Category: Management

More on Management Representations

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

The second section of the management representation letter gets into the heart of how you went about disclosing information to the independent accountant.  This section is titled, “Information Provided” and you should be aware of what is actually being stated here.

  • You are stating that you have responded fully and truthfully to all inquiries made.  Keep in mind one of the bigger concerns is related party transactions – if you know one exists but fail to disclose it, you have technically misrepresented yourself.
  • You provided access to all relevant information which deals with the preparation and fair presentation of the financial statements.
    • Contracts
    • Board minutes (if you had a board and kept minutes
    • Schedules requested, like an amortization schedule for interest
    • Most importantly, unrestricted access (my emphasis) to persons within the entity that the accountant felt was necessary to interview to feel confident about the evidence.

As a quick aside, this is a potential for a scope limitation which is an engagement killer for both an audit and review.  We have had client management tell us we cannot interview certain employees.  Sorry, that is a huge red flag issue.  We don’t like wasting our time talking with employees or business partners who cannot provide evidence, but if you have a purchasing manager and we question the values of inventory, to say we cannot talk with that person means we cannot issue our independent report.  You have been warned.

  • You have recorded all transactions in your accounting system and these show up on the financial statements.  You are the entities first line of defense.  We have been involved with engagements where specific transactions were not recorded, only to find out later that someone (like the owner) knew about it but failed to ensure it was included.
  • You are stating you are either have no knowledge of fraud or suspected fraud or have shared with us your suspicions or evidence.  Think about this representation.  As I have discussed in other posts ,we have discovered odd journal entries which were possibly created to misrepresent the financial condition of the company.  We have required management to represent that they had evidence of this misrepresentation and have taken steps to address the action and then state if they know of anything else.  The fact that it the transaction was caught by us and not management is the problem since it never should have been entered in the first place.
  • You are stating that there are either no instances of noncompliance with laws or have disclosed all such instances to us and have either made allowance for it in the financial statements or are disclosing such.  There was one instance where a construction company bid on a job in a new state.  They started the work and failed to file as a foreign corporation, failed to register as a contractor and failed to file for payroll taxes and workers compensation coverage.  Even though it was eventually corrected, we required an accrual of the expenses and also a note disclosure.
  • You state that all possible litigation and potential claims have been identified.  If your company is being sued for, say a hostile work environment, you should let the accountant know so that a proper disclosure can be prepared.  Your relative guilt or innocence is not the question, the fact that there is a risk is the concern.
  • You are stating that you have disclosed all related parties.  By the way, you are required to disclose related party matters even when you are not doing business with them.
  • The last big one, you state that the entity has complied with all contractual agreements that would have a material effect on the financial statements in the event of noncompliance.  Now, before you say it is never a problem, think about a line of credit that is tied to your inventory by way of a borrowing base calculation.  It requires that inventory over 120 days be excluded from the calculation.   At the end of the year you are on day 119 for 50% of your inventory.  You are likely going to be out of compliance and it may have a material impact.

For the most part, management representation letters are simple and straightforward.  But they are designed to protect the independent accountant by putting you on notice that you are making, and they are relying upon, certain representations.  In the event of a problem their defense is that you represented that you told them one thing and obviously something else happened.  So, to protect yourself, don’t be afraid to add specific language which makes the representation letter more effective for you and the accountant.

We hope this journey through the standard management representation letter has been helpful.  If you have questions about the representation letter, feel free to ask.  And if you would like a proposal on audit or review services, go to our website and learn a little more about us.  We have a page where you can request a proposal and we would love the opportunity to be of service to you.

Management’s Representation

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

We are often asked, “Why do I have to sign this letter?”  The letter being referred to is the management representation letter.  As to the why, because you as management, the owner, the board, are making specific assertions that we, the independent accountant’s are relying upon.

An important part of management’s representation is the concept of materiality.  The representation letter typically includes this paragraph, “Certain representations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if they involve an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.”

In this section you are agreeing to the concept that the dollar value alone is not necessarily indicative of materiality.  I will use a real-world example (one we are currently facing) to explain:  Way back in November 2013, an association approved a special assessment.  Interest was to start December 1, 2013 if the full amount of the special assessment wasn’t paid by November 30.  Unpaid interest earned was about $3,500.  The manager did not accrue the interest for those who hadn’t paid by December 31.    Was it material?  Dollar-wise probably not.  But had it been known that over 30% of owners had not paid their first payment – which would have been obvious had the accrued interest been included – it is quite probably that a reasonable person’s judgement may have been changed.

So what are some of the specific representations you are making?  Regarding the financial statements, you represent:

  • You understand that you are responsible for the preparation and fair presentation of the financial statements.  This is true even if you entrust the preparation of the financial statement to the outside accountant.
  • You acknowledge your responsibility to design, implement and maintain an internal control system and you have fulfilled this responsibility.  This is a big issue; go back to the example above, obviously the control system to ensure that all relevant information was provided in the financial statement was not working properly.
  • You acknowledge your responsibility to design, implement and maintain an internal control system to prevent and detect fraud.  Fraud, by the way, is not just about people stealing it is also about ensuring the financial statements are not intentionally misleading.
  • Related party relationships and transactions have been accounted for and are disclosed.  This could be as simple as renting the building from an LLC owned by the majority shareholder or as complex as contracting with a company where the controller is a silent partner.  You are stating that these types of transactions have been fully documented and are properly disclosed to a reader of the financial statements.
  • Any important events that happened after the balance sheet date are accounted for and/or disclosed.  This means, if you decide to pay a large bonus to key employees after the year-end, at a minimum it needs to be fully disclosed and more likely properly accrued since the bonus no doubt stems from the profit of the year.

These are by no means all the things you are representing regarding the financial statements.  But you get the idea; you have the primary responsibility for all the financial information and making sure it gets in the financial statement.  You can and should bring it up to your accountant (or whoever is preparing the financial statement) if you have the slightest concern that it is something that should be included.

When is that you ask?  The fact it is on your mind means it should probably be disclosed.  The old saying, “When in doubt, let it out.” definitely applies to your financial statements.  Don’t try to suppress bad news or fluff up the good.  You, as management and the board (if it exists) have an obligation to ensure the truth is provided so that the reader can make an informed decision.

If you need help with preparing financial statements or designing an effective internal control system, feel free to contact us through our website.  We have worked with many large and small businesses, non-profits, and associations as auditor and also consultants.  We are here to be of service to you.

Cash Flow and Investors

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

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.

Impairment and the Balance Sheet

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

Typically it goes like this, “I googled this accounting term and it says that I am not required to do what you are saying.”  Ugh

Do not put your google search up against my accounting degree and constant hours of study of accounting principles.  Kubae actually saw that on a coffee cup and I thought it was pretty awesome.  Clichéd but awesome.

As I wrote on my other blog today GAAP is an accounting model that is selected by the organization.  If you elected to follow GAAP then, when a situation arises that GAAP covers, you are required to comply.

Or not.  Remember it is a choice.

We have worked with a few businesses recently who needed their financial statements reviewed.  They each have bank loans with covenants that require their financial statements to be prepared in accordance with GAAP.  And have those financial statements reviewed.

In each instance revenues are down year over year.  In each instance the companies have substantial non-cash assets: inventory, property, facilities and equipment, goodwill.  And we have asked each of them if they determined that their assets are impaired in value.

Sorry but this is a necessary question in a review.  GAAP requires that assets be tested for impairment, that is, loss of value.   And since you have a loan covenant requiring GAAP financial statements you have to follow the steps called for by GAAP.

Or you can say you are not going to follow GAAP.

By the way, you should be worried about value impairment in the situation where revenues are dropping and profits are slipping.  It is a sign that perhaps you have surplus inventory, desks that are not being used, expensive plant equipment that is sitting idle, shop space unused.  Why wait until the CPA says something?

That was a rhetorical question.  At this stage businesses have bigger problems than if their assets no longer have value.  Your bank moving you to special assets is chief among them.  You are focused on profitability because you think that is what the bank is concerned with.  And slamming more expenses into your fragile profit and loss statement is the last thing you want to happen.

Testing for impairment doesn’t necessarily lead to a write-off of value.  But if it does, so what?  If you are carrying inventory that you haven’t moved in a year then maybe adjusting its value to what you can get for it is a good move.  Think about it, you are trying to correct for past decisions and return to profitability.  Your inventory, and other assets, were a reflection of those past decisions and not dealing with them will actually hamper your turnaround.

Capitalized leasehold improvements has been a big issue for us on review.  What we find is that the accountant (even us) records the depreciation/amortization over 39 years.  Why?  because it fits with MACRS.  But it isn’t disclosed properly.  And then the problem is compounded by the fact that the company has a 5 year lease with one 5-year extension.

There are three years left on the extension.  Revenues and profits are down and management is looking for smaller, more affordable space.  And the company is sitting on $350,000 net book value of leasehold improvements.  It is painfully obvious isn’t it?

The value is impaired like it or not.  You don’t have a $350,000 asset, you have a huge rock tied to your ankles while you plummet the depth of the ocean.   Ignoring the problem isn’t going to help.  When it is time to move to the new facility the business will have to take a $300,000 write off for the inaccurate reporting of the economic life.  And that is the year your line of credit renews.

We know this isn’t an easy subject but you elected to follow GAAP.  Look at your assets and ask if it is still worth it.  You should do this even if you are vastly profitable since it is highly likely that there are assets or asset classes that you are no longer utilizing.

Or don’t follow GAAP.  The choice is yours.  Just don’t get mad at the CPA because she questions your balance sheet.

Have a great weekend.  If you would like more information about impairment or any other GAAP issue, feel free to contact us through our website.  We look forward to being of service to you.