April 1st Podcast (#121)

In this April Fools Day podcast, Steve and Ralph Nach tell a pack of lies that encompass the following topics, while drinking a lot of Glenlivet Whisky:

• The FASB has sold naming rights to Glenlivet Whisky, overlooking such local brands as Jim Beam.

• The FASB has a new exposure draft out for review, regarding the handling of extralegal pharmaceuticals, which is essentially accounting for drug smugglers. Discussed the need for an inventory reserve to guard against government seizures. Smugglers could violate the going concern principle, since they could be shut down at any moment; this could impact the application of depreciation to digging smuggling tunnels and the capitalization of smuggling submarines, or catapults to throw drugs over the border.

• Sarbanes-Oxley required a financial expert on the board of directors. NASDAQ is going a step further, and is now requiring a priest on every board. Does a Fortune 500 company get a bishop? And who gets a cardinal?

Obtaining Shareholder Votes (#120)

In this podcast episode, we discuss the effects of NYSE Rule 452, and how to obtain more shareholder votes. Key points made are noted below.

NYSE Rule 452

This episode is about the New York Stock Exchange Rule 452, regarding allowing brokers to vote for directors. The situation  is that the New York Stock Exchange has adopted Rule 452, which basically keeps brokers from voting for company directors on behalf of their customers – or at least, without specific instructions from those customers. This rule has been in effect for all shareholder meetings since January 1st of 2010.

In the past, investors have almost always let their brokers vote for them, because it saves time and they really can’t be bothered to do it themselves. The problem now is that brokers nearly always send in their votes, whereas only about 30% of individual shareholders send in their votes.

Problems with Rule 452

This is a massive problem, because you used to be able to rely on getting in far more than half the votes, because brokers are reliable voters - but now you’re lucky to come anywhere near 50% – so you may not even have enough votes to approve the directors.

And it’s worse that you think, because this rule applies to ALL brokers. That means it affects the shares of all publicly held companies, not just the companies listed on the New York Stock Exchange.

The National Investor Relations Institute sent in a comment letter on this, which very nicely stated that they were a bunch of blithering idiots for even considering it, and which I completely agree with.

But now it’s been approved, so we have to deal with it. If you’re with a company with a really high proportion of institutional investors, you may not see too much of a decline in votes, because there’re only a few investors, and they’re pretty reliable. On the other hand, if you have a small proportion of institutional investors, you are completely and thoroughly screwed, because that means you have lots of individual investors, and they don’t vote.

How to Deal with Rule 452

So what can you do? Well, the first step is to create the longest possible gap between the mailing date for sending out proxy materials and the date of the shareholders’ meeting. By giving the shareholders a long time in which to send in their proxies, you might get a few additional votes in. Though, to be realistic, nearly everyone either votes as soon as they receive their proxy materials, or they throw them away. Nonetheless, give yourself some time.

The next step you can take is to have your stock transfer agent hire an outside firm that investigates bad shareholder addresses. A “bad address” is when the last mailing to a shareholder came back in the mail. And if you have a decent stock transfer agent, they should be keeping track of these bad addresses. You want to fix this, so as many shareholders as possible receive their proxy materials.

If you only have a small number of bad addresses, you might be looking at paying $2 per bad address for a search – and that price can go down if you have lots of them. The search firm needs to get the corrected addresses to your stock transfer agent as soon as possible, so that they go into the proxy mailing. This means that if you’re going to do a bad address search, you need to do it very early – in fact, a good best practice for investor relations is to do a bad address search once or twice a year, just to keep the address list up to date.

And by the way, it’s pretty tough to correct an address where the recipient is in another country. You might be out of luck on that one.

Another step is to set up an on-line voting system, so that shareholders can go to a secure web address and enter their votes. There’s two reasons for doing this. First, you can eliminate the mail float for any proxies that would otherwise be mailed back to you, so you get an early feel for whether you’re going to have enough votes. And second, if you’re running late on getting in votes, you can get a shareholder to enter his votes right up until the last second before the shareholders’ meeting by doing so online.

And other step you can take is to hire a proxy solicitor. If you hire a proxy solicitation firm, they’ll review your shareholder base to see what type of shareholders you have, and then come up with a method for contacting them. They normally use outbound solicitation, which is a fancy term for calling your shareholders from a call center.

To do that, they have to use address databases to locate investor phone numbers, since that’s not something you normally have in your shareholder database.

The best proxy solicitation firms are located in New York City, and you can expect to pay quite a bit for this service. But if the votes are really in doubt, you might want to try them.

And if you want to use a proxy solicitor, you should get them involved up front. If you have a couple of days to go before the shareholders’ meeting and you don’t have a proxy solicitor, then your only choice is to contact them yourself.

Which, in fact, is the final option. You should be checking with your stock transfer agent every few days to see how many votes have come in, and you should start calling investors as soon as you see that there’s even a chance of there not being enough votes. To keep your work load down, this does not mean making 500 calls to all of the investors with 1,000 shares or less. If you’re lucky, there may be just one or two investors with a whole pile of shares, and those are the ones to concentrate on.

And that covers the steps you can take to bring in the votes for a shareholders’ meeting. This used to be a complete no-brainer, but now, because of our friends at the New York Stock Exchange, it’s a major pain.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

Accounting Allocation the Easy Way (#119)

In this podcast episode, we talk about allocating overhead costs as quickly and easily as possible. Key points made are noted below.

The Reason for Overhead Allocation

Overhead allocation means that we apportion expenditures among the cost of goods sold and inventory, which means that we’re delaying some expense recognition until a later period. We do this because we have to. If you look at the GAAP accounting standards, in Section 330-10-30 of the accounting standards codification, it says: The cost of inventory is the sum of the applicable expenditures directly or indirectly incurred to bring a product to its existing condition and location. The bit about “indirectly” is what concerns us the most.

The Objective Behind Overhead Allocation

So let’s look at this from a high level. We’re being required to allocate overhead. We probably wouldn’t do it otherwise, since it doesn’t do anything for us from the perspective of improving management decision making. Instead, we’re just complying with an accounting standard. This means that the real objective here is to allocate overhead as quickly and efficiently as we can.

Now don’t confuse this objective with allocating overhead in order to actually use the resulting information, as you would with an activity-based costing system. That’s a different situation that involves a different objective, and also a whole lot more work.

Quick and Efficient Overhead Allocation

Now, let’s get back to how we’re going to meet this objective of allocating overhead as quickly and efficiently as possible. The first consideration is which expense accounts need to be included in overhead. The simplest path is to go over the expenses list with your auditors, and agree with them whenever they want to include something in overhead. And if they want to exclude something, agree right away. Don’t forget the objective here – quick and efficient allocations. Therefore, if you adopt a list of expenses to include in overhead that the auditors are completely comfortable with, then you’ll never waste time in the future having to re-calculate your overhead allocations because the auditors started getting picky about what to include in overhead.

Next up, consolidate some of those expense accounts that are now going to be included in the overhead allocation. The reason is that auditors do a variance analysis as part of their audit work each year, where they bug you about changes in the general ledger accounts if they exceed a certain percentage change. If you consolidate accounts, then it’s going to take a hell of a large change to trigger an inquiry from an auditor – and that saves you time. Again, we’re meeting the objective of quick and efficient.

Next, you need to figure out how many cost pools to use for the allocation. If you were doing an activity-based costing analysis, you’d have a ton of cost pools, so that you could allocate overhead with great precision. But – this is not activity-based costing, it’s just a lousy overhead allocation. So what we want to do is get away with the smallest possible number of cost pools. Again, ask the auditors what they want. If they try to get all precise on you and want some extra cost pools, this is a good place to push back a little, and try to knock down the number of pools. If you can get away with just one or two cost pools, then that’s very good. Again, the objective is quick and efficient. And slicing and dicing overhead into lots of cost pools is not quick or efficient.

And finally, there’s the basis of allocation, like machine hours or direct labor hours, or square footage used. With the objective in mind, you want an allocation base that easily measured and defended (by you) and easily verified (by the auditors). Whether it’s the most appropriate allocation base is not the point, believe it or not. You’re simply complying with an accounting standard. For example, if you want to allocate overhead based on machine hours used because it’s the most appropriate method, that’s not going to be your best allocation base if you have to set up a machines hours measurement system from scratch. All you’re doing is wasting the company’s time and money, when you could be using a somewhat less appropriate allocation base that’s already being measured.

For example, there’s been a lot of discussion in the accounting press for years about how direct labor is a bad allocation base, because you may allocate a massive amount of overhead based on a pretty small amount of direct labor cost.

The people saying this are entirely correct. But if direct labor is all that you’re measuring, then use it to allocate overhead. The results may not be pretty, but if you can justify the decision, it may still be the quickest and most efficient way to allocate overhead.

I fully realize that what I’ve just said may have outraged any accounting purists who are listening. But just keep in mind what you’re trying to accomplish here. It’s about compliance, not decision making. Never confuse the two, or you’ll spend far too much time making unnecessary overhead calculations.

Related Courses

Accounting for Inventory

Cost Accounting Fundamentals

How to Audit Inventory

Building Customer Relationships (#118)

In this podcast episode, we talk about how to build the right kind of relationship with customers, in order to improve collections. Key points made are noted below.

This is a rather odd episode, because it relates National Signing Day to collecting overdue accounts receivable. So, what on earth is National Signing Day? In the United States, this is the first Wednesday in February, and it’s when top high school athletes sign a letter of intent to play sports in whichever college has been recruiting them. Usually, we’re talking about football players, and by football I mean the American version; that’s where large people in pads and helmets run into each other. This is becoming so big that one of the cable sports networks runs coverage of National Signing Day for the entire day. For those of you outside of the United States, you’re probably shaking your heads and wondering about those crazy Americans – and, you’d be right.

Now, the coaching staff of a college football program is partially judged on the proportion of top recruits that they can pull in on National Signing Day. Of course, part of their success is based on the reputation of the school’s football program, but a very large part of it is based on personal relationships between the coaches and the recruits. This isn’t something that’s developed overnight. Sometimes a college has to build relations for a long time before a recruit is comfortable enough with them to commit on Signing Day.

The Need for Good Customer Relations

You may be wondering how on earth I’m going to link this admittedly overblown event to collecting accounts receivable. But the point is pretty simple. If a customer is having trouble paying its suppliers, and you could see who they were paying first, I’ll guarantee you that they pay the people they know before they pay anybody else. In other words, and just like National Signing Day, the relationship is incredibly important. This has a bunch of implications. First and foremost, if you want to build relationships, it’s pretty tough to have a industrial-scale collections department where anyone is allowed to contact any customer. Instead, you have to assign specific collections people to specific customers, and you have to commit to keeping those assignments running for a long time, probably several years at a stretch.

And on top of that, you need to winnow out any collections people you have who are rude and abrasive, and instead put in people who are a lot smoother, and who really like to chat on the phone. By doing that, you’re switching from beating on customers to building relationships. Now if you do this, don’t be surprised if it takes a lot longer to contact a smaller number of customers, and that’s because you’re trying to lay the groundwork for a relationship – and that takes time.

The Need for Different Performance Metrics

Also, you need to change your performance metrics for the collections staff, so don’t track how many seconds they’re on a phone call. Instead, the only metric that counts is whether they can collect the cash, and it may take months before that metric starts to improve.

The Need for a Different Style of Communication

If you take this approach, the way in which you communicate with customers has to change, too. Anything that allows you to get warm and fuzzy with customers is in, and everything that seems impersonal is out. That means you avoid e-mails and faxes and dunning letters like the plague; and instead, use the telephone – and that’s the talking part of it, not the texting part.

And that may mean visiting customers – yes, in person. If there’s any way in the world that you can get in front of your counterpart in the customer’s accounting department, then do it. This absolutely does not mean sitting across from each other and hashing through a bunch of issues. You may eventually get there, but it really means going out for lunch together and maybe talking about anything but business.

If you can build on that relationship over time, then when the time comes to ask for payment on an invoice, you call them up, you ask for the payment – absolutely never demand it – and more than likely all of that advance work will pay off, and you’ll get paid. And if you don’t get paid right away, don’t be surprised if they at least give you the inside scoop on exactly why they can’t. And that’s valuable information.

Now this doesn’t just mean that the collections people at your company get to know the payables people at the other company. You can also work it at the controller or CFO level. These people tend to stick around longer, so it’s easier to build long-term relationships between controllers or CFOs. And if you can get a customer’s controller to authorize a payment, that’s just as good as getting a payables clerk to do the same thing.

Parting Thoughts

This approach isn’t going to work in all cases. If your company deals with thousands of customers, with each one owing just a little bit of money, then good luck with building relationships! There’s not enough time in the day, so don’t bother. Instead, think like those college coaches – there are only a couple of thousand recruits to deal with in the entire country, so they focus on a small number that are really important. You can do the same thing, and in a business, that means building relations with the biggest customers.

Related Courses

Credit and Collection Guidebook

Effective Collections

Cost Variability (#117)

In this podcast episode, we address the extent to which various costs are actually variable. Key points made are noted below.

How Cost Variability Applies

Let’s say that you need the cost of a product in order to make a decision, like whether to accept a customer’s offer to buy the product at a certain price. This is a fairly routine question. The accounting staff goes to the bill of materials for the product, prints the page, and hands it over. They say you should use the total cost listed at the bottom of the bill of materials. Not so fast.

Costs can change under a lot of circumstances, and you have to know what those circumstances are in order to arrive at the correct cost. You may find that the product cost in the bill of materials is the wrong cost.

Let’s go through some of the scenarios.

The Direct Labor Scenario

The first item is direct labor. This is the labor cost of manufacturing the product. Now, the traditional view is that direct labor varies with production quantities. Actually, that’s not entirely true. The production manager has to have a certain number of people in the manufacturing area to staff all of the machines, so there’s a minimum number of people who have to be on hand in order to run the operation at all. It may be necessary to add direct labor staff as production volumes go above a certain level, but it tends to be in the form of step costs. That means the company adds a whole group of employees at once when it opens up an additional assembly line, or adds a new machine.

So, the point here is that the incremental cost of direct labor depends on not only the incremental volume involved in the decision, but also how much capacity is already being used. If you have an incremental decision to make about selling a few more units of a product, the incremental labor cost really could be zero, because the minimum staffing level is already on site, and there’s no need to add more people to produce the products. On the other hand, if any additional production means that you have to add a new shift, then the entire labor cost of that shift should be assigned to the extra units that you want to produce – and that could be an astronomical cost.

The Purchased Components Scenario

Cost variability is also an issue for purchased components. Suppliers sometimes package their products in sizes that are convenient for them to store and transport. That means they prefer you to buy in quantities of a dozen, or a hundred, and they offer a good price on a per-unit basis if you buy the quantities that they want you to buy.

But what if you just don’t need the quantity that they’re offering? Or what if your production schedule demands a really large quantity? Well, in the first case, the supplier will likely charge a higher price for an odd-lot purchase, and you may get a really low price in the second case. And the pricing difference between these two extremes could be massive.

But if the accounting staff just gives you the cost listed on the bill of materials, that states what the component usually costs, based on the company’s normal purchasing quantities. If you’re collecting information for a production quantity that’s not normal, then you’re dealing with incorrect cost information – again.

So in this case, there needs to be additional investigation into the quantities needed.

To summarize the situation so far, you have to recognize that a company’s existing product cost information is only valid within a very specific range that depends on the current level of production capacity that’s being used, and the incremental quantity of components that you need to purchase.

The Batch Size Scenario

Another issue with cost variability is the cost of a batch. For example, if there’s a lot of equipment retooling involved to manufacture something, then you need to consider the labor cost of the retooling, and the scrap that results from doing test runs on the equipment.

But at an incremental level, you can ignore most batch-related costs. The main reason is that the company is going to pay the wages of the people retooling the equipment, irrespective of whether a specific batch is run or not. Those people are a fixed cost, so for the purposes of deriving an incremental cost for a specific production run, you can ignore their cost.

But this is not the case for any scrap that’s created when they test equipment for the production run. Scrap is an incremental cost, and you should assign that cost to the product.

The Experience Curve Scenario

Another cost consideration when you’re looking at production volumes is the experience curve. This is the concept that your production cost declines by some percentage every time that your production volume doubles. This doesn’t apply to too many situations, since it only creates a major cost savings if you have a monster ramp-up in production. Still, it can be a consideration, and it may result in more cost variability.

The Need for Detailed Costing Investigations

All of this means that you can’t simply ask the accounting staff for a product cost. You need to give them more specifics about the situation for which you need the cost, and they have to conduct an investigation based on the information that you give them.

This also means that they can’t simply print out the bill of materials and call it the product cost. They really have to create a report that defines the exact parameters within which the costs apply. And for a major cost decision, it helps to compile a set of three costs, that apply to the most likely scenario, as well as to lower and higher production assumptions.

Cost Variability Based on Time

Now, so far, the discussion has centered around the incremental cost of a product. But you can also discuss cost variability based on time. The basic concept is that every single cost is completely variable over the long term. The cost of a 30-year lease is fixed for 30 years, but it’s variable if you add on one more day.

This is all quite obvious, but what a lot of people miss is that they don’t track the dates on which fixed costs become variable – and there’s usually a very specific date associated with each fixed cost. Instead, people just assume that those committed expenditures keep rolling on forever.

What you should do is create a table for every large fixed cost in the business that includes the cost and the earliest date on which you have the option to terminate or at least modify it – and then start incorporating that table into your planning process. And by doing that, you’ll find that cost variability applies to everything.

The Perception That a Cost is Fixed

And a final consideration is that some costs are fixed because you perceive them to be fixed, because that’s the way you’ve always treated them. For example, if there’s an advertising line item in the budget, or one for research & development, you may perceive it to be fixed, because that’s what you’ve always spent, and you believe it’s critical for maintaining the viability of the company over the long term.

Over the long term, you’re probably right. But on a very short-term basis, it’s entirely possible that some of these expenditures can be reduced or even eliminated, and they won’t really have much of a short-term impact on the business. If you keep not paying for these items a little longer, there could be a very serious impact on the company. But depending on the time period involved, you may be able to get away with not making these expenditures. So here you have a case of costs being variable simply by changing your mindset about them.

And on top of all these considerations, you can also look at cost variability from the perspective of throughput analysis, which I covered back in episodes 43 through 47.

Related Courses

Cost Accounting Fundamentals

Disclosing Pro Forma Information for Business Combinations (#116)

In this podcast episode, we discuss a new accounting standard pertaining to information reporting for business combinations. The key points made are noted below.

This episode is about the new Accounting Standards Update number 29 for 2010. It’s called Disclosure of Supplementary Pro Forma Information for Business Combinations. If you work for a public company and it does acquisitions, then keep listening.

First, for some background. Up until now, if a public company completes a business combination, it’s supposed to disclose the combined revenue and earnings results of the entities as though the transaction had occurred as of the beginning of the current annual reporting period. This is on what’s called a pro forma basis, so that means you report these combined results separately from the regular income statement, and you state that they’re pro forma results.

Also, the company may be presenting comparative financial statements, which means that it’s presenting the results of multiple periods side by side. If it’s making this kind of a presentation, then it should report pro forma results for the prior period, too, so the reader has comparable information for both the current period and the prior period.

The question is, how far back do you present pro forma information? Some companies have presented pro forma results for as far back as they have comparative information in their financial statements – which may be five years or even more, while others only do it for the immediately preceding year.

Well, this ASU comes down on the side of only adding pro forma information for just the last annual reporting period, and then only if the company is even providing comparative financial information. And, again, this is only for revenue and earnings. So for example, if the company completes an acquisition in the middle of 2012, it’s supposed to provide pro forma results for both entities combined as of the beginning of 2012, and – if it also provides comparative information for additional preceding years, then it only has to issue pro forma results for the combined entities for 2011.

In addition, you’re supposed to include a description of the nature and amount of material, nonrecurring pro forma adjustments that’re directly attributable to the business combination.

Why do this? Well, the second part about new requirements are easy enough. These’re new disclosures, so obviously the FASB thinks this improves the usefulness of the total package of information that a reader of financial statements receives.

As for the first part, the FASB received a half-dozen letters about this issue, and nobody really seemed to care too much about whether you issue pro forma results for just the prior year, or for a bunch of prior years. So, this was probably a case of judging in favor of the reporting requirement that was easier to complete.

These changes should be less expensive than the current situation for those companies that were reporting pro forma results for all of the prior years listed in their comparative financial statements, since now they’re doing it just for the immediately preceding year.

If you’re with a company that was only doing it for just the immediately preceding year, then your will go up a bit, since now you have to layer on the new disclosures about material, nonrecurring adjustments.

On the whole, the core of this change was about standardizing the current disclosure practices, so it’s not really a big deal.

And a final point is that these are all changes to generally accepted accounting principles, not to international financial reporting standards. The international standards do not require pro forma disclosures, and they also don’t call for any of the extra disclosures that we just talked about.

Related Courses

GAAP Guidebook

Mergers and Acquisitions

Public Company Accounting and Finance

Reporting of Pension Loans (#115)

In this episode, we discuss a new accounting rule relating to the reporting of participant loans against a pension plan. Key points made are noted below.

This episode is about the new Accounting Standards Update number 25 for 2010. It’s called Reporting Loans to Participants by Defined Contribution Pension Plans. It impacts a lot of companies, though only in a very minor way.

This new ASU was released by the Emerging Issues Task Force – and, since the EITF deals with smaller technical issues that that’s what we’ve got here – a smaller technical issue. But it impacts a lot of people, because it applies to how you report your 401k plan.

The ASU is about how you classify loans to employees under defined contribution benefit plans. Most everyone has a defined contribution benefit plan, and in most cases, it’s the 401k plan.

Here’s where it gets interesting. If an employee has a 401k account, and he wants to borrow money against it with a loan, then from the company’s perspective, that loan is an investment. And you’re supposed to record an investment at its fair value.

To record a loan at its fair value takes some work, because you’re supposed to do an analysis of things like the market interest rate, and the borrower’s credit risk, and historical default rates. I would be willing to bet that very few companies anywhere on the planet have been going to that much effort. So essentially, we have an area of GAAP that everyone’s been ignoring.

Instead, we all take the easy path, which is simply to record the unpaid amount of principal on the loans, and maybe the accrued interest, and just assume that its close enough to fair value. And why not? It’s easier and it’s probably pretty close to the real situation.

So, the EITF has made official what everyone’s already been doing. According to the ASU, you now record these loans as notes receivable, and you measure them at their unpaid principal balance, plus any accrued but unpaid interest. This is what we call recognizing the status quo.

And they gave some good reasons for it. These loans aren’t really an investment, because the plan can’t sell the loans to a third party, which it can do with a real investment.

And, if the employee defaults on the loan, he was borrowing against his own plan assets, so who cares? That just means that there’s no credit risk.

But there is a small twist to be aware of, and this will change your reporting slightly. You’re supposed to segregate these loans from other plan investments, which means that you should report them separately. And the new classification is called Notes Receivable from Participants, and it is a plan asset.

So in short, you no longer have to do what you weren’t doing anyways, though the reporting changes slightly.

Related Courses

Accounting for Retirement Benefits

GAAP Guidebook

Free Accounting Software (#114)

In this podcast episode, we talk to the president of a company that offers free accounting software (which has since been acquired by godaddy.com). Key points made are:

• Outright offers free accounting software. It charges a fee to file Form 1099s and for certain tax services, but the basic service is free.

• The system pulls in data from credit cards and PayPal and converts it into information that can be included in tax returns, also calculating the amount of tax owed.

• The system is targeted at the small business owner.

• The main orientation of the system is toward the preparation of tax returns.

• Information is stored on the Internet, using bank-level security.

• This approach avoids the risk of losing data when a local computer crashes.

• The system is easy to understand and use, with a minimal need for accounting knowledge.

Related Courses

Accounting Information Systems

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.

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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.

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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).

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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.

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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.

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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.

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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.

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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.

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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.

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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