Accounts Payable Best Practices (#81)

In this podcast episode, we discuss several ways to improve the payables function. Key points made are noted below.

I think a lot of accounting people would agree with me, that payables is the most incredibly paperwork intensive and generally annoying part of accounting.  The accounting staff is forwarded supplier invoices from all over the company, and then it has to figure out which ones are authorized, and if the related goods or services were received – and then pay it on time.  If they don’t, then suppliers get ticked off and call in to demand payment.  It’s not a very pleasant job.

Shrink the Invoice Volume

So… let’s see what we do to streamline it.  The first order of business is to shrink the overall volume of supplier invoices.  A really good way to do this by issuing company credit cards to employees.  This gets rid of a lot of the smaller transactions that would otherwise eat up all kinds of accounting time.  This doesn’t take long, so you can start seeing the results in just a few months.

A much slower way to reduce the number of invoices is to reduce the number of suppliers.  This requires a lot of work with the purchasing staff to arrive at a short list of approved suppliers.  Over several years, you can achieve a smaller number of invoices that have more line items on them; but it’s still an improvement.

And there’s another way of looking at invoice reduction.  Is it the total number of invoices you’re trying to reduce, or is it the data entry of the invoices into your accounting system?  Because if it’s the second one, you can set up a web site and have your suppliers enter their invoices through that portal.  By doing so, you just shifted the data entry burden onto them.  If you’re a large company, with some power over your suppliers, then this works.  If you’re a small company, don’t even bother.  Your suppliers will ignore it.

Streamline the Invoice Approval Process

Another problem is the invoice approval process.  The standard drill is to send every invoice out to the department managers for approval.  If the manager never gets around to approving the invoice, then it doesn’t get paid, and everyone blames accounting.

The solution is called negative approval, where you enter the invoice into the accounting system, and send a copy of the invoice to the manager who should approve it, with a note stating that you will pay it unless you hear otherwise.  If the manager is fine with the invoice, which the case pretty much all of the time, then he throws out the invoice copy, and everyone’s happy.

Except for the internal controls auditor.  The auditor wants to see that there’s clear evidence of approval for every invoice, so you can end up in a tug of war between greater efficiency, and proper documentation of controls.

Eliminate Manual Payment Processing

Another good area for improvement is manual processing of payments.  This means there is no petty cash.  Ever.  It’s not only a waste of time, but there is always cash box pilfering.  If anyone complains, tell them about the company’s corporate credit card program.

Another item is cash advances.  Don’t do it.  It takes time to create the payment, and then you have to track the employee’s payback through the payroll system.  Since the employee who wants this special treatment is essentially treating the company like their private bank, go send them to the real bank down on the street corner, and get a loan.  If a department manager complains that his staff absolutely must have a loan to get through some business travel, then – again – tell them about the company’s corporate credit card program.  These types of manual activities take up a surprising amount of time, which is why it’s important to break the company of the habit of using them.

Minimize Expense Report Analysis

And then we have expense reports.  Some payables departments review these things to death.  Yes, I agree, there are cases of expense report fraud.  But.  It takes a lot of time to track them all down, and the cost-benefit on this is not good.  Instead, do a periodic audit of expense reports, and when you find something suspicious, then flag that person for permanent reviews, and go back and check their old reports.  This is way more efficient.

Enhance the Payment Process

And what about payments.  I really don’t like paying by check.  In fact, I really really don’t like paying by check.  This is partially because I’m an authorized check signer right now, and signing checks is a monumental waste of my time.  Sure, it’s supposed to be a control point, where you carefully review every check – but let’s be realistic here.

Any payment problems should have been spotted much earlier in the procurement process, so even if you find something, the company is probably obligated to pay it anyways.  And also, check signers are really bad reviewers.

If you want to learn about payables controls, then go back to episode 13.  For now, let’s just say that payment should be by the most efficient means possible, and that means electronic payment.  You can set up ACH payments through a lot of accounting systems, and certainly through your bank’s web site.  If you do this, there’s no more check stock to track, no check signing or mailing, no stop payments, no positive pay notifications – it all goes away.

Improve Document Retrievals

Another problem is document retrieval.  If someone wants to research a payment at some point in the future, they have to go to storage, get the invoice, and put it back.  Not only is this time consuming, but it’s quite possible that they’ll mis-file the document when they put it back.  A really good work around is to scan all invoices when they come in, and then attach the digital copy to the invoice record in the accounting system.  That way, there’s no more travel time to storage, and you’ll never lose a document again.

Ensure that W-9 Forms are Received

And then we have the W-9 form.  For listeners outside of the United States, you can tune out on this one.  Within the U.S., we have this annoying W-9 form that all suppliers are supposed to fill out; I won’t bother with the details of why it has to be done, but the basic problem is getting them to return the form.  A lot of companies ignore it until the end of the year, and then they go into crisis mode to track everyone down and beg for a form.  There’s a much easier way to do this, and it’s 100 percent effective.  You simply do not pay the customer the first time around until they submit a W-9.  This requires a little extra work up front, but it saves way more time than the initial cost.

Track Metrics

What about metrics, to see how the payables function is operating?  One option is to create a report that shows all invoices that were paid after the required payment date.  This is brings up a lot of process flow problems that you can fix.  Another good metric is the proportion of invoices paid that are under $100, or some other fairly low target figure.  If your corporate purchasing card program is working right, this should be a small proportion of total payments, and that represents good processing efficiency.  And finally, track the proportion of electronic payments to total payments.

If you follow just these three metrics, then you have the tools to track down mistakes, and to gradually shut down both small payments, and check payments.

Related Courses

Optimal Accounting for Payables

Payables Management

Acquisition Due Diligence (#80)

In this podcast episode, we discuss some of the key items to look for when conducting due diligence on a target company. Key points made are noted below.

Why We Need Due Diligence

Due diligence is the investigation of a target company by the buying company.  This is a seriously detailed review of the target’s operations and financial results.  A novice buyer won’t spend much time on it; but experienced buyers will have seen so many problems over the years that could have been avoided with proper due diligence that they insist on it.

So for an experienced buyer, the objective is to use due diligence to uncover every possible reason why the acquisition will not work.  You want to know all about these issues in advance, so you can think about whether you can overcome them or not.  If not, then walk away.

I’m not going to discuss every possible due diligence question – for that, go to accountingtools.com, click on the Resources button, and you’ll see a due diligence checklist that’s about six pages long.  Feel free to copy it.

What I AM going to do is spotlight some of the key areas where I’ve seen problems in the past – which, by the way, is somewhere around 100 reviews.

Review the Financial Statements

We’ll start with the financial statements, but keep in mind that this is only a piece of the review.  If you just look at the numbers, you’ll miss a great deal.  So, first – the question is, what is not there?  Quite a few companies have an annoying habit of only charging certain expenses at the end of the year, like depreciation and bonuses – so if they give you financials for almost the entire year, then see if these items are included.  If you need to guess at what these extra expenses might be for partial year results, and then go back to their last full-year results and see what expenses they recorded then.

Next, look at the trend of fixed assets over the past five years.  If it’s trending up fast, then you can expect to see that they’re capitalizing expenses.  It might even be legitimate, like for software development expenses, but you need to factor it into the company’s real year-to-year cash flow.  About 2/3 of the software companies I’ve reviewed were capitalizing so much development cost that they looked really profitable, but they were actually close to bankruptcy.

Next, look at the margins.  I look at net margins, not gross margins, because people can fudge the gross margin by shifting expenses out of it.  There needs to be a consistent net margin over several years.  Otherwise, if margins are small and getting smaller, you have to wonder how the acquisition will pay off for the buyer.

Review the Management Team

Next up, and frequently more important, is a review of the management team.  You have to travel to the target company’s location to do this, so you can see these people in their own setting, and see how their own employees react to them.  There are lots of clues to pick up about people, and it requires a lot of face time.

So, what am I looking for?  In all cases, we leave the management team in place, so we have to be able to work with them, probably for years.  So, the most critical issue is to avoid the command-and-control types.  This is someone who is at the center of everything, and who has to make every decision.  These people never ever fit into a larger organization.  When I see a company president like that, I cut short the due diligence, and head for home.

So, how can you spot these people?  One surefire indicator is when they have to be in the room with you during the entire visit; they don’t trust a subordinate to answer questions.  Another method is to ask subordinates what kinds of decisions they have to defer to the boss.

In one case, I spotted it by reviewing their policies and procedures manual.  For every procedure, absolutely everything required the approval of the president.

Now, due diligence discussions can be pretty broad ranging, so I like to drop hints about what it would be like for them to be part of a larger company, just to get a rise out of them.  For example, if I mention that the entire company operates on a single medical plan, or a single pension plan, the point is to see if they’ll complain that their plans are better, and that their employees will suffer under our plans.  I don’t really care about the differences between the plans – I’m trying to learn about their ability to fit in.

Review the Products

After the financials and the people, I look at the products.

If they’re a service organization, then I’ll deconstruct profits right down to the billable percentage and billing rate of each employee or department, so I can figure out exactly where the profits are.

If it’s a product company, then I absolutely want to know if they’re a one-hit wonder that still squeezing cash from the original product, or if they’re actually good at cranking out new products.  You can see part of this by reviewing a time line of when they’ve released new products, but what I really like to see is revenue by product for the last three years.  What I frequently see is that the old mainstay product still hogs the revenue, while the company is piddling away its cash on unprofitable new products.

Review Bottlenecks

And then there’s the bottleneck analysis.  A lot of the time, this means that most of the sales are coming from just a few maxed-out salespeople.  Other times, it’s a machinery constraint, but – usually, it’s people that are keeping the target from growing.

The Sequence of Activities

What is my due diligence sequence?  The financial piece is first, because it’s my initial gate.  If a target is blatantly unprofitable, then the due diligence is over, and I won’t waste any more time.  If things look good on paper, then I schedule a trip, with the intent of spending as much time meeting as many people as possible.  If things still look good – and keep in mind that we’re now down to just a fraction of the initial group – then I go back for a second trip, with more people, and we really dig in. In other words, this is a multi-layered progression.  We don’t want to put too much effort into it, so we build in a number of decision points to see if we should walk away.

Completing the Analysis

So, what is the result of a due diligence review?  Well, in my case, I go in assuming that I’ll find something critical that will make the acquisition fail.  And that’s totally acceptable.  I’d much rather find that out during a fairly inexpensive due diligence review, than afterwards, when we’ve already spent a few million dollars on the deal.

The final due diligence step is to document everything in a report.  This is intended to be a summary of the target company, and its financial and operational results, but I spend the most time specifying the main problems, and whether I think we can fix them.

And last of all, I put in a recommendation.  I leave no room for interpretation by the reader, because if it’s a bad situation, I want them to know.

Oh, and finally – the oddest thing I’ve ever seen in a due diligence is a software company that invested in – graveyards.  The president’s spouse wanted to invest in graveyards, so how could the president possibly say no to that?

Related Courses

Mergers and Acquisitions

Analyst Relations (#79)

In this podcast episode, we discuss how analysts operate and how to deal with them. Key points made are noted below.

What the Analyst Does

The analyst investigates a public company, and creates an analysis of where he thinks the company’s stock price will go.  He normally adds a buy, sell, or hold recommendation to the analysis, and then issues it to his client list.  The clients are paying for this advice, so they want to see some good insights into each company being reviewed.  If there isn’t, then they stop paying for the analyst.  Alternatively, the analyst may work for a brokerage firm, in which case the brokerage will probably dump the analyst if there’s a string of bad calls. So, the analyst is on the hot seat.  This is not a easy job, because it requires a great deal of industry specialization, and excellent contacts within that chosen industry, and good analysis skills on top of that.

Why a Company Needs Coverage

So why does a company need analyst coverage?  Several reasons.  First, if a well-known analyst chooses to cover you, then that’s a mark of prestige for the company.  Also, an analyst can bring a large following of investors, which provides more liquidity for the company’s stock.  And finally, an experienced analyst has lots of contacts, and can direct company management to people who can help them raise funds or place large blocks of stock.  So, it makes a great deal of sense from a company’s perspective to have a strong analyst following.

The Lack of Analysts

The problem is that there aren’t so many analysts around any more.  Whenever there’s a market downturn, large brokerage houses reduce the number of analysts that they keep on staff.  Also, an independent analyst can’t survive very well in a down market, because clients won’t pay his fees when all stock prices are heading downhill.  For these reasons, the analyst population declined over the past decade, and I don’t see it increasing any time soon.

So, how does this impact a public company?  Well, the main impact has been on small and micro cap companies, which have lost all kinds of analyst coverage.

The reason is that a lot of analysts work for large brokerage firms, and each analyst recommendation has to generate the largest possible commission volume for the brokerage house in order to justify the cost of the analyst.  So, if an analyst spends a lot of time creating a great research report on a company with almost no trading volume, then it’s a wasted effort.

How to Obtain Analyst Coverage

This doesn’t mean that it’s impossible for a small cap firm to obtain analyst coverage.  But they need to avoid the larger brokerage firms and target small boutique brokerages and independent analysts, who have a lower cost structure, or perhaps who specialize in the company’s industry.

Your best bet for finding an analyst is to see who is covering competing companies that have a similar market cap.  That type of analyst has already invested a lot of time in learning your industry, so they don’t need to put in a lot of work to provide coverage for your company, too.

How to Maintain Good Analyst Relations

So, what about the care and feeding of an analyst?  If an analyst agrees to provide coverage, then what do you do?  First of all, if you’re not providing guidance, then start doing so, because the analyst needs some foundation information from which to build his recommendations.  If you’re comfortable with it, then also provide investor conference calls, so the analyst can ask more clarification questions.

Second, and this is critical, always provide conservative guidance.  If you issue some really high-end earnings estimates and then can’t make the numbers, the analyst has probably already issued a buy recommendation based on your guidance, and now looks like a fool.  Analysts really don’t like that.

Third, they like to meet directly with management, which is acceptable.  However, you cannot reveal any material information to an analyst that you haven’t already issued to the investing public.  To make sure that you don’t, it makes sense to have the investor relations officer sit in on these meetings and make note of any “indiscretions,” so that the company can file an 8K report to the SEC right away.

So, if you can’t reveal anything new to an analyst, why is a management meeting still important?  Well, the analyst can legitimately pick up a great deal of information from a company visit.

This can include figuring out if the parking lot is full, if there’s too much inventory in stock, and even just getting a feel for how competent the management team appears to be.  On top of that, it’s quite all right to discuss your view of the industry as a whole, and other competitors, and general operating conditions, which allows the analyst to build a piecemeal view of the company and its environment.  This is called the mosaic approach to building a recommendation.

One thing that a good analyst will absolutely pick up on is any weakness in a manager’s knowledge about the company or industry, so make sure that you have a pre-determined answer to the standard questions, like who are the main competitors, and their strengths and weaknesses, and what is the market size, and market growth rate.  One item that analysts love to address is the various risks that the company is subject to, so know what they are, and be prepared to talk about how the company deals with them.

Also, any time you update the corporate fact sheet, or fact book, or issue a press release or an 8K, always send them a copy.  This gives them the best and most up-to-date information, and they really appreciate it.

After the analyst has completed an investigation of the company, he may send an advance draft of his analysis and recommendation to the company.  I think it’s a good idea to note any incorrect information in the report, so that errors don’t start circulating through the investment community.  However, there’s a risk that the company could be seen to have participated in writing the entire report, so it helps to keep the original and corrected versions, so the company can prove in court that it did not write the report.  And under no circumstances should you comment on the analyst’s conclusions or recommendation, because that implies that you are taking ownership of the report.

If an analyst report turns out to be highly favorable, do not under any circumstances publish it on the company web site. The reason is that it gives the appearance of endorsing the report.  Also, what happens if the same analyst then issues a negative report?  Would you post that, too?  Of course not.  Instead, just list on the web site the name and contact information for the analyst.

Also, don’t expect too much from an analyst.

A “strong buy” recommendation only lasts as long as the company’s stock price is below the analyst’s target price.  At some point, the analyst may very well post a “sell” recommendation, though most of the time they waffle with terms like “moderate buy” or “long-term buy” in order not to piss off management.  They realize that those management meetings can be cut off at any time, so the standard drill is to simply back off their strongest buy recommendations.  If they do this, it’s OK.  Eventually, the stock price will drop to the point where they can issue a “Strong Buy” recommendation again.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Controls for Financial Statements (#78)

In this podcast episode, we discuss the controls that apply specifically to the creation of financial statements. Key points made are noted below.

Financial statements are the summarization of all kinds of different transaction streams.  If there’s a problem in any one of those transaction streams, then the error appears in the financials.  However, I’m not going to talk about controls over those types of errors.  That’s already covered in episodes 1 through 15, where I’ve laid out control systems for all kinds of accounting transactions. Instead, I’m going to talk about controls over creating the financial statements themselves.  So let’s get right into it.

Controls Over the Creation of Financial Statements

First is the error of non-inclusion.  This means that you just flat-out forgot to enter something in the financials.  Maybe it was a special journal entry.  Happens all the time.  The best control over this is a standard closing checklist that forces you to look at and sign off on any of the dozens of steps needed to close the books.  For more information about the checklist, go to episodes 16 through 25, which address the fast close.

Second, always document your journal entries.  Otherwise, you end up with journal entries for which there’s no support at all, which drives auditors crazy.  Your best bet is to create a standard journal entry form that requires the signature of a senior-level accounting person.  This means that a second pair of eyes gets to review everything, and that catches a lot of errors.

And yes, this means that you need a closing binder.  This should contain tabs by month, and behind each tab is all of the supporting documentation for every entry for that month.

Third, designate some entries as high-risk entries.  This usually means that it’s something that’s had a high error level in the past, or which involves so much money that any error at all would seriously impact the financials.  For these entries, require a really senior-level reviewer, such as the controller.

Fourth, once you have all of those approved journal entries, only allow one person to record them in the accounting system.  That way, there’s less risk of duplicating or missing an entry.

Fifth, reconcile all of the major balance sheet accounts.  This doesn’t mean piddly accounts, like sales taxes payable, but ones where there’s a serious risk that something is there that shouldn’t be.  I find that accounts like “prepaid assets” or “other liabilities” are just poisonous.  For these accounts, there’s sometimes not just a reconciliation, but also a formal meeting every quarter, just to make absolutely certain about what can be retained and what should be written off.

Spreadsheet Controls

And what about spreadsheets?  There are lots of journal entries that are built on top of spreadsheets, and those spreadsheets can be incorrect.  There’re several controls to consider here.  One is to archive all spreadsheets used in the financials at the end of each month.  I do this.  We store the complete set of spreadsheets in a separate archive subdirectory, and we put password access on them.

By doing so, we have a really good record of what happened in previous months, so we can go back and research the numbers, if we need to.  It also means that we have a presumably clean spreadsheet version, in case the current one was messed up during an update for the most recent month.

Another possibility with spreadsheet controls is to do an annual review of the structure of each one.  This means that someone who doesn’t normally use the spreadsheets takes a look at them from the perspective of content, and formula accuracy, and ease of use.  Sometimes, it can be quite a surprise when the reviewer finds that a spreadsheet not only has a bad formula, but has also had a bad formula for a long time – which you can trace back with the spreadsheet archives that I already mentioned.

Analytical Reviews

Another control that very few companies do is the analytical review.  This means that you compare accounts across different periods, just to see if they’re reasonable.  Auditors make you do it all the time, so why wait for them to show up and put you through the embarrassment of explaining away an obvious mistake?  Just do the review yourself to spot errors.

Now, there’s an easy way to do this, and a hard way.  The hard way is the auditor’s approach, which is to transfer account balances into a separate spreadsheet, and manually compare everything about six different ways.  That is both slow and painful. 

I use the easy method, which is to have the accounting software print out period ending balances for every account for each of the last 12 months.  Then I just skim through this trailing-12 report to see where the blips are.  I circle anything that looks odd, and then hand the report off to an assistant controller to research. Takes me about 10 minutes.

Public Company Controls

If you’re a public company, then consider this control.  You write up a disclosure memo and send it to the disclosure committee for review.  The memo covers the big topics, like whether you have goodwill impairment, or how you’re justifying the accrual of revenue, or risk analysis.  The disclosure committee is usually the corporate attorney, the CEO, and perhaps an outside accounting expert.  These people bring a different perspective on the main issues, and every now and then they come up with a really good point.  So, this is not a tactical control, it’s a strategic one.

Again if you’re a public company, there’s also a potential for issuing financials that don’t match your trial balance.  This is pretty much impossible for a private firm, because the financials are generated directly from the trial balance.  The problem for public companies is that the information is translated into a quarterly 10Q or annual 10K report, and it’s surprisingly easy to lose some numbers during the translation.  Consequently, before issuing any public reports, make sure that you match the financial statements to the trial balance.

After-the-Fact Controls

Now, after the financials are issued, there’s an after-the-fact control, which is to specifically ask the recipients of the financials to contact you if they have any comments.  Company managers are very interested in the financials, since their performance is based on the numbers, so you should create a feedback loop and get people to use it.

And there’s the really after-the-fact control, which is the post mortem.  This means that you get the accounting team together to discuss what went wrong and what went right.  If something worked well, then lock it into the financial statements procedure.  If not, then document what you want to do differently the next time, and create a memo or e-mail that states who is responsible for the new system.

Related Courses

Accounting Controls Guidebook

Closing the Books

Fast Close for a Public Company (#77)

In this podcast episode, we look at ways in which the time required for a public company to produce financial statements can be reduced. Key points made are noted below.

Problems with a Public Company Closing

On top of all the regular closing steps that a company follows to close its books, a public company has one extra step – which is to file either a quarterly 10Q or annual 10K report with the Securities and Exchange Commission.  If you’ve listened to the earlier fast close episodes, you’ll realize that everything else can be completed in just one day.

This extra step is an entirely different story.  Most public companies feel lucky if they can file their 10Q reports in just one month, and the 10K’s take even longer.  So let’s see what we can do to cut back a bit on the amount of time needed.

The first problem is that you have to write either a quarterly 10Q or an annual 10K report as soon as you’ve finished the financial statements.  This is a hard bottleneck, since several other steps can’t start until this is done.  So, you need to assign a specialist to assembling the report.  This person should be totally cleared from all other activities while writing the report.  In my company, I have a part timer who’s the assistant controller for external reporting.  That’s her title, and that’s all she does.  She spends her time before the close just assembling the information that she’ll need, and once the internal financials are done, she has absolute priority over all other projects going on in the department.

Writing the report will take multiple days, even though there’s a lot of boilerplate that can be copied forward.  After you’re through with that step, there are the auditors.

The second problem is that the quarterly results have to be reviewed by an outside audit firm, and the annual results have to go through a full audit.  So right there, you need the cooperation of an outside entity, and which very likely doesn’t have excess staff available to help with a fast close.  Instead, they just schedule you into an open time slot, and that’s what you get.

However, there are some ways to reduce the amount of required auditor time.  First, try to retain the most experienced audit staff for as long as you can.  If the audit firm keeps rotating in new hires, then the review or audit will take longer.  Second, line up all of the in-house staff you can to assist the auditors with absolutely anything they need.  By making life simple for the auditors, you get them out the door quicker.  Third, increase the strength of your internal controls.  If auditors find problems, they’ll spend more time on-site, so the trick is to have super-strong controls that reduce the chance that there’ll be any issues for them to find.

Fourth, and actually the most important, make double-sure that everything the auditors requested in advance is completed before they arrive.  These are called the provided by client items, or PBC for short.  Otherwise, they waste time sitting around, waiting for you to provide them with the requested items.  In fact, though this sounds like reverse logic, it can make sense to delay the auditor start date just to ensure that you have time to put together the entire PBC list.  Fifth, reference supporting documentation in the 10Q or 10K, so the auditors can easily trace back to where you derived your numbers.  We do this by blocking out reference notes in yellow right in the SEC reports, and then remove the notes just before we file the reports.

The third main problem is the legal review.  The company’s legal counsel has to review the report to make sure that it includes all mandated disclosures, and doesn’t include any incorrect or unsupportable statements.  Unfortunately, and just like the auditors, the attorneys don’t work for the accounting department, so the controller has no influence over when they do the work.  However, this is not as bad as it seems, because the attorneys can review the report at the same time that the auditors do, since each party is reviewing the report for something different.  In essence, they can do the work in parallel, so the attorneys aren’t really a bottleneck at all.

But you’re not done yet.  There are still three more steps before you can file the report.  Fourth in line is officer certification of the financials.  Under Section 906 of the Sarbanes-Oxley Act, the CEO and CFO both have to certify that the financial statements fairly present the company’s financial position.  If they don’t, then the CEO and CFO can be fined up to $5 million and spend 20 years in jail.  Given the penalties, it’s fair to assume that they’ll both want to spend some serious time reviewing the report.

But, like the attorneys, this doesn’t have to be a bottleneck.  They may agree to review the report at the same time as the auditors and the attorneys, and just be notified of any subsequent changes.

And then we come to problem number five, which can be a significant problem.  This is the audit committee’s approval of the financials that are contained within the report.  This is usually a very simple conference call that takes about 15 minutes.  The problem is that the meeting date is usually scheduled well in advance – in my company, the audit committee schedules all four quarterly report discussions at the beginning of the year.  So – if you try to schedule the audit committee meeting too soon and you’re not ready, then the audit committee is pissed off.  If you schedule it too late, then you’ve wasted some days when the report could’ve already been filed.

There’s no easy solution to this one.  I prefer to schedule somewhat delayed audit committee meetings for a full year, then make damned sure I can meet their schedule, and then tighten the meeting dates in the following year – and so on.

And finally, we have edgaring.  This is the conversion of your 10Q or 10K report into a format that’s acceptable for filing in the SEC’s edgar system, which is short for electronic data gathering, analysis, and retrieval system.  The usual approach is to outsource edgarizing to a specialist.  These people are inundated with reports coming in from all of their clients at the same time, so it can be more than a one-day turnaround.  The auditors conduct a final review of the edgarized version, and then you can tell the edgarizer to file the report for you.

A couple of pointers regarding edgarizers.  First, consider using a small local firm that might appreciate your business more than a large national firm.  I use a shop where I’m the largest customer, so they turn around my reports in just a few hours.  Also, this is where being ready to file early really pays off, because you’ve beaten the rush – if you file early, you’re ahead of everyone else, so you’re not stuck at the bottom of the edgarizer’s work queue.

So – I dropped a lot of tips regarding how to file public reports quicker, but the basic problem is that you absolutely cannot get the reports filed in anything like the single day that can be done for internal financials.

In a public firm, you have to run through all kinds of external entities over whom you have very little control – there’s auditors, attorneys, the audit committee, and the edgarizer – so you have to measure success in terms of shaving a few days off here and there.

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Budgeting Controls (#76)

In this podcast episode, we describe a number of controls that can be applied to the formulation of a budget. Key points made are noted below.

Budgeting Problems

The annual budgeting process frequently involves multiple spreadsheets, many iterations, and more than one person handling the spreadsheets – and all of that spells trouble.  It’s very easy for errors to creep into the budget, so you need multiple controls to keep them out.  This also applies to implementing the budget, where errors can arise all over again.

Budgeting Controls

Let’s start with budget creation.  Revenue drives everything else in the budget, so it helps to do some review work here.  First of all, verify the impact of revenue assumptions on the company’s bottlenecks.  For example, if the new revenue assumption is for a 20% increase, but there aren’t enough salespeople to find the extra sales, then you have a whopping big error right at the start of the budget.

Next, review the budget for step costing change points.  These are large incremental expenditures that you have to make when volume increases past a certain point.  So if a machining center can only handle 1,000 units of production, after which you have to spend $1 million for a new one, management might want to budget a little south of 1,000 units.

Also, try to simplify the model, which tends to keep errors out.  This can be an annual budget simplification project, where you review last year’s budget, line by line, to see if any line items or formulas can be eliminated.  In some cases, it can mean merging a couple of subsidiaries together for budgeting purposes, which can eliminate whole blocks of the budget.

You can also simplify by budgeting for entire groups of employees, rather than itemizing every employee on a separate line.  So, for example, if you have 100 consultants on staff, put them all on one budget line, using their average rate of pay.

Another simplification trick is to merge small-dollar line items together.  For example, you may have separate line items for telephones, office supplies, and building maintenance.  You could merge them all together into a single account for office expenses.

Errors can also creep into the budget when company managers create their budgets each year.  These people do budgeting just once a year, they don’t like to do it, and so they aren’t very good at it.  This means they’ll very likely enter incorrect budget numbers that have no basis in reality.  You can help them out with budget preloading.  This means that you fill in most of the budget for them in advance for some line items, such as rent expense, telephones, and even payroll.  They can always change these numbers, but in many cases their parts of the business aren’t going to change enough from year to year to call for much alteration in their budgets.  So… the accounting department fills in the blanks for the easier line items; and company managers only have to deal with a small number of more volatile items.

Here’s one that very few people bother with, which is to manually recalculate the budget.  For example, you may have a bad error in a summarization calculation, which makes revenues or expenses look too high or low.  These are amazingly hard to find. If you’re going to do this, have a third party do the recalculating; they’re not emotionally tied to the budget, so they don’t think it’s perfect already – like you do.

After the budget is completely assembled, you may think that you’re done – but there may still be a problem, which is that some parts of the budget went through multiple iterations, but others did not.  This means that one manager might have submitted a budget based on early numbers elsewhere in the budget that have since been superseded.  So, the budget as a whole may no longer hang together very well.  Unfortunately, this means passing out the budget one last time for another review by everybody.  There’ll definitely be another round of changes, but it’s better to catch them now, instead of sometime in the next fiscal year.

Another step is to sign off on the budget.  This means that you put the words FINAL VERSION in the footer line of every page of the budget, as well as the date and time.  If someone has a copy of the budget without this verbiage, then they should throw it out.  Also, the CFO should initial his copy and keep it in a safe place.

And then you have to load the budget into the accounting system.  This is a great place to screw up.  You might load in the wrong version, or mix up debits and credits, or just enter the wrong numbers.  So, once the budget is entered, verify it for every month of the budget year.

Once that budget is loaded, lock down access to the budget module in the accounting software.  Otherwise, a company manager might be tempted to enter the system and reduce his budget targets to make his results look better.  Yes, this means not only requiring a password, but if possible, also using a log to track any changes made to the database.  If you want to be doubly sure about this, consider doing a quarterly review of the loaded budget, just to make sure that it still matches the approved budget.

At this point, we have a hopefully correct budget, and one that’s been accurately loaded into the accounting system.  Next, we should use it – after all, the budget itself is a control over how the company as a whole is operated.  I covered most of this in episode 71, so this is just a refresher.

First, incorporate the budget into a feedback loop.  This means creating a series of reports at the end of each month that’re designed to match the responsibilities of each employee.  For example, you can have a report that shows just a single revenue line item that’s reported to a single salesperson for a single territory; that’s the only part of the budget for which that person has responsibility, so that’s all he should see.  Yes, this means you may be issuing a boatload of reports, but it means that people will pay attention to the budget.

Also, use the budget for performance appraisals.  This is common enough for salespeople, who may earn commission overrides if they make their budgeted revenue numbers.  But also reward managers for making their department expense targets.

Parting Thoughts

In summary, budgeting is not like other accounting transactions, where you do thousands of them every year, and the emphasis is on efficiency.  For the budget, it’s a very complex transaction that only happens once a year.  Because there’s only one transaction, the emphasis should be less on efficiency and more on getting the output correct, and that means you need controls.

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Acquisition Valuation (#75)

In this podcast episode, we discuss the many variations on how to value a business, as well as the expectations of the buyer and seller. Key points made are noted below.

When a buyer is interested in acquiring another company, how does it place a value on the target?

Valuation Based on Market Value

The easiest valuation method only applies to targets that are publicly held.  Since investors have already established a market price for the stock, the buyer and seller can both figure out the total market value pretty easily, and then it’s just a matter of negotiating a premium over that price, which is called a control premium.  Buyers are willing to pay a control premium, because of course, they gain control over the target company, and can then impose a variety of synergies to increase cash flow – and we’ll talk about synergies in a future episode.

Valuation Based on a Multiple of Revenue

Another option is to use a multiple of revenue to arrive at the price.  It’s easy to come up with revenue multiples for comparable transactions, because there are acquisitions going on all the time, and the purchase price and target company revenues are frequently available in press releases.  Now keep in mind that these multiples should be based on recent acquisitions within the same industry, because they fluctuate quite a bit over time, and vary enormously by industry.  There will also be some outliers among those comparable transactions – maybe someone accepted a low price because they were in a cash squeeze, or maybe someone else got a high price, because they had some really good intellectual property.  You generally want to throw out the outliers.

Basing a purchase price on a revenue multiple is a good idea when the target company is growing really fast, because it may not yet have much proven profitability - if any.  This leaves you with really no other methodology to choose from.

But, the problem with the revenue multiple is that it only pays attention to the top line of the target company’s income statement.  It could be suffering from horrible cash flow, and so isn’t really worth anything.  This can really be a problem when an industry starts to consolidate; a common scenario is that a prime target company, with excellent financial results, is acquired first, and the transaction has a really high revenue multiple.

Then other buyers pile into the market, and are met by sellers who see that one massive revenue multiple hanging out there, and they want a similar price.  The trouble is that only the first target was actually worth that kind of money.  This means you have a disconnect on the part of the sellers, who think they’re worth more than they really are.

Valuation Based on a Multiple of Profit

A solution to the problems caused by the revenue multiple is the profit multiple.  This is the purchase price divided by the profit for comparable companies that have been acquired.  This works much better, but the information for comparables is quite a bit leaner.  If you choose to work through an investment banker, they should have access to comparables databases that contain this information, and they can give you a pretty tight cluster of comparables to work with.

Valuation Based on Cash Flows

A variation on the profit multiple is the gold standard of valuation, which is to use a multiple of cash flows.  There are a lot of ways to manipulate net profits to make a company look unusually profitable, but it’s another story with cash flow.  Either a target company churns out cash, or it doesn’t.  So, a conservative, experienced buyer usually wants to derive a valuation based on comparable multiples of cash flow for related acquisitions.

Downward Valuation Adjustments

No matter which one of these models you use, you also need to make a number of downward adjustments, such as for the cost of completing the acquisition, for a possible loss of customers, severance expenses for anyone being let go, upcoming fixed asset replacements, for pension funding, and so on.

Other Valuation Approaches

Now, there are also ways to value a target company that don’t use financial statements at all.  For example, what if the target company has spent several years developing a really neat product?  If the buyer thinks there’s a short time period for getting its own competing product to market, and it isn’t going to make that deadline, then it can put a value on the target’s competing product, and buy the whole company just to get its hands on that product.  This is obviously a special situation, and you don’t see it very much.

There’s also a super conservative approach when you’re looking at buying a company that’s a complete dog.  Its only real asset may be the underlying value of any real estate that it owns.  In that case, the buyer appraises the real estate and other assets, and basically ignores the business.

The Valuation Time Line

So, there we have some valuation methods.  The next problem is, over what time period do we apply the valuation?  The safest and most conservative approach is to value either a target’s revenues, profits, or cash flows based on its audited results for its last fiscal year.  By using an audit, you have some assurance that the numbers are real.

However, a target that has improving results wants to use its trailing 12 months of results, some of which may be audited, and some of which may not.  The buyer can certainly agree to a trailing 12 valuation, but should include a clause in the purchase agreement that some of the purchase price will be placed in escrow, subject to an audit of the results of those 12 months.

The next scenario is the hard one – what if the target company claims that its upcoming sales will be astronomical, and so wants to be valued based on results that haven’t even happened yet?  I see this one all the time.  Some buyers offer additional compensation if future results actually do increase, which is called an earnout.  The problem is that, if results don’t increase – which is to say, most of the time – the former owners of the target company claim that the buyer interfered with their activities, and take the buyer to court.  The result is usually that the buyer ends up paying extra.  In short, promising payments that are contingent on future performance is usually a bad idea.  If you insist on following that path, then budget for the maximum earnout payment, because that’s probably what you’ll end up paying.

Dealing with a Range of Valuations

It sometimes makes sense to calculate some or all of these valuation methods, and see what kind of a range of possible prices you end up with.  The real estate valuation method should yield the lowest price, while the revenue multiple is probably at the top.  Your negotiation range will be inside of these two prices.

Factoring Synergy Gains Into a Valuation

But.  There is one more factor to consider, which is synergy gains.  The buyer should have a list of possible synergies that it expects to obtain – things like increased revenues from combining sales territories, or reducing duplicate overhead expenses.  If the target company is smart, it will negotiate for a piece of those gains, by getting a higher up-front price.

For example, the basic valuation analysis may show a likely price of $10 million, and an additional savings to the buyer of $2 million from subsequent synergies.  A really sharp seller will negotiate not only for the $10 million, but also a piece of the $2 million.

Dealing with Seller Expectations

The real problem with determining an acquisition value is that the seller’s expectations are too high, so it demands much too high a price.  Sometimes a price that’s hysterically high, especially in comparison to what the buyer is willing to pay.  The reason for the difference is that buyers are frequently serial buyers – they do a lot of acquisitions, and so they have a good methodology in place for creating a valuation.  This is not the case with the seller, which may never have been involved in such a transaction before, and so has no experience with valuations.

The usual sequence of events that I’ve seen – many times, almost always – is that you approach a potential target about an acquisition, and they respond with a price that is too high, either because of inexperience with valuations, or because they think the business is about to expand dramatically in just a few more months.

When you run into this massive difference in price, just politely walk away, and be prepared to wait a few years for reality to strike the target, and for the price to come down.  I’ve found – nearly 100% of the time – that if you wait long enough, the target eventually contacts you, and is willing to accept a much lower price.

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Short Sellers (#74)

In this podcast episode, we discuss how short sellers do business and how to deal with them. Key points made are noted below.

What is a Short Seller?

A short seller is someone who expects a company’s stock price to decline in the near term; so he sells borrowed stock with the expectation of earning a profit later, by buying backing the stock later on at a lower price.

Conflicts with Short Sellers

The CFO’s job is to increase the stock price, while the short seller’s job is to force it down, so you’d expect accounting people to treat short sellers like the arch enemy.  We’ll talk about how short sellers work, and how best to deal with them.

The Short Selling Process

The basic short selling process involves three steps.  First, the short seller borrows the target company’s stock, usually from a broker.  Next, he sells the shares on the open market.  And third, the short seller waits for the stock price to decline, then buys back the shares, and returns them to the lending broker.  So if the stock price declines, the short seller makes money, and if the price increases, then he loses money.

Short Selling Risk

Short selling is a very risky activity.  For example, if a company’s stock sells for $10 and its price drops all the way to zero, then a short seller can earn a maximum of $10.  However, if the price increases to $40, then the short seller has just lost $30 – so there’s an unlimited potential for losing money. Given the risk, it’s no surprise that some short sellers will try just about anything to ensure a stock price decline, like planting false rumors on electronic bulletin boards.  They can do this with multiple aliases, so it seems to someone who’s casually visiting the site that there’re a lot of people who are selling their shares.

One of their favorite tricks is to monitor restricted stock holdings, and figure out when the restrictions are coming off the shares under the SEC’s Rule 144.  Since the timing of restriction cancellations are public knowledge, short sellers can anticipate when investors might start dumping large amounts of stock on the market, which drives down prices.  Then they sell shares in advance of the big sell-off, and buy shares back when prices are very likely to be lower.

Dealing with Short Sellers

So, what can a CFO do about this?  Some CFOs may be tempted to force out short sellers by issuing guidance for better than expected earnings results.  This kind of publicity may increase the stock price in the very short term, which creates a squeeze that does drive away the short sellers.

The problem is that the more aggressive guidance will make it really hard to meet investor expectations.  And that means that the short sellers will return in droves, because now the stock price is even higher, and so has a longer way to fall.  If a CFO keeps issuing higher and higher guidance numbers, all the short sellers have to do is wait quietly until the stock price is clearly way too high, and then sell short in even greater quantities, and turn a really big profit.

So obviously, increasing guidance is a bad idea.  So what can you do?  First option: don’t ever issue aggressive guidance.  All that does is raise the stock price to an unsustainable level.  Instead, only issue conservative guidance which the company can comfortably meet on a long-term basis.  This approach flattens stock price volatility, which keeps the short sellers away.

It also pays to monitor the larger investor message boards to see if there’re sudden increases in negative discussions about the company.  Those increases usually coincide with short selling, which you can also monitor on a web site called shortsqueeze.com.  If there appears to be a smear campaign going on, then consider issuing a press release that addresses the allegations.

Another tactic is to issue every scrap of bad news to the investing public at the same time.  For example, if you have a bad quarter and report it as such, this will at least get short sellers to start monitoring the company, and possibly selling short, because they expect that you’ll issue a string of additional bad news that will drive the stock price down even further.  So… when you know there’s bad news, dump all of it on the market at once, so there’s a single stock price decline, and that’s it.  No more additional declines for the short sellers to feed on.

It also pays to be prepared for every reasonably foreseeable emergency.  The CFO can create boilerplate press releases for such issues as product recalls, litigation, or the departure of a key executive.  By having these canned responses available, it gives the appearance that the company responds both quickly and well to a crisis.  If management appears competent, there tends to be less stock volatility, and that keeps the short sellers away.

Short sellers may also get into an investor conference call and pose questions that make the company look bad.  Their intent is to plant the idea in other investors that management doesn’t know what it’s doing, which can drop the stock price.  If this happens, the worst things you can do are to get into an argument, or to give a long-winded and rambling answer.  Instead, make a short and well-reasoned reply, and immediately move on to the next caller.  Do not let a short seller hog time during the conference call.

There’s a short selling ratio that you might want to consider using.  Divide the number of shares being sold short by the average daily volume of shares traded.  This gives you the short interest ratio.  When tracked on a trend line, it reveals when there’s a short selling attack going on.  Also of interest, it shows the number of days of average trading that it takes before short sellers can cover their positions.  As the ratio goes up, this means that it becomes increasingly difficult for short sellers to cover their positions, so they’ll have to scale back on their short positions.

In summary, you should absolutely never increase your earnings guidance in order to drive away short sellers.  Instead, keep guidance conservative, and try to react to rumors with well thought-out press releases.  If you do this, there’ll still be some short selling, but there won’t be enough negative information for short sellers to cause major problems.

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Billing Best Practices (#73)

In this podcast episode, we discuss the various best practices that can be applied to the billing process to make it more effective. Key points made are noted below.

The subject, specifically, is how to create and issue a customer invoice.  Now, this seems pretty simple.  Your accounting software has a standard invoice template, so you call up the pre-defined customer billing information, enter the various line items you’re billing, and put the invoice in the mail.

How to Find Invoicing Problems

You may have noticed during collection calls that customers are not always paying late because they don’t have the money, but instead because of something wrong with the way you created or delivered the invoice.  In other words, collection calls are a really good way to figure out where your billing process is broken.  So let’s go through some of those collection problems and see how we can fix the billing process so that the collection issues go away.

Issue Single-Line Invoices

One of the problems is that a customer won’t pay because it’s protesting one line item on the invoice.  If there are lots of line items, that means all of the other items are being held up too.  If there’s a history of this, and if the other line items are for really large amounts, it might make sense to split up a large invoice into several smaller ones.  In particular, if you think there might be some debate over a particular line item, then put it in a separate invoice.  Obviously this can be outrageously laborious if you deal with all kinds of line items, so reserve it just for the really large-dollar invoices.

Proof Large-Dollar Invoices

And speaking of large-dollar invoices, if there’s a risk that a customer won’t pay a really big invoice because of a typo, then by all means – hand over the larger invoices to a second person, along with all of the supporting documents, and have them proofread the invoice.  Sure, it might delay invoice delivery by a day, but so what?  Proofreading could keep a payment from being delayed a really long time.  Of course, this won’t work if you have thousands of small invoices, but if a really big one comes along, just be extra careful.

Clearly Present the Invoice Number

Another problem you find is that the customer keeps mixing up invoices.  This happens when you don’t clearly state an invoice number, or you don’t show any invoice number at all. The customer expects an invoice number, and he’s looking for one, so clearly position it in one corner of the invoice, put a box around it, and print it in large font and bold.  This sounds stupid, but I think some companies make a game out of how far inside an invoice they can bury the invoice number.  So… take one of your invoices out, and stare at it from the perspective of the customer.  If they have to dig around for key information, then you need to remodel the invoice.  This is your problem, not theirs.

Clearly Present Contact Information

So what if, despite your best efforts at creating a clear invoice, the customer still has a question.  Does the invoice clearly show a contact phone number?  And does someone actually answer that phone number?  This cannot go into the department voice mail.  Nobody checks that voice mail.  You have to make sure that the contact number goes to a real live person.  If not, then the customer will just say “screw it,” stick the invoice in their IN box, and wait until the invoice is past due, so that someone in your collections department calls them.  This is not the customer’s fault, it’s your fault.  You are not giving them a clear way to communicate with you.

Identify the Recipient

Another problem is the invoices that never find their way to the right person.  Invoices have a way of vanishing inside customer organizations, and you never know until they go unpaid, and your collections person finds out that no one ever received it.  There are a couple of ways around this.  First, if you have a sales staff that keeps in close touch with customers, then periodically run your active customer list past the salespeople to see if any contacts have changed. Also, the collections staff should have a pretty good idea if someone has left a customer’s accounting department, so run the list past them, too.

Another option is to mark all envelopes with an “Address Correction Requested” stamp, so that the Post Office notifies you whenever a customer changes its location.

Accelerate the Issuance of Invoices

So what about the timing of sending an invoice.  The standard view, of course, is to mail it as soon as possible after you’ve delivered the goods or service.  I certainly agree with that.  But – if you know in advance exactly how much to bill, you can run the invoices early and mail them early.  As long as you also set the invoice date to the correct date that coincides with delivery, there’s really no accounting problem. By issuing invoices early, you’re giving customers more time to process them for payment, so you should get paid a little sooner.  This doesn’t work for every kind of sale, but keep it in mind.

Consider the Invoice Delivery Method

So what about invoice delivery.  The traditional method, of course, is mailing every invoice.  But there are better ways.  Some companies have set up on-line billing sites on the Internet, and ask you to re-enter invoices into those sites.  If so, by all means take them up on it!  Sure, it’s painfully slow and requires extra staff time.  But on the other hand, you’ll know for a fact that the invoice is in the customer’s accounting system, because that Internet site usually has an automated feed that goes directly into the customer’s accounting system.  And sometimes, you can even use the site to track payment progress.  So, what’s not to like?

Now, what about e-mailing an invoice?  I think it’s one of the best collection techniques once something is overdue.  But as the way to initially send an invoice, I’ve had an amazing amount of trouble with it.  Customers usually want you to send invoices to a generic e-mail address, and then they don’t check the mailbox.  And also, you never know when the customer’s spam filter is blocking your e-mail.  In short, it seems like a good idea, but e-mail is just not a good way to initially deliver an invoice.

And then there’s the wave approach to invoicing, which means that you hit them with multiple copies of the same invoice from all possible directions, like the mail, and fax, and e-mail, and an overnight delivery service.  This really pisses off customers, but if you have someone who finds any possible excuse not to pay, then this takes away an excuse – because there’s no way they didn’t receive the invoice.  I don’t use it much; this is really just for the most annoying customers.

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Office Work Flow (#72)

In this podcast episode, we talk about ways in which the flow of work within an accounting department can be improved. Key points made are noted below.

The accounting department handles a lot of transactions, and that means there’s a lot of paper flow, and also a lot of physical movement within the department.  The trick is to handle those transactions as efficiently as possible, and a good way to look at it is office work flow.

Remove Obstacles

The first step is to take out of the department anything that gets in the way.  This means removing excess chairs, desks, and filing cabinets, as well as unused computers, printers, fax machines, and so on.  Once those items are gone, make a layout chart for the entire department.  On the chart, list all furniture, offices, and cubicles, and then add to it the flow of travel that everyone takes over the course of the day.

Minimize Travel

What you’ll usually see is that there’s a lot of unnecessary travel.  For example, a manager buys a really large copier with all kinds of functions, and puts it in a special copy room way down at the end of the hall.  If you have that situation, then there’ll be plenty of wasted travel down the hall.

Same thing goes for mail.  If a billings clerk is creating customer invoices off and on through the day, she might wander down the hall seven or eight times to drop off envelopes at the front desk.  You get the idea.

The solutions are pretty obvious.  Instead of a central printer or copier, buy a bunch of small ones, so that people just turn around in their work areas, and there it is.  No need to travel anywhere.  This is really a good way to go with printers, because a decent laser printer just doesn’t cost that much anymore.  As for fax machines, I’m not entirely sure they’re even needed, since you can easily give everyone a decent high-speed scanner, and have them scan documents and then e-mail them.

As for travel to the mailbox, just create a mail drop in the accounting department, and have someone collect it once at the end of the day.

Enhance Storage Systems

A special issue is the filing cabinet.  Because of all the paperwork they contain, they’re basically immovable, or at least can’t be moved without a great deal of effort.  So, everyone has to walk to the filing cabinet.

The work flows related to filing cabinets are so repetitive that you may even notice that the carpet is worn out on the travel paths between certain clerks and their favorite cabinets.  So what do you do?

The trick is to have clerks move all the files they need from a filing cabinet into a wheeled bin, and bring the bin back to their work areas.  The intent is to have a whole day’s work sitting next to them, so they only take one trip to the cabinet in the morning, and then one more trip to put it all back in the evening.  That’s not always possible, but it might apply to a few situations.

Enhance the Cubicle Layout

And then we have the issue of cubicles.  They’re pretty fixed objects.  But the work flow of the accounting department can vary quite a bit over time, so you have to work around the cubicles. One option is to take them out entirely, and replace them with desks.  The nice thing about a desk is that it can be moved pretty easily.  You can create small work groups by assembling clusters of desks.  For example, it might make sense to put the cash applications person right next to the collections person, who’s also next to the invoicing person.  That way, all three people involved with customer payments can interact.  This is easy with desks, a lot tougher with cubicles.

Especially cubicles with high walls, which completely eliminate communications.  If you’ve got to have cubicles, then at least have ones with low walls.  That way people can look across at each other much more easily.

Enhance the Cubicle Work Flow

Now there’s also work flow within a single person’s work area.  In case you hadn’t noticed, there are basically two types of people – those with one piece of paper on their desks, and those who are comfortable living in a dumpster.  That second group claims they’re still efficient, but I don’t buy it.

This is a really difficult area to correct.  Someone who’s comfortable with clutter just doesn’t see the point in cleaning up their work areas.  But if you can get through the interpersonal issues, then here’s what to do next.  Empty out the work area.  Completely.  That means the computer, the cables, the files – everything.  Dust it down.  Make it quite clear that you’re taking it right down to the bare walls.  Then very selectively put back only those items that are really needed.  Take everything else, and put it in a holding area for a week or so, in case something else is needed.  After that, stick all the residuals back in the supplies closet, or wherever it belongs.

Now, I’m not talking about just clearing out some excess files.  I mean that you question why someone has an extra pen.  Why they keep an extra Post-it pad.  And etcetera.  The reason is that clutter is incremental, and will start building again as soon as you finish this exercise.  So by taking things right down to the bare minimum, there’s a larger amount of reclutterization needed to return to the bad old days.

And, by the way, this complete overhaul is not something you do just once.  Certainly, try it once a year, and some companies go in for it a lot more frequently.

Now, work flow can also be impeded when you have too much material – of all kinds – hiding inside drawers, and cabinets, and behind doors.  The problem is that low-usage items get parked in these places, and everyone forgets about them, and then you have a lengthy search on your hands when you finally DO need them.  Instead, take doors off of cabinets and remove drawers.  Better yet, eliminate entire cabinets and don’t have drawers.  This forces you to keep everything out in the open, which makes you more likely to file it away where it should have been filed in the first place.

Clarify Office Supply Storage

And finally, we have office supplies.  This impedes work flow when people have to search high and low for supplies.  Obviously, don’t let anyone squirrel away supplies, so that no one else has any.  The objection is that the supplies area is always short of supplies, so people have to keep a private stash.  To get around that objection, assign supplies replenishment to one person, and make sure there’s a review checklist that they go through every single day.  If you do that, supplies shouldn’t run short.

This doesn’t necessarily mean that you keep printer cartridges in a central area.  If there are lots of printers, then keep a few spares next to every printer, or at least in a nearby depot, so that people can swap them out on the spot.

Parting Thoughts

In short, accounting is a busy hive of – inefficiency.  People move around far too much for all kinds of reasons.  But if you remove impediments and cluster the right people together, the resulting efficiency improvements can be amazing.

Related Courses

Lean Accounting Guidebook

Budget Model Improvements (#71)

In this podcast episode, we discuss a number of ways to improve the budget model. Key points made are noted below.

I’ve seen a number of companies churn out some amazingly unrealistic budgets; or to put it another way, I’ve hardly ever seen anyone put out an achievable budget. A big part of the problem is that the mechanics of their budget models are just wrong.  Here are some things to look out for.

Include Capacity Planning in the Budget

First up is a large issue – which is capacity planning.  How many times have you seen a senior-level manager decide that his company can achieve far more sales in the next year, but he doesn’t work through the mechanics of how the company is going to pull in those sales.  Don’t forget – a company’s future results will probably match its historical results unless it takes some significant action to change the situation.

One of the best examples of capacity planning is salesperson productivity.  A manager decides that sales will double, but he gives no thought to the sales staff that has to produce the increase.  If the current sales productivity is $1 million dollars per year per person, then you can’t realistically expect the exact same sales staff to somehow generate twice as much sales volume the next year.  Instead, there needs to be adequate staffing to match historical productivity levels.

And don’t go thinking that you can drop a bunch of raw new recruits into a company and expect them to be just as productive as the old timers.  Instead, and to keep using the same example, the sales staff may need months – or a year – before they can even begin to match the historical sales level of the existing staff.  Which brings me to another budget point, which is – timing.

Incorporate Ramp-Up Time into the Budget

Again, let’s say that management wants to double sales, and you’ve even convinced them to acquire enough staff to do so.  But, how long does it take to ramp up?  OK, we just talked about the sales staff requiring a lengthy training period, but that’s not remotely all of it.  In addition, what is the sales cycle for the customers who are supposed to provide the extra revenue?  If more equipment is needed to produce for those new incoming orders, what’s the lead time to buy, and install, and test it?  And what about adding other overhead staff, such as customer support or engineering?

The ramp up interval for all of these activities can be enormous – what if you discover that it takes a half a year before you can even begin to expect additional sales?  Hmm.. Sounds like you won’t meet the target.

Incorporate Staff Turnover into the Budget

And another budgeting issue is the turnover of new staff.  Let’s face it, you can’t hire perfect people based on a couple of interviews.  Sometimes, you’ve got to let them go, or they look elsewhere.  Depending on the industry and position, the turnover among new recruits could be really high.  If so, this slows down your timing even more, so those budgeted revenue increases are beginning to look mighty far down the road.

Incorporate Step Costing into the Budget

Now, I’d like to circle back around to another part of capacity planning, which is step costing.  This is when you reach a certain activity level, and you just have to incur a really large new expense in order to manufacture one more unit of production.  The new expense could be anything – a new factory, a production cell, a major new hire.

For example, a manager decides to double revenues, but the factory foreman tells him that this will require 100% utilization of the factory.  The manager tells the foreman to do it, but doesn’t realize that this is a mathematical impossibility, because some downtime is always needed for ongoing maintenance.  And, the cost of that maintenance keeps going up as you get closer to 100% utilization.  The result is no authorization to increase capacity, and instead the company does not meet its budget – since it can’t – and it incurs massive expenses in order to operate too close to the 100% utilization level.

Instead, the budget analyst needs to know the earliest and most likely points at which the really big new step costs must be incurred, and make sure that everyone else knows about it, too.

Incorporate Cash Needs into the Budget

Another major problem with budgets is going into financing fantasy land.  For some reason, managers don’t seem to realize that a massive ramp up in operations requires a lot of new working capital – their budget models may not even contain this information, so they just follow the budget, find themselves running short on cash very suddenly, and then have to scramble to fund money at the last minute.  A much better alternative is to have a working capital calculation within the budget, and keep referring to it as you go through the various budget model iterations.

If anything, keep it on the front page of the budget, where no one can miss it.  That way, you can easily see what each new budget iteration does to your cash needs.

Reduce the Number of Accounts

There’re also a lot of low-level efficiency improvements you can make to a budget model.  For example, reduce the number of accounts that you budget for, since each one requires some time to maintain.  If a line item is too small to bother with, then merge it into some larger account.  Also, if you have some hard numbers that just aren’t going to change, like scheduled rent payments, then lock them down, or at least change the cell color to something glaring – like red.  That way, no one will touch those cells.

Set Variable Costs to Vary with Activity Levels

Another issue is variable expenses.  This isn’t just the cost of goods sold, but also things like training, or telephones.  These expenses change as a cost driver changes, so set up the cost driver in the model, and have those expenses vary automatically with the drivers.  For example, if a company usually pays out $500 per year in training expenses for each employee, then just create a formula that automatically plugs in an expense based on the head count.  By setting up some of the expenses under a formula, you don’t have to worry about making changes to those expenses as you go through multiple budget iterations – they take care of themselves.

Centralize the Variables

And yet another issue is where you put all of your variables.  If you sprinkle them all over the model, it can be really difficult to find them all, let alone update them.  So instead, put all of them in one place.

Additional Enhancements

Now, what about having managers create an entirely new budget for themselves every year?  That can be a laugh.  Since they’re not trained in creating budgets, they have a terrible time creating anything that reflects reality.  Instead, if the budget analyst knows what the general strategic direction is, then have that person go ahead and plug in the bulk of the budget line items, which are mostly based on historical information anyways.  Then she makes notes on the key items that the manager has to decide on, and goes over just those items with the manager.  The result is a budget that probably has the right amounts in the right months, and also wastes the least possible amount of manager time.

And finally, the budget will be viewed as nothing more than an annual annoyance unless you integrate it into two key systems.  The first one is purchasing. If the budgeted expenses are loaded into the purchasing system, it can issue a warning when expenditures exceed budgeted amounts.  This tends to keep managers extremely aware of their budget commitments.  The second item is the performance pay system.  Bonuses should be paid based on what managers committed to in the budget.  If they don’t make plan, they don’t get a bonus.  It seems simple, but most companies don’t link the budget to pay, so the budget is ignored.

Related Courses

Budgeting

Capital Budgeting

Breakeven Analysis and the Margin of Safety (#70)

In this podcast episode, we discuss breakeven analysis and the margin of safety; how they are calculated and when they should be used. Key points made are noted below.

What is Breakeven?

Breakeven is the revenue level at which you earn exactly no profit.  The calculation is to add up all of your fixed expenses, and divide by the gross margin.  So for example, if you have $10,000 of fixed expenses and your gross margin is 40%, then you need to sell $25,000 in order to break even. The breakeven point will go up if the amount of fixed expenses goes up, or if the gross margin goes down.  Conversely, the breakeven point goes down if the amount of fixed expenses goes down or if the gross margin goes up.

How Breakeven is Used

So why do we use it?  It’s good for two kinds of financial analysis.  The first is when you’re looking at a business unit for the first time, usually as an outsider, like a consultant or bank analyst, and you want to find out how much money it can potentially make – or not make.  For example, if a factory can potentially produce $1 million of revenue, and the breakeven point is at $200,000, then there’s lots of upward potential for profits.  But where you really see the usefulness of breakeven is in the reverse, where the breakeven point is so high that the company literally can never earn any money.  The breakeven point is higher than its ability to produce.

I’ve seen this last one a surprising number of times.  It’s amazing how many business owners have no clue that their cost structures don’t allow them to ever earn any money.

The second type of breakeven analysis is for incremental management decisions.  Usually, this involves one of two sub-levels of analysis.  The first is what happens to the breakeven point if a company accepts a large order that has a relatively small gross margin – if the new gross margin is really small, then breakeven analysis shows that the order may clog up the factory’s entire capacity.

This also brings up a good point with breakeven analysis, which is that a company may have to accept price drops in order to find enough orders to max out its factory capacity.  The result is that, sometimes, the highest profit level is somewhere below a facility’s maximum capacity.

The second analysis, and the one I get involved with the most, is whether purchasing new equipment is worthwhile.

I’ve seen a couple of cases where adding a complex new piece of equipment increases the fixed cost base so much that there’s no way the company can break even, or only do so if nearly its entire capacity is used.  I don’t want to duplicate what I’ve said before about capital budgeting, so go back to Episode 45 to learn more about that.  For the purposes of this discussion, just keep in mind that you can really attract management’s attention when they realize that a large asset purchase can render an entire factory completely uneconomical.

Also, please note that the point when a company usually makes the most profit is at the point just before a company invests in new equipment.  Once it makes that new investment – usually to increase capacity – costs go up, there’s not enough product demand to use the new capacity, and therefore profits drop.

What is the Margin of Safety?

A variation on breakeven analysis is called the margin of safety.  This is the percentage by which a company’s sales can drop before it reaches its breakeven point.  It’s a really useful concept when a company thinks that some of its sales might be at risk of going away, such as when a single customer has a large proportion of its sales.  By calculating the margin of safety, a company will know how much revenue it can lose before it’ll begin losing cash.

The calculation for the margin of safety is to subtract the current revenue breakeven level from the current sales level, and dividing by the current sales level.  For example, if the current sales level is $1 million and the breakeven point is $600,000, then sales can drop 40% before reaching the breakeven point.

Breakeven and the margin of safety are useful for analyzing management decisions, because they’re so incredibly simple.  Managers understand them right away, so you can easily create a before-and-after PowerPoint slide for a pricing or purchase decision, and they can see the relevant outcome.

Problems with Breakeven Analysis

The real problem with breakeven analysis is that people don’t know when to stop using it.  The tendency is for someone to first use it for a company-wide or factory-level analysis, and then keep drilling down, to the point where they do a detailed breakeven analysis for a single product.  The result is a report that shows a whole range of breakeven points for a company’s products, and which might even lead to some of them being discontinued. I’m sure the person who creates this level of detail thinks he’s doing a good deed, but all he’s really doing is working up the management team over what is actually a large pile of false information.

When you run a breakeven analysis on a single product, you’re probably allocating expenses to the product from a variety of work centers; and you’re also probably including direct labor when you calculate the gross margin.  But that’s flawed reasoning, because if management drops a product because of a high breakeven point, it’s just voluntarily dropped a bunch of revenue, while the factory as a whole still has all of the same fixed cost structure.

In short, you can get way too granular with breakeven analysis.  It’s best to stop using it at the product line level, because that’s the point at which you can usually assign specific people and equipment to a group of products.  And if it’s too difficult to break out costs at the product line level, then don’t use breakeven there, either.  Instead, confine the analysis to the factory level.

When to Use Breakeven Analysis

This means that you don’t need to use breakeven all that frequently.  A company may have thousands of products, but perhaps only a dozen or so product lines, and quite possibly just a few factories – and only at the higher levels is breakeven appropriate.

Another issue is how frequently you should run a breakeven analysis.  The answer is – not frequently at all.  Most fixed expenses and gross margins don’t alter very fast, so if you run the calculation once a month, any breakeven changes will be so insignificant from the previous month that everyone will ignore it.  So if you calculate it once a year, that’s fine.

Now, these frequency recommendations are based on a steady-state environment, where there aren’t many changes.  However, you should run a breakeven and margin of safety for any major changes, like a new price point, or if some new equipment is purchased.  So in total, depending on the size and number of changes within a company, you might only dust off a breakeven calculation a half-dozen times a year.

Related Courses

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Listing on a Stock Exchange (#69)

This podcast episode covers the essentials of what it takes to be listed on a stock exchange, including the application process and listing fees. Key points made are noted below.

The Need to Trade on an Exchange

If a company wants to be publicly held, there’s not much point in doing so unless it involves trading on an exchange.  Without being on an exchange, a company has all kinds of costs associated with being public, but there’s not much of a market for its stock.  Instead, it’ll probably trade on the over the counter bulletin board market, and not many people trade there.

The reason it’s so hard to trade over the counter shares is that institutions, like pension funds, don’t trade there.  Their investment rules very specifically state that their investment managers can only buy or sell the stocks or bonds of businesses that are on an exchange.  In a lot of cases, the rules are way more restrictive than that, so a company has to be trading on a specific exchange, or be listed within a certain index on an exchange.

Which Exchange to Pick

So, in short, you have to be on an exchange in order to experience any significant trading volume.  The next question is, which exchange?  There are many exchanges all over the world, but in most cases, a company likes to stay close to home and use an exchange right in its home country.  It’s just easier from a regulatory perspective.

In this case, since I’m in the United States, I’ll focus on the key exchanges there, which are the American Stock Exchange, the NASDAQ, and the New York Stock Exchange.  The American Stock Exchange is called the AmEx for short.

The Listing Application

To be listed on one of these exchanges, you have to go through a listing application, which takes anywhere from three to six months to complete.  I generally see the process taking closer to six months than three months.  The exchange sends you a boilerplate set of questions, which cover things like the total number of shares outstanding, the number of shares held by insiders, the number of independent directors on the audit committee, and whether there’s any fund raising activity going on.  The questions aren’t especially difficult, but it’s only the first round of questions.

Once the exchange receives your answers, it assigns a listing analyst to the application.  That person is overworked, and might not even open up the file for a month.  Eventually, he’ll review it, and dig through all of your latest public filings, and then send back more questions that are a lot pickier.  Expect at least three rounds of these questions.  Then the listing analyst sends the application to a supervisor, who does another review.  This one tends to be shorter, but by this time, three months have very likely already gone by.

Targets to Pass

Now the exchange will look at some hard quantitative targets.  You’ve got to pass each one of these, or you will not be listed.  The first one is the total number of round lot shareholders.  A round lot shareholder is anyone owning at least 100 shares of your stock.  The American and New York Exchanges require at least 400 of them, and the NASDAQ requires 300.  The reason for this rule is that the exchanges want the shares to be owned by quite a few investors, so there’s a better chance of trading occurring.  If there were just one shareholder, it’s possible that nobody would buy or sell it.  So this is a volume trading requirement.

Another requirement is the market valuation of the company.  The exchanges don’t want tiny little companies trading on them, so they have some hard requirements to keep out the small guys.  This is called a market capitalization test.  Market cap is the total number of shares outstanding times the current stock price.  The market valuation test varies quite a bit by exchange, so under one very specific scenario, you can get away with just a $50 million market cap on the AmEx, whereas the New York Stock Exchange can require a market cap of as much as $375 million.

And then we come to a very troublesome requirement, which is proving that the company is profitable.  Each exchange has a several different set of standards that you can try to qualify under.  So for example, the AmEx will let you in if you’ve had $750,000 of pretax income and stockholder’s equity of $4 million, and will even waive the market capitalization requirement if you have that.  On the other hand, one of the standards imposed by the NASDAQ requires aggregate pre-tax earnings of $11 million in the past three years.

And then there’s the stock price.  The larger exchanges don’t like low stock prices, so they impose minimum limits for listing applicants.  You generally need at least a $2 stock price on the American, and $4 or $5 on the NASDAQ.  Some companies will try a reverse stock split in order to increase their share price, but that’s usually a bad idea.  A reverse split attracts short sellers, so a company may find that its stock price did not double as a result of the split, and in fact it may be close to what it was before the split.

By the way, if you can get your stock price up to the minimum requirement for just one day, that’s not good enough.  The listing analyst will review a short-term history of the stock price to see if it appears to be sustainable at the minimum level.  If there are a few dips below the minimum, that’s OK – but there can’t be a trend where the price appears to be permanently heading below the minimum level.

This may sound like a lot of requirements, but I’m actually painting a simplified picture.  Each of the exchanges use multiple listing standards that you can qualify under, so for example, if you’re not profitable, then maybe you can qualify under another standard that has more onerous requirements for market capitalization or retained earnings.

Generally speaking, a smaller company wants to start on the American Stock Exchange, because its listing requirements are easier.  It can also choose to list on the NASDAQ Capital Market, which has roughly the same standards, but a higher stock price standard.  If it’s bigger or more profitable, then it can try the NASDAQ Global Market, which has tougher standards.  The largest companies will want to list on the New York Stock Exchange, which has the hardest of all the listing requirements.

Staying on an Exchange

Now what about staying on an exchange?  Each exchange has continuing listing standards which are easier than the initial entry requirements.  The main sticking point is the stock price.  Basically, if it drops under $1, the exchange drops you.  This is not the case for the American Stock Exchange, which doesn’t have a minimum standard – but they will delist you if you get into financial difficulties.

The Cost of Being Listed

And finally, what does all of this cost?  The AmEx and NASDAQ Capital Market both charge about the same initial listing fees, which are $45,000 to $75,000.  The NASDAQ Global Market’s listing fee is in the range of $100,000 to $150,000, and the New York Stock Exchange will usually charge somewhere between $150,000 and $250,000.

But of course, they’ll also impose an ongoing annual fee for you to remain on the exchange.  The current maximum annual fee for the AmEx is $34,000, the NASDAQ Capital Market charges about $28,000, and the NASDAQ Global Market charges $95,000.  The New York Stock Exchange has a much broader fee structure, but basically caps its annual fee at a half a million, though it’s possible to pay under $100,000.

Parting Thoughts

This has been an extremely condensed view of the listing process. A really complete treatment would need a podcast about 20 times longer, but the basic premise is that if you’re fairly small and not very profitable, you start out on an exchange that’s designed for your needs, like the AmEx or NASDAQ Capital Market.  You won’t have access to all possible investors, but they at least give you the opportunity for a fairly active trading environment.

As you get bigger, and you want access to more investors, switch upmarket to the NASDAQ Global Market or the New York Stock Exchange.  It’ll cost you more, but there’s likely to be significantly more trading in your stock.

Related Courses

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Tax Technology (#68)

This podcast episode covers how you can apply the most current tax technology to the filing needs of a business. Key points made are:

• Tax technology is based on compliance, filling out tax forms; regulatory complexity drives the output of these systems.

• Tax technology tends to be 5-10 years behind other business systems.

• It is relatively common for tax software to be tied into a corporate ERP system.

• Tax laws are so specialized now that few people are authorities on all tax areas of a business.

• An overriding goal for a public company is to make sure that there are no tax surprises, since the CEO and CFO are certifying that the financial statements are accurate. This means that incorrect tax filing calculations must be eliminated.

• The Big Four audit firms are taking the best tax talent away from corporations, so the corporate level of expertise is falling.

• A tax department needs good policies and procedures, as well as data collection systems for both structured and unstructured data. It must have a high level of real-time access, combined with excellent data security. All tax filings should be based on a single database.

• Best to use software as a service, in order to have a central database that is readily accessible from anywhere.

• Tax software should include modules for data collection, project management, resource management, audit management, and tax filings.

• Tax professionals will still use electronic spreadsheets, but should exercise tight control over them.

Related Courses

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Value Stream Mapping (#67)

In this podcast episode, we discuss value stream mapping, especially in regard to how it can be used to improve accounting operations. Key points made are noted below.

The Value Stream Mapping Chart

This episode is about value stream mapping, or VSM.  What it does is show you where there’s waste in a process.  It doesn’t show you how to eliminate it, but it does point out where you can find it. All of the VSM information you collect goes into a VSM chart.  The chart identifies all steps in a process, and key information about each item.  The “key information” can vary quite a bit by process, but it’s common to find things like total work time required, cycle time to complete a transaction, and error rates.

The chart also identifies the amount of time spent between steps, where the information from the last step is batched together, and consumes transit time to get somewhere else, and then parks in an inbound queue in front of the next process step.  It’s really common for the time between steps to be longer than the time during steps.

The Need for a Consultant

To create a VSM chart, you really need to bring in a consultant.  It takes a fair amount of time to collect information, and you probably don’t have enough staff available on-site to do the work.  Also, it isn’t something that you do just once.  Instead, you do an initial measurement, act on the information, then measure again to see what happened, and then keep measuring as long as you keep taking action steps.  In addition, it makes sense to re-measure the process at longer intervals to see if it’s backsliding.  Because of all this work, it really makes sense to hire a specialist who comes in at prearranged intervals, does the work, and gets out.

A consultant is also useful, because the people being measured don’t like being measured, and they have less chance of pressuring a consultant into fudging the numbers than they would with a fellow employee.

Using the industrial Engineering Staff

If you just can’t afford a consultant, then another good source is the industrial engineering staff.  They do this kind of analysis all the time, and they might do some kind of internal billing arrangement in exchange for helping out.  You could also try the internal auditing department, but VSM data collection is so repetitive that they might not want to help – and besides, they’re looking for control problems, and a VSM chart does not highlight control issues.

Information Structuring

So how do you structure this information in a VSM chart?  It’s not difficult at all.  First, create a series of blocks across a spreadsheet, with each one being a separate step in a process.  Then fill in identifying information about each step within each block, in sequence.  So for example, if you’re documenting a procurement cycle, the first block might be to submit a requisition, the next block is for processing a purchase order, and the third block is to receive goods at the warehouse – and so on.

Beneath each block, jot down the information you want to collect.  For example, there might be an error percentage field, and another field for the number of full-time equivalent staff used for the task – whatever it might be, the information goes directly under the block that you’re measuring.

Also make note of the processing time required under each block, and then also note the time required between steps.  With all of this information, you can quickly glance at an entire process, and decide where to direct your attention to improve it.

What you do with a VSM chart depends on what you’re trying to improve.  For example, if overtime is too high an expense, then you can track overtime for each step, see where the most overtime is located, and concentrate on overtime reduction in that area.  A more common issue is document error rates.  In this case, you may need to do two VSM charts.  The first one reveals which process contains the most errors.  Then you run the VSM again, but now as a drilldown for just that one process.  It’s quite likely that a single machine, or work practice, or employee is responsible for the bulk of the errors.

If process time reduction is the issue, then chances are good that you need to focus on the time between process steps, with the greatest emphasis – obviously – on whatever gap requires the most time.

All of these examples bring up an interesting point, which is that you can run multiple VSM charts on the same process, in order to fix different things.  On the first pass, the goal may be process time reduction, so that’s what you measure, and that’s what you reduce.

The next time around, you focus on errors only, and you reduce those.  But at some point, these different goals will probably interfere with each other.  So for example, let’s say that you’ve just shrunk a process way down, but you did so by cutting out some controls that resulted in more errors.

At some point, you’ll need to come to terms with which goal is more important, and back off a bit with the other conflicting goals.

Where to Use Value Stream Mapping

So where does VSM work best?  Definitely in high-volume processes, because this is where it makes the most sense to try to wring even a few extra seconds out of a repetitive process.  Conversely, don’t even bother if there’s really low volume, or where people constantly switch around among different jobs during the day.  If there’s no volume, then measurement results aren’t very reliable, and there’s not much payback from making an improvement.

Given these restrictions, there’re really only a few places in an accounting organization where value stream mapping can help – and those places are pretty obvious.  You should be looking at customer billings, cash receipts, and payables, in particular.

If you liked hearing about value stream mapping, then you might also like to listen to a discussion of accounting run charts, which show you how to track process performance over time. That discussion was back in Episode 32.  There are also articles about value stream mapping and accounting run charts on accountingtools.com.  To access them, just go to the website and enter a few key words in the search bar at the top of any page.

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Obsolete Inventory (#66)

In this podcast episode, we discuss how to identify potentially obsolete inventory, who should examine it, and how to get rid of it. Key points made are noted below.

If you have inventory, then some of it is obsolete. Period. If you don’t think so, then you’re not investigating it very well.  The trick is to form a group who’s responsible for obsolescence, then creating a system for finding it, and then figuring out how to dispose of it.

The Materials Review Board

The group you need is called the materials review board, or MRB.  This group has members from every department that has something to do with inventory, which means someone from accounting, engineering, logistics, and production.  For an example of why you need so many people, the engineering staff may want to keep some parts that they’re incorporating into a new product design.  Or, the logistics department knows that it’s impossible to obtain a particular part, so they’d rather hang onto it for service parts use.

This group is responsible for periodically reviewing the inventory, to see what goes and what stays.  To do this, they need information about which items are obsolete.  There are several ways to get it.

The Where Used Report

The best way is what’s called a “where used” report, which is really common in material requirements planning systems.  It’s a report that lists all of the bills of material in which a part is used.  If there’s no “where used” bill for an inventory item, then it’s not being used anywhere.  Kind of good key indicator of obsolescence.  To make it work better, make sure you deactivate any bills of materials for products that are no longer being manufactured.

The Last Date Used Report

Another option is the “last date used” report.  It’s not a common report in most manufacturing software packages, but it’s easy enough to create with a report writer.  All you want is the product name and number, the quantity on hand, and the last time the item was used.  Then sort the report so that the oldest items go first.

Now, this report will tell you if something hasn’t been used for a long time, but it doesn’t tell you if it will never be used again, since it might be a critical part of a product that’s coming up for a new production run in the future.  So use it with care.

Use Old Count Tags

But what if you don’t have an inventory tracking system, or you don’t think you can rely on it?  Well, if you do a year-end physical inventory count, then just leave the count tags on the inventory items.  If items get used later in the year, then the tags will be thrown away.  But if they aren’t used, then you can tour the warehouse a few months later, and just see which items still have tags on them.

This is an imperfect method, since lots of tags will be ripped off by mistake – after all, the warehouse is a high traffic area.  Also, if a whole box of parts has a single count tag on it, then the warehouse staff can easily work around the tag and still remove parts from the box.  So, be careful in using this technique.

Examine Engineering Change Orders

One last possibility is to look at the engineering change order records in the engineering department, or ECO.  The ECO describes what new part is replacing an old part on a product, because the engineering staff redesigned the product.  So, comb through the records and figure out which items have been replaced.

What to Do Next

So – we have several methods for locating obsolete inventory.  What do we do with it?  The next step is to summarize it for the materials review board.  To do so, list in a single report the name of each item, with the warehouse location, quantity on hand, the last year’s usage total, the planned usage total, and the extended cost of what’s on hand right now.

The MRB really wants to know about that last item, the extended cost.  This is the company’s investment in the inventory, and the MRB should really focus on the big dollar items.  Incidentally, if the warehouse is packed with inventory, the MRB may actually be more interested in the cubic volume of storage space taken up by the obsolete inventory – so the report could contain that information, as well.

The MRB then decides on whether to dispose of the obsolete inventory, when to do so, and also how much of it to get rid of.  In many cases, the logistics department still wants to retain some, because of service parts needs.  So, the MRB has to create an authorization memo that states all of this information.  Once it’s complete, the logistics department has to dispose of it.  And the sooner the better, since inventory drops in value over time.

Disposing of Obsolete Inventory

And how do we dispose of it?  One of the best ways is to have the service department call customers and see if they’d like to buy it as service parts, which means you can sell it at a good price.  It may also be possible to return the parts to the supplier, though there’s always a restocking fee, usually in the range of 15 to 20 percent.  Sometimes the supplier only issues a credit for them, so you’re still stuck with buying something else from the supplier with the credit.

Of course, there is always ebay.com, or any other on-line auction service.  This works pretty well for consumer goods, not so well for anything else.  Another option is to bring in a salvage contractor, though they only pay a fraction of the total value of the inventory.  If you use one, make them buy in bulk, and not pick over the inventory for the real values.  That way, you can dump more inventory on them.

And finally, you can also donate the inventory to a non-profit, and take a tax deduction.  It can take some time to find a good recipient, so this is a labor-intensive option that many companies just don’t bother with.

And finally, it’s actually better to throw obsolete inventory into the dumpster than it is to keep it in the warehouse.  That way, you free up shelf space for other inventory, and you no longer have to insure it.

Preventive Measures

Now, what about preventive measures, so that inventory never becomes obsolete?  A good one is to have the logistics department review any upcoming engineering change orders in advance.  That way, they can draw down existing stocks with a final production run, and then implement the change order.

Another option is to require the engineering staff to only design from an approved parts list, so fewer parts get used on many products.  And finally, you’ve got to keep the purchasing staff from buying in bulk.  Even if it’s a great deal on something, you just don’t want a two-year supply of a part sitting on the shelf.  The longer something is in the warehouse, the better the chance that it’ll become obsolete.

Related Courses

Accounting for Inventory

Inventory Management

Responsibility Accounting (#65)

In this podcast episode, we discuss the nature of responsibility accounting, and how such a system can be operated. Key points made are noted below.

How Responsibility Accounting is Used

Under responsibility accounting, the basic point is that every cost incurred must be the responsibility of someone, somewhere in the company.  That’s it.  Doesn’t sound too complicated, but it means that the accountant should create a whole subset of reports below the company-wide financial statements, and distribute them to every responsible party.

These reports come in three flavors.  The first is a profit center, where the recipient is usually in charge of an entire facility, and wants to see everything, including revenues, expenses, and profits.  There’re usually not a whole lot of profit centers in a company.

The second flavor is a cost center.  This is where there are no revenues directly associated with an activity.  It could be an accounting department, or perhaps a production cell on the factory floor.  This tends to have a pretty small number of expense line items, but they many involve hundreds of managers.  So you could issue hundreds of cost center reports.

And there are also revenue centers.  Kind of obviously, they only report on revenue results.  This type of report goes to the sales staff and product managers, though product managers can also receive full profit center reports.  These reports can itemize sales right down to individual stock keeping units, and so they can be fairly hefty.

Now if you’ve never issued responsibility reports, you may ask why you should start.  Well, consider the distribution of the normal set of financial statements.  It goes to the senior management team, perhaps some subsidiary managers, and that’s about it.  No one else knows what’s going on, until they get called into a senior manager’s office near the end of the year, and get blasted for having cost overruns or profit shortfalls that they knew nothing about.

But if you have responsibility-level reports, practically every manager gets something.  It may be a really short report, with one line item on it.  But if that’s what they’re responsible for, then that’s a good report.

How Overhead is Allocated

So, what about allocated overhead?  Lots of companies like to allocate overhead to individual subsidiaries, or to departments within those subsidiaries.  It can be things like corporate overhead, or the cost of janitorial services.  Allocating overhead is a really bad idea.  The main point of responsibility accounting is that you only see in a financial report those items for which you are responsible.  That’s it.  Nothing else is included.  Therefore, take out overhead allocations.

But this doesn’t mean that overhead is never reported anywhere.  After all, this can be a really large number.  What you do is only report it to the person who is – what a surprise – responsible for it.  So, you should report corporate expenses to someone like the chief operating officer.  Or, if you have janitorial expenses for an entire facility, you can report those expenses to the maintenance manager, and to the manager of that entire facility – but don’t report it to the department managers within that facility.  They can’t do anything about it, so don’t bother them with it.

Contents of a Responsibility Report

So… what exactly goes into a responsibility report?  You can certainly send out just the last month’s results.  But that doesn’t give the reader anything to compare it to.  To fix this, the most obvious option is a budget versus actual report, both for the current month and for the year-to-date. The trouble is, some of the most enjoyable science fiction I’ve ever read involves budgets.  In a lot of cases, they don’t even bear a slight resemblance to reality.  And strangely enough, the budgeted results are always better than the actuals.

A better alternative is to run a rolling 12-month report, which shows actual results for each of the last 12 months.  This has nothing but actuals in it – no budget allowed.  This gives readers a really good idea where everything is trending, which I find is much better information than a budget to actual comparison.

A variation on the rolling 12-month report is to do it as percentages, so that revenues appear as 100%, and the various expense line items are fractions of that 100%.  I think it has some value, but most users prefer seeing the underlying numbers.

How to Roll Out Responsibility Reports

Now, any controller who wants to just close the books each month and get on with life is shaking his head and wondering where to find the time to issue this massive number of additional reports.  Well, there are a couple of solutions.  First, see if your accounting package automatically prints and e-mails reports.  If it does, then set up all the responsibility reports in one massive batch, and run the batch right after the books are closed.

Second, you can push responsibility reporting down into the organization in stages.  The traditional financials are for the top level of managers.  Then go down one level, and you’ll probably find that you need about three times as many customized reports for this group.  Then push down another level, and you’ll triple the number of reports again, and so on.

The number of new reports needed at each level is directly associated with the span of control at each level of management.  If the span of control is five direct reports for each manager, then you can expect to create five times as many reports when you go down one additional level in the organization.

In essence, address one management level at a time, and stop issuing more reports when you can longer support the extra workload.

So far, we’ve talked about creating reports for all kinds of responsible parties.  But – what if no one seems to be responsible for something?  There are situations where an expense is incurred, but no one is authorizing the expense – it just happens.  This is usually minor stuff, like office supplies, and it isn’t an overwhelming concern.  But on the other hand, if you find a stray item, then bring it to the controller’s or CFO’s attention.  They should park it under someone’s jurisdiction, and should make sure that the newly responsible person knows about all it.

Related Courses

Accounting Information Systems

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SFAS 141R, Business Combinations (#64)

In this podcast episode, we discuss the new requirements of SFAS 141R, Business Combinations. Key points made are:

• Most assets and liabilities associated with an acquisition transaction should be recorded on the acquirer’s balance sheet at fair value.

• Any noncontrolling interest in the acquiree is valued at its fair value.

• The acquisition method is now used, instead of the purchase method.

• Everything should be valued as of the acquisition date.

• The cost of the acquisition is charged to expense as it is incurred, because these expenditures do not meet the definition of an asset.

• In-process research is recognized as an asset; it is amortized or written off later.

• Contingent consideration (an earnout) is to be recognized up front, at its expected fair value.

Related Courses

Business Combinations and Consolidations

Mergers and Acquisitions

Investor Relations: Guidance (#63)

In this podcast episode, we discuss the need for issuing earnings guidance to the investment community, including tips regarding the nature of that guidance. Key points made are noted below.

The Need for Guidance

Without guidance, investors have no idea how a company will perform in the future, and so they have to make their own guesses.  Since no one is basing their guesses on any real information, you’re going to see a broad range of estimates.  And that translates into a great deal of stock price volatility, because everyone assumes that the company’s stock should be at a different price point.

Now, stock price volatility is not good.  First, it attracts short sellers, who make money from rapid changes in the stock price.  It also drives away institutional investors, who prefer stocks whose prices move within a narrow range.  Since institutional investors are driven away, there’s less demand for a company’s stock, and so its price declines.  This results in a higher cost of capital for the company, because it has to issue more shares in order to raise money.  So, there’re some major consequences to not providing guidance.

Also, let’s say that a company has no analyst following, which is normal for smaller public companies.  If so, there is no one who can independently provide earnings predictions, which leaves the marketplace completely devoid of information.  So, the absence of any analyst following makes it even more useful to provide guidance.

When Not to Issue Guidance

But there is one case where it still makes sense to avoid issuing guidance – That’s when management doesn’t have a clear picture of future results.  This is most likely when a company is buying a lot of companies, or it’s entering new markets.  If so, its results may vary so much that it really isn’t helping to issue guidance that’s quite possibly wrong.  Under this scenario, it’s better to state the situation, and promise to provide guidance at some point in the future, once results become more predictable.

It’s also possible that a company’s forecasting systems are so crappy that it’s routinely issuing poor guidance.  In this case, the investment community will assume that the management team doesn’t know what it’s doing.  If so, it’s better to stop issuing guidance until it has better forecasting systems.

So, let’s say that you consider those issues, and decide to provide guidance – which is usually a good decision.  If so, the next question is – what kind of guidance.

The Type of Guidance to Issue

The usual type of guidance is for a range of possible results, and includes all the major factors that would be of interest to an investor, such as revenue, gross margins, net income, and earnings per share.  The range of projected results should be fairly broad the further into the future you go, since that’s the most uncertain.  Short-term results should fall within a tight range.

Here’s an example.  We’re raising our guidance for the fiscal year ended December 31.  We now expect the year’s sales to range between $120 and $135 million, resulting in net profits of between $14 and $17 million, and diluted earnings per share of between $1.43 and $1.49.  For the following year, we’re expecting sales in the range of $130 to $160 million, resulting in net profits of between $16 and $21 million, and diluted earnings per share of between $1.48 and $1.60.

An alternative is to provide guidance using percentages.  By doing so, an analyst can construct his own models of a company’s performance, and plug in the latest guidance to arrive at his own conclusions about the company’s likely performance.  For example:

Our projected revenue growth is 7-10 percent.  Based on our estimated increase of five percent in the cost of goods sold, we’re projecting gross margins in the range of 50 percent to 55 percent, with the low end of the range based on seven percent revenue growth and the high end based on 10 percent revenue growth.

If a company isn’t willing to provide this level of guidance, then a lesser alternative is to discuss the general financial situation, or the long-term strategy.  For example, you could say:

Our long-term strategy is to expand our franchising model throughout the North American region, with a target store opening rate of 150 per year.

A different method is to release a broad range of non-material information.  Analysts then use it to create their own models of a company’s operations and its likely operating results.

This is called the “mosaic” approach, because they have to piece together lots of  information into a composite picture of the company.  It’s for a company, because it avoids any specific guidance, but it’s a royal pain for an analyst, who has to work much harder to create an earnings model.

Now, once you decide to release information to the marketplace, be prepared to continue issuing it for a long time.  Otherwise, the market can react quite negatively when information is discontinued, since they assume that the company is hiding information.  So, if you think that information that was included in guidance is now irrelevant, then be sure to explain the reason for the discontinuance in some detail.  Otherwise, you might be looking at a decline in your stock price.

When to Update Guidance

If you give guidance, then update it on a regular schedule.  This usually means issuing quarterly guidance, right after the quarterly 10-Q report is released. Analysts depend on quarterly guidance, so they can revise their own estimates of company performance.  If a company elects to forego quarterly guidance in favor of some longer period, it’s possible that some analysts will find it too difficult to provide estimates regarding company performance, and they’ll drop their coverage.  If this happens, stock price volatility may increase, because there’s uncertainty about how the company is doing.  So, provide frequent guidance updates to avoid excessive movement in the stock price.

There are some cases where it’s reasonable to issue guidance even more frequently than on a quarterly basis.  For example, if a company has an analyst following and a number of them are projecting really high or low results, consider giving immediate guidance to put them back on track.  By doing so, analysts can alter their projections at once, thereby keeping the company’s stock price from tracking in accordance with those incorrect estimates.

Also, if a company doesn’t revise its guidance, then the investment community assumes that the information in the last guidance is still current.  So, if circumstances have changed, and made the current guidance misleading, then issue new guidance in advance of the normal guidance release schedule.  But only do this if the level of change is very substantial.

Whether to Issue Aggressive Guidance

Under no circumstances should you ever issue aggressive guidance, where it’ll be difficult for the company to achieve the forecast. What happens then is a short-term ramp up in the stock price, followed by a price crash when the company can’t achieve its own guidance.  If a company repeatedly issues aggressive guidance, then you end up with very high price volatility, which drives away long-term investors.

A much better alternative is to always provide guidance that’s within the management team’s comfort zone.  If everyone in a company knows they can attain the guidance levels, then they’ll be less fixated on reaching the target, which reduces the risk of fraudulent reporting.  Also, by providing reasonably conservative guidance, analysts will find a company to be more trustworthy and reliable, and so they’ll be more likely to provide coverage.

But, this doesn’t mean that you should always issue excessively low guidance.  If a company routinely exceeds its guidance by a large margin, then analysts will expect the same thing in the future.  So, if a company were to only meet its own guidance, analysts might treat this as poor performance.  Therefore, the best level of guidance is to issue slightly conservative numbers.

In short, use guidance whenever you can forecast results with some reasonable degree of accuracy.  Where guidance causes problems is when it’s too aggressive, so be consistently just a bit conservative.

Related Courses

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Accounting Standards Codification (#62)

In this podcast episode, we discuss the structure of the accounting standards codification that has been produced for all GAAP accounting standards. Key points made are noted below.

The Need for a Codification

The Financial Accounting Standards Board is combining all accounting standards into a single database that’s indexed with a standard coding structure.  This means you no longer have to look up a Statement of Position, or an Emerging Issues Task Force consensus, or a Statement of Accounting Standards.  Instead, it’s all in one place.

Now keep in mind that this doesn’t change GAAP at all – but it does reorganize a couple of gazillion GAAP pronouncements into about 90 topics.  This means you’ll spend less time researching accounting problems.  And on top of that, every time they issue a new standard, they’ll drop the new text directly into the new coding structure.

Exceptions to the Codification

There are two exceptions to what you’ll find listed in the codification.  One is guidance issued by the Securities and Exchange Commission, though even in that case, some of their content will be included.  And the other exception is governmental accounting standards, which aren’t included at all.

The Verification Phase

This codification project is now in a one-year verification phase, while users check it out and make comments.  After verification is completed at the end of 2008, this will supersede all other accounting standards. While the verification phase is going on, you can sign up for it for free and browse through it all you want.  To do that, go to asc.fasb.org.  You have to register to use the site, but that only takes a minute.  I strongly suggest that you try it, because it’s really well done. If you look at the main FASB web site, which is fasb.org, you’ll notice that it’s functional, but they could use a professional web designer to clean it up.  But the codification site is an entirely different story, because it’s an exceptionally fine piece of work.

The Codification Layout

Here’s how the layout works.  Down the left side of the page, they itemize the top levels of the codification, so you’ll see just major categories, like assets, liabilities, equity, revenue, and expenses.  And – the part I like – they have a category at the bottom for industry-specific GAAP.

My personal favorite is steamship company GAAP, which is parked way down at the bottom of the list.  Not sure that applies to anyone anymore.

The top level also contains two other categories.  One is called Presentation, and obviously it covers how to present information, so it has subcategories for things like the balance sheet and income statement, but also more specialized topics, like earnings per share and interim reporting.

The other category is their catchall, which is called Broad Transactions.  It contains topics like business combinations, derivatives, and leases.

If you click on any of these categories, you can drill down through their menu system for as many as four levels.  So for example, if you start at the Expenses level and then select the Compensation sub-level, that takes you to Retirement Plans, and from there, you can go to Defined Benefit Plans.  But that’s pretty deep.  In most cases, the menu structure stops at three levels.

So let’s say that you drill down all the way to the underlying text.  If you do, you’ll have a selection of categories of information to choose from, like an overview, scope exceptions, the glossary, and of course the main discussion.  But rather than clicking on each item in turn, your better option is to click on a button called “Join all Sections,” which merges all of this information into a single web page.  I find that this makes it easier to read.  Now once you get to this page, you’ll find that it also has lots of hyperlinks to cross-references.

Other Codification Features

The site has some other nifty features, too.  If you go back to the home page, it has a tab on the right side that directs you to tutorials for how to use the site.  And for all of us old-timers, there’s an awesome cross-referencing tool, where you can plug in the name of the original GAAP source, and it returns a list of where the same information is now listed under the new coding structure.

So for example, if you want to cross-reference an AICPA statement of position, you access the SOP category, the system comes back with a drop-down menu containing all of the current SOPs, then you select one, and click on the Generate Report button.  Then it returns a complete list of where every single paragraph in the SOP can be found in the codification – with a hyperlink, of course.

So, what about the codification system itself?  Well, it uses four levels, with a three-digit topic going first, then a three-digit subtopic, then a three-digit section, and then a paragraph.  This is going to take some getting used to, especially when everyone has memorized their favorite accounting standards, and now has to convert this over to a new number.  For example, many of us know what FAS 123R is, because it deals with stock-based compensation, and that’s been a hot topic for years.  Well, now we have to remember that it’s subtopic number 718.

Yes, the new coding structure will take a fair amount of time to get used to, but on the other hand, this means we finally have a simplified way to research accounting topics.  And that beats the old system, which was pretty arcane.  Sure, we could navigate through it, but any newcomer to the field must have been wondering why they had to memorize all of those reference acronyms and numbers, like SOP 97-2 for software revenue recognition, or FAS 133 for derivatives.

Oh, and by the way, once you’ve memorized the new codes, there’s a search feature on the home page, so just plug in the code and it takes you straight to what you need.

So, how good is the new codification system?  Well, because of the excellence of the web site, I have to rate this an A+ effort.  To everyone involved in the project, which has been about 200 people for the past four years, you did a nice job.

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GAAP Guidebook