Employee Management Systems (#113)

In this podcast episode, we discuss the benefits of using a computerized expense reporting system. Key points made are:

• Employee spend management reduces the time required to submit expense reports by automating the entire process.

• These systems automate data entry, automatically reconcile expense reports, and can reimburse employees.

• Employees can access these systems using a mobile phone, which is also used to take pictures of receipts.

• The payment system can be linked to your travel itinerary, and can automatically capture your credit card charges.

• The exact solution chosen will depend on the size and structure of the company, and whether employees engage in international travel.

• The system may need to be adjusted to account for the company’s travel policies.

Related Courses

Expense Report Best Practices

Lean Accounting Guidebook

The Transition from Auditing to Industry (#112)

In this podcast episode, we discuss the many differences you will face when switching from auditing to industry. Key points made are noted below.

This episode is a bit different. A professor at the University of Denver asked me to speak to her accounting students about the job transition from being an auditor to working in industry. The differences are huge, which makes this an interesting topic, so I’m putting a much shorter version of it on the podcast.

The Reason Why We Audit Right Out of School

A lot of students get their accounting degrees and go straight into auditing, because there’re auditing firms who want to hire them right away. And there’s a fair amount of prestige in working for one of the Big Four audit firms, or one of the larger regional firms. So, there’s a good chance you’ll start your career in auditing.

When you’re an auditor, you’re main task is judging the work of your clients. That makes you similar to a policeman, or a judge – a very well-trained one, but that’s what you are. That also means you’re not in a creative job. You don’t get the satisfaction of making things. You don’t create systems. You may review the systems that other people created, but that’s it. And furthermore, clients don’t like you. They throw a party after you leave. That’s the essence of the job.

As you progress as an auditor, you do pick up quite a bit of knowledge about how different companies operate, and you’ll learn about how to apply a lot of accounting standards to real-world situations. At some point, you’ll start to specialize in a particular industry, and you’ll have a core group of clients in that industry. Then your learning curve starts to go down, and you’ll find that you’re still a policeman or a judge, but you don’t have the offsetting benefit of learning about a lot of new things. In short, you’ve reached a career plateau, probably with the title of audit manager, and with about four to six years of experience. And if you can’t bring in new business, this is as far as you’ll go as an auditor.

When to Switch to Industry

And this is the point where a lot of auditors decide to make the switch to working in industry. Chances are good that you’ll end up working in whichever industry you specialized in as auditor. When you get there, you’ll probably be in an assistant controller position, or if the company is a small one, you’ll be the controller.

How the Job Changes

Now, the first massive difference you’ll see is that your emphasis just went from rendering an opinion on financial statements to making the next payroll. You may have noticed that constructing a cash forecast is not on the CPA exam, but now it’s really important! So you have to start thinking in terms of cash flow instead of financial disclosures. Welcome to operations.

The next thing you’ll notice is that you’re really a process engineer, because a large part of the job at this level is transaction processing. You have to know how information flows through the company, and how it rolls up into the financial statements. Depending upon the level of mess you walked into, there could be control problems everywhere, and you need to fix them.

This requires setting up policies and procedures, and training people to use them, and being diplomatic about it. And if you get it right, no one really notices. But if you get it wrong, everyone does. So this is one of those basic structural issues that you have to pay attention to all the time. And, guess what? When you were an auditor, you never learned about policies and procedures, or how to do hands-on training. Though you should have a pretty good feel for how a process ought to work, and where to fit in control points.

Another transition item is that you no longer have to be quite so conversant in either U.S. or international accounting standards. You’re now working in a single industry, and you only have to know about the standards for that industry – and those standards probably haven’t changed much for a number of years. So, you’ll find that you just don’t have to keep up as much on accounting standards. And that means that accounting knowledge goes from being your first job requirement as an auditor to maybe the third or fourth most important thing in industry.

You’ll also have an interesting time creating financial statements. So far, your mindset has been to create financials that present accurate results. And as an auditor, you pick over the presentation and the disclosures to get the financials package just right. Now you need to produce financials every month, and management screams bloody murder if you don’t get them out fast.

This means that, again, you’re in process engineering mode.

You have to know the closing process really well, and where the trouble spots are likely to be, and you put out something that’s pretty close to accurate in a couple of days. More than likely, you’ll have a few corrections floating around that you’ll fix in the next month’s financials.

So you can see the difference. Auditors always complain about client financial statements that are not exactly right, with perfect supporting documents. Whereas company controllers have to create financials 12 times a year, and they accept that it won’t be perfect every time.

The Work Environment

And then there’s the work environment. Two issues that play a big part in the work environment are intelligence and age. The best audit firms pick from the best accounting candidates in the best colleges, and the result is a group of smart, young people. Sure, the senior managers and partners are in their 30s and 40s – or older – but the bulk of the people are in their 20s, maybe up as far as 35 years old. And a lot of them are singles. And as an auditor, you get used to being in this environment.

Then you move into industry, and it can be quite a shock. You’re likely dealing with a large clerical staff. They know their jobs very well – they may be great at accounts payable, or billings, or payroll, or collections. But they may not have college degrees, and their knowledge of accounting may be totally from in-house training. And they may be much older. Some people may be close to retirement. Many are married, with kids.

I’m not saying this a bad environment, it’s just an extremely different one. You have to get used to a family environment where everyone does not go partying after work, because they’re having dinner with their kids and then they’re helping them with homework.

And if it’s a small company and you’re the only trained accountant, this can feel a little lonely.

The Promotion Issue

And a final item is promotions. In a audit firm, the rule is up or out. You expect a promotion every year or two, and if you don’t make the cut, you leave. In industry, and especially in a small firm, there may be no promotions unless someone above you leaves. So if you’re hired into a specific position, expect to stay there. A lot of the time, the only way you can get a promotion is to leave and apply for a higher position at a different firm.

Parting Thoughts

So, bottom line on the transition from public accounting to industry – there are very few points of similarity between the two, which can make this a tough transition. On the other hand, a lot of auditors don’t find their work to be very creative, so they enjoy the switch. But, there are others who really get into accounting standards, and they can’t figure out the daily grind of an accounting department. Those people usually head back into auditing. And that’s it.

Related Courses

New Controller Guidebook

Variance Analysis and Horizontal Analysis (#111)

In this podcast episode, we discuss the problems with variance analysis and how to use horizontal analysis instead. Key points made are noted below.

The Nature of Variance Analysis

Variance analysis is using a bunch of different types of variance calculations to figure out why actual results vary from a standard that you set up at some point in the past. So, for example, the labor rate variance measures the difference between the actual rate paid and the standard rate that you’re using for a baseline. And, the material price variance measures the difference between the actual price paid for materials and the standard price. Obviously, these calculations both measure changes in the rate that you pay for something.

The other type of variance is a usage variance. For example, the labor efficiency variance measures the amount of labor used in comparison to the standard number of hours that you expected to use, and the material yield variance measures the amount of materials you used in comparison to the standard amount that you expected to use.

And there’re similar variances for overhead. You get the general idea.

Now, variance analysis started in the first half of the 1900s, when there were really large, high-volume assembly lines that ran pretty much the same product, over and over again, for a long time. And in those situations, variance analysis could be useful for finding out what when wrong, since the same production system would probably be in place the next month, or the next year, for that matter, and you could tweak the system to reduce the variances.

Why We Don’t Need Variance Analysis

The trouble is, production doesn’t work that way anymore, and yet we still have accountants running around calculating the same variances. My case is, that the bulk of variance analysis should go away. Here’re some points to consider.

The first issue is the increased use of just-in-time systems, where customer orders drive production. If there’re no orders, then there’s no production. This means that your labor variances could be wildly negative in comparison to whatever your standards may be, since the standards assume a specific amount of steady production.

The second issue is that variances are only calculated after the end of each month, and by the time the accounting staff sends the variance results back to management for review, the issues are so far back in the past that they’re irrelevant.

A really good variance analysis system would give feedback to the production staff within moments of something happening, so that they can act on it right away. Well, the accounting staff is not geared to do that. Accountants are better at aggregating financial information from a database, and summarizing it for consumption at much longer intervals.

Let’s try a third point. You go ahead and calculate all of these variances. What are they actually telling you? Not much at a gross level. For example, what if the labor efficiency variance is $50,000? Can I take some action based on this information? Of course not. I have to drill down further, and figure out exactly what happened, such as needing to use overtime to make a rush delivery to a customer. Because you have to drill down a long ways to obtain any information that you can actually act on, it takes even longer to get usable information into the hands of management.

And here’s a fourth point. Variances are based on a standard. Who sets the standards, and what do the standards mean? The real poster child for this issue is the material price variance, because the purchasing staff decides what the standard will be. Since the purchasing department is being judged on how well it can buy in comparison to the standard, you can bet that they try very hard to keep the standards extremely achievable.

Bottom line, standards are set to make the standard setters look good, or at least they try all kinds of politics to make the standards come out that way. And if all you’re using variance analysis for is to cover people’s butts, why use it at all?

The Need for Horizontal Analysis

So, those are some reasons why I haven’t used variance analysis for years. But, if I’m not using variance analysis, what do I use? I can’t very well just hand out financial statements with no explanation of what went wrong or right. Making recommendations to management is part of a controller’s or a CFO’s job, so you have to analyze operations somehow.

What I prefer to use is called horizontal analysis. It’s very simple. Just prepare financial statements that show results for the last 12 months on a rolling basis, so the most recent results appear, along with each of the preceding 11 months. You can do this with almost any accounting software, or you can build it on a spreadsheet. Either way, the information is easy to put together.

Horizontal analysis just means that you’re comparing results over the months, and looking for spikes or dips that you don’t expect. When you spot one, investigate it, usually by digging through the detail for that account in the general ledger. For example, rent expense should only change when there’s a change in the lease rate. So if I see a sudden jump in the expense, then I know a subtenant didn’t pay their rent, and I can take action on that.

Horizontal analysis has a bunch of advantages over traditional variance analysis. First, it doesn’t compare anything to standards, which is hokey anyways. Second, it’s based solely on financial information that’s entirely within your accounting database. That means all of your answers are in the general ledger, and not somewhere screwy, like the bill of materials or labor routings.

And third, everyone reads it. You should be sending these rolling-twelve month financials to the entire management team, so that everyone can see the same spikes and dips that you see. If you include the reasons for those items in the notes that go with the financials, then you’ll have done your duty; you’ve told management what’s going on with their company’s financial results.

Now, if the financial statements are extremely summarized, like having a single line item for general and administrative expenses, then either create a more detailed version of the financials, or else do the horizontal analysis at the individual account level in the general ledger, rather than using the financial statements.

And, by the way, you can certainly use horizontal analysis for all of the financial statements, not just the income statement. It’s just as useful for examining cash flows and the balance sheet.

So, in short, don’t even try to use old-fashioned variance analysis. You’ll just spend a lot of time creating incomprehensible information that no one will use. Instead, use horizontal analysis. It’s simple to use, and you can investigate problems more easily. And… that’s it.

Related Courses

Business Ratios Guidebook

Key Performance Indicators

The Interpretation of Financial Statements

The National Investor Relations Institute (#110)

In this podcast episode, we talk about the functions of the National Investor Relations Institute (NIRI). Key points made are:

• NIRI represents financial communicators in public companies.

• NIRI provides education about investor relations best practices and SEC rule changes, and provides community activities for its members. It also represents members before government agencies and legislators.

• NIRI issues a periodic newsletter.

• NIRI members usually come from the investor relations department.

• NIRI has 32 chapters in the USA; 85% of its members belong to a chapter.

• The typical NIRI member has a finance background, and so needs training in capital markets, communications, and legal issues.

• There are investor relations certificate programs available, but full degree programs are sparse. One of the better providers is the University of San Francisco.

• New topics that NIRI is discussing with its members are dark pools, the use of social media, video, website content, and governance (including pay disclosures).

Related Courses

Investor Relations Guidebook

GAAP vs. IFRS for Fixed Assets (#109)

In this podcast episode, we cover the differences between GAAP and IFRS in the accounting for fixed assets. Key points made are noted below.

Recordation Differences

Fixed assets is an area where there’re really significant differences between GAAP and IFRS, so if you’re using GAAP right now and you think you’ll be switching over, then expect to be doing things differently in the future. The biggest difference is that IFRS allows you to either record a fixed asset at its cost, or to revalue it to fair value. But if you do revalue it, you have to revalue the entire class of assets, not just one asset within a class. By making you revalue an entire class of assets, IFRS makes sure that you can’t use selective revaluations. And the same thing goes for investment property. Under GAAP, you carry it at cost, but under IFRS, you have a choice of using either cost or fair value.

The obvious question is, how do you account for a change in an asset’s fair value under IFRS. Well, if an asset increases in value, then you recognize the gain in other comprehensive income and the offset is to a revaluation surplus in equity. And if the asset value decreases, then you recognize it as a loss. Now, if the value decreases and then goes back up again, you can recognize a profit to the extent of the original loss, and then drop the rest of the gain into other comprehensive income.

Asset Revaluations

Of course, there’s a problem with revaluing assets all the time, which is that it’s expensive and it’s time-consuming. So IFRS recommends revaluing about once every 3 to 5 years. And if you do revalue, IFRS recommends that you use a professional appraiser. So if you want a guaranteed job, become a professional appraiser.

Asset Impairments

Another major difference is the treatment of asset impairments. Under GAAP, if you have an impairment, then it’s charged to expense, and you cannot take it back. But under IFRS, if the asset’s value goes back up, you can take back the amount of the impairment. And also under IFRS, if you’re valuing fixed assets at their fair value and you recognize an impairment, then you treat the impairment as the reversal of any upward revaluation that you already recorded, to the extent of the revaluation. If the impairment exceeds the revaluation, then you charge the remainder against current income.

I really like the way this is handled under IFRS. Or – well – to be more specific, I really don’t like the way it’s handled under GAAP, which is very, very conservative. If an asset’s fair value goes up, you really should have the option to take back an impairment charge. And by the way, the way they calculate an impairment loss under the two systems is slightly different, but it shouldn’t result in much of a net change between the two, so I won’t go into the differences here.

Asset Overhauls

A less important difference is that if you pay for a major overhaul of an asset, you have to add the cost to an asset under IFRS, but you generally charge it to expense under GAAP.

Intangible Assets

And that covers the significant differences for tangible fixed assets. But then, we have intangible fixed assets, which are things like copyrights and patents. And there are some major differences here, too.

First, under GAAP, you charge all research and development costs to expense right away. But in IFRS, you charge research to expense but you capitalize development and then you amortize it. Now in order to capitalize development costs, you do have to meet a bunch of criteria, so it’s not that easy. Still, for a company doing a lot of development work, this could be major change.

And also, if you recognize impairment of an intangible asset under GAAP, then you can never reverse the impairment. But, under IFRS you can, though not if the intangible happens to be goodwill.

And finally, under some very limited circumstances, you can revalue intangible assets under IFRS, but you cannot do that under GAAP. The problem with revaluing an intangible asset is that there usually isn’t much of a market for this kind of asset, so you just can’t justifiably revalue it. And if you can’t justify a revaluation, then you have to carry it at cost.

Parting Thoughts

So, overall - there are a couple of key points to remember. First, GAAP is very conservative and rigid when it comes to valuing fixed assets, whereas IFRS allows you to take advantage of fair value changes, which is way more common sense.

Second, you could see a lot of companies in the R&D field finding an excuse to switch to IFRS, and then start capitalizing their development costs. But keep in mind, if you do that, you still have to amortize the costs eventually, so there may a reportable drop in development expenses in the first year or two, but over the long term, there won’t be much of an impact on their profits.

And finally, it does sound pretty nifty to be able to revalue your fixed assets, but you also have to pay for the appraisals, so there is an out-of-pocket cost if you choose to go down that path.

Related Courses

Fixed Asset Accounting

GAAP Guidebook

How to Audit Fixed Assets

International Accounting

XBRL Tagging (#108)

In this podcast episode, we discuss the requirements for XBRL tagging in financial statements. The key points made are:

• XBRL is short for extensible business reporting language. It was developed to improve transparency in financial reporting.

• XBRL is required by the SEC for the reporting of all publicly-held companies, starting in 2009 in a staggered rollout.

• The SEC mandates that XBRL be used to tag all numbers in the footnotes, as well as the financial statements.

• XBRL is also required in other countries, such as the Netherlands, China, the United Kingdom, and Australia.

• Expect to spend around 300-400 hours per year doing financial statement tagging. You can conduct tagging activities in-house, or outsource it.

Related Courses

Public Company Accounting and Finance

The Milestone Method (#107)

In this podcast episode, we discuss the details of the milestone method of recognizing revenue. Key points made are noted below.

Reason for the Milestone Method

This is a new revenue recognition method, and the FASB even gave it a new heading in the accounting codification. The new code for it is 605-28, in case you want to look it up. The milestone method is designed for recognizing research and development situations where you get paid only if a milestone event occurs. A milestone might be something like completing a certain phase in a drug study, and once that happens, you receive payment from a third party.

A key part of the milestone method is that it’s designed for situations not just where there’s a milestone event, but also where the event is uncertain. That means the milestone method does not apply when you’re going be paid just after some time goes by. Instead, you have to perform something, and there is some uncertainty about whether you can perform whatever it is.

Revenue Recognition

Under the milestone method, you recognize all of that payment as revenue as soon as you complete the related milestone, but only if the situation meets all of these criteria: First, the consideration being paid should only relate to past performance, so there’s no advance payment involved. Second, the consideration has to be reasonable in relation to the deliverables. In other words, you can’t set up an arrangement where there’s this massive payment tied to an early deliverable, just so you can recognize the revenue early. No such luck. Third, the consideration has to be reasonable in relation to either the work you performed or enhancing the value of the product. And finally, if even a portion of a payment made under a milestone arrangement can potentially be refunded under some sort of future penalty or clawback arrangement, then you can’t use that, either.

Since the second and third items are judgmental, you can expect auditors to review them pretty closely. If you try something really outlandish in this area, I’d expect the auditors to ask for a lot of documentation to support what you did.

Now, the measurement is not exactly precise. That means there’s some wiggle room, and if someone wants to build a little extra into the payments linked to early milestones, they can probably get away with it. I’m not advocating that, just saying that it’s possible.

Documentation Requirements

And another point is that you’re supposed to document all of this at the start of the arrangement. Payments that are linked to milestones are normally written into the contract with whichever third party is making the payments, so this pretty easy in terms of documentation.

However, that also means that if the contract is not clear about when payments are supposed to be made, you’ll have problems justify any revenue recognition under the milestone method. So if you do have a contract where payments aren’t clearly linked to milestones, you may want to create a contract amendment with the third party that makes this more clear.

Another issue is that you can choose to use the milestone method for one contract, but then recognize revenue in some other way for another contract, as long as it has different deliverables. So there’s no need to be monolithic about this and force everyone to use the milestone method everywhere. Having said that, though, you may be introducing too much complexity if the accounting staff has to deal with multiple recognition methods.

In some cases, you may have no choice. If a contract simply has no milestones, other than a single payment at the end, then you can’t use the milestone method.

There is a small twist on the ability to use a different revenue recognition method, though. If you use something other than the milestone method, it’s OK to do so, unless you end up recognizing all of the revenue in the period when the milestone occurs. In other words, you cannot use a different method if it massively accelerates recognition.

Disclosure Requirements

So what do you have to disclose?

If you’re using the milestone method, you should describe the overall arrangement, and each milestone and the related payments. You also have to disclose the amount of consideration recognized in the period for specific milestones.

Parting Thoughts

At a general level, the milestone method isn’t necessarily new, it’s just that there wasn’t any GAAP guidance for it at all – so people came up with their own milestone methods. By issuing this standard, everyone now has to do it the same way.

So how does this compare to international financial reporting standards? It doesn’t compare, because there’s nothing to compare it to. IFRS does not cover this area at all.

Related Courses

Revenue Recognition

GAAP vs. IFRS for Inventory Accounting (#106)

In this podcast episode, we cover the differences between how GAAP and IFRS treat the accounting for inventory. Key points are noted below.

LIFO Costing

The first item is last in, first out costing. It’s allowed under GAAP, and it’s specifically prohibited under IFRS. If you don’t know what LIFO is, it’s just like the name implies – the assumption is that the last item of inventory that you purchase is the first one to be used, which means that your inventory layers can be incredibly old, and that also means the cost of those inventory layers may be a very long ways away from their current replacement cost.

This is the number one issue if you’re currently using a LIFO costing system. No need to be alarmed just yet, but you may want to start thinking about what it will take to convert to a different costing system. If when you do convert, presumably those inventory cost layers are at really low costs, and when you recognize them, your profits will be way to high during that conversion period, and you’re going to pay a lot more than normal in income taxes.

Overall, this is a good change, though converting away from LIFO will be a pain for anyone who’s using it. LIFO has never had much basis in reality, and it was really developed to dodge taxes. So it’s better to let it go away.

Agriculture

There’s very minimal coverage of agriculture in GAAP, but under IFRS, you can recognize what they call biological assets at fair value – so, for example, if the market rate for soybeans changes, you can record the difference in income right away. So that means you are allowed to report at fair value, even if it’s in excess of cost.

And by the way, when they say you can do this for biological assets, that means more than just agriculture. They define a biological asset as a living animal or plant, so you can apply fair value to cattle or even a fish farm.

Lower of Cost or Market Accounting

Another item is lower of cost or market accounting. This is when you’re supposed to write down the value of inventory if the market value is lower than cost. Under GAAP, if you have a lower of cost or market write down, then that write down is permanent, and you cannot write it back up if market prices later go up.

Not the case with IFRS. You can reverse a write-down.

Being able to reverse lower of cost or market losses makes a lot of sense. The whole concept of lower of cost or market is based on adjusting to market, but GAAP only allows an adjustment if the market value drops, and never allows you to benefit if the market price comes back up – which is far too conservative. So, I like the IFRS approach quite a bit. It’s more common sense.

And speaking of lower of cost or market, the calculation is different. Under GAAP, it’s just as the name implies – you record the lower of inventory cost or its market value. And actually, there’s a bunch of persnickety extra rules that set up boundaries for the amount of the write down.

Under IFRS, it’s the lower of inventory cost or net realizable value. And net realizable value is defined as the estimated selling price of the inventory, minus the estimated cost of completion and any estimated cost to complete the sale.

The IFRS calculation is somewhat simpler, so I’m automatically in favor of it right there. But really, the overall concept is the same, and so it’s just not a large difference.

Presentation of Inventory Losses

And another topic is the presentation of inventory losses in interim periods. Under GAAP, if there’s an inventory loss in an interim period that’s caused by a market decline, but you expect the decline to be reversed later in the year, then you don’t have to record the loss in the interim period.

Not so with IFRS, which really sticks closer to the concept of fair value accounting. Under IFRS, you still have to record the inventory loss in interim periods, even if you expect the loss to be reversed.

The net effect of this last item is probably somewhat more variation in reported profits under IFRS, but on the other hand, it takes away any possibility of manipulating the results in interim periods.

Parting Thoughts

Taken as a whole, I think these changes are for the better. And, as we – eventually – go through some of the other differences between GAAP and IFRS, I think you’ll find that the international standards are generally better.

However, one comment on the whole issue of when IFRS will replace GAAP. I’ve just through all of the source documents for both IFRS and GAAP, because I was writing new books on both, and it really struck me that, even with the newer standards that are supposedly involving lots of input from both sides, there’re still a remarkable number of differences that are not being resolved.

It looks to me as though the staffs of both organizations are just motoring along, and churning out standards that are not quite the same. The Securities and Exchange Commission can command all publicly held companies to use IFRS, but most companies are not publicly held.

So, unless somebody higher up, like the United States Congress, finally steps in and commands that GAAP will go away, I’m not entirely sure that it ever will, and especially for non-public companies.

Related Courses

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Revenue Recognition for Multiple Deliverable Arrangements (#105)

In this podcast episode, we cover recent changes in the requirements for revenue recognition for multiple deliverable arrangements. Key points are:

• There have been increased disclosure requirements, both in regard to quantitative and qualitative information.

• Disclose the nature of these arrangements and the timing of their performance.

• Disclose any termination provisions.

• Disclose the factors, inputs, and assumptions involved in setting prices.

• State the timing of revenue recognition.

• The relative selling price method is mandated, using vendor-specific objective evidence. If this evidence is not available, then use third party objective evidence; if that is not available, then estimate what the selling price would be.

• There are a dozen specific implementation examples in the FASB guidance.

Related Courses

Revenue Recognition

Conversation with the PCAOB's Joseph St. Denis (#104)

In this podcast episode, we discuss the functions of the Public Company Accounting Oversight Board with Joseph St. Denis, director of its Office of Research and Analysis. Key points are:

• The PCAOB was established by the Sarbanes-Oxley Act. It regulates those auditors who audit public companies. It does risk assessments, inspects audit firms, and looks at audit quality and control systems. It can levy fines and impose penalties. It also promulgates auditing standards for public companies.

• The Office of Research and Analysis does risk assessments with a surveillance group that spots elevated risks of audit failure. It uses pattern recognition data mining systems to detect problems, and also engages in some surveillance of international firms.

• Emerging issues include fair value disclosures, consolidations, revenue recognition involving multi-element transactions, and debt issues relating to the 2008 financial crisis.

Related Courses

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Cost Reduction Analysis (#103)

In this podcast episode, we discuss the best ways to reduce costs in a manner that negatively impacts the organization the least. Key points are noted below.

Let’s say your company wants to reduce expenses. The simplest method that we’ve all seen is to order the same percentage cut in expenses in all areas. The CEO will say that this is the only “fair” way to make reductions.

Problems with Cost Reduction

The trouble is, some departments are better managed than others and the good ones operate pretty lean. Those managers can have a really hard time figuring out where to cut expenses. On the other hand, if a department is being managed poorly, then that manager has probably let some excess fat build up in his budget, and he can more easily meet the reduction target. So if you implement the same cuts everywhere, the bad managers look like heroes, and the good managers struggle to keep their operations going.

And another problem is that when a manager is told to cut a certain amount of expense, he does it – and then he reallocates the work load around the remaining people, so you have to expect a period of reduced productivity, while everyone learns the new parts of their jobs. And, at least for a while, some things will be done poorly, or late, or not at all – and what if those things are in critical areas, like customer service?

In essence, you cannot cut deep into an organization and expect to keep everything running properly. If you try, then everything is stretched too thin, and at some point you start seeing fallout, like losing burned out employees, or poor customer service.

The Binary Approach to Cost Reduction

So, the better way to handle cost reduction is black-and-white. Literally. Either you decide to continue doing something, or you don’t. There is no middle ground, where you shave away a few expenses here and there.

For example, your company operates a bunch of retail stores, and it has to cut expenses by some large percentage. It could do this by reducing store hours at all of its stores to save money on payroll, but that cuts into revenues. Or it could cut the staff at every store. But that reduces customer service. Or, it can look at the profitability of each store, and close the ones that aren’t producing.

The last option is the best one. The reason is, that store profitability is on a bell curve. That means there’re always a few bad ones. So, do you take resources away from the profitable stores to support the bad ones?  Because if you do, you’re effectively driving down the profits of the good stores, and that means you’re essentially driving the whole company into mediocrity.

And, you can move the concept up a notch, and review the profits of an entire region of stores, to see if you should drop the entire region. This may make sense if they’re all serviced by the same distribution center, since it wouldn’t make much sense to pare back to just one store in a region that’s being supported by a big warehouse somewhere.

Not everyone is in retail, of course, so let’s look at it from the perspective of the business unit. Let’s say you have a flight operation that does aerial photography. This should be tracked as a complete profit center, which means that you’re offsetting the cost of the airplane, and the flight crew, and fuel, and sales staff, and operations manager against revenue. If the entire unit is losing money, then the decision is really whether you should drop the entire business unit, and not trying to get by with one less pilot, which brings up other issues with flight safety.

So let’s change the example and talk about functionality instead of stores or business units. What if the company focuses all of its expertise on marketing, and its losing its shirt trying to operate a distribution warehouse?  The question is not how to reduce expenses at the warehouse; the real question is why the company is in the warehouse business at all, and how can it outsource the entire operation.

Customer Profitability Analysis

Or let’s change the example to a customer. Which ones generate all kinds of revenue volume, but requires so much support staff time that the company actually loses money on them?  The decision here is to either jack up prices to that customer, or drop the customer. And by the way, this is a difficult analysis, because if you decide to drop the customer, your assumption is that all of the support expenses vanish – and that may not be the case. Customer support tends to be spread around among a lot of people, so if you drop a customer, the offsetting expenses you were hoping for tend to be reabsorbed back into the company.

And that means that if you’re looking at the customer base to cut expenses, your best bet by far is to raise their prices. If you can’t raise prices, then know in advance exactly who’s being laid off when you get rid of the customer.

Impact on the Accounting Department

So this is all very nice, but how does it impact the accounting department? You may have noticed that these analyses all involve giving information to senior management about the profitability of just about every aspect of a company.

These reports aren’t something that the accounting staff suddenly scrambles to assemble when the company is in a crisis. It isn’t like you should be handing over these reports to management, and they say “whoa, I didn’t realize we were losing so much money doing that!”

If that’s the case, then accounting is not doing its job. Instead, you should be preparing these reports well before there’s a crisis, so that management is well aware of the expenses, and which profit centers are having issues. If management has this information in hand all the time, and the CFO drives an ongoing cost review process, then hopefully there’ll never be a need for more drastic action.

Parting Thoughts

And another point. When I say these decisions are all black-and-white, go or no go decisions, I’m doing so to make a point that it’s generally the best way to reduce expenses. Now in reality, sometimes a business unit or a store or some other function is so badly managed that you can send in a good manager and fix it. So I’m not saying that as soon as something goes south, you dump it. However, I am saying that you shouldn’t spend forever trying to fix it. If it’s clear that something will at best be a marginal performer, then – yes – the decision should focus on eliminating the whole thing.

So, why is this extra level of cost reduction analysis better than across-the-board cuts? I’ve listed a lot of points already, but another one to consider is that the impact on the company as a whole is massively reduced. You completely cut out those (hopefully) few pieces of it that’re really losing money, and leave the rest entirely alone. Depending on how you handle it, people elsewhere in the company may not even release that there’s been any cost reduction at all.

Related Courses

Cost Management Guidebook

Financial Analysis

The Fund Raising Road Show (#102)

In this podcast episode, we discuss the mechanics of a fund raising road show. Key points made are noted below.

Overview of the Fund Raising Road Show

The overview is that you line up an investment banker who sets up a bunch of meetings with potential investors, who are usually fund managers. Then you prepare a presentation, go on the road, and present it to each investor, one by one.

This is already a big difference from the non-deal road show, where you’re going for volume of contacts. Instead, if you’re raising money, you allow about an hour and a half for each investor meeting.  The investment banker is in charge of lining up the meetings. The usual drill is to block out several days in one city, so you make the rounds to every interested party, and then switch to a different city and do it again.

Who Goes on the Trip

The usual traveling group is just the CEO, the CFO, and the investment banker. Most investors will have just one or two people in the room, so the groups are very small. This means you don’t need a projector. Normally, you travel with a few copies of a printed PowerPoint presentation, and send a batch ahead to your hotel. Don’t fly with 50 pounds of presentations. I’ve done that. You have better things to deal with than hoisting all of that paper into an overhead bin in the plane.

Presentation Essentials

The key presenter is the CEO. If an investor is ready to drop a few million into your company, then he want to be eyeball to eyeball with the CEO. The CFO is certainly there to cover some parts of the presentation, but expect the CEO to cover about 2/3 of the material.

Like any presentation, you practice in advance multiple times, and the investment banker should be there to make suggestions. I also like to track the amount of time spent on each page of the presentation, to see if we’re lingering too much on some topics. Figure on no more than ½ hour for the presentation, so there’ll be lots of time for questions.

Clothing Choices

Clothing is big factor on a road show. No one will notice if you show up wearing a nice suit, but they absolutely will notice if you don’t – or if your clothes are wrinkled or smell bad. Also, some investor conference rooms are small and stuffy, so you’re going to overheat. That means bringing super lightweight, very high quality suits, and also bring way too many shirts. If you can get back to the hotel for breaks or meals, then swap out shirts, so you’ll look more presentable later in the day. I pack two shirts per day.

Travel Arrangements

The next issue is flying. If at all possible, fly in the night before, so there’s one less way to not miss your first meeting. There are other ways to screw up a road show, but this is one of the main causes, so get there early.

Next, do not rent a car. Rent a limo. This is an absolute, especially if you’re presenting in New York City, where driving is a zoo. There is no way on earth you can expect to be on time for investor presentations if you’re also trying to find their address. Let a professional driver figure that out for you. Otherwise, you’ll show up for meetings looking frazzled – assuming you show up at all.

This also means that the driver needs a copy of your itinerary every day. That way, you get out of one meeting, collapse into the car, and let the driver take it from there. The stress reduction is monumental.

If you insist on renting your own car, then at least bring along a third person who is only responsible for driving, and who has a GPS and a complete list of all the addresses that you’ll be going to.

Building Access

Next problem: Getting access to buildings. This is simple enough in most cities, since you just walk in the door and go up the elevator. Not so in New York. Because of 9/11, you have to show your driver’s license at the security counter and get a badge. It doesn’t take that long, but if you’re rushing to make a meeting time, it’s just one more thing that gets in the way.

Meeting Essentials

Now, as for the meetings themselves. Cell phones must be off or on vibrate. It’s rude to have your phone ring during a presentation. Since everyone checks messages between meetings, that means there’s a high risk you’ll forget to shut it off again. Bottom line, your best bet is to just leave it on vibrate all day.

Next, if there’s a lot of sunshine coming into the room, then you should face the window. That means the investor can look into the room, and doesn’t have to squint when he looks at you. This meeting is for the benefit of the investor, not you, so you’re the one doing the squinting.

In regard to the investment banker: The banker does introductions, and then retires to the end of the table and does e-mail on his blackberry. He essentially does not participate again until the end of the meeting, when he asks if the investor is interested. That means you’re on your own for the entire middle part of the meeting.

This is not necessarily a bad thing. Most of the time, you’re probably talking to a fund manager who is simply trying to get a general feel for your company, and for you. If he’s not interested, then he’ll simply decline any further contacts, and he goes away. And that means he’s almost never going to be abrasive. Instead, expect a fair number of interruptions of your presentation for questions – which will likely be polite.

Whenever an investor asks a question, write it down. More than likely, you’ll hear about it again from some other investor, so it’s best to be prepared the next time.  When the meeting is over, you get back in the limo and go over the questions that were asked. Also, you can spot check each other with suggestions for tightening up the presentation.

The Daily Schedule

As the day goes by, it’s likely that you’ll fall behind on your schedule. If so, the investment banker should call ahead to warn whoever’s next in line that you’ll be late. The best way to avoid this is to block out lots of time in between scheduled meetings, but even so, it is difficult to stay on schedule.

Eating Arrangements

You may be invited to a meal with an investor. If so, obviously, do it. However, keep in mind that you may be doing a half-dozen presentations per day, so you will be wiped out by dinner time. If you can, leave dinners open, so you can relax.

Parting Thoughts

And that’s the mechanics of a fund raising road show.

One more point, which you may consider just a cute observation, but its true every time – if you walk into the office of a fund, and there’s no receptionist, that’s a good sign. That means they’re paying attention to their expenses, and they’re probably not overbearing, so they might be good to deal with. At the other extreme, if you see multiple well-dressed and expensive-looking receptionists, you are so doomed. That’s the sign of a pretentious investor who’s going to offer you really bad terms. In those cases, we just go through the motions and move on to the next meeting.

Related Courses

Corporate Finance

Investor Relations Guidebook

Accounting Troubles at Lehman Brothers (#101)

In this podcast episode, we cover the underlying accounting issues that contributed to the collapse of Lehman Brothers. Key points made are:

• Lehman improperly accounted for repurchase agreements, recording sales of the securities held as collateral, without any offsetting repurchase liability. Normally, these agreements are legitimately used as window dressing at month-end to make the balance sheet look better, but are not recorded as sales.

• This approach gave users of Lehman’s financials the false impression of having higher-quality assets than was really the case, by making the firm look less leveraged. At the time, they had a 17:1 debt to equity ratio, and proper treatment of these transactions would have increased the ratio even more.

• They pushed the envelope by stretching the accounting rules, which would not have been possible under principles-based accounting, such as IFRS.

• They essentially made up their own accounting rules, and the auditors (Ernst & Young) went along with it, based on a legal opinion from a British law firm. EY also knew of the practice for a number of years prior to the financial crisis.

Related Courses

Fraud Examination

Fraud Schemes

GAAP Guidebook

A Look Back at the Podcast (#100)

In this podcast episode, we discuss what has happened to the show during the preceding 99 episodes, spanning about four years. Key points made are noted below.

I hardly ever talk about the podcast itself, since that’s not why you listen to it. Still, I figure doing this once every hundred episodes won’t bother people too much.

Recording the Podcast

I started Accounting Best Practices about four years ago, with some very basic recording equipment.  The first couple of episodes were horrible. You may have heard about how easy it is to record a podcast, but it’s more difficult to do one that actually sounds good. So, I spent about $500 for some basic equipment, and posted the episodes on iTunes, and then took them right back down again.

And then it took about a year to swap out all of the equipment and get everything working just right. So now I record through a professional-grade microphone, which then goes through a bunch of rack-mounted filters that stack about a foot high, and then it’s stored in a Marantz digital recorder. The full rig ended up costing about three thousand dollars.

I need all of those filters because my voice is not the best. In fact, it gets so gravelly that I can’t record before ten in the morning or after four in the afternoon. And on top of that, I speak with very strong sibilance, which is the “S” sound, so one of the filters is called a de-esser, which reduces the “S”. In fact, if I crank up the de-esser too much, it sounds like I have a lisp.

Once I had the recording system figured out, I went back and re-recorded all of the earliest episodes and reposted them. I also got a professional voice talent to record the introduction. There have been a couple of versions, but I think the latest one is the best. It’s done by Emma, who’s located near London.

The Show Format

I also kept altering the format of the show. There were some pretty long shows for a while there, with multiple segments. I finally altered the format to match another podcast, called – believe it or not - Grammar Girl. Grammar Girl is about using the correct grammar, and she has quite a large following.

What I liked was that she blew through the intro really fast, and told you what the episode was about within just a few seconds. That way, you’d know immediately if you wanted to listen to the rest of the podcast. And that’s where the seven-minute episodes come from, with just one topic on each episode.

Interviews

The next thing I wanted to do was get in some interviews. So I called around and recorded a few talks with other accounting authors, and even got some decent interviews with companies that put out accounting products.

The trouble is, companies just don’t believe it when you offer them free marketing, so most of the places I contacted either didn’t return the call at all or else acted really suspicious. So, after way too many calls to line up interviews, I finally backed off. It’s just too difficult. So, there may be occasional interviews in the future, but there won’t be very many.

You also may have noticed that I had a partner for a while there, named Ralph Nach. It was great to have him, because Ralph is an accounting trainer, and he really knows the subject matter, and he also talks better then me. I’d love to have him back, but this podcast is not a minor commitment. I spend three hours to create every seven minute episode. Ralph wasn’t doing any of the production work, but he sure as hell was doing a lot of the speaking preparation, and after a while, it just took up too much time.

The Number of Listeners

Speaking of commitment, I started doing this as marketing for my books, of course, but there’s no way that extra book sales pay me back for all the time required. I think the real issue driving me is just the number of listeners, because there really are a lot, and that creates an obligation to keep going.

So far, there have been 626,000 total downloads, and that works out to 6,300 downloads per episode. That doesn’t mean that there are 6,300 regular listeners, though. There was a huge spike in downloads back in February of 2007, when the show was featured on iTunes. In case you’re wondering what kind of impact that has on a show, the download volume per month went from 11,000 in January of 2007 to 58,000 in February, and right back to 11,000 in March.

Episode Popularity

In terms of popularity, the most downloaded show of all time was number 58, which was about forward-looking statements. But that was during the iTunes spike that I just mentioned. Outside of that one-time hiccup, the original series on accounting controls has been the most popular, with about 10,000 downloads each.

Copyright Issues

I haven’t copyrighted anything about Accounting Best Practices, so if you want to copy it, pass it around at work or at school, then of course, go right ahead. I would like to hear about how you’re using it, just for my own edification. So far, I’ve heard from an oil company in Bahrain that keeps a copy for its accounting staff, and the same goes for a master’s degree program in Singapore.

Parting Thoughts

The strange thing is how little I hear from anyone. If you like the podcast – then, please – go to iTunes, look up the podcast, and right a review. Also, if you have any suggestions for future shows, then please send me a message. My e-mail is bragg.steven@gmail.com.

And finally, about advertising. I don’t intend to allow any on the show, because it’s already there. I usually plug one of my books at the end of each episode, and that’s enough. Accounting Best Practices is all about giving you some good, usable information, and I’m not going to water that down with a bunch of additional advertising.

The Non-Deal Road Show (#99)

In this podcast episode, we cover the mechanics of a non-deal road show. Key points made are noted below.

Types of Road Shows

A road show is one of two things. You’re either going on the road to generally talk about the company to the investment community, or you’re going on the road to raise money. The approach is different for each one, and I’m going to tackle the first version now. In the first case, it’s called a non-deal road show, because you’re not trying to raise money. You normally schedule a non-deal road show right after you’ve released your quarterly results on a Form 10K or 10Q. With this timing, you’ve just made all of your financial information public, so it’s fairly difficult to say anything during a presentation that’ll get you in trouble.

Road Show Destinations

So that’s the timing. Another issue is, where do you go? Well, a non-deal road show should move around the country, so you don’t keep visiting the same people over and over again. If you keep going to the same place and talking to the same people, then nobody new finds out about your stock, and that means that nobody new buys it. And if nobody is buying your stock, then why have a road show at all?

The People You Meet

Now, a non-deal road show is about meeting people in volume. To be successful, you should meet with a lot of people within just a few days. Chances are, you don’t even remotely have the contacts to personally line up a road show. Instead, you use an investment bank or an investor relations firm. They line up the investors and brokers, and then you just show up and do the presentation.

Most of these presentations are to stockbrokers, because there’s a multiplier effect. You talk to them, and then they turn around and talk to their clients about you, so by talking to a couple of hundred brokers, you end up reaching potentially a couple of thousand investors. Now brokers are a different breed. They can show up late and wander out early, and their dress code can be absolutely unique. You may see more sneakers than suits, and I’ve run across a lot of Hawaiian shirts in these meetings, too. And if you offer alcohol, they will take advantage. My favorite was the guy who ordered a beer, and drank it off, and then got it filled to the top with wine – twice. And that was a lunch meeting.

Anyways, the main point is that a broker is coming to your meeting, so treat him with respect. Offer him a decent meal, if you’re doing a lunch meeting, and keep the presentation short. Absolutely do not go droning on in a broker meeting. These people have very little time to listen to you, so get the presentation over with fast – say 15 or 20 minutes – and then open it up to questions.

Road Show Questions

And you will get some very interesting questions. Keep in mind that brokers rarely research your company in detail, so their questions can be really off the wall. My favorite was when the CEO and I were presenting a company that did geographic information systems, like land grid, and somebody asked how we competed in the market against Russian spy satellites. Oh boy. Still, after a few meetings, you’ll have heard just about every possible question, so the meetings do become more routine.

Building a Mailing List

A non-deal road show is not just about presenting information. You also want to build up a mailing list of the folks you’ve met. A good way to do this is to offer a door prize, and people have to put a business card into a pot in order to qualify for it. Then you bring back all the cards and dump them into a database.

One door prize that we used on one trip was a really nice book about recipients of the Congressional Medal of Honor. The reason for that was that one of our board members had been awarded the Medal of Honor, and we got him to come along on the road show and do a short speech. Since he’s a fairly well-known television commentator, that really helped to bring people to the meetings. The problem was that at one of the meetings, a stockbroker walked off with the book – just stole it – so we had to order another book for the person who actually won the prize.

The Road Show Presentation

Now, because you’re dealing with a lot of people, you really need to have a presentation on a projection screen. It’s not workable to just hand out a PowerPoint binder and walk them through it – though there should be a handout.

This type of presentation has some implications. First, you will need a lot of handouts, so you have to lock down their contents before the trip starts, print out a bunch, and either lug them around or mail them ahead to the various hotels. If you’re doing multiple cities – sometimes several cities in one day – then it can be tough to link up with the handouts if you mailed them ahead.  For that reason, I prefer to carry quite a few with me, and then replenish the supply from whatever we already mailed ahead.

As for the projector, I prefer to drop that one on whoever is organizing the trip, so that they supply it. And then I bring another one as a backup. I’ve never had a projector fail, but of course, having said that, it’ll probably blow up on the next trip.

Another issue about a non-deal road show is that you’re talking in front of a lot of people. And let’s face it, most accountants are a pack of introverts. We don’t like to do this. The worst I’ve ever seen was at a CFO conference in London. I was presenting, but I had some time off, and so I sat in on someone else’s presentation. And this poor guy was dying – sweat just dripping off him, and he had to keep stopping to wipe the fog off his glasses.

There are some ways to avoid that. Before the trip begins, stand up in front of an empty room and run through the speech four times. At least, that’s the number I use. I find that I screw up a lot on the first pass, but that I’m not really getting much better after doing it four times, so that’s a good stopping point.

The other thing you can do is just before the presentation. Stand in the doorway to the meeting room, and greet everyone who comes in. You don’t necessarily have to shake hands, but make eye contact and say something. If you can engage in some small talk, that’s even better. Then, when you look out on the audience for your speech, you at least have a little familiarity with the audience. This really helps.

Now, to turn that around, that means you do not stand off a corner in a little group before the presentation starts. You really, really should mingle with the audience.

Non-deal road shows get a lot easier over time. After you’ve done a couple, you only need to tweak the presentation each time, so there’s less need for any sort of elaborate dry runs. And also, you’ll have already been hit with every possible question, and you’ll know how to answer them.

It still makes sense to have someone review the presentation and make suggestions every now and then, so it doesn’t get too stale, but that’s basically it. So in short, a non-deal road show is about spreading the word in a canned presentation to a lot of people. It’s more stressful at the start, but it gets easier over time.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Dealing with Investment Bankers (#98)

In this podcast episode, we cover the reasons for using an investment banker, as well as tips for how to spot a good one. Key points made are noted below.

Role of the Investment Banker

If you want to either raise money or sell your company, there’s a good chance that you’ll be dealing with an investment banker. An investment banker acts as an intermediary between you and either potential investors or acquirers. Their job is to link you up with the other party, and consummate the deal. They have a couple of areas of expertise that makes them really valuable.  One is that they know how to translate what your company does into a package that someone either wants to invest in or buy. You may think you can do this on your own, but they do it all the time, and they know what works best.

Part of their assistance here is in doing a really fine presentation. The investment banker should create the PowerPoint presentation for you, and have several dry runs of the presentation with the management team.  Please keep in mind that you do the presenting – at most, a banker may do an introduction at a presentation, but after that, he pretty much sits down in the back and answers e-mail on his Blackberry and just tries to stay awake.

And their other area of expertise, and this is a huge one, is their contacts. They know tons of investors and acquirers – in fact, this really is their business.  They’re routinely getting in touch with nearly all of the senior management of companies that do acquisitions, and they probably know almost every fund manager who might want to invest.

And by the way, part of this is through junkets. The larger investment banking houses routinely put on things like multi-day golf tournaments and bring in really good speakers, and then they invite all of these buy side people to attend for free. For an investment banker, this is all part of the job.

And the final area where they provide assistance is in closing the deal. Now, they are not your attorneys. But – they handle most of the major negotiation points with the other party, and they’re pretty good at improving the terms of the deal.

Investment Banker Fees

This all sounds great, but what do they cost?

An investment banker is very expensive. If you’re trying to raise money, you’d better expect the banker to take at least 6% of however much you raise. Though if you’re raising a lot of money, the percentage goes down. If you’re selling a business, the minimum fee for a reputable firm is usually around $1/2 million dollars, and they’ll make even more money if they can sell the company for more than some pre-determined price. And on top of that, you can expect a monthly retainer that’s generally around $10,000 a month.

This sounds like a lot. Actually, I think a good investment banker is worth every penny. In a really sweet deal, they may be able to line up the exact investor you want, or the perfect acquirer, and it may seem effortless. But keep in mind, without the banker, you never would have found that other party. And also, the retainer really isn’t that much money, so the banker is working almost entirely on contingency.  If you raise no money or don’t sell the company, then the banker only gets the retainer. So they have a really good incentive to perform.

How to Obtain Investment Banker Services

So at this point you might think – grudgingly – that an investment banker is worth it, and you’ll go out and get one. Well, that’s not quite the way it works.  A good investment banker selects you – not the other way around. One banker told me that he interviews an average of 30 companies for every one that he agrees to work for.

And there’s a good reason for this. An investment banker works long hours, and he only makes real money if he performs. So he doesn’t want to work for a company that he knows in advance is going to be a tough sell. Instead, he wants the easiest sale he can possibly make. And for that reason, you can expect to meet with an investment banker, and decide to hire him, and then find – much to your surprise – that he doesn’t want to work for you.

The Fund Raising Time Line

So let’s say that you reach an agreement with a good investment banker. What kind of time line are you looking at to raise money or sell your business. It’s still a long time.  The banker may take a month to create a really good presentation, and then another month to line up a meeting schedule, and quite possibly another two months after the meetings to close a deal.

And if you’re talking about selling your business, then add another two months. It’s not that an investment banker isn’t efficient.  It’s just that there are lots of third parties involved, and so you have to work around a lot of schedules. So even with a really professional banker, it’s still going to be a slow process.

The Best Investment Bankers

Now, what makes a good investment banker. Essentially, it comes down to how comfortable you feel with him. Or her. You tend not to hire an investment banking firm, you tend to hire the specific partner or vice president who’s going to work with you.

I happen to really like a vice president who works out of the Baltimore office of Stifel Nicholaus. I just like him, and I think he’s really competent. It doesn’t necessarily mean that I’d be as happy working for someone else at a different office of the same firm. So ultimately, it’s about the personal interaction.

But there are some other indicators.  A big one is who takes responsibility for the PowerPoint. Smaller investment banking firms or one-man shops will just send you a few copies of presentations done by other companies, and tell you to put together something like that. That’s not so good.

A good banker will assign a specialist to create your presentation, and they will construct it for you.  It not only shows an advanced level of professionalism by the banker, but it leads to a much higher-quality presentation.

Another indicator of a poor investment banker is not being selective with the target list. A poor investment banker doesn’t necessarily know everyone on the buy side, so he just sprays a teaser letter to every possible investor or acquirer.  The banker does this because then you owe him a fee if you eventually do a deal with anyone he contacts on your behalf, even if you don’t do the deal through that banker.

It also harms you, because now your name is plastered all over the buy side, and if you don’t do a deal right away, then it’s kind of difficult to go back and re-contact everyone in the industry a few months later for a second try. They wonder why you couldn’t close a deal the first time.

And another bad sign is when the investment banker tries to ram a bad deal down your throat, just so he can earn his fee. He is certainly obligated to tell you about any offer made, but if he actually recommends one that’s clearly not in your best interests, then shut him down and look for a different banker.

And a final indicator of a poor investment banker is a badly organized road show. If the banker doesn’t have directions to the next meeting, or doesn’t have phone numbers for whomever you’re meeting with, then he is not doing his homework.

As you might have guessed, I’ve seen all of these issues with investment bankers.  Unfortunately, these are problems that you only see after you’ve hired the banker, so if you find a good one, it’s best to stick with him for later deals.

Related Courses

Business Valuation

Corporate Finance

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Recording Revenue at Gross or Net (#97)

In this podcast episode, we discuss the criteria for reporting revenue at either gross or net. Key points made are noted below.

The Two Revenue Recordation Methods

Recording at gross means that you record all of the revenue from a sale on your income statement. Now at this point, you’re probably saying, hello, that’s what I’m already doing. Well, there is another way.

Recording at net usually means that you’re only recording a commission on the sale as your entire revenue.  If there isn’t strictly a commission, you can still report revenue at net by netting the amount billed to the customer against the amount paid to the supplier.

Presentation Impact of the Methods

Recording at gross or net has no impact on your bottom line, but the difference in reported revenue is gigantic.

A commission may only be for a few percent of the total revenue, so your company looks a lot smaller if you record revenue at net.  And this means that some companies prefer to record their revenue at gross, just to give the impression that they’re much larger than they really are. Their main concern is that some investors value a company based on a multiple of its revenues, so reporting a pile of revenue could result in quite a payoff if they sell the business.

So that’s the basic issue. Now, most companies record all of their revenue at gross. At the other extreme, if you’re paid a commission, and it’s called a commission, then you record the commission as your revenue, and that is net reporting.

Which Way to Record Revenue

The trouble is, there’re lots of situations that fall into a gray area where revenue could be reportable at gross or it could be reportable at net. For example, what if you’re a broker for magazine subscriptions, or you have a third party drop ship all of your product sales to customers, or what if you sell airline tickets, or sell anything that’s on consignment? These are the cases where it’s not so simple.

The Emerging Issue Task Force set up a bunch of guidelines for this in their issue number 99-19. The title of the issue is “Reporting revenue gross as a principal versus net as an agent.” I’m going to talk about the EITF’s guidelines, but keep in mind as I go through them that recording the situation at gross or net is a matter of judgment. There’s a continuum of situations with gross reporting and net reporting at either end, and you have to figure out where you’re positioned between the two. The trouble, and I’ve confirmed this with several audit partners, is that as long as your revenue situation is in a gray area, and you document your decision, you can pretty much argue a case to report revenues either way.

So.  The guidelines. Here are the indicators that should point you in the direction of reporting revenue at gross:

First. You are the primary obligor in the sales transaction.  This means, are you responsible for providing the product or service, or is the supplier? If you’re doing the work or shipping the product, you can probably record at gross.  This one is a major determinant.

Second, you have general inventory risk. So, if you take title to the inventory before you sell it to the customer, and you take title to any returns from customers, you can probably record revenue at gross.

Third, you can select suppliers. This one is important, since it implies that there isn’t some key supplier operating in the background who’s actually running the transaction.

Fourth, you have credit risk.  This means that if the customer does not pay, then you eat the loss, and not a supplier. However, if you’re only at risk for losing a commission if the customer doesn’t pay, then you’re probably looking at recording the revenue at net.

And finally, if you get to set the price, then you probably have control over the entire transaction, and you can record the revenue at gross.

Now, what are the guidelines that point you in the direction of reporting revenue at net?

The first is that the amount you earn is fixed.  This indicates a commission structure, which is sometimes set up as a fixed payment per customer transaction. A twist on this is if you earn a percentage of what the customer pays, which is also an indicator that you report revenue at net. In either case, you’re really just an agent for someone else.

And the other two guidelines for reporting at net are just the reverse side of some earlier guidelines.  If a supplier has credit risk, or if a supplier is responsible for providing products or services to the customer, then you’re probably looking at reporting revenue at net.

For most companies, you can pretty easily pick which guidelines apply to you, and in most cases you probably record your revenue at gross. But here are some considerations.

Let’s say that you run an Internet store, and you collect money from customers, and then instruct a supplier to ship the goods to the customer.  In this case, you have credit risk, so there’s an indication that you can probably record revenue at gross.  And in fact, most Internet stores do.  But what if there’s also a statement on the website that the website operator only accepts orders on behalf of suppliers, and the operator is not responsible for any problems with shipments?  Chances are, you’re now looking at net revenue reporting.

Let’s try a different arrangement, where you develop specifications for custom products with the customer, and then you find a supplier who can make it.  In this case, you can record revenue at gross, because you have credit risk and you get to pick the supplier.

Here’s another example. You’re a travel discounter, and you negotiate with the airlines for reduced prices. You then advertise the reduced rates to the public. You bill the customer, and you’re responsible for delivering the ticket to the customer. But – once the customer receives the ticket, the airline is responsible for all subsequent service.  There’s no inventory risk and the primary obligor is the airline, which points you toward net reporting. On the other hand, you can set the price and you bear the credit risk, which tends to point toward gross reporting.

This is an interesting one, because you can go either way. The EITF says that the primary obligor issue overrides the other ones, and that one points you in the direction of reporting at net.

And that brings us back to my earlier point about documenting your position.  You could have two companies in the same industry with identical business models, and one can record revenue at gross and the other at net – and they may both able to justify their positions to their auditors. So, this is one of those screwy topics that can go in either direction.

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Recording Reimbursed Expenses as Revenue (#96)

In this podcast episode, we discuss how to record expenses that are to be reimbursed by the customer. Key points made are noted below.

Reasons Why Reimbursed Expenses are Recorded as Revenue

This issue was addressed by a group called the Emerging Issues Task Force, or EITF.  The EITF passes judgment on smaller technical topics, and generally they do quite a good job of it.  But on this one, I wonder if they were passing around the bottle during their discussions.  And – by the way, one of my co-authors claims that the Accounting Standard Board actually had a pony keg in one of their meetings, and that might explain some of the accounting standards.

But anyways, the EITF came up with a pronouncement called EITF Issue number 01-14. The title is “Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred.” I think they designed the title to put you to sleep, so they could slide the contents right on by. If this thing was an infomercial, they would have called it something like “Easy Way to Overstate Revenue – Operators are standing by.”

So, what the EITF said was that out-of-pocket expenses are things like travel and entertainment and photocopying charges.  Sometimes, customers agree to reimburse the company for these expenses. The question the EITF addressed was whether you treat these customer payments as revenue or as a reduction of the underlying expense.

Their conclusion was that you report the payments as revenue.  Ouch.  The main reason they gave for doing this was that customer payments for shipping and handling costs are already treated as revenue, and this is basically the same sort of thing.

The EITF also stated that this makes sense, because the buyer is benefiting from the expenditures, rather than the seller. Also, the seller has credit risk, because it receives reimbursement from the buyer after it paid for the expenditures. And to be fair to the EITF, they made one of those “on the other hand” points, which was that the company is earning no profit on these expenses, and that tends to point toward treating them as an expense reduction rather than as revenue. Despite that, though, the EITF came down on the side of recording reimbursed out-of-pocket expenses as revenue, and so that it what you’re supposed to do.

Reasons Why We Should Not Do This

Now, as you can probably tell, I’ve been busy sharpening the knives on this one.  I’m not going to tell you to handle this differently, but I will point out some holes in the argument.

First, when I’m going through a due diligence analysis on a possible acquisition, one of the first things I do is see if they have any reimbursed out-of-pocket expenses, and strip that number out of revenue.  The reason is that it skews the results of the company to make it look like it’s doing more business than it really is. This is really critical if you’re buying a company based on a multiple of its revenues.  I don’t advocate buying a company based on that type of valuation, but some people do, and this issue causes them to overpay. So right there, you know something is wrong when people are deliberately stripping out that figure – it’s a clear revenue overstatement.

My second point is theoretical, which is that revenue should reflect the revenue-generating activities of the company, like providing consulting services or shipping a product.  Being reimbursed for out-of-pocket expenses is not a revenue generating activity.  It simply means that either entity could have paid for the expense up front, and it happens to have been more convenient for the seller to do it. So, consider a situation where the buyer gives its corporate credit card to the seller, and it tells the seller to use the card to pay for all of those out-of-pocket expenses. Now the expenditure path goes completely around the seller, and the buyer pays.  The seller records no expense, and no revenue. You get the same result in your accounting records if you use the seller’s reimbursement payment to simply offset those expenses in your records, which flushes out the expense. But you’re not allowed to do that.

Now all of this may seem like a lot of arguing over nothing, since the seller records no change in profit no matter how you handle out-of-pocket reimbursements – only the revenue and offsetting expense figures are impacted. Nonetheless, it can give the impression of a business being larger than it really is.

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Rule 10b5-1 Trading Plans (#95)

In this podcast episode, we cover the need for and use of 10b5-1 trading plans for stock purchases and sales by corporate insiders. Key points made are noted below.

In a public company, people may have material information about the company that hasn’t yet been put into any filings with the SEC.  If they try to buy or sell shares with that kind of information, then it’s illegal insider trading, and they can get in a pile of trouble.

Rule 10b5-1

And that’s where this Rule 10b5-1 comes in.  The SEC created it so that insiders can create a legitimate stock trading plan that won’t get them in trouble for insider trading. This trading plan contains a pre-set buying or selling program, and it’s valid for a certain period of time.

Now, to make a 10b5-1 trading plan valid, it has to contain certain types of information.  It has to state which securities to buy or sell, and the allowable price points or ranges to do the trading, and the volumes to trade. In addition, the insider is not allowed to alter the trading instructions in the plan once it’s been set up.

Another key item is that you can’t just set up a trading plan at any old time.  It has to be when you’re not aware of any material information about the company that hasn’t already been disclosed to the investment community.  To be safe, that means you should initiate the trading plan right after issuing either a Form 10-K or 10-Q, since all material information should be in those documents.

And one other item is that the insider must be able to prove that subsequent trades were, as the lawyers say, “pursuant to the contract” – or in English, that the trades followed the rules that you set up in the trading plan. Obviously, this is tough to prove if you altered the plan or you engaged in some additional trades.  So to be safe, once you set up that plan, leave trades up to the broker. Don’t muck around with it.

That all sounds simple enough, and it is – but there’s a twist.

Cancelling a Trading Plan

The SEC has ruled that you can cancel the trading plan, on the grounds that you can’t be held liable for trades that haven’t yet occurred. Okay, so what does that mean?

Let’s say you created a six-month trading plan to sell some stock, and it’s been running for a month.  Then you think that the stock price is probably going to decline – or maybe it already has declined. Guess what? You can cancel the plan. So, this means there’s not really much downside risk with a trading plan.

Of course, you could be accused of getting around the intent of the Rule if you cancelled the plan based on insider information. But, the SEC has not yet gone after people for canceling their trading plans, so who knows?

A company might even create a policy to not allow its employees to terminate their trading plans early.  By doing so, they’re eliminating that loophole that the SEC opened, and its makes the company look a bit more ethical.

Using Short-Term Trading Plans

You can achieve the same thing, and make it look quite a bit more legitimate, by setting up a series of short-term trading plans. You let each one expire after a short time, and then adjust the terms of the next plan to match market prices. If you follow this approach, then consider creating plans that run for three months a piece.  That way, you can legitimately install a new trading plan right after each quarterly SEC filing.

Parting Thoughts

That covers the essentials of a 10b5-1 trading plan. Clearly, they’re quite useful if you’re in a position where you want to trade stock, but you’re always aware of insider information. So, how do you create a trading plan.  That’s the easy part.  Every brokerage already has a basic template, so you just fill in the blanks and sign it.

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Rule 144 (#94)

In this podcast episode, we discuss the intricacies of Rule 144, which governs the sale of restricted shares. Key points made are noted below.

I’ve been talking a lot lately about registering stock. Rather than stringing out the topic, I’m going to polish it off in this episode and the next one.  The next episode will be about Rule 10b5-1.

Overview of Rule 144

So, what is Rule 144? This is an important one.  And even if you don’t have any particular need to know about it as an accountant, you may very well want to know about it as an investor – because a lot of people use it.

So let’s say that you own stock in a public company, but that stock is not registered, so you can’t sell it.  And you want to sell it. If you flip over the stock certificate and take a look at the back, it probably has a legend on it – right in the middle – that says the shares have not be registered, so they can’t be sold, pledged or hypothecated.

Now I didn’t have a clue what hypothecated meant – maybe something to do with aggressive hyphenation – so I looked it up. The definition is “hypothecation describes the posting of collateral to secure the customer's obligation to the broker.” So, you can’t do that, either.

Rule 144 Requirements

You want to remove that pesky legend, so you can sell the shares.  You do it with Rule 144. The SEC has a couple of requirements, and if you meet these items, then you can have the legend removed.  Here’s the first one:

And it’s the most important one – there’s a holding period. You must have owned the securities for at least six months, and that’s if the company has been issuing its normal reports to the SEC, like the annual Form 10K and quarterly Form 10Q.  If the company has not been keeping up with these filings, then the holding period is a year. So, this is the big one.  If you’ve held onto your shares this long, and you’re not an affiliate of the company, then you’re basically in good shape, and you can have that legend removed.

Ah, but what if you’re an affiliate?  An affiliate is someone who’s in a control position.

The real definition is kind of lengthy, but basically it’s people who can directly affect company operations, like board members, the CEO, CFO, division presidents, and people who own more than 10 percent of the company.

If you’re an affiliate, then things become a lot more restrictive. I won’t quite go so far as to say that you’re screwed, but it is a lot more difficult to sell your shares. So let’s return to those SEC requirements.  We’re now at rule number two.

For affiliates, there’s a trading volume formula, which means that the SEC is going to make you string out your stock sales.  The rule states that the amount of shares you can sell in a three-month period can’t exceed the greater of 1% of the total outstanding shares, or (if the stock trades on an exchange) the average weekly trading volume during the past four weeks.

So for this rule, if the stock is trading on an exchange, chances are good that the trading volume will be high enough that it drives the number of shares you can sell.  But if the shares only trade on the Pink Sheets, then the second part of the rule doesn’t apply, and you can only sell an amount equal to 1% of the total shares in any three-month period.

And then we have the third rule, which also only applies to affiliates.  They’re only allowed to sell their shares through a broker as a routine trading transaction.  This one means that the SEC doesn’t want affiliates trying to solicit orders to buy their stock.

And then we have the final and fourth rule, which is that an affiliate has to file any proposed sale with the SEC on a Form 144.  This is only if the sale is for more than 5,000 shares or the dollar amount is for more than $50,000, and this filing is for any three-month period.  If you keep selling past the three month period, then you keep amending the Form.

So, you can see that being an affiliate is a bit of a pain. But there is a way out of these affiliate rules. If you’ve held those shares for at least a year, and you’ve not been an affiliate for at least the last three months, then you can sell without all of those extra conditions. And if the company is still filing all of the usual reports with the SEC, then the holding period drops from a year to just six months.

So that covers all of the rules.  Let’s say that you meet all of the requirements – how do you get that pesky legend off the back of the certificate?

How to Remove the Certificate Legend

Here’s the procedure. First, send the certificate to a broker.  The broker contacts the company’s attorney, and asks for an opinion letter.  The attorney will want a standard representations letter from the broker, and a copy of the certificate, and the Form 144, if there has to be one.

Then the attorney writes the opinion letter and sends it back to the broker. The attorney will also send a copy of the letter to someone at the company, so the company knows you’re probably going to be selling shares.

Once the broker receives the opinion letter, he sends it and the stock certificate and some other information to the company’s stock transfer agent.  And after all of those steps, the stock transfer agent creates a new stock certificate without the restrictive legend, and sends it to the broker.

At that point, you can go out and buy a stiff drink – and you can finally sell the shares.

Parting Thoughts

Though – to be fair – most of this discussion has been about the extra rules for company affiliates.  If you’re not an affiliate, then Rule 144 is pretty awesome.  You just hold the shares for the minimum amount of time, and then you get the legend removed and sell the shares.  Nice.

And that’s how people can sell restricted stock.  As you may have noticed, Rule 144 is really for investors, not the company.  The only real impact on the company is that the attorney who handles the opinion letters is probably going to charge the company for having issued the letters, and that may be a couple of hundred dollars for each letter.

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