analytical procedures – Accounting Clarity

Do you have a checklist for your month end closing process? Have you added running analytical testing to your checklist?

Managing multiple association accounting systems does not leave a lot of time to thoroughly review everything, which is, of course, why we created our checklist in the first place. I can determine what has been completed and by whom and then spot check their work. It also helps that we have solid systems to fully vet transactions as they are incurred and which work hard to detect and prevent fraud – but still, the goal is to provide full information for the month and year-to-date so we struggle with determining what might be missing.

First, look at some relationships between your balance sheet and your statement of operations. Certain accounts have very comfortable relationships – think inventory and cost of goods sold while others may be more tenuous. Also, keep in mind that the purpose is to help you determine if the statements appear reasonable; so don’t overdo the number of calculations.

Some key ratios you should consider running at month end to help you pinpoint potential problems:

Days in Accounts Receivable

This will give you a sense of potential collection problems without having to dig into the aging: Take your monthly revenue and divide by 30, this is daily sales. Then divide this amount into your accounts receivable balance. Now, the two most important questions you should ask yourself: Is it over 30 days? Is it higher than prior periods? If it is more than 30 days, you have sales from prior months which have still not been collected and if it is increasing, then you have many sales which are not being collected and you might need to consider increasing your allowance for potential bad debt.

Days in Inventory

This will give a good idea if inventory is being handled well without worrying about a potential physical count of inventory. Take your cost of goods sold and divide by 30, which is the daily cost of sales and then divide this amount into inventory. Is the pattern consistent with prior months? Did you see an unexplained change that skewed the results well beyond prior months? A large increase could indicate that some CoGS were not adjusted properly or that potentially you have inventory which is not turning over, potentially indicating obsolescence.

Sales Growth Rate to change in A/R

Comparing the growth in sales to the change in accounts receivable can also provide an indication of deteriorating a/r quality. If your sales increased by 5% from the prior months but your accounts receivable increased by 25%, it could indicate that collection problems might exist.

Gross Profit Percentage Month Over Month

If your company sells products, this could help you address a change in your business or in customer demand – either of which could indicate other potential problems. You will want to map out your gross profit percentage – which is revenues less cost of goods sold and divided by revenues – for each month over the past few years. First, compare it to the past few months, is the trend consistent? Then compare it to the same month in prior years. If you are trending downwards both over time and in comparison to the same period in prior years, this could indicate possible issues with the costs of materials or production issues, both of which can have long-term impacts to your business.

Labor Costs to Revenues

One area where a small business can be caught off-guard is in labor costs. Unplanned overtime can be especially painful so always watch to ensure that overtime is planned and paid for, either in revenue premiums or in additional sales. If labor is consistently increasing during months of slow or no sales growth, perhaps your overtime policy needs to be re-evaluated to ensure that it is not out of control. graph hr rev to ave

In this example, taken from a client who was experiencing reduced profits, we were able to identify the driver was in fact over 1,400 overtime hours. There were two primary drivers of this, first was that department managers did not actively plan work for the week, leaving things to be completed on Wednesday and Thursday so they could be shipped on Friday. Since there was always a lot of work to complete, the teams were working 2-3 extra hours on those two days, even if Monday and Tuesday had the teams with substantial idle time. Second was that there was no policy to require the manage to authorize the use of overtime in advance.

Analytics can help you understand how your business operates. It can point out areas where additional effort might be called for and also help management isolate and test potential issues to see if a change can help improve performance.

I was asked yesterday to explain my blog about reviews the other day and how the CPA overlooked the fact that the manager recorded the full special assessment instead of unearned interest income. It was a great question.

What actually tipped us was the foot note for the receivable. It said, in part, that monthly payments were required by owners (including interest).

When we looked at the manager’s profit and loss statement for the special assessment fund, it showed

Interest income $0
Interest expense $20,000

The second clue was looking back at the special assessment fund balance.

2014 $80,000
2015 $65,000
2016 $50,000

Each year the equity is being reduced because the interest expense was being recorded but there was no offsetting interest income. Since there was a special assessment receivable, an effective review test would be multiplying the average receivable balance by the stated interest rate.

In this case, the average receivable balance was $300,000. This multiplied by the 6.0% interest rate meant $18,000 of interest income would be expected. The association recorded no interest income. This is a very large deviation from expectations.

Under SSARS, Statement on Standards for Accounting and Review Services, the accountant performs certain analytical tests and compares those to industry standards, historical evidence and certain expectations driven by experience with both the client and the particular industry. In this case, our experience with special assessment receivables led us to believe that there should have been interest income. Although if the accountant simply compared it to the prior year, then the zero matched the zero in the prior year and even the year before that.

This would be incorrect though. Another requirement of SSARS and GAAS is to maintain professional skepticism, or the willingness to look beyond the assumption that an explanation may be correct.

So, we said, “Wait a second, how can it be zero if we calculate $18,000? How could the prior year be zero when the average receivable was $400,000? We then asked the question of management and they said it was always zero.

And our response was, so what? It didn’t feel right. In short, we were skeptical that their explanation was sufficient. Remember, the foot note said each payment included interest. This meant that somewhere along the way the preparer of the financials read a document that stated this.

Sure enough we found that document. Sure enough we found the next document which showed the original entry and that it included the full amount of the special assessment – including interest. That is, by the way, why the fund balance had a positive balance all the way back when it was created. The special assessment “revenue” was higher than the costs of the renovation project. It should have, at best, been a break even.

We could then model it and show the board how the financial statements were incorrectly reporting the special assessment. We then showed them how it was supposed to be.

No, it hasn’t been cheap for the association. It was all driven, unfortunately, by not having the financial statement reviewed in the year of the special assessment. Having the statements reviewed years later almost guaranteed that it would be overlooked. It is possible that it could have been overlooked in a review of that year too, I am not saying that it would have been caught necessarily, but the odds would have definitely been improved.

So yes, board members, especially treasurers, you can run your own analysis. If you would like, I can send you a spreadsheet with some of the more common ratios and analysis to help you get a good overview of your financial statements before your accountant sets in on the review. It can’t hurt and could potentially head off a disaster.

Have a great day. If you would like to learn more about how to analyze your non-profit, business, or property association, feel free to contact me and request the spreadsheet. C.O.R.E. Services is here to be of service to you.

Tag: analytical procedures

The power of analysis