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.

 

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.

 

When Assessments become loans

We had an interesting one come up last week.  A 100 unit condo Association passed the following in a resolution:

  • Monthly payments of $200 per month
  • Term of the assessment is for 10 years
  • The assessment is transferred to the buyer at time of sale unless the buyer demands it to be paid in full at time of sale

This passed in February of 2016.  The association waived the 2016 audit (not wise) and then contacted us for a 2017 audit.  The dilemma?  How should this transaction be recorded?

The board and management argued that it is a monthly, on-going assessment.  But we are not so certain that is the correct way to handle it.  As we dug deeper we discovered:

  • Bank loan with a principal balance of about $1.8 Million dollars at 4.0% interest
  • Monthly payments on the loan of $20,000
  • Can pay any amount of principal after year 3 of the loan

We believed their assertion was incorrect and requested they capitalize the full receivable as a loan.  Our reasoning?

  • The present value of the payment stream could be calculated using the interest rate provided by the bank as the minimum interest charged
  • The assessment was directly tied to the repayment of the bank loan
  • The assessment was assumable but only if the buyer accepted it, otherwise it had to be paid in full at time of settlement

It is important because most state laws require disclosure of outstanding balances due from owners.  There is a huge difference between stating that the amount in arrears on an assessment is $0 and there is a $20,000 special assessment balance outstanding.  In some instances, the amount disclosed on the resale certificate is the maximum amount of liability that the buyer can assume at closing.  Management disclosed the seller’s maximum amount due on the disclosure.

Finally, since the buyer could assume, but didn’t have to, all the available evidence indicated that it should be treated as a loan to the owners.

Now there is a 10 year receivable to record.  There is interest to charge to the owner which splits their payment into two parts – principal and interest.  And because they didn’t adjust it correctly for 2016, the Association’s cost for the financial statement is going to almost double to correct for the prior year.

All of this could be avoided by consulting with a CPA firm which specializes in association (CIRA) accounting and auditing.  If you are a board that is looking at doing something that hadn’t been done before, it will be well worth the few hundred dollars you will be charged to get an idea of the complexity involved in accounting for the activity.  Can your management handle this type of transaction?  Will their software perform the calculations correctly?  How will our reports change?  All of this is as important as making sure you legally dot your “I’s” and cross your “T’s”.  Otherwise, don’t be surprised when your auditor says, “No, sorry it can’t work that way.”

Ask your accountant or feel free to reach out to us.  We are happy to assist you in any way we can as a little work up front can stop a landslide later.

At C.O.R.E. Services, we focus on being a strong independent check on management and their assertions. Which is why we enjoy working with Property Owner Associations. The boards are dedicated but typically outsource the management who record the transactions and prepare financial statements for the board to review. Our audits are designed to help the board and owners rely upon those statements. You can find more information about us on our website.

Accounting Standards

One of the big issues we face, as auditors, is an entity following an accounting standard for its financial statements.  Which begs the question, what is an accounting standard?

The best way to look at it is that an accounting standard is the expectation of how transactions should be recorded and disclosed in financial statements.   For generally accepted accounting principles, also called GAAP, this way of recording and reporting transactions is presented in the Accounting Standards Codification, or ASC’s.

Why should anyone care?  That is the question we are struggling with this week.  It seems that there are some, even in professional accounting, who are unsure why GAAP should be followed.  I have shared with you some of our more interesting conversation with clients and their management but we have similar discussions within the profession.

The simplest answer is, eliminating confusion.

GAAP, with all its faults, is just what it says it is, generally accepted.  This doesn’t mean universally accepted but it does mean that most of us agree that transactions should be recorded and reported a particular way.  By agreeing, up front, on how transactions should be completed, we get rid of the guesswork and the uncertainty of everyone deciding on their own.

Yes, this is all wonderfully theoretical but the vast majority of small businesses, non-profits and HOA’s don’t care about GAAP, is the argument we hear.  No doubt.  But the people who put their money into it should.

On a simple level, you are approach by a friend, a contractor lets say.  He wants you to be a guarantor on a project.  It seems he can’t get bonding.  You agree but only if you look at his financial statements so you know what you might be getting into.

He hands you a single piece of paper.  On it it says,

Cash        $500,000
A/R       $2,500,000
Profits                 $3,000,000

Are you ready to sign on the dotted line to guarantee this upcoming project?  If so, please write me immediately because I have an investment idea for you!

Of course you are not going to accept it.  Not because you question the numbers, per se, but because you don’t understand how they came into being.  In short, this is confusing isn’t it?

What would you like to know?  How about how he decides to recognize his income?  Perhaps how he elects to record expenses?  Does he have any debts that are not on the books?

You are interested in his accounting principles.  Now, if you happen to know how most (not all) contractors do accounting, you could ask something like,

Other contractors I know record revenues based on how much of the work is completed, is that how you record it?  I have read several other financial statements from contractors and they all have some amount of construction costs, how do you record costs?

If everyone could pick and choose the policy they want to follow we don’t have standards.  You would not have an ability to compare one company against another in the exact same industry – you would not even be able to follow a single company from year-to-year.  Accounting standards enable you to do this.

Look, we know GAAP can be complex.  But in all fairness, your entity is complex.  If you are a retailer of candy bars and you sell for cash only, you have very simple accounting.  If you take money today for work that will be done over the next three years, you created complexity.  And if you do work today and allow people to pay you over the next three years but only in relationship to how effective your work is, you created a nightmare.

As a reader, you should want to know how an entity records and reports transactions.  You should want to feel comfortable that a lot of other similar entities are doing the same thing.  In short, you want to feel good that the financial statements you are looking at are, in fact, generally accepted.

If you don’t like GAAP, then don’t play with other people’s money.   Don’t ask lenders, don’t ask investors, don’t ask me.  If you are the only person who relies upon how you do the accounting do it any damn way you please.  I mean, lets be honest, you won’t even look at a financial statement.  You will log into your bank to see how much cash you have and make all your decisions based on that.

But if you expect others to put their faith in you, then embrace GAAP.  Ensure you prepare financial statements for them to read that comply with the standards the accounting profession has provided.  The standards don’t exist to make your life miserable, they exist to help you get the funding you need.  Overwhelm your reader with good, actionable information and they will return the love.  They may not give you money, but they will likely do what they can to help you succeed.

Because honesty and integrity are still rewarded in this world, even if it often doesn’t seem like it.

Have a great weekend.  And if you are looking for an auditor or CPA firm to review your financial statements, or just help you make sure your financial statements are useful to your readers, feel free to get more information and contact us through our website.  We are here to help you rely upon your management, even if that is you.