Category: Management

Dad, What do you do?

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

Brendan and I have been going to the gym 2-3 times a week and lifting weights.  He is starting to learn how to control free weights and he is enjoying charting his progress.  The other day, while we were between sets, he asked me, “What do you do as an accountant?”

One of those exciting moments every parent of a pre-teen lives for!

So I explain to him that I am an auditor, which is not really an accountant but a scientist.  He seemed puzzled but I pressed on.

“Do you remember learning about the scientific process?” I asked, he replied yes and then started to explain that you first set a hypothesis, test the hypothesis, and then draw a conclusion from your test.

I told him that is what makes an auditor a scientist.  We follow the exact same pattern.

Whenever an auditor begins work, we start by creating a hypothesis.  We changed it around a bit to state we test assertions but in reality we create the hypothesis about management’s assertions.  Ok, that is a little wonkish so perhaps an example.

The books show that the company has $100,000 in a bank account.  Management has made several assertions:

  • That the $100K Exists
  • That the Company has a Right to the money
  • That the $100K is Complete and all transactions are recorded
  • That it is actually Valued at $100K
  • That it is actually Classified as a bank account
  • And that management Cutoff all transactions on the right date

Six assertions on one little bank account but any one of them being an incorrect assertion possibly means that the $100K isn’t really.  So, as an auditor/scientist, the first thing we do is form the hypothesis; and our hypothesis is always a negative.  For instance, some of the hypotheses for this bank account could be

  • There really isn’t a bank account with $100K in it (it doesn’t Exist)
  • The bank account is in the name of another business (There is no Right to it).
  • Management failed to get checks signed and mailed by year end (The transactions are not Complete)
  • The account is in Peso’s in a Mexican bank (the Value is not $100K dollars but 100K Pesos)
  • The account is an investment account (it is not Classified correctly)
  • Management recorded deposits that were actually received later (they didn’t get a good Cutoff)

We create these hypothesis and then test them.  For a bank account, we have a ready-made solution – the bank confirmation.  We send out a letter to the bank and ask them to say they agree, or confirm, managements assertions.  The bank writes back and says, “Yes, there is $100K in the bank, it is actually in US Dollars and it is a demand deposit business checking account in the Company’s name.

One confirmation and poof, four assertions are taken care of.  Our hypotheses were disproven and we can safely say that, as far as those assertions go, management was correct.  As a matter of fact, one of the best forms of evidence for an auditor is when a third party can provide evidence that a transaction exists.  We can confirm a lot and prefer it whenever possible as it can help us with more than one assertion – other tests typically only go after one assertion at a time – which means we can spend hours trying to prove the remaining assertions.

Oh yes, by the way, I lost him at the six assertions – he is only 13 after all.  And, to be honest, he is far more curious about the times we catch people making poor choices and how we deal with it.

I told him to read my blogs.  No, he prefers Star War’s books.  But someday he will.  In the meantime, I hope you begin to have an appreciation of what steps we take as auditors to ensure that management is recording transactions to your books accurately.

An audit is designed to prove that the financial statements being presented are fair and accurate.  Management makes those six assertions on every account and ever dollar reported.  So, the next time you are meeting with your auditor, ask him about management assertions and how they design their hypothesis.  If nothing else, it is a great way to find out if they pay attention to their checklists!

Have a great day.  If you are looking for a firm to perform a review or audit of your financial statements, we would love the opportunity to be of service to you.  Go to our website, look us over and then click the Get a Quote tab.  We are a little wonkish but love to get the job done right and on budget.

 

GAAP and Projections

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

I have a new project which I started at the end of last week and which must be ready for discussion by Friday.  I need to pull together a projection for a start-up company, determine its capital requirements, figure out how it should be structured by debt and equity class and then make sure that, given a certain range of possibilities, what the ROI is going to be.

Did I mention this has to be done by Friday?

It is interesting and I have a great model I have developed over the years (in my humble opinion) that helps me focus on the big picture while also making sure I cover the necessary ingredients.  One area I have spent a lot of time updating is the revenue projection side.  First, I am trying to design a revenue model which takes certain assumptions, like lead generation rates through sales close rates and figure out how many sales will happen.  And then from there how many sales support people are needed.  And then…

Sorry, I was going to slide right in and describe why I like modeling this so much but really, today I am writing to discuss how Generally Accepted Accounting Principles (GAAP) are causing a serious headache for me in this projection.

Naturally, my first irritation is the requirement of recognizing stock awards as compensation expense, although I know intuitively that it is something the employees earn.  It is still a challenge because the only “cash” part of this is the amount paid in taxes to gross up the award.  Why am I worried about it?  Because I am thorough and don’t want anyone to say they were “Unaware” that earnings were going to be lower than projected because GAAP treats stock compensation differently than cash models.

The bigger concern is the new GAAP on revenue recognition.  You remember, the one I have blogged about here recognizing that this particular headache was coming.  Well, this projection is impacted by it because, naturally, it is a software company that licenses its program on an annual subscription and offers free, unlimited tech support.  Love it.  Revenue recognition side?  Not so much.

I spent about 6 hours last night after the game (nice to see the Saint’s work hard to try and lose but they managed to survive until next week – not much hope there) updating my assumptions page and working through the model to address control and amortization of revenue.  No, I am still not done but I am getting closer.  What I can tell you is, I don’t like the results.

On a cash basis, this particular start-up should get to positive operating cash flow in about 14 months; right now it takes about 52 months to get to profitability under GAAP.  I am also seeing about $8,000,000 in deferred revenues.  That is, by the way, cash collected from customers that the company cannot claim as revenue.  Yes, it is software and there is no right to refund but still, under the control principles in new GAAP, the revenue is unearned.

How I get there is to make certain assumptions about purchasing patterns and I am making a rather aggressive assumption that most purchases will happen in the first part of the year.  It is more intuition at this stage but my research indicates that this is the likely time when this sort of software is installed – something about New Year resolutions.  So, this is only a few months of overall deferred revenues but it is enough to throw off accounting ROI.

Don’t get me wrong, I think the most important information comes from cash flow.  How quickly cash is burned through, minimum cash levels, marketing expenditures are absolutely essential to figuring out minimum equity positions, acceptable leverage, target interest rates; all that delightful CFO stuff that can make or break a project.   But still, I think that potential investors have a right to know everything about the project they are taking under consideration and GAAP is one of those things – because at the end of the day, if the goal is to go public, then GAAP is the beast to tame.

Like I said, I try to be thorough.

I will keep you updated, probably at the end of the week when I meet with the ownership to review what I have and start changing assumptions and figure out what to add.  They want to start pitching by the end of the month so I have my work cut out for me – because I am doing this on top of everything else I do!

If you are looking for an accountant who might be able to help you get to that next level, either by acting as your controller or CFO (or combination) feel free to contact me and lets schedule a time to talk.  I enjoy being of service to growing entities and risk-takers.ready for discussion

Have a great day.

 

Transaction Approval

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

Typically, anything I write that deals with HOA’s and Condo audits are written on C.O.R.E. Beliefs.  But, I already wrote a nice little article about reserve funds there and also today’s issue, while stemming from a condo audit, is applicable to every type of business entity out there.

We are currently struggling with a condo audit.  The association has been around for about 20 years and every 5 years or so the board decides to spend money on an audit.  Like all good auditors, we are performing some tests of transactions in the non-audited years to ensure that the money has been accounted for correctly.  Specifically, our concern is the reserve fund.

The first thing we noticed was board meetings did not often have quorum.  Quorum is a fancy Latin term for “who decides”.  It is the minimum number of selected representatives who have to participate in meetings in order for votes to have affect.  So, why is this a concern?

In many associations – and non-profits need to be concerned here too, quorum is typically defined as a “majority of the board members”.  In this particular case, there were 5 board members so a quorum would be 50% plus 1.  Three in this case.  At several meetings only two board members were in attendance.

The board then conducted business.  It discussed contracts for reserve fund expenditures and approved them.  Bad form.  And bad business.

The whole point of quorum is to ensure that the meetings are adequately represented.  You want to make sure that there is robust debate where called for and a full airing of the concerns when necessary to ensure that funds are spent wisely.  When debate doesn’t happen you get decisions that can be challenged.  Which is where we are today.

The problem for us is that we are auditing the records.  They approved a siding project, which was funded from reserves, and did not document how much it was approved for.  There was no indication that there were three (3) competitive bids submitted or even requested.

The initial invoice, prepared on a percentage of completion basis, indicated that the base contract was $98,000.  The total paid to the contractor was $129,000.  We can’t find any reference that the change orders were request or approved by the board.  And it happened when there were 5 different board members.  The five current members were not even involved in that particular project.

Getting proper approvals is an important aspect of taking care of business.  It could be that you, the owner of your company, wants to approve every transaction at time of payment by signing a check.  Or it could be you are the executive director of a non-profit which has a policy that commitments over $5,000 must be reviewed and approved by the finance committee.  Regardless of the process, it is the fact that there is a check and balance that makes it work and when someone overrides that part, you get all sorts of troubles.

Ideally, the board minutes would have documented the issue – siding replacement – and the names and amounts of the competitive bids submitted.  There would be debate about the relative merits of the quotes and then a final approval of the winning bid.  All completed at a properly called board meeting with quorum.  Ideally, there would be another meeting where changes to the scope of the original work order were discussed and approved.  We don’t have that.

We are struggling with a way to remain in the audit and issue an opinion.  We think the owners deserve to know what is going on and a properly worded Disclaimer of Opinion could help them understand and maybe even want to participate as board members.  But, our options are rather limited and we may be forced to withdraw, which doesn’t really help anyone.

What can you do if you are either a board director or are thinking of becoming one?  Make sure that you follow your by-laws and/or state law when it comes to how meetings are carried out.  Know the number required for quorum and make sure you have sufficient notes in the minutes that someone can follow the work and see how the decision was made.  You will save yourself a lot of grief, and an expensive “non-opinion” audit report.

Have a great day and if you are looking for a proposal for audit or review services for the upcoming year, please consider C.O.R.E. Services.  You can find out more about us on our website.  We look forward to the opportunity to be of service to you.

Using accounting to deceive

~ C.O.R.E. Beliefs ~ 1 Comment

I have received a few google alerts recently about companies that are being accused of using their accounting and financial statements to deceive readers.   It is sadly a far too common occurrence.  For readers of financial statements – like those who are owners in a homeowners or condominium association – knowing what to look for can help you determine if the information could be incorrect and maybe even fictitious.

First up on the balance sheet is cash.  While it is difficult to determine if the amount of cash is bogus there are things to look for, especially in associations.  If the financial statements show lots of cash but you are receiving messages from the board saying that they are worried about having to increase assessments – ask how that can possibly be.   There could be a logical explanation but every once in a while something is just flat our wrong.

Accounts receivable is one of the places where potential problems may really lurk.  Accounts receivable are sales that have not been collected – i.e. an IOU from the buyer.  For most businesses, one month’s sales in receivable would be expected, but watch out.  I once worked on an engagement for a hotel chain where the accounts receivable kept increasing and was approaching almost 10 days of revenue.  The a/r was used to hide the theft of cash sales and the controller didn’t catch it.  Ask yourself, if you owned a business like that, would you let someone promise to pay you later?

Inventory is another big area where accounting irregularities can show up.  Ask yourself, does the inventory seem excessive?  An easy way to tell is to divide the cost of goods sold by 12 and then compare that number to the amount reported as inventory.  Is it close to or less than 1:1?  That would mean that inventory is turning every 30 days.  If it is over 1.5:1, or more than 45 days, be careful.  Inventory goes obsolete quickly these days so lots of inventory may mean lots of write-offs coming soon.

Fixed assets, or property, plant and equipment can be gimmicked as well.  WorldCom tried to pull off this method of lying to their investors.  This is one of those areas that is harder to tell if something is wrong but the best thing to do is look at how fast the investment in fixed assets grow.  If sales have grown on average 3% over the last 5 years and fixed assets grew 12% this year, it may be worth questioning.  It is definitely worth looking at when fixed assets grows consistently at 12% year over year and sales isn’t going anywhere.  That is a sign of trouble.  We performed a review this past year where we required management to write down their asset value because we felt that the fixed assets were overstated.

Keep in mind that most entities that want to fool you will want you to focus on their profits – which means that revenues exceed expenses.  The easiest way to do that is to move expenses to the balance sheet; the receivables, the inventory, the fixed assets.  Look at expense trends and if you see an expense, like cost of goods sold, drop as a percentage, and then check if inventory went down that same percentage.  If it went up, it could be a sign something is wrong.

The vast majority of financial statement issuers are above board and honest.  To help keep them that way, remember to read the statement critically and be willing to ask questions, especially if you have a financial interest in the issuer.

Have a great day.