Dealing with an IRS Audit (#387)

When you receive an IRS audit notice, this is not necessarily a hair-on-fire moment. The IRS may not think that you’ve broken the law, but it’s likely that something in a recent tax return triggered their attention. Maybe it was some kind of statistical anomaly in one of your tax returns, or your reported numbers don’t align with the reporting from some third party. Or maybe your company was just randomly selected. Who knows – and I wouldn’t worry about it at this point. Right now, the most important issue is dealing with the audit.

Types of IRS Notices

Let’s start with the type of notice that the IRS sends.  It will state whether you’re subject to a correspondence audit, an office audit, or a field audit. A correspondence audit is conducted by mail, and usually focuses on one or two very narrow issues. An office audit requires you to bring records to an IRS office for review. And finally, there’s a field audit, which is the most intrusive; it takes place at your company location and involves a deeper examination of your records. I’m going to focus on the field audit.

Early Actions to Take

As soon as you receive the notice, notify the senior management team. They need to know what’s coming, and be sure to keep them updated as the audit progresses. Next, assign responsibility for IRS interactions to someone who understands how to deal with the IRS. If you’ve never done this before, it could make sense to bring in an outside advisor, like a tax attorney or a CPA, and route all communications through that person. By doing so, you’re creating a buffer between the accounting staff and the IRS examiner, which can reduce the risk of misstatements or off-hand comments that could get you into trouble.

If you take this approach, then you’ll need to fill out a power of attorney, which is IRS Form 2848, so that the IRS knows who to talk to. From that point on, the tax expert representing you is negotiating with the IRS on your behalf. This step is huge. The amount of money you spend bringing in an expert is nothing compared to what you might otherwise pay to the IRS in fees and penalties.

Document Preparation

Next up is preparing documentation. The IRS is going to want to see substantiation for your deductions, credits, tax positions taken, and so forth. They’re not going to accept a verbal explanation; they want proof.

To get this right, you’ll need to get a team together within the accounting department as soon as possible, and work with your tax expert to find the documents you need and get them ready for review. Waiting is not a good option, since you need to find out early on if you’re missing any documents, and so will need to reconstruct whatever’s needed. The longer you wait, or the fewer the staff assigned to this, the greater the risk that you won’t be prepared for the audit.

Next up, take a hard look at those documents to see if there are any potential weaknesses. For example, maybe your claimed maintenance expenses were really high, so see if some of the repair bill should have been capitalized. Or maybe there are loans to shareholders that should have been characterized as distributions instead. By going through this review process, you can anticipate an examiner’s questions, and come up with well-supported explanations. By going through this process, you may be able to avoid handing over documents that are irrelevant or maybe just confusing. You’re required to be truthful, but you’re not obligated to volunteer unrelated information.

Dealing with the Audit Team

Now, let’s say that the audit team shows up at your location. First of all, be respectful, and absolutely never be adversarial. Put them in a good, quiet office, preferably somewhat away from the accounting staff. And, importantly, talk to your staff in advance and designate who is allowed to talk to the IRS team; no one else talks to them. All documentation goes through the people who are designated to represent you.

When the IRS team is on-site, it’s following IRS audit procedures, and makes decisions based on the evidence that your people provide it. If the examiners think that this evidence isn’t sufficiently clear, they might request additional documents or explanations. Your designated tax expert should review each of these requests, and may decide to push back if the request appears to be overly broad; remember, it’s always in your best interests not to let examiners go rooting around in your business, so keep their focus as narrow as possible.

Negotiate with the Audit Team

At some point, the IRS team is going to reach some preliminary conclusions, which may result in significant payouts. If so, and if your tax representative disagrees, it’s time to offer alternative analyses that are based on the tax law or court cases. If your expert can deliver a well-reasoned argument, this could influence the examiner’s conclusions.

The examiner then issues a preliminary report. If you agree with it, then your management team settles with the IRS, and you make whatever the tax, interest, or penalty payment may be. However, you may disagree with some or all of the report. If so, you have a right to appeal the decision, which goes through the IRS Office of Appeals. It may be worth an appeal when there’s uncertainty in the tax law about your situation. Appeals officers will evaluate the appeal, and if there’s some risk that they won’t win in court, they might offer a settlement for a reduced amount. On the other hand, if they’re not willing to offer a settlement, it's likely that they think they have a solid court case; if so, you might want to shut down the appeals process and just pay up.

In addition, you might have the option to take the matter to U.S. Tax Court, or U.S. District Court, or the Court of Federal Claims, depending on the circumstances. Doing so is expensive and takes a lot of time, so you generally don’t want to take this approach unless there’s a large payment involved.

In addition, the amount of penalties paid could be up for discussion. The examiner may propose penalties for negligence, understatement of income tax, accuracy-related issues, or the failure to file certain information returns. If you can prove that the business demonstrated reasonable cause, then it may be possible to get penalties reduced or maybe even waived entirely. For this, you really, really need a tax expert on your side who has dealt with the IRS before. Don’t try to handle it internally – your staff does not have the expertise.

The Post-Audit Review

At this point, the audit is over, but you’re not done yet. Conduct a post-audit review. Begin by tallying up the cost of the audit, in terms of the cost of your outside representatives, and staff time, and taxes and interest and penalties paid. It’s probably a lot of money – which you could have saved if you had better accounting systems and oversight of your tax filings. This is a good time to discuss those upgrades.

A further thought - if your business routinely engages in activities that attract IRS attention, such as related-party transactions, large deductions, or international operations, then develop the documentation that supports your tax positions. Maybe dial back on your more aggressive tax positions. And certainly retain tax advisors who can keep you up-to-date on changes in the tax law, and provide tax opinions for your more complex transactions. By taking these steps, you’ll be in a better position to defend against the next audit, and maybe avoid one entirely.

In short, an IRS audit doesn’t have to be a crisis. It’s a structured process that requires a lot of staff time and expert assistance. Yes, you may end up paying out a fair amount of cash; but if you use the experience to improve your systems and tax-related decision-making, it’s less likely to be an issue again in the future.

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Accounting for Hospital Cost of Goods Sold (#386)

How does a hospital determine its costs of goods sold for the medical products used in patient care?

Cost of Goods Sold Inclusions

The cost of goods sold as it relates to patients covers things like bandages, IV fluids, medications, artificial joints, and pacemakers that are either administered or implanted during a hospital stay. These expenses are not actually called the cost of goods sold. Instead, they’re listed in the income statement as medical supply expense, or maybe as the cost of patient care supplies.

Another consideration is which items are not included in the cost of goods sold. That would be things like linen, reusable equipment, and capital assets – such as ventilators, infusion pumps, or that Bair Hugger that I just mentioned.

Cost of Goods Sold Process Flow

The foundation of the cost of goods sold calculation is the same as what you’d find in any other organization. These items are received and logged into inventory, and then charged to the cost of goods sold when they’re used. The difference from other businesses is that the cost of goods sold is usually calculated on an individual department basis. This means that you have a cost of goods for Emergency, and Surgery, and the pharmacy, and so on. These cost of goods figures are then rolled up into a single cost of goods sold total for the entire hospital.

Inventory Tracking Systems

Let’s talk about the inventory tracking systems being used. For anything remotely expensive, a perpetual inventory tracking system is used that monitors the exact quantities on hand. Or, for anything cheaper, such as gloves, you use a periodic inventory system, where items are ordered in bulk and only reviewed at longer intervals; in this case, there’s no need to be exactly correct in regard to how many units are on hand. If you run out, just go back to the supplies area and bring out another box.

Cost Assignment Processes

Now – how does a hospital figure out exactly which costs are assigned to each patient? After all, they have to bill the cost to the insurer. There are two ways to do it. One is with a charge capture system, which is the most common. With this approach, most medical products used on a patient have a corresponding charge code. So, for example, when nurses open a sterile kit or administer a medication, they scan the item and charge it to the patient. This creates a charge for the billing, and a consumption record for supply cost tracking. If the staff follows the scanning procedure, then this is a very accurate approach.

But, it’s not very effective for high-volume, low-cost items like gloves or gauze. In these cases, a hospital uses an allocation method, and assigns an average cost to patients for each day they’re in the hospital. Alternatively, the hospital could charge a standard rate that’s based on the procedure; for example, the supplies used during a colonoscopy differ from the supplies used for a pacemaker implant.

In short, these two approaches represent a blend of accuracy, with the charge capture system, and practicality, with the allocation system.

Standard Cost Usage

Next up, what about how costs are tracked? Hospitals typically track supplies using a standard costs, which is a predetermined estimate that should be fairly close to the actual cost. Standard costing simplifies pricing, so that a hospital is consistently charging the same amount to a range of patients when the same supplies are used.

It’s not always that easy to keep a reasonably accurate standard cost on file, for a couple of reasons. First, there may be contracts with suppliers, who change their prices whenever a new contract takes effect; if so, you have to adjust the standard cost file. Or, the hospital might be due for a rebate, but only after it achieves a certain volume of purchases.

A variation on the concept is called GPO tier advancement. GPO stands for group purchasing organization, and it refers to a cluster of hospitals that get together and order in bulk from a set of suppliers. Whenever the purchasing volume of the group exceeds a certain threshold value, the hospitals in the group advance to a higher tier, where the supplier prices are lower.

For example, Tier 1 might be base pricing for low-volume purchasers, while Tier 2 represents an improved discount, and Tier 3 is the best possible discount. Whenever there’s a change in tier, the associated standard costs have to be changed. This can involve a lot of reconciliation work, since a fair number of items that are still in stock were priced at the old standard cost, and now any additional items being purchased are coming in at a new standard cost.

Variance Analysis

As a further complication, hospitals have to adjust back to actual costs when they prepare financial statements. The difference between the total of these standard and actual figures is then recorded as a variance in the income statement. Ideally, management wants to see a purchase price variance, as well as a usage variance which shows how unit usage levels varied from expectations.

The Importance of the Cost of Goods Sold

Why is all of this important in a hospital? There are a bunch of reasons. First, the management team needs it to figure out the profits by service area, such as orthopedics or cardiology. They also need it to negotiate reimbursement rates with insurers. And, like any other business, they need to understand where supplies are being wasted or lost. Medical product waste may involve expired items, supplies that were opened but not used, and quite probably undocumented consumption.

And on top of that, there may be regulatory compliance issues, such as the extremely rigid tracking controls that a pharmacy has to impose on any controlled substances, like Oxycontin.

In short, hospitals use a mix of charge capture and cost allocation systems, use different inventory tracking systems to arrive at a cost of goods sold, and calculate that cost separately for different service areas within the organization.

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Accounting for CDFIs (#385)

What is a CDFI?

A CDFI is a financial organization that been certified by the U.S. Department of the Treasury to provide affordable loans and financial services to underserved communities. There are actually four types of CDFIs, but I’m going to focus on just one, which is nonprofit loan funds. What they do is issue loans to entities like small businesses, minority-owned startups, and affordable housing developers.

CDFI Accounting Issues

This might sound like a finance topic, but there’s an accounting component to it, as well. The key issue is that the loan fund is making loans into a segment of the economy that’s at higher risk of default. So in addition to the usual accounting, which is recording a note receivable and interest income, the accountant needs to pay a lot of attention to the collectability of those loans. The outcome is usually a fairly hefty loan loss provision.

For the accountant, the loan loss reserve can be a real challenge, especially during volatile conditions when the default risk goes up. Instead of waiting for actual defaults, a CDFI uses a forward-looking model that incorporates macroeconomic indicators like unemployment rates, inflation, and GDP contraction. It then adjusts the reserves as conditions worsen or improve.

On top of that, loans are grouped by risk characteristics, such as the borrower profile or the industry type, and each segment is stress tested using different economic scenarios. In essence, these “what if” models are used to ensure that the reserve is adequate if economic conditions really head downhill.

The goal is to ensure that a CDFI remains solvent and credible, and given its customer base, this is not easy.

And on top of that, the accountant will need to prepare the footnote disclosure for the financial statements. This includes a description of the methodology used to estimate credit losses, and the policy for charging off delinquent loans.

CDFI Funding Sources

Now, let’s talk about funding sources. A CDFI can get cash from three sources, which are grants, program-related investments, and debt.

It used to be quite common for a CDFI to receive grants from the CDFI Fund of the U.S. Treasury, but that group was just fired in early October by the Trump administration – all of them – so that funding source is gone, at least until the next administration comes along. That still leaves a few other sources of grants, which are local governments and foundations.

Keep in mind that a CDFI is a nonprofit, so it records grant funds as contributions. If a grant includes donor restrictions, such as only allowing the money to be used for loans to minority-owned businesses, then it’s recorded by the nonprofit as a net asset with donor restrictions.

Or, a foundation might lend money to a CDFI at below-market rates, which is done to support affordable lending. When this happens, the nonprofit records it as notes payable or long-term debt, depending on what the terms are.

In addition, if the organization is structured as a depository institution, then it also takes in customer deposits, which it can then loan out. These deposits are recorded as liabilities.

Because of the variety of funding sources, a CDFI has to be pretty careful about segregating the funds it receives, where some funds are unrestricted, and some are restricted and have to be monitored to ensure compliance with donor requirements.

CDFI Revenue Recognition

The revenue recognition for a CDFI is a bit different. Part of its revenue comes from interest income on its loan portfolio, but some of it comes from contributed revenue. As I already mentioned, a CDFI might receive a grant from a government or a foundation. When it does, it recognizes the grant as revenue; however, it can only do this when it meets the conditions associated with the grant. For example, a grant might be spread over three years, so the associated revenue can only be recognized over those three years. Or, if the grant requires matching funds from some other source, then there’s no revenue until the matching requirement is met.

Once loans are issued by a CDFI, the accountant then monitors the status of each loan, and can only record an interest income accrual if loans are being paid on time. Once they’re classified as nonperforming, then the accrual has to stop. This is usually when a loan payment is 90 days past due. When a loan is classified as uncollectible, it’s written off against the allowance for loan losses. If a borrower later repays part of that amount, it’s recorded as a recovery, which increases income in the period when the payment was received.

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Dealing with the Office of Foreign Assets Control (#384)

The Office of Foreign Assets Control

Accountants can become involved with the Office of Foreign Assets Control. This is very much a niche subject, because it’s primarily something that impacts nonprofit organizations within the United States that send money elsewhere. For example, when there’s a major earthquake in another country, or a hurricane, or a war, donors usually send their money to a nonprofit aid agency, which then turns around and sends the funds to the impacted areas. Seems simple enough, but it’s not.

At this point, a nonprofit runs into an issue that impacts both the accounting and finance functions. The Office of Foreign Assets Control, which is usually called OFAC, deals with sanctions and blocked persons. In addition, there’s the IRS Form W-8, which certifies the foreign status of the recipient of funds for tax purposes. We’ll get back to the W-8 in a minute.

Let’s start with OFAC. It’s part of the U.S. Treasury Department, and its job is to enforce economic and trade sanctions. In essence, it decides who American companies can do business with. That includes individuals, companies, banks, and even entire countries. The rules apply to every accountant who touches an international transaction.

Now, here’s where it gets tricky. OFAC defines “property” very broadly. It’s not just physical assets; it’s any financial interest or transaction that involves a sanctioned party. That means a single wire transfer or a loan repayment can become “blocked property” the moment it passes through a U.S. bank if it involves someone on the Specially Designated Nationals list, or even if a sanctioned party owns more than half of the entity receiving the funds.

For accountants working in nonprofits that have international operations, that’s a major concern. You might be trying to send money for food, medicine, or emergency shelters, but if any part of that transaction touches a blocked party, you could be required by law to freeze the funds and report the transaction to OFAC.

At the same time, there’s another layer to consider, which is the humanitarian exception. OFAC recognizes that sanctions can’t completely choke off aid that’s intended to save lives, so it includes specific authorizations called general licenses.

These allow certain types of humanitarian transfers, but the permissions are very narrow. The party sending the funds has to prove that the transaction really and truly fits the criteria. And if it doesn’t, a specific license has to be obtained before the funds can move.

In practice, this means that nonprofit accountants have to confirm that the recipient, its bank, and even its affiliates aren’t linked to sanctioned people. They have to verify that every payment is documented and justified within the scope of the license. This is boring as hell; it’s spreadsheets, and signatures, and a lot of discussions with compliance officers.

The Form W-8

Now, while all of that’s happening on the sanctions side, you also have to deal with the Form W-8. This is the IRS form that foreign parties have to submit so that they don’t automatically get hit with thirty-percent withholding on income coming from the U.S. There are several versions of the Form W-8 that I won’t get into, depending on the nature of the payment. Accountants see these forms all the time when paying foreign vendors, and consultants, or perhaps from someone receiving a grant.

The form is simple enough. It tells the IRS, “I’m not a U.S. taxpayer. Here’s where I reside. Here’s whether I’m entitled to treaty benefits.” Without it, the payer must withhold thirty percent and report the payment as if the recipient were unknown. So when a U.S. nonprofit pays a relief worker or a supplier who’s located abroad, that form determines whether the funds are fully available or reduced – a lot – by a withholding.

Documenting a Payment

The complication comes when both systems – OFAC and the IRS – overlap. Imagine that you’re the controller for an international relief organization based in Chicago. Your team is wiring half a million dollars to an NGO operating in a country that’s under partial sanctions. The NGO submits a Form W-8, claiming treaty benefits under its home country’s tax treaty with the United States. Everything seems routine, but your bank’s compliance department flags the transfer. It turns out that the NGO’s local banking partner is partially owned by a sanctioned government entity.

This is a problem. The W-8 tells you it’s a legitimate foreign entity for tax purposes. But OFAC says that, under the fifty-percent ownership rule, the banking chain could make this payment prohibited. You can’t process the wire until the situation is cleared. What began as a simple transfer to fund emergency medicine is now a complete mess.

If you’re that controller, you have to bring in an attorney to figure out whether the payment qualifies for a general license.

You document every step in your screening process. And, if necessary, you have to apply for a specific license from OFAC. Only when all of that work is done can you release the funds.

On the tax side, you’re not done yet. You have to verify that the Form W-8 is correctly filled out. This means verifying that the foreign tax identification number has been provided or marked as not legally required, and that the treaty claim matches the type of payment, and that the form was signed by someone with authority, and that it hasn’t expired yet. A W-8 is typically valid until the end of the third calendar year after it’s signed, unless there’s a change in circumstances. So if the foreign entity moves or changes ownership, you’ll need a new form within thirty days. So much fun.

When you think about it, both systems — OFAC and the IRS — are really about the same thing, which is verifiable integrity. They ask, “Who are you dealing with, and can you prove it?” OFAC wants to ensure that the money isn’t funding a prohibited activity. The IRS wants to ensure that tax obligations are properly allocated. Accountants operate right in the middle, which is a painful place to be. If these requirements become too onerous, I can see a lot of nonprofits deciding to not send money to any foreign entity that would be considered even remotely questionable. Not only is there a great deal of expensive bureaucracy involved, but a nonprofit could also be hit with fines that can reach into the millions – for just one violation. And, for that matter, a failure to collect or validate W-8s can make the payer liable for the taxes that should have been withheld.

In short, complying with sanctions and tax requirements is not easy, and it’s not going away. So, the next time you hear about an international organization rushing funds to a crisis zone, remember that there’s a team of accountants supporting the funds transfer. They’re verifying beneficiaries, confirming licensing, reconciling W-8s, and ensuring that no money ends up where it shouldn’t.

And a final thought. Why did I focus on just nonprofits in this episode? For-profit organizations have to deal with these issues too, but there’s one important difference. For-profits set up supply chains in other countries, and once they’re set up, there isn’t really a whole lot more to worry about. But nonprofits are always sending money into disaster areas, and that involves making payments to different players on the other end all the time. Which brings up the issues that I’ve noted in this episode.

Accounting for Labor Unions (#383)

A labor union is officially defined as a collective organization of workers that negotiates with employers over pay, benefits, and working conditions. The overall intent is to give workers greater bargaining power.

Labor Union Tax Treatment

Legally, a labor union is organized as a nonprofit entity under Section 501(c)(5) of the Internal Revenue Code. This is not the better-known 501(c)(3), where donations are treated as tax-exempt. Instead, Section (c)(5) lumps labor unions in with farm bureaus and agricultural cooperatives, where the intent is to improve the conditions of work – that would be unions – or of products – which would be the farm bureaus and cooperatives. For these types of organizations, Section (c)(5) provides a federal income tax exemption, but they are not classified as charities, so you cannot deduct any contributions to them.

Accounting for a Labor Union

So, let’s get to the accounting. A labor union has two main sources of revenue, each of which is tracked separately. The biggest is member dues, which are paid on an ongoing basis. Depending on the situation, they’re usually forwarded to the union by employers, which deduct the dues from member paychecks. The second largest source of revenue is initiation fees, which are charged when a new member joins the union.

All other forms of revenue are supplemental, which is to say that receipts may be few and far between. For example, a foundation might issue a grant to a union, or the union might earn interest on its investments. Or, the union might earn some modest revenues from the sale of merchandise or training programs. Maybe the most interesting one is the special assessment, where the union charges its members for a special activity, such as to increase the size of a strike fund, or to help pay for a lawsuit.

But out of all the revenue sources, the key one by far is member dues. This has got to be tracked separately, which is why – of course – there’s union management software. These systems have automated dues tracking that reconciles employer remittance reports with individual member accounts. The software also posts receipts to the general ledger. Some examples of these software packages are UnionWare and Union Impact.

Now as for operating expenses, I’ll only deal with the unique items. A labor union incurs a bunch of expenses in the area of representation and negotiation. This means paying for negotiators, grievance handling, and arbitration. This does not just involve the cost of labor – there’s also a significant expense for travel, and meeting facilities, and in specialized cases, the union might also need to pay consulting fees.

But there’s more. A union might also pay benefits directly to its members, of which a massive one is strike benefits during a work stoppage. And on top of that, a union might pay for training programs and educational assistance. The training cost may include holding workshops for members, as well as sending the staff to conferences and conventions.

In addition, unions like to engage in a lot of lobbying to influence legislation in their favor. This means incurring expenses for political action committees and lobbying.

And finally – one more unique area – unions can spend a lot of money on recruiting new members, which means paying for outreach campaigns, putting on events, and paying staff organizers. This is actually a really critical area for unions, since there is such a thing as member churn. You have to bring in enough new members to replace the ones that leave, which means that this expense can be substantial.

So, that covers revenue and expenses. What about accounting issues? The biggest one is always the tracking of member dues, since that’s where the bulk of their revenues come from. Dues reconciliations can be fairly hard, because you have to adjust for members who’ve changed employers, or who work multiple jobs, or who shift between full-time and partial-time status – all of which can impact their dues obligations.

Here's another accounting issue. Unions have lots of layers. There may be a local, which is a subdivision of a national union that represents workers in a specific area. Above the locals is the national union, and there might be an international organization above that. When this is the case, you have to allocate member dues between each of these organizational layers. And, while doing so, you also have to account for the transfer of funds between each of these entities.

Another accounting issue is the handling of funds. An accountant for a union might set up a strike fund to pay members during a strike, and a defense fund to pay for any number of member legal issues, and a political action fund, and a training fund. These are needed to ensure that funds are set aside for specific purposes, but are also needed to ensure that a union doesn’t break the law – which it will if it diverts strike funds to some other purpose, like lobbying.

Another unique accounting area relates back to all of those funds being spent on political action committees and lobbying. When you do that, you have to segregate these expenses in order to comply with campaign finance laws.

Labor Union Reporting

And along a similar line, the Department of Labor requires that unions sent it a very detailed annual report; the level of detail that has to be reported depends on the volume of receipts that a union receives. For example, if a union receives at least $250,000 in a year, then it has to file the most complex form, which is the Form LM-2; it requires information about receipts and disbursements, itemizations of the larger disbursements, employee compensation, and a bunch of asset and liability ending balances. The main issue here is that unions have more reporting requirements than other types of nonprofits, which can be a major administrative burden.

Labor Union Fraud Issues

I’ll touch on one more issue, because it appears in the news every now and then – which is the theft of funds from unions. Unions have an inherently difficult control environment, because they receive funds from many employers, and then disburse it at multiple levels. You could lock down the theft opportunities with a large accounting staff, but most unions are understaffed, and so don’t have enough people to watch over this.

As an example, several officials of the United Auto Workers union, including two former presidents, were convicted of embezzling millions of dollars of union funds between 2017 and 2021. Another example is the American Federation of Government Employees – the treasurer of one of its locals embezzled more than $80,000 of union funds in 2021. And then there was the financial secretary of a United Steelworkers local that embezzled more than $150,000 back in 2016. In short, yes – controls are a very major concern for unions.

Accounting for Wind Power (#382)

Asset Capitalization

The topic of this episode is the accounting issues for the wind power industry. Let’s start with the capitalization of assets. A wind power installation is comprised of turbines, blades, gearboxes, and towers. Turbines have a useful life of about 25 years, while the blades don’t last as long – usually in the range of ten to twenty years. The issue with blades is that they’re subject to weather damage, and so might have be replaced a couple of times over the life of a tower.

Gearboxes last for the shortest amount of time, usually in the range of seven to ten years, and require a lot of maintenance even during that period of time. And finally, the towers that support all of these other items can last for 25 to thirty years. They’re made of heavy steel, and so last longer than the other components.

Given the differences in asset lives, each of these asset types has to be recorded and depreciated separately.

Another issue, and one that’s similar to solar power installations, is the capitalization of interest costs. If you’ve incurred debt to pay for an investment in a wind farm, then you should capitalize the cost of the interest incurred during the construction period, and then depreciate it over the useful lives of the related assets.

Asset Impairment

A somewhat related issue is asset impairment, and this is where wind power can differ a lot from solar power installations. An issue that’s cropped up in just the past few days is that the current administration thinks that wind farms are not good, for a variety of reasons, and so is withdrawing its approval from a number of wind farms, especially off the coast. I won’t get into the reasoning, but the main point from an accounting perspective is that a withdrawn operating license means that an entire wind farm would then be inoperable, so that you’d have to write off the entire capitalized cost. All of it.

However, it’s not really that simple. You would write off a wind farm when it’s probable that the facility will not be operable – which could depend on the outcome of one or more lawsuits and regulatory challenges. And that might take years.

During that time, you’d have to get with your legal team to estimate the probability of the facility being shut down, and recognize impairment based on that analysis. This is more of a qualitative issue than a quantitative analysis, so whether an impairment should be recognized at all, and in what amount, can be really hard to determine.

But there’s more to asset impairment than just presidential disapproval. An initial site analysis for a wind farm might estimate a certain wind speed over a certain number of hours per year. If you then install the towers and find that the wind speeds are lower than expected, then that reduces the amount of revenue generated, which can trigger an impairment. And on top of that, you may find that there are mechanical failures, especially in regard to the blades and turbines. If so, you may have to write them off and install replacements.

Asset Retirement Obligations

Which brings us to asset retirement obligations. A wind farm operator will probably have to recognize a liability for the cost to dismantle a wind farm at the end of its useful life. Dismantling is not an option – a requirement to do so is usually built into the operating license.

This can be expensive, because you have to dismantle and remove some very large structures, and excavate the foundations, which can extend ten to fifteen feet underground. In addition, fiberglass blades can be very hard to recycle. This is because they’re made of a fiberglass and reinforced plastic composite, which makes them nearly impossible to melt down. Instead, they may end up in a landfill, or be shredded and used as a cement reinforcement.

You also have to remove underground cables, substations, and transmission tie-ins, and restore the land. And on top of that, the jurisdiction in which the wind farm is located might decide to tighten up its reclamation requirements at some point in the future, which can increase your obligation even more.

And, if the wind farm is located offshore, then the retirement obligation can be an order of magnitude greater, because you have to conduct seabed restoration, and remove underwater cables, and eliminate anything that could impact ship navigation.

Revenue Recognition

The next accounting topic is revenue recognition. A wind power provider earns revenue under a power purchase agreement, where it sells electricity to a customer, usually at a set price and for an extended period of time. Under this arrangement, revenue is recognized when the system delivers electricity to the customer. If a wind farm goes offline for any reason, such as when the wind speed drops, then there’s no revenue.

The business might also sell renewable energy certificates. As I mentioned in the last episode, a renewable energy certificate represents the environmental attributes of one megawatt-hour of electricity that’s been generated from a renewable energy source. So, when a wind farm generates electricity, it produces two outputs, which are the actual electricity and a renewable energy certificate, which certifies that the electricity was produced from a renewable source. These certificates can be sold separately from the electricity, so that some other organization can claim to have used the renewable energy even if they didn’t directly receive the electricity. This third party would use the certificate to either meet its own sustainability goals, or meet a regulatory requirement to use renewable energy.

Under these certificate arrangements, the producer of wind power recognizes the value of the certificates when the electricity has been produced. It usually records them as inventory that’s being held for sale, and values them at fair market value, which is the rate at which the certificates are trading in the local market. When it sells a certificate, it recognizes revenue when control over the certificate is transferred to the buyer.

Market prices for renewable energy certificates can have a lot of variability, even within a short period of time, so if the seller retains ownership of the certificates for an extended period, it might have to test them for impairment.

One more revenue issue is that the seller might sell both electricity and renewable energy certificates to the same customer. If so, it will need to break out how much of the revenue generated is associated with the electricity, and how much is associated with the certificates, and record them separately.

Expense Recognition

There are also a couple of expense issues to be aware of. Wind farms are typically constructed on grazing or farm land, where the landowner is entitled to a percentage of the proceeds from any revenue generated, rather than just being paid a fixed fee. If so, you’ll need to calculate the amount of revenue sharing paid to the land owner, which is recorded as an expense.

Another expense is leases on land use. This is usually structured as a very long-term lease that covers the entire estimated life of the assets installed on the land. If so, you’ll need to record a long-term lease obligation, which includes the right-of-use asset.

Accounting for Solar Power (#381)

I’m only going to cover businesses that set up solar panels and sell the resulting power into the power grid, not the panels installed on someone’s house.

Capitalization of Solar Costs

Let’s start with the obvious accounting item, which is capitalizing the cost of the panels. This includes the cost of not just the panels, but also any associated racking systems, and batteries, and inverters. In case you’re wondering, a solar panel produces direct current, and an inverter is needed to convert direct current into alternating current, which is what your typical power grid produces. But we’re not done capitalizing yet, because we also have to capitalize the installation cost, and permitting and inspection fees, and interconnection fees. The interconnection fee is the one-time charge to hook up the solar panels to the local power grid.

And on top of all that, if you’ve taken out a loan to pay for everything, then you’re supposed to capitalize the cost of the interest incurred during the construction process. In short, pretty much every initial cost is capitalized.

Depreciation of Solar Assets

There are also depreciation issues. Solar panels have a fairly long useful life, so they can be depreciated for anywhere from 20 to 30 years, but inverters and battery storage systems wear out sooner – anywhere from five to 15 years – so you have to record these assets separately and depreciate them over different periods of time.

Impairment of Solar Assets

A further issue is the impairment of solar assets. There are lots of issues that can cause impairment. For example, solar panels naturally degrade over time. The typical degradation rate is between 0.5% and 0.8% per year, which can be worse in a harsh climate where there are greater temperature extremes or higher humidity. If there’s a higher-than-expected rate of degradation, then you have to record an asset impairment.

And there are other issues that might trigger an impairment. For example, there might be a fire, or flooding. Or, for that matter, if there’s a decline in the tariff rate on solar panels, then the market value of the existing panels declines, which triggers an impairment. Another cause is technological obsolescence, which happens whenever more efficient panels become available.

And, for that matter, you’re going to have asset impairment if there’s a long-term drop in the demand for electricity, since that lowers the revenue you can potentially receive; this last one may not be so big of an issue if you’ve entered into long-term contracts to provide electricity at fixed rates. Nonetheless, given the long-term nature of this asset, there’s a pretty good chance that one or more of these triggering events could occur over the life of a solar asset. In short, an impairment charge is quite possible, if not likely.

Revenue Recognition

The next accounting topic is revenue recognition. A solar power provider earns revenue under a power purchase agreement, where it sells electricity to a customer, usually at a set price and for an extended period of time. Under this arrangement, revenue is recognized when the system delivers electricity to the customer. If the solar array goes offline for any reason, or if it’s cloudy, or snow covers the panels, then there’s no revenue. Which is why there are so many big solar installations in warmer areas where there aren’t many clouds – it’s all about the revenue.

The business might also sell renewable energy certificates. First of all, what are they? A renewable energy certificate represents the environmental attributes of one megawatt-hour of electricity that’s been generated from a renewable energy source. So, when a solar array generates electricity, it produces two outputs, which are the actual electricity and a renewable energy certificate, which certifies that the electricity was produced from a renewable source. These certificates can be sold separately from the electricity, so that some other organization can claim to have used the renewable energy even if they didn’t directly receive the electricity. This third party would use the certificate to either meet its own sustainability goals, or meet a regulatory requirement to use renewable energy.

Under these certificate arrangements, the producer of solar power recognizes the value of these certificates when the electricity has been produced. It usually records these certificates as inventory that’s being held for sale, and values them at fair market value, which is the rate at which the certificates are trading in the local market. When it sells a certificate, it recognizes revenue when control over the certificate is transferred to the buyer.

Market prices for renewable energy certificates can have a lot of variability, even within a short period of time, so if the seller retains ownership of the certificates for an extended period of time, it might have to test them for impairment.

One more revenue issue is that the seller might sell both electricity and renewable energy certificates to the same customer. If so, it will need to break out how much of the revenue generated is associated with the electricity, and how much is associated with the certificates, and record them separately.

Decommissioning Solar Assets

Another accounting issue relates to decommissioning solar assets, which means dismantling and disposing of solar panels at the end of their useful lives. This might involve recognizing an asset retirement obligation early on, which is adjusted based on your most recent best estimates of which the decommissioning will cost.

Decommissioning can be fairly expensive, for a couple of reasons. First, some solar panels contain hazardous materials, like cadmium and lead, which require special disposal operations. And on top of that, batteries contain all kinds of toxic materials. And second, the cost to recycle panels is fairly high, and for the parts you can’t recycle, there’s a landfill charge.

Accounting for Water Authorities (#380)

The topic of this episode is the accounting issues pertaining to water authorities. This is not a small area, because there are about 150,000 water authorities of various sizes just within the United States. Even a smaller country may have a few thousand of them.

The Nature of a Water Authority

To begin, what is a water authority? It’s a government entity that’s responsible for managing the supply and distribution of water within a specific area. In some cases, it also includes wastewater management.

Enterprise Fund Accounting

So, let’s get into the accounting. These organizations are accounted for as enterprise funds, which means that they’re accounted for pretty much like private businesses, where they charge fees in order to recover their expenses.

Infrastructure Accounting

They tend to be really heavy on infrastructure investments, like dams, pumps, and pipelines, so a major part of the accounting is capitalizing the cost of these assets correctly and depreciating them over, in some cases, a really long time. To do this properly, you need to maintain detailed accounting records that support how each asset was valued, as well as any additions, retirements, and impairments.

And, as I just noted, all of that infrastructure is subject to impairment. If the service utility of an asset declines, you’re looking at an infrastructure impairment. For example, what if a water authority spends a few million dollars on a pipeline from a reservoir, and then there’s a drought? If the reservoir dries up, then the pipeline is useless, and you could be looking at a massive impairment charge.

Infrastructure Funding Sources

Another accounting issue relates to how that infrastructure is financed. This is usually through revenue bonds, where the authority pays back investors from the revenue it receives from the projects being funded. For example, you might issue $50 million in revenue bonds to finance the construction of a dam, and then pay back the investors from the fees charged to the users of that dam. This means that the accountant has to record the principal and interest portions of each payment made back to the bond holders.

An alternative form of financing for infrastructure could come from a government grant. These grants are classified as non-exchange transactions under government accounting, where the recipient has to recognize both revenue from the grant and the related asset. As the accountant, you have to make sure that the water authority is complying with the terms of the grant. For example, you might only be able to draw down the grant if the water authority incurs specific types of qualifying expenditures.

There’s an additional issue that arises when these grants come from the federal government. If so, and the grant is for at least $750,000 within a fiscal year, then the water authority has to undergo an audit. The intent is to make sure that the funds are used properly, but from the accountant’s perspective, it’s just one more paperwork issue to deal with. These audits can take a lot of time, since they also include an examination of controls.

Revenue Issues

A water authority makes its money primarily from user fees and connection charges. These fees are probably subject to approval by the local government, which could result in losses. This is more of a finance issue than an accounting issue, but if you’re handling the accounting, you’ll likely be spending a good chunk of your time documenting why the authority needs to increase its rates.

Another revenue issue is the manner in which revenue is recognized. This is accrual basis accounting, so you recognize revenue when it’s earned, not when cash is received from customers. The implication here is that you can’t release financial statements unless you’re pretty comfortable with the accuracy of your water usage tracking systems.

Pollution Remediation Obligations

A unique expense that a lot of water authorities have to deal with is pollution remediation obligations. For example, they might have to deal with the cost of replacing lead pipes. If so, the accounting is to recognize the estimated cost of these replacements as soon as they can be reasonably estimated. This can be a massive expense, so as the accountant, you may find that the local government is picking over your estimates to see how accurate they are. And that annoying picking will continue each year, as you update the estimates.

Retirement Plans

Another accounting issue is retirement plans. A water authority might participate in a public retirement plan, which means that someone else is administering the plan. As the accountant, you’ll be generating the related journal entries based on what the plan administrator is reporting to you.

Control Systems

And then we have systems of controls. Water authorities have to set up and monitor some unique controls. For example, you’ll need controls over the misreporting of water usage and the manipulation of meter data. And, from the perspective of the accounting software, you’ll need access controls over who can alter the rates being charged to customers. The purchasing side of the business needs a lot of controls, since water authorities can spend vast amounts on construction. There need to be controls over how supplier contracts are authorized, and whether contractors have actually finished the work for which they’re being paid.

I’ve only touched on the most unique accounting issues that you’ll have to deal with in a water authority. As a general observation, the main annoyance will probably be the degree of public oversight over customer billings and requests for rate increases, since these are issues that impact the voting public. If you’re the type of accountant who likes to work quietly behind the scenes, it could come as quite a shock when outsiders want to inspect your work, and maybe criticize it. Something to think about.

AI Tools for Accountants (#379)

The topic of this episode is artificial intelligence tools for accountants. I could go into the background of how AI models are generated, but what’s of more interest to practicing accountants is how to actually use these models in their day-to-day accounting activities. What I’m going to do is describe some of the products that are out there right now, so you can get an idea of what’s available.

AI for Financial Planning and Analysis Software

Let’s start with financial planning and analysis software, and I’m going to use Datarails as an example. What they’ve done is layer AI on top of their software, so it runs an automated trend and predictive analysis to spot issues that you might not otherwise see. That’s useful for flagging problem areas before they escalate. For example, it might spot sales cresting for a particular product way down in just one region, which you might not see by manually scanning the data – which means that you could then take steps to scale back on the inventory for that item in that particular region. In addition, it uses AI to automatically generate presentations from the underlying data. This can keep you from spending hours creating a PowerPoint presentation for upper management. So in this case, the AI component provides value by spotting trends and anomalies, as well as by saving time in constructing presentations.

Datarails is not the only company using AI in its financial planning and analysis products. Oracle and Planful have similar capabilities, and I’m sure you can find other products. The main issue here is that these are higher-end products, where customers expect these companies to be on the leading edge of innovation. So, unless you’re willing to spend a lot of money on software fees, you probably won’t have access to these features just yet. Over time, of course, a lot of these features will probably trickle down into less expensive products.

AI for Auditing Products

Let’s switch over to auditing products. All of the Big Four audit firms have auditing software with AI features. Deloitte operates Argus software, while Price Waterhouse has Halo, EY has Helix and KPMG operates Clara. Each one of these systems has an AI engine that reviews large datasets for risk scoring, and irregular transactions, and in at least one case, even scans client contracts to see if they’re dealing with revenue recognition correctly. The great advantage here is that these systems can scan the entire population of a client’s accounting data, rather than just a sample, which massively reduces audit risk.

Operating these systems is expensive, but it’s cost effective for the Big Four, since their clients are big and rich, and so can afford the fees.

There are similar systems available for smaller audit firms that can’t afford to develop their own systems in-house, such as Inflo Audit and Mindbridge AI Auditor. All of these systems are good at flagging unusual transactions, which reduces audit risk. And, some of them even auto-generate workpapers based on your past engagements. So in these cases, the AI component provides value by spotting anomalies, and by reducing the drudgery of creating workpapers. Which is pretty much the same general types of capabilities that we just saw with the financial planning and analysis software.

AI for Accounting Software

And what about standard, off-the-shelf accounting software? AI is starting to appear down at the low end of the market, where QuickBooks Online detects anomalies in your bank feeds, and can even predict when your customers are going to pay their bills – which is kind of nice for cash forecasting.

Lets try another lower-cost package – Zoho Books. It has a smart journal entry feature that recommends which accounts to charge transactions to, which is useful for recurring entries.

Okay, let’s move up market a bit, to Microsoft Dynamics. They have an AI feature that automates bank reconciliations. And NetSuite, which uses AI for automated payment approvals, and also uses AI to assist with matching incoming customer payments to outstanding invoices.

Let’s go way up-market. Oracle’s enterprise resource planning software has an AI feature that evaluates employee expense claims for policy violations or fraud. And let’s not forget SAP, which has a bunch of high-end features. It has predictive accounting, which projects future revenue and expenses using order data and historical trends. Or, and a personal favorite of mine, it uses AI for three-way matching, where the system automatically links supplier invoices with purchase orders and receipts – which can eliminate a pile of work in the accounts payable department.

If there’s one common feature that the AI applications have in accounting software, it’s drudgery elimination – which is to say that it doesn’t necessarily eliminate tasks, but it does present you with the likely best way to proceed – such as with a proposed recurring journal entry, or a proposed three-way match. You still have to review it, but the system now takes away a good chunk of the work. Over time, this may result in some reduction in the low-end work of the accounting department, but on the other hand, you may need better-trained people who understand how the systems work, and who are mostly interested in dealing with anomalies.

And finally, I just have to bring up an earlier prediction, which was in Episode 237, back in 2017, when I took a guess at how artificial intelligence might impact the accounting profession. I’m going to rate that one a swing and a miss. I predicted that artificial intelligence would be used to automate collection calls. Nope, none of the current collection software packages do that. Instead, they use AI to recommend which collection method will work best, and the best timing for contacting customers, and for suggesting follow-up strategies. Which all represent modest efficiency gains, but not the home run of turning over the entire collections effort to a computer. Which concludes my baseball analogies.

What I’ve just brought up represents what a bunch of product designers all think are currently the most cost-effective AI enhancements that can be applied to the accounting profession right now. As time goes by, I’m sure we’ll see more advances. So stay tuned.

Related AccountingTools Courses

AI for Accountants

The Accounting PhD (#378)

Should you earn an accounting PhD? If you become an accounting professor, what are your options for going back into accounting practice?

The Accounting PhD Options

If you get a PhD in this field, the main career track is to be an accounting professor. You could get a job in something else, such as working with an audit firm or being an accounting manager. But if you do, consider whether the cost-benefit is effective. It will take a solid five years of work after getting a bachelor's degree, and possibly a master’s degree, too, and during that time your compensation is going to be pretty low. So, you’ll be trading away a half a decade of your life in exchange for a PhD.

So let’s talk about the roles for a freshly-minted PhD. I’ll leave the obvious one of being an accounting professor for last, and start with auditing. As I’ve pointed out in other episodes, the audit track at a major audit firm is designed to take in younger people and put them on a rigid path that either kicks them out or turns them into partners about 15 years later. So if you’ve already spent the minimum of an extra five years to pick up a PhD, you’ll already be well behind all those other youngsters. You might even be starting off as a staff auditor and reporting to people who are younger than you.

Next up. What about applying for a job as an accounting manager in the private sector? Sure, you could, but I’m not sure if there’s any advantage to having a PhD. Manager positions require a history of – well, managing – which you will not have built up while getting the PhD. If anything, having a PhD on your resume might even be off-putting for potential employers, since they won’t know if you’re planning to leave the job to go back to academia.

And then we have the accounting professor option. The good news is that there’s a shortage of professors out there, so you can probably get a job. Though a downside is having to move to wherever the university is located, so you might end up in a less desirable location. Compensation is a tough one to pin down. According to the job sites, you can start at under $100,000 and go over $200,000, while the mid-range is somewhere around $125,000 to $175,000.

In short, the only realistic career track for an accounting PhD is to become a professor. For any other adjacent career tracks, having a PhD doesn’t provide you with any particular advantage, and if anything, it could be a hindrance.

I’m not trying to argue a case not to get a PhD, though. If you like to teach, then this could be perfect for you. And especially if you like taking your summers off. And if you can get tenure, then it’s a very stable job.

Moving from Academia Into Business

Next, what is the career path if you want to go from an accounting professor into accounting practice? As I’ve already pointed out, going into the private sector as a manager or going into an audit firm as an auditor don’t really give you any advantages. But there are a couple of possibilities.

One option is to go into a highly specialized area, like the accounting for derivatives. This might be the case where a large bank or an international company wants to have an on-site expert who can reliably deal with that very specific area. In essence, you’d be locked into a role as an expert, so there might not be a great chance at being promoted out into a more general role. The same option goes for a large audit firm. The Big Four always have people on staff who are expected to be absolute experts in very specific areas, and they’re expected to advise audit managers who have questions. These positions can pay quite well.

And then there’s the possibility of going out on your own as a CPA. A lot of accounting professors have CPA certifications, and if so, then this is an OK option. If so, putting “PhD” on your business card might attract a few more clients who might be impressed by it. On the downside, as a sole practitioner, you’ll have to attract clients, and that is not easy. You’ll likely be working with smaller clients, and to do even that, you’ll probably have to charge lower fees.

Which brings me to one more option, and maybe the best one for accounting PhDs. If you’re already a professor, then a common side gig is to do consulting on any number of topics. You can do research on topics that might attract the attention of large multinationals, and build up quite a good consulting practice on the side. If it eventually generates enough income, then you might be able to drop the professor position and just be a full-time consultant.

So, in short, an accounting PhD tends to result in exactly one job, which is accounting professor. And once you have it, you’d better like being a professor, because the options to get back out are rather limited – or at least very tightly defined.

Capital Budgeting in a Trade War (#377)

The topic of this episode is based on current events in the United States, and it is how to do capital budgeting during a trade war.

Trade War Issues

Let’s define the issues. When a tariff is imposed, the importer of the goods pays the tariff amount to the government, which means that it’s up to the importer to decide whether to absorb the cost of the tariff or to pass it along to the customer through a price hike, or a combination of the two. Given the massive amounts of the tariffs being imposed, it’s extremely likely that a large part of the tariff cost is going to be passed along to the customer. That’s the first issue.

The second issue is the duration and amount of the tariff. Usually, the tariff amount is low, and the probability of it changing is also low. In fact, tariffs usually only change when a new trade deal is approved by the government, which is pretty infrequent. And when a new trade deal goes through, tariffs generally go down, not up. But in this case, the tariff amount is high, and the volatility of the changes is also high, which makes for an extremely uncertain environment.

The third issue is how long the tariffs are likely to last. In this case, there’s a high probability that the tariffs will be eliminated or at least reduced at the end of the current administration, so we’re looking at a duration of somewhat less than four years. And keep in mind that this is a trade war, so other countries are imposing similar tariff amounts on goods being imported from the United States.

Capital Budgeting in a Trade War

Given these issues, how do you make a capital budgeting decision that makes any sense? The first consideration is that you’re looking at making an investment in what is now a high-cost, protected market. This means that the United States is the worst possible place to invest in large facilities from which you plan to export goods to other countries – and especially because it’s very likely that other countries are going to slap tariffs on any goods that you ship to them from the United States.

Instead, any investment should result in just enough capacity to meet local demand within the United States for the duration of the current administration. If there’s a large step cost in that facility that you’ll have to pay for to increase your capacity level, then the wise choice is to not incur the step cost, and instead keep the capacity level lower, so that you’re not investing too much. If that means that you lose some sales, then so be it.

Another consideration is that, if you’re producing goods within the United States, the cost of some of your inputs will probably increase, because some of them are coming in from outside the country, and tariffs will be getting charged on them. Since you’re the customer for these supplies, that means that your costs are going to go up. And when that’s the case, you’ll probably have to increase prices to your customers, which means that demand will decline. And that gets back to the need to keep your investment in new capacity as low as possible.

Your next consideration is how to spread the risk of loss, in case tariffs are later dropped, and cheaper competing goods start coming in from outside the country. There are a couple of options. First, consider outsourcing your manufacturing to someone who’s already constructed facilities within the country. Sure, the per-unit cost will probably be higher, but on the other hand, you’re not investing in new facilities. Another option is to enter into a joint venture deal with some other company, so that you can split the risk with them.

Another option is to pause all investments in the country until the current administration is out of office. After all, you can always invest in other parts of the world. The United States is responsible for about 15% of global trade, which of course means that 85% is everywhere else. So, a pretty safe option is to work on other capital investments elsewhere, and just avoid the uncertainty.

A lesser option is to sell off your investments in the country and get out entirely. This is an unlikely option, since a reasonable assumption is that the tariffs will go down or be eliminated in four years, and business gets back to normal. However, if the next administration decides to continue with the tariffs, then you’ll need to explore whether your business can realistically generate any profits within the country, and then maybe consider selling out.

Yet another possibility is to apply a really high discount rate to your net present value calculations for any proposed new investment, based on the extremely high risk level in the current environment. If you can come up with a wildly profitable investment that still generates a positive net present value, then have at it. This sort of investment would be quite rare – something that can start generating positive cash flow almost immediately, with a large return, so that the payback period is really short. The downside is that I have no idea how you’d even come up with a reasonably valid discount rate; it would probably be a wild-ass guess.

Here's another option. Spend the next few years investigating suppliers within the United States to see if they can reduce their prices and increase their quality levels to match what you’re already getting from your suppliers elsewhere in the world. I’m assuming that this might be a substantial effort, since you’d already be using adjacent suppliers if it made sense to do so. This sort of investment is relatively low, and it could take a couple of years to bring the new suppliers up to your standards. But by the time the trade war is over, you may have shorter supply lines, which reduces your transportation expenses, and which protects you in case there’s another trade war at some point in the future.

And one other possibility. You could treat this time as a good period for experimentation, and just invest in pilot projects to see if some new business ideas might be profitable. These investments would be small, so losing your investment would not be a big deal. And if any of the pilots work out, then you’d be well positioned to make larger investments after the trade war is over.

Related AccountingTools Courses

Budgeting

Capital Budgeting

Transfer Pricing (#376)

The Nature of Transfer Pricing

Transfer pricing refers to the prices at which assets are transferred between related businesses within a multi-national business. So for example, let’s say that you have a cell phone manufacturer that produces computer chips in South Korea, and then inserts the chips into phones that are assembled in Vietnam, with the phones then being sold in India. Which, in case you’re curious, is exactly what Samsung does.

The manufacturer has to set a transfer price at which it sells the chips made by its South Korean subsidiary to its Vietnam subsidiary. When setting this price, the number one decision is how you want to allocate profits between the subsidiaries. If South Korea has a higher corporate tax rate, then it makes sense to set a low price for its chips, so that the South Korean subsidiary reports a very low profit, and maybe no profit at all. That way, the income tax paid will be very low.

Meanwhile, the Vietnam subsidiary, which is subject to a lower tax rate, is buying chips for a low price, and so reports much higher profits. The result of this price setting is that the parent company, overall, is paying a lower tax rate.

Now, of course, if companies did this all the time, then the countries that impose higher corporate tax rates would never collect any money from their multi-nationals, since reported profits are all being shifted elsewhere. Which is why the national tax authorities impose what’s called the arm’s length principle, which states that a transfer price should be similar to what unrelated parties would agree upon in a free market. Well, that’s nice, but how does a government prove that a company is following the arm’s length principle? There are a bunch of ways.

Transfer Pricing Documents

First, most countries requires businesses to submit a set of transfer pricing documents. The names of these documents may differ by country, but there’s usually a master file, which contains the organizational structure and operations of the business, as well as its transfer pricing policies, and how it allocates income across jurisdictions. The master file helps tax authorities get a big picture view of an organization’s operations.

Next, there’s the local file. This contains country-specific details on intercompany transactions, and how the business justifies its transfer pricing.

It contains information about the nature and value of related-party transactions, and identifies who those parties are. It also identifies the transfer pricing methodology used, and why it was used. We’ll get into transfer pricing methodologies in a minute. The reason for this report is to give tax authorities a clear view of how profits are being allocated within their jurisdictions.

And finally, there’s the country-by-country report. This contains a breakdown of revenues, profits, taxes paid, and economic activity by country. Its useful for comparing recognized profit to the activity level in each jurisdiction; if there’s a high activity level but a low recognized profit, there’s a good chance that the government will be asking some questions.

All three of these reports are usually issued annually.

Advance Pricing Agreements

So far, this reporting is fairly passive. The business prepares it and sends it to the government in which it has operations. What does the government do with it? One option is the advance pricing agreement, or APA. This is a formal agreement between the business and the government that states in advance the transfer pricing methodology that the business is going to use, so that there are no surprises. In essence, both parties agree on what’s going to be a fair approach, and which transactions it’s going to apply to. These agreements are usually good for somewhere in the range of three to five years, and may be rolled forward without too much additional discussion.

A business might enter into an APA with just one government, which is called a unilateral APA, or it could enter into the agreement with several countries at once, which is called a multilateral APA. The advantage of having a multilateral one is that all parties agree on the pricing arrangement, which helps to avoid any disputes between the parties.

A further benefit of an APA is that a business is at less risk of being targeted by a government audit. These audits examine whether a company’s transfer prices are reasonable. If the government finds any evidence of accounting inconsistencies or manipulation, then the business is going to be hit with penalties and interest. Some countries impose double taxation on these adjustments, so they can be a really big deal.

General Anti-Avoidance Rules

Now, some organizations can get into some serious tax avoidance strategies that are technically legal, but which go against the nature of the underlying transactions. Governments deal with these situations using what are called general anti-avoidance rules.  These rules give tax authorities the power to override tax arrangements that are primarily designed to avoid taxes, and which lack genuine economic substance.

For example, let’s get back to that cell phone manufacturer. Let’s say that it sets up a subsidiary in a zero-tax jurisdiction with no employees or assets, and it routes most of its profits there through some complicated transfer pricing arrangements. Even if those prices seem justifiable on paper, tax authorities could say that the structure has no real business purpose other than avoiding taxes. Therefore, the tax people can ignore it and tax the company as if the income was earned elsewhere.

Transfer Pricing Methods

And, as I mentioned earlier, there are different approaches to transfer pricing – I’ll give you a quick summary of the main methods. There is the cost plus method, in which a subsidiary is allowed to add a markup to the costs that it has incurred, which results in a transfer price. Next up is the profit split method, which allocates the combined profits from the entire value chain to each subsidiary, based on each entity’s contribution to the final product. And then there’s the resale price method, which starts with the resale price at which a product could be resold to an independent third party, and then subtracts the gross margin that an independent reseller would earn to arrive at the transfer price.

Another option is the comparable uncontrolled price method, which compares the price charged between subsidiaries to the price charged to an outside party, to see if it’s reasonable. And finally, we have the transactional net margin method, which sets up a net profit margin relative to the most appropriate base, such as revenues, expenses, or assets related to an inter-company transfer.

I’m not going to explain the details for each of these methods – the point is merely to point out that there are a lot of ways to develop transfer prices, all of which are legitimate, and which can result in differing amounts of profits being recognized in each subsidiary of a multi-national company. So, given the number of options available, it should be no surprise that accountants pay a lot of attention to transfer pricing, and negotiating with governments to get their favored approaches accepted. Which could result in millions of dollars of tax savings.

The Transfer Pricing Career Path

One last item - the career path for an accountant working in this area. First, it’s a good niche to be in, both from the perspective of the company accountant and the government auditor, because both of them can positively impact the cash flows of their employers.

A company accountant can get into this profession by concentrating on cost accounting, while the path for a government auditor also includes cost accounting, but in addition, spending some time as either an internal auditor or as a public accountant, in order to gain experience with auditing work.

And one word of warning; this is a niche area, so you may have trouble getting promoted out of this field, on the grounds that you’re too valuable within it.

Related AccountingTools Courses

Essentials of Transfer Pricing

The Future of Accounting (#375)

The Future of Accounting

What do you think the future of accounting might look like from a business perspective? Will there be more AI, fewer people, will skills change, and do you see anything other than the current accounting process being used?

If you drill down right to the root of what causes changes in the field of accounting, it’s not changes in the accounting standards, and it’s not changes in the labor market. It really comes down to technology changes, and how they’re incorporated into existing accounting systems. Over the last few decades, what I’ve seen is small bolt-on applications being introduced, and which gradually get incorporated into the major accounting software packages. Or, if you use a lower-end accounting package, then you just acquire them on the side and use them on a non-integrated basis. But either way, it would be reasonable to expect that someone will keep dreaming up more efficiencies over time.

Will there be major efficiencies that really cut into the need for accountants? It’s impossible to predict a future invention, since it hasn’t happened yet, but based on the history of accounting systems advances from the past few decades, I would say no. If anything, accounting is a fairly secure field. So, one of the questions posed was, will there be fewer people? If you look at the cost of the accounting department as a percentage of sales, it will probably drift down slowly over a really long period of time, because there will be more efficiencies within the department, simply because best practices are incrementally being installed. That does not mean major layoffs. And, since the economy is usually expanding, that would mean that the market for accountants will probably expand, not contract.

Artificial Intelligence in Accounting

Next, will there be more artificial intelligence? I got a request for a podcast episode on this topic last year, and I haven’t done one yet, because I just don’t see it. There are certainly some niche areas, like using AI to scan transactions for any hints of fraud. And it could be used to write the footnotes for financial statements – though in that case I’d be petrified of putting out incorrect footnotes, so it would take a heavy manual review. Overall, though, I just don’t see the impact. And yes, I will probably do an episode on this later in the year that’s a bit more specific. But overall, I think AI will have a fairly small impact on the accounting profession.

Changing Skills in Accounting

Next, will skills change? Yes, of course. Skill requirements always change. That’s been an ongoing feature of accounting in general, because each best practice that comes along usually requires some extra knowledge. For example, there was a time when inserting a bar code on an invoice was useful for scanning invoice information into the accounts payable system – so you had to learn about bar codes. And then there were biometric scanners for timekeeping systems, which were followed by timekeeping apps on employee phones. And now there’s artificial intelligence, so I’m sure there are accountants all over the world who are going to conferences to figure out how they can use it to become more efficient. For most organizations, I would guess that there’s always some new skill set that’s required for the next new incremental advance. And there always will be.

Changing Accounting Processes

Next, do I see anything other than the existing accounting process being used. No, I don’t. The standard accounting process is baked into every accounting software package on the planet, and every accountant is trained to use those systems. There have been some advances for specialty applications, like backflush accounting, but those only apply to niche areas, and are only available on the most expensive accounting packages anyways. For everyone else, the standard accounting process really hasn’t changed very much.

Variations in Accounting Changes

Now, to go a bit beyond the initial set of questions. If you split accounting into two fields, which are financial accounting and management accounting, then the future of accounting looks a little bit different. Financial accounting is the very standardized process of recording business transactions and generating financial statements. This is the area in which most technology advances occur, because it contains lots of high-volume activities that can be standardized. If you’re going to see job losses, this is the place for it, because ongoing best practices can always make high-volume applications a little more efficient.

Management accounting is intended to assist management with its decision-making, which means reporting on unusual variances, and capital budgeting analyses, and product profitability analyses, and so on. These are much lower-volume applications, so it’s not as cost-effective to implement best practices in this area. Which means that the nature of the work is more likely to stay the same, which means that there’s less risk of accounting jobs going away.

In short, some areas within the field of accounting are more subject to change than others.

Accounting for Tariffs (#374)

Tariff Definitions

First of all, what is a tariff? It’s a tax that’s imposed on imports. There are two types of tariffs. The most common is the ad valorem tariff, which is a percentage of the value of the imported goods. There’s also the specific tariff, which is a fixed fee that’s based on a measurable unit, such as $10 per ton imported.

And one other definition. A tariff is the rate charged on imported goods, while a duty is the amount actually paid. For example, a tariff on something might be 20 percent, while the associated duty that’s paid turns out to be $120.

The Process for Paying a Duty

Next, what is the process for calculating and paying a duty? The importer or their customs broker classifies the goods using the Harmonized Tariff Schedule of the United States, which assigns a 10-digit code to determine the correct tariff rate. And by the way, the Harmonized Tariff Schedule is kind of large. It has about 17,000 tariff classifications. Tariffs can vary a lot by classification, so importers are routinely trying to change the classifications of imported goods to reduce the amount that they pay.

Moving on, the importer has 15 days from the arrival of the goods at a U.S. port to file entry documents with the U.S. Customs and Border Protection Agency. And, because that name is too bloody long, I’m just going to refer to it as U.S. Customs. The key item in this packet of documents from an accounting perspective is the commercial invoice from the seller to the importer. The duty is then calculated based on the value of the goods, which includes the cost of any insurance and freight.

Next, within ten working days after filing this information with U.S. Customs, the importer submits CBP Form 7501, which is called the Entry Summary, along with the calculated duty. Payments are mostly made to the government by ACH, so it’s a direct debit from the importer’s bank. In limited cases, you can also pay with a credit card or a check.

U.S. Customs then reviews the documents and the payment. If everything checks out, then the goods are released for delivery. Sometimes, Customs may hold the goods for inspection, or request additional information.

And then, there are situations in which the importer wants to request a refund from U.S. Customs, which is known as a drawback. You can get a refund when you either destroy imported goods or turn around and export them back out of the country. An importer can also get a drawback for imported materials that are used to manufacture goods that are later exported. There are some paperwork requirements for this, but basically, an importer has to file a drawback claim within five years of the import date. Otherwise, no luck with the refund. Also, U.S. Customs will retain a one-percent processing fee on the refunded amount, though this only applies to certain types of drawbacks. Getting the refund can take months – figure on waiting anywhere from three to six months for it.

Accounting for Tariffs

So, what is the accounting for all of this? Well, the first accounting issue is making sure that you properly aggregate the cost of the imported goods, so that it includes the cost of freight and insurance. This is the customs value, and it’s the basis for calculating the amount of the duty.

Next, multiply the customs value by the applicable tariff rate to estimate the duty. Based on this estimate, create an accrual entry that debits a duty expense account for the amount of the duty, and credit an accrued liability account. This duty is added to the cost of the imported goods.

Then, when you pay the duty amount to U.S. Customs, debit the accrued liability account for the amount paid, and credit your cash account.

In addition to all that, it’s quite possible that there are some uncertainties about either the customs value that was used to calculate the duty, or the tariff rate that was applied to it. If so, there’s a reconciliation process that you can enter into with U.S. Customs, which might result in an alteration to the duty amount. If so, that calls for another accounting entry, which might occur well after the imported goods have already been sold. If so, this could result in a significant increase or decrease in the importer’s cost of goods sold, and possibly well after the fact.

The Financial Investment Impact of Tariffs

That covers the accounting. But in addition, I’d also like to cover the current tariff situation from the perspective of the chief financial officer. When you’re a CFO, the really large capital investment decisions are always going to go across your desk. For example, building a car assembly plant in Mexico, versus the United States. These types of massive investment decisions are based in part on the existing tariff rates, as well as expectations for where those rates will be during the discount period for the investment – which probably covers something in the range of ten to twenty years.

As long as you have some certainty about the applicable tariff rates, then you can make an investment decision, and reasonably expect a decent outcome.

It’s usually not too hard to do so, since the existing tariffs are covered by a treaty – in my example, that would be the USMCA Agreement, which covers the U.S., Canada, and Mexico. The president can override that treaty, because Congress has given him the authority to adjust tariffs on imports that threaten to impair national security. I’m not entirely sure how the import of cars assembled in Mexico is a threat to national security, but that’s how he has the authority to do this.

So, let’s say that the tariff suddenly goes up by 25%, and then the change is withheld at the last minute, and then it’s imposed again the next month, and so on, and so on. As a CFO, what do you do? One option is to rebuild the assembly plant in the United States, but keep in mind that these are massive investments, and they take years to construct. And you also have to convince suppliers to set up their operations adjacent to your new plant. And then there’s also the issue of higher expenses for pretty much everything in the U.S., as well as construction delays from permitting. If you were to rebuild everything in the U.S., then the cost to construct a car goes up – by a lot – which means that you have to increase the prices of your cars, which in turn will probably drop demand. And that will kill your profits.

So, again, what do you do? If it were me, I’d review every pending project to see which ones have the lowest cost disadvantage in the United States, and which can be built fast, and then use those commitments to try to keep avoiding the imposition of new tariffs on cars coming in from Mexico. Basically, do the minimum until the next administration comes along in four years, and hope for more stability with tariffs.

In short, constantly threatening big tariff increases will probably result in a small increase in U.S. investments in the short-term, but overall, I can see the major corporations looking at their investment calculations, and deciding that the prudent thing to do is to just wait for four years. Which, overall, results in less investment.

Accounting Training for the CFO (#373)

The Level of Accounting Training that a CFO Needs

What areas of accounting are most important to know to be an effective CFO? Lots of chief financial officers do not come up the promotion path from the accounting department. They could also be promoted in from the treasury side of the business. When this happens, you have lots of expertise in raising money or investing it, but really don’t have any idea what goes on in the accounting department. You may not have taken any accounting classes at all, so this whole area is something of a black box.

The main item to understand is that you don’t need an excessively detailed understanding of accounting to be a CFO – things like how journal entries work, or the details behind the month-end closing process. If you have a reasonably competent accounting team, then they will take care of all that. Instead of going deep, I suggest getting a book on accounting for managers. AccountingTools sells one of these books, and you can find other competing books on Amazon. These books provide you with a basic introduction to accounting concepts, and talk about the financial statements, how to interpret them, the types of accounting reports that are of most use, and how accounting impacts different parts of a business. You can read through one of these books in a couple of weeks in your spare time, and that gives you a high-level understanding of what’s going on.

Is that enough? No. Being a CFO means that you’re responsible for risk management, and there are a fair number of areas within accounting that can go wrong. And you will be the person who’s responsible for those failures. For example, if you become the CFO of a publicly held company, you have to personally certify that the financial statements being released every quarter are accurate. If the financials are not accurate, then you personally could be criminally liable.

The Need for Controls Training

Given that you might end up in jail, I think that controls are a pretty good place to gain a deeper knowledge. Now, does this means that you should go crawling all over the company, digging into every control that’s ever been installed? No. That would be a bad use of your time, especially since larger companies may have hundreds or even thousands of controls in place. What it does mean, though, is that you’ll need to offload this work to the internal audit department, or maybe an outside firm.

Let them dig through the company and report back about any shortcomings in the controls. But this isn’t just about delegating the work. You’ll need a fairly in-depth understanding of what controls do, and what makes for a strong or weak control environment. So, in this one area, I’d suggest taking a course on accounting controls, or buying a book about it.

The Need for Risk Training

In addition to controls, you’ll need to understand any accounting areas in which there’s a significant risk of failure. For example, if your company sells software packages that include an installation component and a training component, that means you have a complex revenue recognition environment. In this case, you’d better get a book or a course on revenue recognition. If that’s not the case, and instead your company only sells lawn supplies for cash, then I wouldn’t worry too much about revenue recognition.

Here's another one. What if you’re the CFO of a high-fashion business, where the clothes you sell can go out of style at any moment? Better read up on the accounting for inventory, then, or else you might be caught with an overvalued inventory. But if your company doesn’t even deal with inventory? Then you can skip the topic entirely.

Training Areas to Skip

There are also some areas in which your knowledge of accounting can be pretty low and stay that way, because they’re basic nuts and bolts accounting topics that are usually fairly well run. That includes billings, accounts payable, and maintaining the general ledger. As long as they have the appropriate controls, of course.

Industry-Specific Training

And then there are very specific accounting topics that you’ll need to know about only in certain industries. For example, if you’re the CFO of an oil & gas firm, you’ll want to know all about the capitalization of drilling expenditures. Or, if you’re the CFO of a shipping company, you’ll really need to understand the capitalization of dry docking expenses. And if you’re running a nonprofit, then you’ll need to understand the finer points of how to classify expenditures as program-related or as management and administration – and if you get wrong, you’ll get pounced on by donors. So, when you’re hired into one of these businesses, sit down with the CEO and the controller, and discuss whether any of these super-important accounting topics exist – and then dig into them in detail.

Training to Manage the Department

That covers understanding accounting from a risk management perspective, but not from a management perspective. If you are the CFO, then you’re responsible for the accounting department, which means having an understanding of how it runs. To do this, your best bet is to get a book on the controller position.

I have one called The New Controller Guidebook, and you can find other ones on the market. The main point is to understand when the accounting department is operating correctly, and when it isn’t.  This doesn’t require an in-depth knowledge of accounting, but you will need a set of metrics for the department. For example, you might want a report on the time taken to produce financial statements each month, or the number of early payment discounts that were lost, and certainly something that lists the total compensation expense of the department. You can benchmark that last number against industry standards to see if it’s reasonable. It’s important, because compensation is the biggest expense within the department.

Training for the Financial Statements

Outside of risk management and overall department management, the other area in which to get some training is your employer’s financial statements. As the CFO, you’re the person that investors and lenders are going to talk to about specific items in the statements.

Which means that you need to fully understand every single line item in the financial statements, as well as all of the footnotes. Look at this from the perspective of a CFO who’s running a public company. You might do quarterly earnings calls with investors, and they can badger you about absolutely anything that was included in your quarterly Form 10-Q report. So you’d better be prepared.

This means that you’ll need a detailed knowledge of the structure of financial statements and the ratios that outsiders are likely to apply to them. This isn’t difficult. I sell a book called The Interpretation of Financial Statements, as well as the Business Ratios Guidebook, and again, you can find alternatives on Amazon. Read these books in detail, and keep them on your bookshelf. You might have to refer to them a lot, especially during your first few months on the job.

In addition, you’ll need to sit down with the controller and go over the contents of every single line item in the financials, so that you really understand what goes into them. And, you’ll need to do this after every set of financial statements is released, because you’re the one who’s going to be asked about them.

So, what is the learning curve like for all of this? Steep, for the first few months. And if you change industries, then there’ll probably be a whole new set of accounting rules that you’ll need to learn. But realistically, once you get over the initial hump of book learning, it’s mostly about keeping up-to-date on changes within the accounting department, and on changes in the financial statements.

Related AccountingTools Courses

Accounting Controls Guidebook

Accounting for Managers

Business Ratios Guidebook

New Controller Guidebook

The Interpretation of Financial Statements

The CPA Firm Business Model (#372)

The topic of this episode comes from a listener, and it is, please talk about the billable hours model of CPA firms. Do you think that is what’s preventing people from becoming CPAs? Do you think billable hours are an employee surveillance tool? Having enough billable hours and staying within budgeted hours causes me enormous stress. End quote.

Well, that certainly covers the experience of a lot of new auditors! To respond to that, I’ll describe the business model of a large audit firm. Then you can see why new auditors are under so much pressure.

The CPA Firm Business Model

The sole focus of this business model is how much money an audit partner can make. And believe me, they make a lot of money. In order to make that money, they have to tweak how their organizations operate. This involves a couple of changes that put a lot of pressure on their employees. One of these changes is a billable hours goal. When I worked for Ernst & Young, the audit partners came back from one of their retreats and proclaimed that everyone had to work an average of ten billable hours per working day. I have no idea what that number is now, but the main point is that any auditor is going to be reminded – frequently – that they need to meet their billable hours goal. This can be really hard, unless you want to work late and on weekends.

The second point is that you can’t just record any old hours against a client account. You have to charge hours that are actually billable. There’s always a cap on how much of a fee clients are willing to accept without a lot of pushback, so the audit partners want their employees to charge roughly as many hours as were charged against an audit job in the preceding year. If they charge more than that, then the excess is maybe not revenue for the firm, and the partners don’t make as much money.

Therefore, and on top of meeting a billable hours goal, you also have to be efficient. This is really hard for a lot of new auditors who are fresh out of school. They know about accounting and auditing in theory, but they haven’t seen it in practice before. So the expectation to get up and running right away, and also meet a billable hours goal, can be quite a shock. This is why a massive number of new auditors quit in their first year. They find that they can’t be both efficient and billable all at once. It’s not impossible, but it’s designed to be really hard.

Which brings me to the third part of the business model. The focus in a large audit organization is up or out. There’s a very specific promotion path, where you have to be promoted into the next level every year or two, or else you’re counseled out. This occurs at all levels, including at the partner level.  And even if you’re a successful partner, you’ll still be forced to retire, once you reach the mandatory retirement age. And yes, they have to force out nonperforming partners in order to make room for new partners. If you have too many partners in the business, then the profits have to be split among too many people, and that does not maximize the profits that each partner receives.

For example, you might have worked hard for years, make it all the way to senior manager, and then get hit with a new goal, which is to bring in new business. If you can’t generate the revenue – and it’s not easy – then you’ll eventually be pushed aside, to make room for someone coming up behind you. And, what if you do make that revenue target? Then you get promoted to junior partner, rather than full partner. Why is there such a position? Because it puts one more layer between you and the pot of gold that’s paid out to the senior partners.

Exceptions to the Rule

There are a few exceptions. If someone is an amazing specialist in one or two areas, then they may be kept there. For example, my wife turned down a promotion to senior manager for five consecutive years. She kept turning it down, because her billing rate would go up by so much as a senior manager that she knew she wouldn’t be able to generate enough billable hours. She was a really good project manager, so they let her stay where she was. Eventually, though, she was forced to take the promotion, and only lasted another couple of years before her billable hours dropped enough that she just couldn’t stay there any longer. She wasn’t forced out, but she was extremely unhappy. And, there were quite a few nights when I’d have to tell the kids that mommy couldn’t read them a bedtime story, because she was still at work. A few times, she got home at one o’clock in the morning. So, she eventually resigned. And there you have a real-life example.

Nonetheless, the up or out process applies to nearly everyone, and the point is to make sure that there’s always a constant stream of fresh blood coming up through the organization. And somewhere in that new group will be a few people who take to auditing right away, and who are willing to put in the hours to be sufficiently billable, and who can eventually bring in new business, too. As for everyone else, you’re out of luck.

And that is the audit firm business model. You force people to be extremely billable, you weed out the ones who aren’t efficient, and you dump nonperformers to make room for new people.

Why People Still Work at CPA Firms

This sounds brutal, and it is. Why would anyone put up with this crap? The reason is pretty simple. Working for a major audit firm is a big item to have on your resume. If you last a couple of years, then that gives you a big advantage in getting a mid-level accounting job in the private sector. If you can make it to audit manager and stick around another year or two, then you can probably pick up a controller position at a client. Or, if you bail out as a senior manager, it’s not unreasonable to expect a CFO position to open up for you somewhere else. In short, everyone knows the system is rigged against them making it all the way to partner, but they all put up with it anyways.

Does the Business Model Reduce the Number of CPAs?

Now, let’s go back and address a couple of other items that the listener brought up. Does this system prevent people from becoming CPAs? Yes, of course it does. A lot of people quit in the first year – usually about twenty percent of the new hires – and most of them never want to come near the profession again. So in their case, the experience drives them away from the CPA certification. Even if they already passed the CPA exam, they simply have no interest in being a CPA anymore, and they’re not willing to stick around long enough to complete the experience requirement.

Are Billable Hours a Surveillance Tool?

Now, let’s address that other listener question, which is, do you think that billable hours is an employee surveillance tool? Not exactly. It helps to understand how you’re assigned to an audit job. There’s usually a scheduling person within the firm who assigns auditors to jobs. The audit managers talk to these schedulers all the time, to see who they can get on their jobs. If you understand auditing and you’re efficient, then word gets around pretty fast, and all the managers will want you to work for them. But if you’re not, then that information gets around just as fast, and you’ll find that you’re not being scheduled on jobs anywhere near as much. In essence, you’re the last kid on the playground who gets picked to be on a team. And that means that your billable hours will drop, and you won’t make your annual goal. And if you don’t make the goal, then you’re out.

The Differences Between US GAAP and UK GAAP (#371)

What are the differences between US GAAP and US GAAP?

FRC vs. FASB

The first difference is that UK GAAP come from the Financial Reporting Council, which is located in London, while US GAAP comes from the Financial Accounting Standards Board, which is based in Norwalk, Connecticut. And as an aside, I’m not sure how long the Financial Reporting Council is going to be around. Back in 2018, an independent review council recommended to the UK government that it be replaced, but nothing ever happened. Since then, there seems to have been quite a bit of dithering within the UK government over how to replace it.

At a high level, UK GAAP is essentially a variation on International Financial Reporting Standards that generally allows for fewer disclosures than are required under IFRS. A bigger business in the UK will typically use IFRS, while a smaller business or a subsidiary of a larger one would use UK GAAP.

Asset Revaluations

A significant difference between the two standards is in the area of asset revaluation on the balance sheet. This is generally not allowed under GAAP, especially for fixed assets. That is not the case under UK GAAP, which follows the IFRS practice of allowing you to revalue assets to their current market values. This does not mean that you have to revalue certain assets under UK GAAP, only that it’s an option. Since revaluations require more accounting work, I generally advise against it.

Interest Capitalization

A potentially large difference involves whether you can capitalize the cost of interest on construction projects. Under US GAAP, you would capitalize this cost. Under UK GAAP, you have the choice of doing that or charging it to expense. I kind of like the UK approach, since there’s less accounting work involved in just charged off interest expense as it’s incurred.

Intangible Asset Treatment

And then there’s a difference between the accounting treatment of intangible assets. Under US GAAP, you have to conduct at least an annual impairment test for any goodwill assets or other intangible assets that have indefinite lives. UK GAAP has the annual impairment test as well, but it also requires some sort of useful life for all intangible assets, without exception, which is usually capped at ten years. This means that impairment testing is less necessary, since the underlying asset is going to be written off over time anyways.

And speaking of impairment testing, there’s another difference. Under US GAAP, you conduct impairment testing using undiscounted cash flows, while UK GAAP mandates the use of discounted cash flows.

Inventory

Another difference is in the inventory area. Under US GAAP, you’re allowed to use last-in, first-out accounting to value your inventory, while it’s not allowed under UK GAAP. Instead, UK GAAP only allows the use of first-in, first-out accounting, or weighted-average accounting. I think the UK GAAP has it right on this, since there’s very little basis in reality for using the LIFO system. Instead, it’s really just an excuse to drive down your reported profits, on the assumption that your inventory cost is increasing over time.

Product Development Costs

And then we have product development costs. Under US GAAP, you nearly always have to charge all development costs to expense as incurred. That’s not the case under UK GAAP, where you can capital these costs, but only if you can prove the technical feasibility and commercial viability of the product, as well as management’s commitment to sell it. This difference can be fairly significant. That being said, you can also elect to just charge off these expenses under UK GAAP, no matter what.

Contingent Liabilities

There’s another difference in the area of contingent liabilities, though it’s really just a change in the wording. Under US GAAP, you recognize a contingent liability when there’s a probable outflow of resources to settle an obligation, and you can reasonably estimate the amount. Under UK GAAP, it’s essentially the same thing, but now it’s called a provision instead of a contingent liability.

Related AccountingTools Courses

GAAP Guidebook

A New Year's Resolution (#370)

I sometimes talk about something other than accounting, if I think it might be of interest. So, I’ve timed this episode to be just prior to new year’s day, in case you want to try out my suggestion, and roll it into your new year’s resolutions.

The main problem with new year’s resolutions is that they almost never work. You might resolve to walk a bit further during the next year, or go to the gym, or maybe try to stop eating sweets. Good luck with that last one. I ate a couple of chocolates yesterday.

But. I’ve found something that works for me, and has been working for years, so I thought I’d pass it along. I set a target activity for a really stout piece of cardio work that going to happen sometime in the next year – probably in the second half of the year, which forces me to work towards it for months. And this is something that’s actually pretty exciting, and which requires a bit of a monetary investment to do it, so that I’m really locked into the project.

In order to achieve that target, I have to set up a series of training goals that really need to be met in every single month leading up to the event, or else I may not be able to do it. As an example, in 2024, my cardio target was to hike the Grand Canyon rim-to-rim, and to do it in October, when the temperatures are lower. This is not an easy target. You go down 5,500 vertical feet from the South Rim, hike 24 miles across, and go back up 6,500 vertical feet to reach the North Rim. And to make it even more challenging, there’s a shuttle that leaves the North Rim at two in the afternoon to bring you back around to your starting point, so you’ve got to complete the whole thing by 2 p.m., or else you’re pretty much screwed.

That’s a challenge. To train for it, I did a half marathon trail run in each month of 2024 leading up to the hike. And to train for each half marathon, I did a ten-mile trail run about every third or fourth day, on an ongoing basis. Which adds up to a lot of training. And on top of that, I decided to lose five pounds, since I didn’t want to be carrying any extra weight through the Grand Canyon. Now, normally, I have a hard time taking off weight. But when you’ve got a goal like that coming up, it really focuses the attention. So, yes, I lost the weight.

And in case you’re curious, I started from the South Rim at 2:30 in the morning with a headlamp, and finished at the North Rim nine hours and 42 minutes later. And got there in time for the shuttle.

In case you think this was a one-time event for me, no, not really. Let’s roll it back one year. In 2023, the target was the Laugavegur Trail, which runs from north to south in the backcountry of Iceland. If you look up any listing of the most iconic hiking trails in the world, you will definitely find it. The Laugavegur is 34 miles long, and the elevation gain is 7,000 feet. The usual approach is to take a bus from Reykjavik, which is the capital of Iceland, and which drops you off at the northern trailhead at about noon. Most people then take four days to backpack the trail, and they stay at huts along the way. At the south end of the trail, there’s another bus that takes you back to Reykjavik, and it leaves at 2 p.m. Though in this case, there’s also a late bus that departs about four hours after that.

I set a target of starting at the northern trailhead at noon, and catching the bus from the south trailhead at 2 p.m. the next day. So, 26 hours in total. That meant going ultralight with just enough equipment to camp out for one night. And to make things more interesting, there are a bunch of stream crossings to get through, and there have been a few drownings. The risk of drowning is really pretty low, but the crossings will slow you down.

The final score on this one was 24 and a half hours, trailhead to trailhead, and I got to the south end in time to catch the bus back.

So to prepare for the Laugavegur goal in 2023, I had the same intermediate goals of doing a half marathon trail run in every month, with lots of ten-milers to prepare for the half marathons. In fact, the half marathon goal has worked out so well that I’ve now done one in each of the last 103 consecutive months. And that streak is still going.

One problem that has come up over the years is a certain amount of wear and tear. But I’ve found that, if you stay on top of these issues, you can keep going. For example, I had a partial Achilles tendon tear a few years back. Well, there’s an electrical stimulation treatment that can heal the tendon. I had to take a few weeks off and go to the doctor’s office every few days for treatments, but it healed up, and I kept running. The main takeaway from that one was to do a very specific set of lower-leg stretches every single day. So that’s what I do, and the problem has never come back.

Or, here’s another one. I run on some very rough trails, and I was starting to roll my ankles all the time – which is not good. Well, there are strengthening exercises for your ankles that involve using a large rubber band. After a couple of weeks, I stopped rolling my ankles, and it’s never happened since.

In short, over the long term, there’s always going to be an injury, and you might be tempted to stop at that point. Instead, I suggest going to see a doctor immediately, and figuring out the options. With the proper therapy, you might be able to keep going, and actually come out of it with a better training regimen.

And, in case you’re curious, yes, I have another goal in mind for 2025, and it’s to climb the highest peak in Spain. I’m training for it now.

One more item – and call this one a pro tip, in case you plan to hike the Grand Canyon rim-to-rim. If you’re using a GPS to track your mileage, it doesn’t work so well on the north side of the Grand Canyon. The reason is that the trail goes through a slot canyon there, where your GPS has a hard time picking up satellite signals. I found that my GPS was off by almost two miles by the time I got to the North Rim. So, be aware.

And a final thought. If you’re not especially athletic right now, don’t go setting a new year’s resolution to do something that might kill you. A mid-range goal is perfectly acceptable. So if you set a goal and wake up at night, wondering what on earth you were thinking, that’s probably a bit too much of a stretch goal.

All right, one more thought. If the goals I’ve covered in this episode seem like a lot, just keep in mind that there’s always someone out there who is absolutely superhuman. For example, people also hike the Grand Canyon rim-to-rim-to-rim. Which is 48 miles and at least 12,000 vertical feet. And if you think that sounds crazy, the trail running speed record for the rim-to-rim-to-rim is five hours and 55 minutes. Don’t try to keep up with these people. Just set goals that work for you.

Accounting for Crypto Assets (#369)

Accounting for Crypto Assets

Until recently, the rule under Generally Accepted Accounting Principles was that crypto assets were to be classified as intangible assets. This means that when you purchase a crypto currency, you record it at the purchase cost. After the acquisition date, you could not increase the recorded value of the asset, even if the market value went up. Instead, all you could do was record an impairment to the asset if its market value went down. So essentially, it was a one-way ratcheting mechanism that resulted in the lowest possible cost being recorded.

The original reason for this treatment as an intangible asset was that crypto currency was considered to have such a volatile price that it couldn’t be considered a form of cash. And on top of that, it wasn’t issued by a sovereign government. So it couldn’t possibly be considered a form of cash – or, could it?

The problem is that crypto currencies do have value, and – depending on the currency – that value may go up by quite a lot. This resulted in a disconnect, where a business might be recording a crypto asset value on its balance sheet that was far, far lower than its market value.

So, as you might expect, the Financial Accounting Standards Board got a lot of complaints – about 500 of them – about the official line on how to account for and disclose crypto assets. This resulted in a change in the accounting that was announced at the end of 2023. I haven’t brought it up until now, because it’s set to go into effect in about two weeks.

Accounting for Crypto Assets at Fair Value

The new accounting is to account for crypto assets at their fair value, with any changes being recognized right away in net income. What this does is match the reported value of your crypto asset holdings to their market value at the end of each reporting period. If the market value has declined from the previous reporting period, then you recognize a loss. Or, if the market value has increased, then you recognize a gain.

This is a definite improvement in the overall accounting, since now you can really see the current value of someone’s crypto assets. An additional change is that crypto assets have to be listed separately on the balance sheet from all other intangible assets. This makes sense, because the other intangibles are measured differently, with a cost basis that’s subject to impairment testing.

If anything, it looks as though crypto assets are being accounted for like investments in equity securities. That being the case, I have to wonder why crypto assets are still being reported adjacent to intangible assets, when they really ought to be stated further up in the balance sheet, as part of investments. And someday, maybe that will happen.

Crypto Asset Disclosures

Which brings us to the required disclosures. A good one is a required breakdown of your crypto asset holdings. You have to disclose the name, cost basis, fair value, and number of units for each significant crypto asset holding, plus the same information in aggregate for any crypto assets that are not individually significant. This is really useful. Let’s say you’re a lender and you want to evaluate the riskiness of someone’s crypto holdings – this disclosure provides the detail that you need.

There are also some less useful disclosures. For example, if you sold any of these assets, you have to disclose the difference between the cost basis and the sale price. Not sure I see the point.

There’s also an annual roll forward requirement, where you have to present a table that shows crypto asset beginning balances, and subsequent purchases, subsequent sales, and gains or losses. I’m not seeing a good use case for that one, either. Still, overall, this is a significant improvement in the accounting for crypto assets.

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Accounting for Cryptocurrency

Accounting for Carbon Credits (#368)

What is a Carbon Credit?

We begin with, what is a carbon credit? It’s a permit that allows you to emit a certain amount of greenhouse gases, which usually means carbon dioxide. Each carbon credit gives you the right to emit one metric ton of carbon dioxide or its equivalent in some other greenhouse gases. And by the way, one metric ton equals about 2,200 pounds. Governments issue these credits when they’re trying to reduce emissions in order to reduce the effects of climate change.

Carbon credits are part of a cap-and-trade system, where the government sets a cap on the total amount of greenhouse gas emissions that it’s going to allow per year. The intent is usually to reduce the amount of this cap over time, which forces companies to reduce their emissions of greenhouse gases.

Under the cap, a company can either receive or purchase the carbon credits that it needs. For example, if the government issues a manufacturer a permit to issue one thousand tons of carbon dioxide and it doesn’t actually use all of this amount, then it can sell its excess credits. Conversely, if it emits more than a thousand tons, then it has to buy credits for the overage, or else pay the government a penalty.

Under this system, you could buy the credits from an official offset project, such as an operation that plants trees that soak up carbon dioxide. And as an aside, AccountingTools is a partner of the National Forest Foundation, and in the past twelve months, we paid to have a little under 10,000 trees planted. In case you’re curious, each tree planted ends up sequestering about a half of a ton of carbon dioxide over its lifetime, so our annual payments end up sequestering a little under 5,000 tons of carbon dioxide. And we’ve been doing this for a long time. AccountingTools doesn’t actually emit many greenhouse gases – that’s pretty negligible. We just think that it’s a good idea to do something like this.

Anyways, a company can buy these carbon offsets from a third party, or it can purchase carbon credits on an exchange, which is run by the government. When everyone wants to purchase carbon credits, that increases demand, so the price of a carbon credit goes up. Or, if everyone is reducing their emissions, then demand goes down, so the price of a carbon credit goes down.

So in short, the whole concept of carbon credits is designed to create a financial incentive for companies to reduce their emissions.

How to Account for Carbon Credits

The next question is, how do you account for it? That is a multi-step process. The first step is to identify the nature of the carbon credits. Did you buy them on an exchange because of a legal requirement do so, which is called a compliance credit, or did you buy them voluntarily to offset your emissions, which is called a voluntary credit. For example, if you were to buy credits from a provider that plants trees, that would be a voluntary credit.

The next step is to determine the accounting treatment. There’s some argument about whether they should be classified as inventory or as intangible assets. I would say that most use cases would favor recording carbon credits as some form of inventory. If the credits are then used to offset internally-generated greenhouse gases, you would charge them to expense from the inventory account. Or, if you sell the credits to someone else, then you could also charge them to expense from the inventory account.

I’m not really seeing the use case for recording the credits as intangible assets, unless you’re just holding them with no intent of use – which would mean that you’re holding them as an investment that’s expected to appreciate over time.

You can make up your own mind about which way to go with the classification.

There’s no question that the initial recordation of the credit should be at its purchase cost, and you can add in any transaction fees, though there shouldn’t be many. An interesting option if you’re using international financial reporting standards is to subsequently adjust the cost of the credits to their fair value. This option is most possible if the credits are being traded on an exchange, so you can just revalue the credits at the end of a reporting period based on the price at which the credits are trading at that time.

Of course, if you’ve been listening to this podcast for a while, then you’ll realize that I would never recommend adjusting anything to its fair value if you can possibly avoid it. After all, adjustments like that require work, and I don’t advocate spending extra time on accounting transactions if it can possibly be avoided.

So. The next accounting activity occurs when you use up the carbon credits. This is done when you’re officially offsetting carbon dioxide emissions that have just occurred. That involves a credit to eliminate the recorded intangible asset or inventory item, and a debit to an expense account.

Personally speaking, I would record that expense within the cost of goods sold, since it’s directly associated with the operations of your business.

Another possibility is that you sell the credits on an exchange. If so, that could result in a gain or a loss, depending on how supply and demand have impacted the market price of the credits. Realistically, most companies use up all or most of their credits, so the amount sold tends to be pretty small.

And here’s a final issue – impairment. If you’re holding carbon credits that are losing value over time – probably due to a decline in demand on the relevant exchange – then you may need to test them for impairment and write them down to their market value. This applies to credits that are being recorded as intangible assets. If you’re recording them in an inventory account, the same general concept applies, but now it’s called the lower of cost or net realizable value.

From a practical perspective, a business is likely to hold only just enough carbon credits for its own needs, and flush them out fairly quickly – which means that the probability of having an impairment is not all that high. Also, the theory behind setting up a cap-and-trade scheme is that the price of these credits should gradually go up over time, thereby creating an incentive for businesses to emit fewer greenhouse gases. Consequently, the odds of having to take a write-down are relatively low.

Who Accounts for Carbon Credits?

A final point here is whether this whole concept of carbon credits applies to you. In the United States, there’s a cap-and-trade system that covers the eleven states in the northeast, plus California and Washington. Several Canadian provinces also have it, and the Canadian government is setting up a nationwide system that covers its oil and gas sector. China has a system that covers its electricity production. And of course, the European Union has had such a system for a while now. In most cases, these cap-and-trade systems are only targeted at certain sectors, and usually only for larger businesses. If you’re not in one of the targeted areas, then it does not apply.

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Environmental Accounting