Debit This, Credit That, isn’t that Accounting?

Sometimes all you can do is simply stare at a speaker and wonder what is going through his mind.  “Accounting says you have to debit receivables and credit revenues.”

Um, no.

Accounting makes no such claim.  Effective accountants (and auditors) know that often earning revenues is divorced from demands for payment.  Demanding payment is a contract right – your attorney might require a retainer, your roofer wants a deposit, you want to be paid for the feet of pipe laid; but none of these are revenues. Yet.

Accounting is about reporting the economic substance of a transaction.  Accounting has to look for features which support the premise that the efforts necessary have been expended and accepted by the buyer in order to record revenue.  It doesn’t have to be hard, but it does have to be consistently applied.

Take for example, that piping contractor.  Let’s say he has a contract to

  • Dig a 1,000 foot ditch for $20/foot
  • Lay 1,000 of 24″ concrete pipe at $18/foot
  • Backfill and compact the trench for a lump sum of $8,000

The contract requires that the contractor submit a schedule of values (work completed) in order to be paid.

On the first billing, the contractor submits the schedule for the 1,000 feet of ditch dug for $20,000.  The effective accountant does not immediately do this for the invoice:

  • Accounts Receivable       $20,000
  •     Contract Revenues                         $20,000

That is because the rules for recognizing revenues is not based upon something as arbitrary as a schedule of values.  The smart accountant understands that the true measure of the revenue for a contractor is based upon an analysis of costs expended to actual anticipated costs.  So the accountant creates a little spreadsheet:

Anticipated Period Actual
Contract Revenue Costs Gross Profit Costs % Complete Revenue Billings Over/Under CIE BIE
ABCD     46,000   35,000          11,000   6,500 18.57%       8,543   20,000          11,457     –   11,457

The Company incurred only $6,500 of costs in the period.  This represents less than 20% of the total anticipated costs for the project.  The reality is, the contractor front-loaded the bid.  This is perfectly acceptable – provided the owner accepts the schedule of values and is a great way to get project funds in early.  But, GAAP says to recognize the contract’s revenue based on the relationship between actual costs incurred and the estimated total costs to complete.

In this case, only 18.6% of the project costs were incurred so really only 18.56% of the contracts revenues are earned.  The remainder is considered unearned revenues or, in construction accounting parlance, Billings in Excess of Costs and Gross Profits.  The accounting principle is called the percentage of completion method of accounting for long-term construction contracts.  The rule says that the form – the schedule of values – is not the appropriate measurement for recording revenues: The comparison of actual to anticipated costs is the appropriate basis for recording revenues.  Economic substance over the form.  $8,500 not $20,000 for revenues.

Accounting is more than debits and credits.  That is, assuming you need to know what is actually happening economically in an enterprise.  Most non-employee investors in a business should be thinking about the true substance of transactions and how they impact today’s profits and tomorrow’s cash flows.  Revenues and profits generate true cash flow, not the other way around.  The effective accountant knows this is far more important than debits and credits.

 

Agreements Matter

I have been summoned to a meeting.

I was helping a developer client with a sticky problem.  Once of the LLC’s was showing unequal capital accounts and I was tasked with trying to figure out why and then work with the LLC’s tax advisor on getting it straight.  Now the members wanted to discuss the impact of the plan to correct the problem their not following the operating agreement created.

The capital accounts were all out of sorts with a low of about $4K and a high of $50K.  Now, it is important to realize that the LLC was owned equally, 20% each for five members.  Distributions were all over the place.  All distributions happened on the same day but for entirely different amounts.  There were no instructions in the operating agreement to allow for disparate distributions.

The LLC’s CPA and I set up a meeting to review what had been happening and why.  The concern is that at least one capital account will go negative in 2019 and there is a plan to sell the project in 2020.  Not surprisingly, there is no claw-back or capital restoration provision in the LLC operating agreement.  So, someone was getting a bunch of money upfront with no requirement to take less than their 20% of the net proceeds upon sale.

The stuff of lawsuits.

Here is the frustrating part.  The tax advisor knew what they were doing was going to cause a problem but what could he do?  It was why he had his team set up the first layer of reallocations – to try and address the shifting of cash without the shifting of income.  Clearly it wasn’t enough.

I give him credit, he had tried to address this matter repeatedly over the previous 3 years.  He shared with me all his emails and memos to the manager and members.  To the members, it wasn’t a problem, until it was; capital accounts are edging towards negative territory.  His efforts to get the Members to see reason wasn’t working and it was now becoming a serious problem as almost 20 individuals were involved in this LLC.

The basic issues:

82% of the space is occupied by tenants controlled by the members.  Each of these tenants pays the same lease rate / square foot.   This is so even though they do not occupy the same amount of space.  Tenant 1, which is controlled by Member A occupies 25% of the total SF while tenant 5, controlled by Member E occupies less than 8%.

This isn’t as irrational as it sounds.  I agree that the goal should be to charge market rates for the space being occupied.  The 5 controlled tenants are paying $32.00 / SF.  It is a class A office building in downtown.  Each of the controlled tenants is occupying and using all the space they are paying for.  Is $32/SF reasonable?

Or perhaps that is the wrong question.  If we determined that the rent was overpaid, wasn’t it logical to offer a rent rebate back to the tenant?  After all, the tenant is the one who paid the rent, not the member.  The ownership of the LLC members was not the same as the tenant.  And remember, none of the members actually leased space; their businesses did.

What the CPA and I agreed to was that none of the tenants were overpaying rent, even though they are controlled by a member.  A business with 20 employees (tenant A to a tee) would occupy 5,500 SF of class A space.  They would pay anywhere between $20 and $40 / SF.  A business with 6 employees (tenant E) would pay between $24 and $48 / SF.

What we want is the members to accept that certain tenants (the affiliated tenants) are occupying the space and paying the rate / SF they are, due to the superior negotiating strength of the respective Member.  In short, Tenant 1 management was convinced to pay fair rent in this building for the space occupied.  Neither tenant nor member used a leasing agent.  Tenant was unable to negotiate a lower rate due to the control.  If this is true, couldn’t the argument be that the Member who put the tenant into place should get the benefit of the premium paid to the LLC for the additional rents paid and costs avoided?

Naturally being accountant’s we had to make it a little more complex but we ran it by counsel and the lawyer felt it was reasonable.  We had economic substance – a rational reason to reallocate cash flows and we had a model which supported the calculation.  Our reasoning that larger spaces could command a discount is sound and the fact that the controlled tenant didn’t (or couldn’t) request lower rents was because of the control of the Member.

The calculation actually allowed us to document almost all the distributions.  Three tenants had been overdistributed during the prior 4 years and two received less than they should have.  The largest over distribution is about $37K and the Member with the largest deficit was only $27K.  These can be corrected in the last distribution of 2018.

The downfall of this plan is that we would be creating specific allocations of the revenue.  The only way to do this fairly was to treat the payments as guaranteed payments.  That means that the Members could potentially see a tax hit for the payments.  Naturally, no one is happy about that and this is the reason for the meeting next week.  Also, no one wants to amend the prior returns as the sheer number of returns involved amounts to almost 200 separate amended returns.

Since I don’t know the tax situation of any of the individual members I can’t say with certainty what the net effect would be when passed through to all the various owners.  My gut instinct is almost zero; which means the concern is overblown.  But people fear what they have been conditioned to fear; in this case, each Member has a different tax advisor who has considerable influence over the client and each tax advisor has a different take on taxes.  Me personally?  I think that taxes are an ordinary cost of being in business: Make money – pay taxes.  But like any business cost, there is no need to pay more than you should.

I happen to agree with the LLC’s tax advisor.  the net cash flow from the rents after debt service should be distributed only in relationship to the Members ownership, i.e. 20% each.  If they wanted it another way, the structure should have been different – that is, perhaps the tenants should have purchased their space similar to a condominium arrangement and then they could have redistributed the net back to the owners.  But, that isn’t the structure they wanted.  They wanted to keep it simple.

While I understand the argument from the Members, it doesn’t stand scrutiny.  The rents charged were within an expected range.  Yes, Member A has a point; in comparison to smaller spaces for the other tenants, his company is overpaying.  But in relationship to the rest of the market, the lease rate was reasonable.  I can see where the Member could say he was being forced to shift income and cash flow to the other members if they didn’t reallocate; so what? This could have been easily avoided by the Member owning a smaller building and leasing it to his business as the sole tenant.  That isn’t what they wanted.

All this simplicity created enormous complications.  So, it is extremely important to think through your organization and how you want to generate revenues and distribute profits because in many cases your options are limited by the structure of your agreement.   Agreements matter and trying to smash a complex arrangement into a simple business agreement will cause nothing but headaches.

 

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 Overhead

When I first start evaluating a financial statement, I try to group costs together logically.  It is far too typical for most businesses to rely upon the canned reports and these are almost always prepared in GL Number order.  But a clearer picture can be developed by grouping the costs of revenues separate from the overhead and the overhead into 4 main groups.

The overhead groups I prefer follow the Throughput model:

  • Labor Overhead
  • Marketing Overhead
  • Facilities Overhead
  • General

A little bit about the groupings:  Labor overhead includes not only those who are on payroll but also consultants and outsourced staffing.  So, for instance, if your company outsources janitorial services, this expense is reported in labor, not facilities.  My approach is to put all labor into labor overhead, including production labor, unless it is truly variable – which most is not these days.

General is the catch-all classification.  There are two services I typically would group into general – legal and auditing.  While both are still people performing services, these are services which your business typically cannot provide internally.  Otherwise, if it cannot clearly fit into one of the other three groups, put it in general for now.

Let’s say your business does $1.0 Million in sales monthly.  Your direct material costs are $350K and you have depreciation on equipment which manufactures the products you sell of $50K.  Throughput, which is the measure of how much money you generate to cover overhead and profit, is $600K.

Continuing our analysis:

  • Labor Overhead runs $400K  or 66.7% of throughput
  • Marketing Overhead is $50K  or 8.3% of throughput
  • Facilities Overhead is $50K or 8.3% of throughput
  • General Overhead is $30K or 5.0% of throughput

In total you are spending $530K to generate $600K of throughput.  88.3% of every dollar you bring in is consumed by your overhead, of which most is tied up in labor costs.  You see, when you separate out your labor into different categories, such as production labor, sales commissions, accounting and office staff, you can lose sight of the total amount you are spending to generate throughput.  It isn’t that these separate amounts are not important, but when you are looking at leveraging your business, having expenses scattered everywhere can lead to a misunderstanding.

Properly grouped, we can start analyzing.  There would be two points of reference to the analysis, average and best case.  Both of which can be found in the prior year’s records.  For the average, I would recommend taking the last 5-7 years of information and reformatting to match the groupings above.  You are looking for a trend and what you will likely find is that throughput has remained fairly steady but labor overhead has crept up.  It isn’t necessarily bad, but it does indicate that more money is being paid out for peoples time but the company is not getting much in return.

The comparison to best case can be a real eye opener though.  Here you find the year where there was the most profit and then compare where you are today with the overhead structure in place when the company made vast profits.  In almost all cases, you will find that the company increased spending across the board relative to that maximum profit year.

So, instead of giving a bonus to the employees and management, the company raised base compensation.  The company went from a 50,000 sf facility to 100,000.  When you study this great year you start realizing that perhaps it was luck and you were betting it would continue – only to find out it didn’t.

GAAP statements have their purpose.  But managing to GAAP can be dangerous to the bottom-line.  It is all too easy to want to capitalize everything into your inventory but that means that today’s costs are probably being buried and will be recovered in a later year.  But in the meantime, your costs are possibly growing out of control which is impacting your current cash flow picture and may even hurt you in the future if you have to reduce prices to be competitive.

Consider using the Throughput model for evaluating your internal financial statements.  I think you will be surprised at how much information it can provide you to help you make better business decisions.

If you would like more information or would like to discuss how effective analysis can help you understand your operations and profitability, feel free to contact mecontact me anytime.  I am here to help.