumstances a little, lets say you developed a commercial building.  To keep it somewhat simple there are 3 investors and a lender, A, B Developer and Bank.

  • A invested $5,000,000 with a guaranteed 10% return and is supposed to receive the first $500,000 in cash annually after debt service
  • B invested 5,000,000 with a guaranteed 15% return and is scheduled to receive their payment after a $100,000 developer payment to Developer
  • Developer receives their $100,000 payment and then can receive any residual cash
  • The developer predicted about $1.5 Million in annual cash flow after debt service

Cash flow after debt service is $900,000.   Obviously this is somewhat disappointing, especially for B.  According to the accounting,

  • A receives their $500,000
  • Developer receives their $300,000
  • B only receives $250,000 out of their $750,000

B thinks that developer is taking more money than allowed for.  From B’s perspective, Developer received $300K when they should have only received $100K and the other $200,000 belongs to B.

In the course of trying to explain this, we had to dig a little deeper.  We identified that Developer also invoiced for maintenance – $200,000.  The bookkeeper inadvertently recorded it to the wrong account but the damage is done.  B is threatening to sue for failure to perform.

This is where a good sources and uses statement comes in handy.  We were able to lay out how funds came in and how funds went out.  We started from the accrual basis  and created columns to eliminate the various transactions to get to the pure cash in and out.

By identifying how first funds, and then cash, were handled, B was able to understand that the transaction was first recorded incorrectly and second was not a cash transaction.  We actually pointed out that the invoicing for the maintenance was agreed to by the members and could have been paid out as an ordinary business expense but Developer felt it best to try and satisfy B first to the extent possible.  The remaining cash was actually being held onto as a reserve for some defects that were noticed

As powerful as full GAAP statements can be, sometimes it is the simplest statements, like a sources and uses that can make people understand what is actually going on.  Yes, had B read the full financial statement they might have seen what was going on, and yes B could have handled it better than assuming improper behavior on the part of Developer, but the truth is, when you think you are not received your due one tends to see only things from your own perspective.

So the next time you are facing a question over how money and value are coming and going from your activity try a sources and uses statement.  I think you will be surprised how well it might help the situation.

Have a great day.  If you have any questions about this topic or anything else related to business or management, feel free to contact us through our website.  We are here to be of service to you.