Tag: Generally Accepted Accounting Principles

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

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

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.

 

Impairment and the Balance Sheet

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

Typically it goes like this, “I googled this accounting term and it says that I am not required to do what you are saying.”  Ugh

Do not put your google search up against my accounting degree and constant hours of study of accounting principles.  Kubae actually saw that on a coffee cup and I thought it was pretty awesome.  Clichéd but awesome.

As I wrote on my other blog today GAAP is an accounting model that is selected by the organization.  If you elected to follow GAAP then, when a situation arises that GAAP covers, you are required to comply.

Or not.  Remember it is a choice.

We have worked with a few businesses recently who needed their financial statements reviewed.  They each have bank loans with covenants that require their financial statements to be prepared in accordance with GAAP.  And have those financial statements reviewed.

In each instance revenues are down year over year.  In each instance the companies have substantial non-cash assets: inventory, property, facilities and equipment, goodwill.  And we have asked each of them if they determined that their assets are impaired in value.

Sorry but this is a necessary question in a review.  GAAP requires that assets be tested for impairment, that is, loss of value.   And since you have a loan covenant requiring GAAP financial statements you have to follow the steps called for by GAAP.

Or you can say you are not going to follow GAAP.

By the way, you should be worried about value impairment in the situation where revenues are dropping and profits are slipping.  It is a sign that perhaps you have surplus inventory, desks that are not being used, expensive plant equipment that is sitting idle, shop space unused.  Why wait until the CPA says something?

That was a rhetorical question.  At this stage businesses have bigger problems than if their assets no longer have value.  Your bank moving you to special assets is chief among them.  You are focused on profitability because you think that is what the bank is concerned with.  And slamming more expenses into your fragile profit and loss statement is the last thing you want to happen.

Testing for impairment doesn’t necessarily lead to a write-off of value.  But if it does, so what?  If you are carrying inventory that you haven’t moved in a year then maybe adjusting its value to what you can get for it is a good move.  Think about it, you are trying to correct for past decisions and return to profitability.  Your inventory, and other assets, were a reflection of those past decisions and not dealing with them will actually hamper your turnaround.

Capitalized leasehold improvements has been a big issue for us on review.  What we find is that the accountant (even us) records the depreciation/amortization over 39 years.  Why?  because it fits with MACRS.  But it isn’t disclosed properly.  And then the problem is compounded by the fact that the company has a 5 year lease with one 5-year extension.

There are three years left on the extension.  Revenues and profits are down and management is looking for smaller, more affordable space.  And the company is sitting on $350,000 net book value of leasehold improvements.  It is painfully obvious isn’t it?

The value is impaired like it or not.  You don’t have a $350,000 asset, you have a huge rock tied to your ankles while you plummet the depth of the ocean.   Ignoring the problem isn’t going to help.  When it is time to move to the new facility the business will have to take a $300,000 write off for the inaccurate reporting of the economic life.  And that is the year your line of credit renews.

We know this isn’t an easy subject but you elected to follow GAAP.  Look at your assets and ask if it is still worth it.  You should do this even if you are vastly profitable since it is highly likely that there are assets or asset classes that you are no longer utilizing.

Or don’t follow GAAP.  The choice is yours.  Just don’t get mad at the CPA because she questions your balance sheet.

Have a great weekend.  If you would like more information about impairment or any other GAAP issue, feel free to contact us through our website.  We look forward to being of service to you.

 

Cost of Goods Sold

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

Happy Tuesday.  Today I am having lunch with Delena Meyer of Way Enough Decision Coaching.  I was fortunate enough to work with her at my last Company where we had to work through some growing pains. For an Organization facing pressures (aren’t we all) it is worth bringing in an outside consultant to bring a different viewpoint and work with the management team to find ways to move forward together.  I will have more to write about Way Enough Decision Coaching tomorrow but I strongly recommend her if you want a coach who can cut to the chase.  Her number is 360.281.4743.  Give her a call and let her know you were referred by John.

Cost of Goods Sold

Inventory is typically the largest dollar value of current assets in many small businesses.  This is especially true in retail, wholesale, construction and manufacturing.  When goods are sold, the dollar value of the items is adjusted from inventory to cost of goods sold (CoGS).  Which by the way, typically means that cost of goods sold is the largest “expense” item on the Income Statement.

I can hear my editor now, “John, if it is such an important number, why aren’t you tracking it on the Dashboard?”

The answer is, of course, that we are tracking it – using the amount in Accounts Payable as a reasonable substitute.  The goods in a business are almost universally purchased on terms so a healthy business will typically have inventory approximately equal to the amounts owed vendors.

I will spend more time on inventory in a later blog post, but the big take-away for today is that CoGS represents a significant item and it is the largest opportunity for error and irregularity in small business.

A Client Story on CoGS

About 2009, the firm had a client, ABC (named changed to protect the innocent) which was a specialty manufacturer.  The Company had borrowed a substantial amount of money from the Bank and had also bought out a major shareholder and owed on a term note.  The Bank required ABC to have a reviewed financial statement.  The information below is what the financial statements reported each year.

2005 2006 2007
Inventory
Raw Material       5,000,000    5,500,000    5,200,000
WiP       2,000,000    1,800,000    1,600,000
Finished Goods       1,000,000    1,300,000    1,000,000
Total Inventory       8,000,000    8,600,000    7,800,000
Revenues      18,000,000  19,500,000  20,500,000
CoGS      14,000,000  15,400,000  16,500,000
Gross Profit       4,000,000    4,100,000    4,000,000
Profit Margin 22.2% 21.0% 19.5%
Net Profit      (2,500,000)   (2,750,000)   (1,500,000)

The 2008 Surprise Change to Cost of Goods

The client sent over their internal financial statements and trial balance in February 2009 showing the following information:

2007 2008
Inventory
Raw Material    5,200,000    6,000,000
WiP    1,600,000    1,750,000
Finished Goods    1,000,000    1,250,000
Total Inventory    7,800,000    9,000,000
Revenues  20,500,000  21,000,000
CoGS  16,500,000  14,500,000
Gross Profit    4,000,000    6,500,000
Profit Margin 19.5% 31.0%
Net Profit   (1,500,000)    1,250,000

The first thing the staff noticed was that CoGS dropped by $2,000,000.  When you look a little deeper, you realize that inventory increased by $1,200,000.  For the professional, this looks a little suspicious so we started digging.  By asking the following questions (and others) we discovered the truth.

  • How can sales remain flat while CoGS drops by 12%?  Is there a new customer willing to pay a hefty premium?
  • Did ABC stop what it was doing at the end of the year and physically count the inventory?  Who reviewed the count sheets?
  • What are 2009 sales projections for ABC?  Given that we are in a tight credit situation, will sales grow in excess of 20% over 2008 to justify the investment in inventory?

The answers we received sadly required the firm to withdraw from the engagement.  But the point of the story is that as a small business, you should ensure your management team is on top of things like Cost of Goods Sold.  The balance is potentially large, there are huge dollar amounts flowing through the account and a small change in the margins can impact your profitability – and potentially your banking relationship.

My recommendations for staying on top of your CoGS:

  1. Require a full physical inventory count at year-end.  No matter how good your accounting system, a physical count helps keep the computerized data synced.
  2. Review your gross profit margin monthly.  If you are averaging 40% gross profit and it suddenly dips to 30% for no reason, ask questions.  It may be legitimate, it could be a posting error, or it could be something like fraud.
  3. Go out and spot count a few high dollar inventory items and compare your count to the accounting system.  You doing it yourself will show your team how important you think inventory and CoGS is to your business.
  4. Don’t try to hide a business problem by adjusting your CoGS.  In the story, the business had to show a reasonable profit margin in 2008 or the bank was going to place ABC in Special Assets.  ABC still ended up in Special Assets. Also, the CFO was terminated, shareholder/manager compensation was reduced by 80% and the business could no longer pay the notes to the retired shareholders.  4 years later the Company was liquidated for about $0.15 cents on the dollar.  A few years later I ran into the banker and he said that the Bank may have been willing to work things out with ABC had they not tried to fool them. Sad.

If your business sells goods, your CoGS plays an important part of your profitability.  It is intimately tied to your inventory levels and can be challenging to stay on top of.  Knowing how CoGS is related to your revenues and feeds out of your inventory can help you grow profitably and with fewer headaches.  Talk with your accounting professional if you have questions or feel free to send me an email if you would like to discuss this article or anything else regarding your business.

Have a great day.

Accounting for Revenue

~ C.O.R.E. Beliefs ~ 1 Comment

Happy Monday!  I hope you enjoyed your weekend.  Here in Vancouver it was nice and warm, upper 90’s both days, and it was a weekend with the boys which made it even better.  Did you do anything fun?

Revenues in Small Business

The accounting for revenues in a small business can be a little tricky.  Depending on your industry, sending out an invoice does not automatically make the amount “revenues” under Generally Accepted Accounting Principles (GAAP).  However, for your purposes as the small business owner, sending out that invoice as early as possible can be extremely important for your cash flows.

The 3 Reasons Not to Record the Invoice as Revenue

Under GAAP, revenues and costs are supposed to be matched so that someone outside your business who reads your financial statements – such as your banker when you apply for a loan – can understand your costs in relation to your income.  But there are other reasons to consider not recording some invoices as revenues at the time of invoicing your customer.

  • The Invoice is for a Deposit on Work to be Completed Much Later

At my last Company, we often charged a deposit of 50% to secure time on the master schedule.  Since many of these projects were worth over $20,000, the plan was to ensure the Customer had “Skin in the Game”.  From a cash flow perspective, it was great to get the money in before we had to start ordering materials and parts.  From an accounting perspective, however, we faced several potential issues.

  • Customer wanted to cancel the work

Eventually, a customer cancels the work that they requested.  If you are lucky enough to have the customer cancel in the same month, then there is no problem as the receipt of the money and the repayment happens in the same month and they cancel each other out.  But what if the customer cancels 2 months later?  Your Income Statement looks odd as Month 1 reports all this income and then Month 2 shows either a negative income for that amount or you show some sort of discount or allowance or perhaps you have a refunds account.  If it is only you looking at the financial statement, then it is probably not a problem, but if you have someone like your banker or insurance agent looking, you have to explain, which may cause them to question your accounting. Plus, the risk is your Company spent the money and has to scramble to find funds to repay the deposit. 

  • Labor and materials are not being used on the project for 3-9 months

This is somewhat along the lines of what we discussed above.  In month 1 you record all your income and then month 4 you have all your expenses, you cannot really tell how well you are doing by looking at your financial statement.  If you are trying to run your Company by the numbers, this may cause you to think things are going well in Month 1 and not-so-well in Month 4.  By using some method for project accounting, you can see how well your projects are doing over time, but these will not roll-up to your Income Statement.

  • The Invoice is for Work to be Done Over Time

Think Ongoing Contract like in a gym membership.  Lets say you give your customer a chance to pay monthly or offer a discount to pay in advance for a whole year.  Those who take advantage of the discount are still going to use the gym (well potentially use the gym but that is a different matter) over the next 12 months.  To match up with the members who pay monthly, you may want to make sure that your accounting team keep a different schedule (perhaps in Excel) which tracks who has paid and the charge per month for the year.

Revenues in small business are not always easy.  If you are the only person who will ever look at your books, then you can keep them anyway you want and work with your outside accounting firm at year-end to get the numbers right for tax purposes.  There are benefits to running your books to record revenues when invoiced, but there are perhaps many challenges to this as well.  Talk with your accounting professional for advice on the best way for your business.

If you have questions and would like a free, no obligation consultation, write me using the contact form below and we can have a conversation about your concerns and how to address them.

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Have an awesome Monday.