An Uncomfortable Moment

The other day I was speaking with another CPA firm’s leaders about opportunities to cross-refer – they don’t do audits or reviews and we don’t do taxes – and I was asked what one of my most uncomfortable professional issues was.  I dislike airing my dirty laundry but at the same time, I have found that being forthright about these things helps me heal as well as hopefully provide a lesson for other professionals.

In 2002 I was “interviewed” by a joint task force investigating abusive tax practices.  Even today I am upset with myself for having put myself in that position.

I was in my 7th year (2000) and was recently given responsibility for managing the tax team along with the accounting and auditing team.  Beyond knowing what was, and more importantly wasn’t, allowed, the owners felt I could apply some of our audit processes to tax.  It was fun redesigning the entire workflow to streamline the processes.  I was also part of the local chamber and about that time I was asked to give a presentation on tax planning for small businesses.

After my presentation, I was approached by two gentlemen who wanted to discuss an idea they had.  I am always game for a business conversation so I set an appointment with them.  They gave me some materials they put together and asked if I would read them to plan for the meeting.

As I read their stuff, I became concerned about what they were trying to do.  I made my notes, did lots of research and came to the conclusion that what they wanted to do wouldn’t fly.  But…

And this is where things went sideways for me.  I love a challenging problem.  So I decided to change the scenario, restructured how it should work, Identified potential pitfalls and even created the basic literature to help them with sales.  All told, I invested about 20 hours into this before we even met.  But I felt good – I took a problematic process and modified it to where it would work.

When we finally met, they appreciated the information but were disappointed that I felt their plan wouldn’t work as they had originally conceived it.  I walked them through my analysis and they seemed to have a response to every point.  This seemed odd, so I asked them about how they had come to so much knowledge about this… and they divulged that they had been to 3 other firms who each had found flaws in their plan: I was the only one to offer a full rebuttal and a new concept though.

They asked me how confident I was in my research and I told them very confident.  They then offered us $15,000 to help them formalize the documentation and issue a tax opinion on the plan.  That was a good sized engagement and I felt I had convinced them that my way was superior to theirs – even if they couldn’t offer a huge tax benefit to participants.

The next week I met with their in-house accountant and their attorney, along with the owners.  Once we got going they kept pushing to use their original plan as they felt it was bullet-proof.  I told them that if they felt it was bullet-proof then they didn’t need me.  I explained that their plan would never fly; they kept saying that it was being done by this firm on the east coast.  They got another lawyer on the phone from back east who allegedly represented the firm who was “killing it”. He agreed that it was a “gray area” but he was certain it could pass an IRS challenge.

I did a lot of soul searching on the matter.  They were certain they were right and I was certain they were too aggressive.  I felt our more conservative approach would survive a challenge, which was most likely to happen since they were targeting larger corporations with their plan.  In the end I wrote the opinion letter based upon the plan I outlined, not theirs.  I wrote them a separate letter stating why their plan would not work, quoting chapter and verse of the tax code.

They thanked me, paid our bill and I never heard from them again.  But I did hear from the task force about 2 years later in 2002.  It seemed they decided to use our tax opinion letter to support their more aggressive plan.  One of their customers used it to justify their participation, were audited, and showed the IRS auditor our opinion report who then pointed out that the plan they put in place was not the plan I wrote an opinion on.

Which led to my being interviewed.

I missed the warning signs.  I understood opinion shopping but hadn’t really faced it before.  I was quite proud of that research and how well we documented the situation.  It was complex and challenging.  But I failed to heed my own warning signs.  I saw the problem and thought they could see the elegance and superiority of my plan.  In the end they saw their greed and willingness to use people to get the results they wanted.

It was an uncomfortable experience and I don’t recommend it to any professional.  It did, however, give me great life, and business lessons that I still use to this day.

  • Go with your gut.  As a professional advisor, you have to trust your instincts.  Not every client is a perfect client and if you feel they are not a good fit, go with it.  There are other client opportunities out there.
  • Be wary when clients shop other advisors.  I think a client interviewing several potential firms is a smart move, especially for business clients.  I encourage it.  But it is entirely different when they seem to have paid several firms for advice they don’t seem interested in heeding.
  • If a client plans on using your work to stay out of trouble, make sure it is effectively documented.  We had an engagement letter and I kept copies of all our drafts and research.  We also kept all their correspondence which showed their thoughts and plans.
  • Finally – slow down.  I love a good juicy complex problem.  I enjoy research, writing and presenting.  But I jumped into it before I knew the client.  I inadvertently talked myself into this engagement by buying into the solution I presented.  Had I gotten to know them a little better, we would have likely turned down the work.  Yes, a good sized engagement is always hard to turn down, but having to sit for an interview with law enforcement is almost always going to be uncompensated.

Be selective.  I have come to understand me and my passion for problem solving.  But I have also learned that not everyone’s problem is worth the energy.  I like underdogs, I love winning.  I have learned to love learning (losing) by choosing the work I want to do for clients I am passionate about working with.  Having fewer, more engaging clients who value your input and expertise is much better than tons of clients who treat you as a commodity.  Quality over quantity every time will help you become healthy, wealthy, and wise.

 

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.

 

 

How Small Business Can Apply GAAP Successfully

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.

To Whom does the Auditor Answer?

One of my google alerts brought an interesting article about the auditor and the relationship the audit firm has with management and the board.  It seems that many boards are concerned that the auditor appears aligned with management and not the shareholders.  This is, sadly, not a new problem, but it is one that C.O.R.E. is trying to address is our own little world of auditing.

At C.O.R.E., we understand our loyalty lies to the reader of the financial statements – that is, the shareholders.  We are engaged by the board on behalf of the owners to audit management.  Ensuring that current and prospective owners get the best information about their association is key to our success, but sometimes getting owners the best information means upsetting management.

Upsetting management, however, potentially hurts the pocketbook of the auditing CPA firm.  In many situations, management offers very profitable consulting opportunities to the auditor.  Systems design, software evaluation, and other arrangements are absolutely essential to the financial health of an organization and a CPA is highly qualified to offer those services.  The problem is the potential for the auditor to be compromised – that is, does the auditor get the consulting gig because they went soft on management?

If you don’t think it is a very real possibility think again.  Can you imagine anyone hiring a consultant who just got through bashing them?  If a CPA firm had the chance to earn $100,000 consulting with management or $30,000 auditing the client (or both hopefully), is it possible that the auditor might turn a blind eye to a problem found on audit for the chance to earn more money?

And in the small and medium sized entity market, it is potentially even more painful.  The small CPA firm gets most of its new business by referral.  But referrals are hard to come by when your work upsets management.  This has impacted us directly – we have had to issue specific communication about management violating internal control systems to an entity’s board.  The Chair of the board was also the president who hired his son, the person who broke the rules.  That organization and six other companies found a new CPA firm because they wanted someone less “negative”.   Seven entities is a lot of billing.  Financially, would we have been better off remaining silent?

This is not an attempt to justify the auditor’s failure to live up to their responsibility to protect owners and stakeholders.  An auditor who accepts a consulting job with a client needs to consider it a bribe, or worse, an attempt to make them complicit in management’s failure.  That is the auditor’s failure.

But the greater failure is on behalf of the boards of directors who have the primary responsibility to protect the shareholders.  When you ask management to interview auditors, when you accept management’s recommendation to terminate the CPA, when you accept management’s excuses for their misdemeanors, you are abrogating your responsibility.

But you can start to address the problem.  It will require boards to start holding management accountable.  And, when it comes to engaging the auditor to attest to your organization’s financial statements:

You, not management, should

  • request proposals from auditors
  • interview the auditor
  • determine if the auditor takes any fees from management for consulting
  • ask how auditors get clients – board or management referral
  • never allow management to dictate non-GAAP policies without auditor approval
  • interview new auditors every 3-5 years
  • demand that the auditor refuse to accept any consulting arrangement with management

As long as the board, or its audit committee, continues to allow management any involvement in the process of selecting, engaging and compensating auditors, this problem will not go away.  The board must make it clear to management that the auditor is the board’s tool to review management and its adherence to appropriate accounting policy and not someone who is there to help management look good.  And the board must make it clear to the auditor they look to them to protect the owners and their investment.  This is your chance to hold both auditor and management accountable, will you step up to the challenge?