A Focus on Cash Flow

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 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.

 

 

What to Look for in an Auditor

“Why should we engage C.O.R.E.?”, asked the condominium board president.  It is an interesting question which deserves an entertaining answer.  And, even though Kubae says I should never do it, I always answer that question with another question.

“What do you hope to get from your audit?”

If you are looking for an independent CPA firm who believes that it is important to hold management accountable, then you should engage C.O.R.E.  If you want to feel good that the financial information you are using for decision-making is accurate, you should engage C.O.R.E.  If you want to understand how to better protect your neighbor’s hard earned money, then you should engage C.O.R.E.

If you are interviewing audit firms for your association, you may want to think about asking the following questions of the prospective firms:

  • Have you ever had a disagreement with management?  If so, explain the disagreement and how it was handled
  • Who do you believe is responsible for the preparation of the financial statement?
  • What steps do you take to ensure that client money isn’t misappropriated by management?
  • How do you handle GAAP departures when management doesn’t record a transaction correctly?
  • What are the three biggest weaknesses you see in association accounting overall?
  • Who do you believe is your client?
  • Have you ever caught management doing something which showed a significant weakness in the internal control structure?
    • What did you say about it?
    • Did you help management resolve it?
    • Did you help the board understand the weakness and how to address it in the future?

Each of these questions will give you insight into how the auditor might respond to your particular needs when it comes to auditing your association’s financial statements.  It is important to remember that your role, as directors, is oversight, not operations.  You are there to make sure that the management team you hired is presenting accurate information that you can use in making decisions about your association.

You want to make sure your auditor takes their role as independent, objective auditors seriously.  They do not need to go out of their way to find fault with management, but the reality is, they have almost total control over how your money is being spent.  You should want your auditor to focus on their spending of your money to ensure it is done to support your association.

As a director, you want to feel confident that the financial information that management presents is accurate and follows some standard.  How your auditor handles a GAAP departure could be important as the more management does things “their own way” the harder it is for you and your neighbors to follow it.  Make sure your auditor challenges management’s accounting treatment so you get the best information possible.

You want to feel confident that your auditor is looking for risk of material errors.  Your auditor should have a strong idea of what could go wrong and plan the audit for those key risk areas.  Thinks like spending money over the approved budget; paying themselves above their contract without the board reviewing the additional charges; hiring businesses where there is a conflict of interest.  The auditor should be on the look-out for those activities.

Keep in mind that the auditor works for the board.  This means you will want to interview the auditor and approve the audit engagement letter.  The audit is focused on management’s work so you never want to allow management to select the auditor.  Keeping these questions and approach in mind will help you get the maximum value from your audit and auditing professional.

Have a great Monday.

 

An Open Letter to Certain Community Management Companies

Dear Community Management Company,

In response to the emails we have been receiving, please allow me to once again point out to you certain truths regarding the relationship between the auditor, the board, you as management and the owners.  This is a very important point to understand and can save you from performing an inordinate amount of rework, recriminations, general ill-feelings and time wasted writing pointless emails to me about how your feelings are hurt.

First, please understand that we are performing an audit of the financial statements prepared by management on behalf of the readers of that financial statement – i.e. current and prospective owners.  We are engaged to perform the audit by the board of directors who are elected by the owners’ within the association.  Our audit is on the financial statements prepared by you, as management.

It has likely not slipped by you that you, as management, are not included in the chain of authority.  We are engaged to audit your work.  The people who hire us, as part of their fiduciary responsibility, verify that we are independent of management.  That means we do not work for you, are not paid by you, and are not responsible to you.  We are, in fact, completely independent of you.

Auditor independence is an ethics requirement.  Auditor independence means that we are not involved in any manner with the people or companies we are auditing.  One step that we at C.O.R.E. take is to verify, prior to the start of any engagement: be it audit, review, consulting or other, that the work we are being asked to do does not put us in a position where a reasonable person might conclude that our work could be compromised because of some other relationship.

This doesn’t mean, by the way, that we cannot perform consulting or even management services.  We can even elect to perform certain services on behalf of management.  As a matter of fact, given the, shall we say, ethically challenged behaviors we have witnessed of late, we are seriously contemplating offering association management services.  The owners have the right to have someone looking out for their best interest and we think we are a superior choice for the right board and association.

What we could not do, is perform an independent audit of that association for which we are also performing management services.  THAT, is a conflict of interest.  The board and owners deserve to have someone independently examine our work to ensure we comply, not only with GAAP, but with basic common-sense internal control.  The obvious things like getting board approval for writing yourself a check in excess of your contract.  And the not so obvious things like performing and paying yourself for work that the board authorized another contractor to do.

Being able to offer a superior service to what you are offering is not a conflict of interest.  It is competition.  Modern capitalism encourages those who can offer a superior service at a reasonable price to put inferior businesses in that marketplace – OUT OF BUSINESS.  Walmart put tens of thousands of small time corner drug stores out of business and there was never a conflict of interest – there was just good old fashioned competition.

But you are correct, we could, in theory, leverage our position as the independent auditor to point out your significant internal control weaknesses over your clients’ money to suggest they hire us instead.  But if you were to think about it you would realize that would create a conflict of interest.  I cannot audit someone with the intention of going to work for them in another capacity because, you guessed it, there are ethics rules against it.  And we take our ethical responsibility seriously.  You do not want to even hint otherwise.

No, I do not owe you an explanation for a report to the board on your material weaknesses over internal control.  No, I am not obligated to help you fix your accounting errors.  No, I don’t have to ignore your failure to follow ethical business practices.  And, finally, no, I don’t have to communicate with you directly.  Unless you are ready to pay my rather hefty consulting fees.  Which, by the way, I couldn’t take, because it would cause a conflict.  Elegant, isn’t it?

Competing with you for management services is not a conflict of interest my dear management company friends.  Making journal entries to paper over your accounting errors 12 months after the fact possibly is.  Perhaps other auditor’s don’t see the irony, but make no mistake, we do.

Because if a board ever questioned your logic, they would wonder why they have to pay three times:

  • Once for you to get it wrong in the first place
  • Once for the auditor to make adjustments to fix your error
  • and you the second time to post the journal entries to the accounting system you control and shouldn’t have gotten wrong to begin with

Please, management, remember that the auditor does not work for you.  We are ok if you don’t want to refer us to your boards – they will find us anyhow.  We are even OK if you want to form a CPA firm to perform audits in competition with us.  We actually encourage it – after all –

you might learn something.

And for those management companies who take their responsibilities seriously, we would like to work with your boards in auditing you.  We appreciate that are open to the fact that sometimes things go wrong and you want to get it right.  We are thankful that you are open to constructive criticism and are willing to evaluate how our thoughts on effective internal controls might work better for you.  And we are happy to refer our audit clients to you.  Not because we are friends or you give us a kick-back but because you have your clients’ interest in mind and that makes our job just a little bit easier.  So thank you and we look forward to auditing you.

Have a great day.