The Power of Illusion

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.

 

More on Management Representations

The second section of the management representation letter gets into the heart of how you went about disclosing information to the independent accountant.  This section is titled, “Information Provided” and you should be aware of what is actually being stated here.

  • You are stating that you have responded fully and truthfully to all inquiries made.  Keep in mind one of the bigger concerns is related party transactions – if you know one exists but fail to disclose it, you have technically misrepresented yourself.
  • You provided access to all relevant information which deals with the preparation and fair presentation of the financial statements.
    • Contracts
    • Board minutes (if you had a board and kept minutes
    • Schedules requested, like an amortization schedule for interest
    • Most importantly, unrestricted access (my emphasis) to persons within the entity that the accountant felt was necessary to interview to feel confident about the evidence.

As a quick aside, this is a potential for a scope limitation which is an engagement killer for both an audit and review.  We have had client management tell us we cannot interview certain employees.  Sorry, that is a huge red flag issue.  We don’t like wasting our time talking with employees or business partners who cannot provide evidence, but if you have a purchasing manager and we question the values of inventory, to say we cannot talk with that person means we cannot issue our independent report.  You have been warned.

  • You have recorded all transactions in your accounting system and these show up on the financial statements.  You are the entities first line of defense.  We have been involved with engagements where specific transactions were not recorded, only to find out later that someone (like the owner) knew about it but failed to ensure it was included.
  • You are stating you are either have no knowledge of fraud or suspected fraud or have shared with us your suspicions or evidence.  Think about this representation.  As I have discussed in other posts ,we have discovered odd journal entries which were possibly created to misrepresent the financial condition of the company.  We have required management to represent that they had evidence of this misrepresentation and have taken steps to address the action and then state if they know of anything else.  The fact that it the transaction was caught by us and not management is the problem since it never should have been entered in the first place.
  • You are stating that there are either no instances of noncompliance with laws or have disclosed all such instances to us and have either made allowance for it in the financial statements or are disclosing such.  There was one instance where a construction company bid on a job in a new state.  They started the work and failed to file as a foreign corporation, failed to register as a contractor and failed to file for payroll taxes and workers compensation coverage.  Even though it was eventually corrected, we required an accrual of the expenses and also a note disclosure.
  • You state that all possible litigation and potential claims have been identified.  If your company is being sued for, say a hostile work environment, you should let the accountant know so that a proper disclosure can be prepared.  Your relative guilt or innocence is not the question, the fact that there is a risk is the concern.
  • You are stating that you have disclosed all related parties.  By the way, you are required to disclose related party matters even when you are not doing business with them.
  • The last big one, you state that the entity has complied with all contractual agreements that would have a material effect on the financial statements in the event of noncompliance.  Now, before you say it is never a problem, think about a line of credit that is tied to your inventory by way of a borrowing base calculation.  It requires that inventory over 120 days be excluded from the calculation.   At the end of the year you are on day 119 for 50% of your inventory.  You are likely going to be out of compliance and it may have a material impact.

For the most part, management representation letters are simple and straightforward.  But they are designed to protect the independent accountant by putting you on notice that you are making, and they are relying upon, certain representations.  In the event of a problem their defense is that you represented that you told them one thing and obviously something else happened.  So, to protect yourself, don’t be afraid to add specific language which makes the representation letter more effective for you and the accountant.

We hope this journey through the standard management representation letter has been helpful.  If you have questions about the representation letter, feel free to ask.  And if you would like a proposal on audit or review services, go to our website and learn a little more about us.  We have a page where you can request a proposal and we would love the opportunity to be of service to you.

GAAP and Projections

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.

 

Agency and revenue

One of the more interesting challenges we had in the past twelve months was convincing a client that they didn’t really have revenues and expenses but instead commissions.  It actually held up the issuance of the review of their financial statement until we had agreement.

The issue in question had the following fact pattern:

  • OpCo (the client we were reviewing) had a contract with a larger business (GenCo) to provide a specific set of services at a price established by GenCo.
  • OpCo would sign up customers who would receive GenCo services
  • OpCo did not purchase GenCo goods or services for resale
  • GenCo provided all the technical expertise and it was included in the price customer paid

When OpCo submitted their financial statements, it reflected $2.0 Million in revenues and $1.5 Million in “cost of sales”.  OpCo, anticipating the issue, engaged another firm to address the ASC 605-45 “Principal versus Agent” issue.  This firm’s research concluded that the revenue met the criteria for reporting as a Principal.

We disagreed.

Our starting point was at the 50,000 foot level.  Why does it matter if revenues are reported net or gross?  The client was insistent it had to be gross.  In any type of attest engagement, the big red warning flags start coming out when a client is insisting on a specific treatment.  By asking a few questions about their motivation we discovered that they were trying to woo a prospective buyer who was only interested in a target with a certain level of turnover.

Knowing this, we applied the key points of ASC 605-45.   The first issue is, “Who fulfills the contracted services?”  Our reading of the contract clearly indicated that GenCo had the technical team which would provide the services. OpCo had sales agents who went out and signed up customers but those customers were ultimately engaging GenCo.

The next key point was, “Who set the price?”  The contract stated that the base price for GenCo’s service was $15,000 and their suggested customer price was $20,000.  OpCo earned 50% of the spread between the final negotiated price and the $15,000.  While this was a little tricky, the substance is that GenCo set the floor and ceiling prices.  As a matter of fact, no customer agreement had a price above $20,000 and the only time it was lower was when a customer had multiple sites and therefore earned a volume discount.

Another major point, but related to the first one, was “Was the service modified in anyway by OpCo?”  Since the service was provided by GenCo and, other than having an OpCo sales agent complete the paperwork, there was no ongoing involvement by OpCo EXCEPT for sales follow-up, it appears that OpCo did not modify the service.

We ended up in a meeting with the client’s senior management and the other firm.  We pointed out the flaws in the logic and, ultimately, the risk to both the Company and us as the reviewing firm, if we allowed the statements to be issued on a gross basis.  The net effect was the same: The problem is that there was going to be reliance upon the statement which could have been considered misleading.  The client agreed to restate the financial statements to report only the “commissions” earned.

If you are unsure if your accounting treatment is correct and would like to discuss the impact of how you are reporting, feel free to contact me.  We will look at the big picture and work our way down to the appropriate level of detail so you can feel comfortable that your position is accurate.  Remember, your business is issuing a financial statement that someone plans to rely upon so using an inappropriate accounting model could cause you problems down the road. And if you would like more information on how our audit and review services could be helpful to your business or non-profit, find out more about us here.

Have a great Tuesday.