Tag: Accounting

Leading versus Lagging

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

Accounting is a universally accepted lagging indicator.  Profits are so last month, the balance sheet is yesterday’s news, and don’t get me started on net book value of equipment.  As strange as it sounds though, most people making decisions seem to be ok with all the things that happened yesterday and in some cases things that happened years ago.

One of my favorite lines in a presentation is, “Running your business by your accounting information is like driving with your windshield blacked out and being forced to steer by looking in the rearview mirror.”  It is dangerous and will ultimately run you off the road and yet many people find comfort in looking at past performance and remembering the good old days.  But you have to start looking at other things in order to make better decisions.

Let’s start with revenues.  Quick question, are you tracking your sales funnel?salesfunnelex

Looking at this, we can begin to make an educated guess at where sales are heading next month and perhaps beyond.  With $30K sales in final negotiations and $80K in the proposal stage, you know that with a closing ratio of about 45%, you are looking at close to $50K in revenues closing in the next month.  Meaningful?  Compared to saying that the company did $42K last month and $68K in the same month last year?

revenueproductsyr.png

While it might not seem like a leading indicator, this one could be if properly used.  This tracks the revenue by products, not based upon their model, but based upon the year that it was originally introduced.  If your company prides itself on bringing new products to market but you are unsure how new products fare, this could be an eye opener.  In this particular case, the bulk of the revenues is generated by legacy products, followed closely by near-legacy product sales.  Is this a problem?  Perhaps, especially if you find out that your advertising and promotional dollars are being spent to keep legacy products in front of customers, or that you are spending a ton of money on advertising the new hotness and it is not taking off.

This reminds me of a recent conversation I had with a client.  It seems that one of their major customers is going to merge and most likely will no longer buy products from them. The obvious question, how are you going to address the concern?

No problem he says.  They are going to lay off employees.  We have been spending almost $750K a year on R&D and we haven’t gotten anything out of it.

I was voting on cutting senior management compensation by 98% and moving them to some sort of incentives based on new products and new channel sales but I guess slowly going bankrupt by starving the company of new products is a much safer bet.  After all, every “VP” should be guaranteed a paycheck.

Find a creative way to look at your company’s data, especially sales.  If you are not tracking sales prospects, start now.  Your sales people will give you lots of reasons why it won’t help, but don’t take no for an answer.  If you have new products that are not selling, find out why.  My bet is that somewhere along the way there is a disincentive to either buy or sell.  Customers are getting a better deal on your old products or your sales peoples’ commissions are better on legacy products.  Or it is a dog and you need to dump it!

Don’t simply rely upon accounting reports when it comes to managing your business.  Get creative, tell your controller or CFO to get creative when it comes to predicting future sales and expenses.  Yesterday’s news is important to someone, but that someone doesn’t have to be you.

 

The Power of Illusion

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

ASC 606.  While I think it can be a very useful tool in some situations, like with condominium and homeowner associations, I am not convinced that it will help a reader, an investor, anywhere else.  That is because it is almost uniformly built on the concept of management choice – which sadly can lead to poor decisions that ultimately hurt investors.

In a perfect world, I think the concept of ASC 606 is inspiring.  Finally, a reader can see what has been committed to and what prices will end up being paid.  What a great way to predict a company’s ability to generate future cash flows.  But that isn’t what is going to happen. I have seen enough at my end of the spectrum to know that anytime subjective measures are involved, those impacted want the measures skewed in their direction.  And something like ASC 606, which almost completely makes determining revenues subjective, simply is going to take this to a new level.

This reminds me of an attest engagement on a contractor.  The contractor stated that they had a maintenance contract which runs for 12 months with options to extend an additional 12 months and 6 months.  No problem.  We though.  We asked for the contract, the controller hemmed and hawed.  Why?  She put the information into the disclosure so there must be a basis for its inclusion.

Apparently not.  It seems that the customer is not so thrilled and has expressed that they won’t extend the contract.  But there is a catch.

The customer is also the ultimate customer on several other contracts.  It seems that the customer accounts for about 60% of the revenues for this company and when this contract goes, there is about a 99.8% chance that the other contracts are not renewed and new contracts won’t be awarded.

This all came to a head when we questioned the fade, or loss of gross profit, over contracts.  Long-term contracts are handled on the guesstimate method.  We use the “objective” measure of actual cost incurred in relationship to the guess of total estimated costs.  The total estimated cost is management’s choice, its illusion, which drives not only gross profit recognized but also the percentage of completion.

We identified a problem.  The fade, or the loss of gross profit over time, on contracts was starting to become noticeable.  The graph shows what we noticed:

fade analysis

The gross profit percentage ends up remarkably lower over time.  There is really only one reason for this, the inability to estimate accurately.  Notice that all fade is in excess of 5 basis points, the smallest fade being 7 points on project ABC.  If this were a $10,000 project, that wouldn’t be a big issue but it is their second largest contract.  And worse, you can see that on one job they estimated an increase in gross profit in year two only to have it plunge to a net contract loss of 5%.

GP Fade

I know I know, the point.

The problem is that they estimated their new contract, the one likely not to get extended at 45% gross profit.  The trend though, is clear: Gross profit fades lower consistently over time.  The trend indicates to us that the project will end up at 30% overall.  The project AAA is recorded at 5% complete which means the company has recorded over $100K of gross profit.  The trend says that, at best, they have earned $67K.

But wait, there’s more.

Since the original estimated cost in year one is too low, this changes the percentage of completion.  Not a lot, but enough.  The true fade, after revising the percentage of completion is

true fade.png

Huge.  So huge, in fact, that it can’t be ignored.  It totals out to about $375K of gross profit incorrectly recognized in earlier years.

Of course, our concern is not really those older contracts, it is the new one, the one which is likely not to be extended.  It is our concern that current gross profit is overstated by about $50K AND it is likely that this contract won’t be reupped and that there will be no future contracts with this customer.

With the loss of this customer, revenues will drop 50%.  Given the fade problem from poor estimates, the company has not had the gross profit it envisioned on these projects which has forced it to borrow heavily to meet its operating needs during the end phase of these projects.  The borrowing, by the way, is from both the bank and the new projects with higher initial gross profit that will ultimately fade away.

Since we are independent CPA’s attesting to the financial statements, we are held to the standard that we think the company in question can continue as a going concern for at least one year from the date of our report.  We ran several different scenarios, none of which succeed in changing the trajectory.

I would like to say there was a happy ending.  I guess in a way there was.  Management, the sole owner, decided to terminate our engagement.  The next year, the owner filed for bankruptcy.  The bank never got is independent accountants’ report by the way.  They didn’t call the loan and ended up with over a $500K loss due to the reorganization.

It is tempting to believe that management wants accuracy and objectivity in its reports.  But as with estimated costs to complete, ASC 606 is open to management’s very subjective and capitalistic approach.  Management is responsible for

  • determining what makes up a contract with a customer
  • selecting at least one (and possibly only one) performance obligation
  • Allocating the contract price over the performance obligations
  • Determining when the performance obligation is complete so that the price can be recognized

These all have similar requirements – management’s ability to use good judgment.  And much like with contract estimates under old GAAP, it will be well-nigh impossible for an independent CPA to challenge management’s assertions, until it is too late.

 

It’s worth it

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

This week, well actually almost this entire month, has been trying to overcome bad advice and management practice which was provided to a client.  I would love nothing more than to share names, opinions, and actions which got this entity into the mess they are in but that won’t solve the problem.  It would make me feel a whole lot better though.

Last night, after spending another 7 hours trying to figure out how to take incorrect balances and make them right, while at the same time trying to write the letter which explains to them why they now owe new balances, I asked myself, “Is it truly worth it?”

And when I almost convince myself to really question what I am doing, I think about the poor accounting clerk at the unnamed management company who, several years ago, no doubt discovered that what was being done, was wrong.  This accountant, filled with the righteous fury of making accounting meaningful, marched up to the unnamed boss at the management company, and laid out the facts.

“We are wrong.” The intrepid accounting person said.

“You are fired.” Said the boss.

Shooting the messenger is so much a part of the game isn’t it?  When things are not going well, it is easier to get rid of the those who question the steps, who report the unpleasantness, than to deal with the problem.  For the people who don’t want to hear it, they get silence and are grateful.  The ones who sounded the warning likely become gun shy and possibly vow to never raise a concern again.  There mantra might become, “It’s just how they do it here.”  Without realizing that by mouthing the phrase, they too become caught in the trap of decay.

Let’s be clear.  I think that when you start to simply accept poor behavior you become part of the problem.  When you see your manager using the company car on weekends, the same week you were involved in a termination of an employee who borrowed a work hammer, and you are silent, you are part of the problem.  Excusing the behavior of the manager simply because she is manager means that the rot won’t end.

Wrong is wrong.  Oh don’t misunderstand, no one will thank you for taking the stand.  Not your boss, not your bosses boss.  If you are lucky, you keep your job but get stuck with the title SNITCH.   But maybe, just maybe, people will start acting a little more ethical, at least in your presence.  And maybe, just maybe, they will act a little more ethically all the time because frankly it is too much work always looking over their shoulder to see if you are watching.

To that accounting clerk who, years ago, noticed that their employer was doing something completely wrong and called them on it, I thank you.  I know you tried and you succeeded.  Perhaps not as quickly as you might have hoped long ago but you are being vindicated.

One journal entry at a time.

Is it worth it?  Yes.  Doing right by people isn’t a zero sum game, it is the easiest way to live.  And like any questing knight, when you see people not wanting to correct a mistake, don’t be afraid to call them out.  Do it for the sake of the game, not because you expect an atta’ boy (or girl).  The greatest rewards in life are from within, when you can lie your head on the pillow and say, “Thank you, me, for a job well done.”

Auditing investments

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

It is always refreshing to see associations which take responsibility for their future replacements by trying to find investments which can actually grow beyond the rate of inflation.  A solid investment plan can help them ease the burden of reserve assessments by using collected funds to grow at an accelerated, but reasonably safe, rate of return.

Auditing these investments is challenging though.

Conceptually, auditing investments is not any harder than auditing cash.  Except that investments carry certain additional disclosure requirements and the treasurer typically has little to no exposure on how to record the transactions let alone report them to be audited.  Which means that our work as the auditor grows significantly.

You see, Generally Accepted Accounting Principles (GAAP) requires that the investments be reported as either trading, available for sale or held to maturity.  How many investment advisors even understand what can be assigned to these categories?  And our role, as auditor, is to make sure that the investments are properly categorized and that the related gains, losses, and earnings is properly reported in the statement of activity; i.e. the profit and loss statement.  To ensure that they are properly recorded in the period, the accounting department has to know the difference between realized and recognized gains and losses, temporary impairment, other than temporary impairment and put those in the right reporting areas.

Which of course leads to another big accounting issue, accumulated other comprehensive income.  This is the series of holding accounts for the unrealized gains.  You have to know how to close out the transaction to recognize the ultimate sale of the investment.

Did I mention that you have to also track bond premiums and discounts and do some accounting work to get the amortization right?  Again, all this has to be tracked correctly to report in accordance with GAAP.

The rub is that treasurers and boards don’t really understand the complexity of this and often don’t really care.  Their issue is the investment and the return, not its reporting.  Which brings us to our dilemma.

Trying to account for, and then audit, investments can add a substantial cost to the engagement.  It is a cost that probably won’t be valuable to the board and owners in the association.  So, do we allow for a GAAP departure on the investments and simply say they are recorded at cost and have associations report gains and losses at the time of sale?

It is a difficult position.  On the one hand we want the statements to fairly represent the financial activity of the association but on the other hand we don’t want to drive up the cost of the engagement to the point where they find another auditor.  One who perhaps will take huge shortcuts on the reporting and auditing side.  Yes, we see that far too often as well.

So, putting your reserve fund to work by investing it strategically and at reasonable risk is a fair approach to managing the money.  But there are other things to consider besides the actual investing and you, as a board, need to be aware of these issues and take a position on how to report this to the owners in your association financial statement.

Have a great day and an awesome weekend.  And, if you are looking for an experienced audit team to help you maintain effective controls over your association’s finances, feel free to contact us anytime.  We look forward to the opportunity to be of service to you.