Accounting for Marketing Expenses (#133)

In this podcast episode, we cover the various rules relating to how you account for marketing expenses. The key points are noted below.

This episode is about marketing expenses. I’m responding to listener’s question, which is: When are marketing creative costs, such as for designing promotions, packages, and point-of-sale, expensed? The question goes on with an example, which is, if these costs were incurred last year, but the related marketing program hits in this year, in which year do you charge the expense?

Accounting for Advertising Expenses

The best answer to this is under Generally Accepted Accounting Principles, in an area called Other Expenses in the accounting codification. There’s nothing about it at all in the International Standards. What GAAP talks about is advertising expenses, which is really a subset of marketing expenses – and the question was about marketing expenses. So I’ll go over what GAAP has to say about advertising, and then we’ll extrapolate back to the question from there.

So. GAAP says that you have two kinds of advertising expenses. The first is the cost of producing advertising, and the second kind is the cost of communicating the advertising. The part we’re interested in is the cost of producing advertising, since that most closely relates to the question about marketing creative costs. Under GAAP, you charge the cost of producing advertising to expense as you incur it, no matter when the actual advertising associated with it actually occurs.

OK, that gives us some good detail on the issue. I would say that producing advertising is pretty close to designing the promotions, and so on, that were referenced in the question. And so it’s reasonable to say that the same rule applies. So, you should charge marketing creative costs to expense as soon as you incur them.

Other Marketing Rules

Now, while we’re here, let’s see what other rules there are regarding marketing.

There’s a rule that allows you to treat sales materials, like brochures and catalogues, as prepaid supplies. This means you can record these items as an asset, and then charge them to expense as you use them up. But, at whatever point you stop distributing them, you have to charge the remaining asset to expense.

I’ve done this, and it’s a pain in the ass. The trouble is that absolutely nobody is keeping a good count of however many brochures are still in stock. So, right in the middle of trying to close the books at the end of the month, you have to go off and count the bloody brochures, and figure out how many are gone, and how much to charge to expense.

And on top of that, brochures have a habit of sticking around for years, so you’re always in that gray area of whether you should write off the remaining stock or keep it on the books. So the accounting just drags on.

Without question, my advice is to not even bother. Unless the company is spending a massive amount on these materials, it’s so much easier to just charge it to expense as soon as you buy it.

Another issue is the cost of communicating advertising. You can charge it to expense as soon as you incur it, or when the first advertising takes place. And you have to be consistent in using one approach or the other.

Accounting for Direct Mail Advertising

Now, what about direct mail advertising? This is where you’re incurring a cost to distribute some kind of mail piece, and you expect a certain number of responses back. In this case, you can record the cost as an asset, but only IF you can prove there’s a relationship between the costs incurred and future benefits from the mailing. Mind you, you have to prove the relationship, which means using historical results for the same product or similar products. If you can’t prove that the mailing is going to generate revenue, then you have to charge the cost to expense right away. Of course, that brings up the issue of why you’re doing the direct mailing at all, if it’s not going to make any money.

Anyways, if you can prove a relationship, then you can record the cost as an asset and then charge it to expense as you recognize revenue from the direct mail campaign. And that means you have to prove the revenue came from the campaign, which means there should some kind of offer code included in the mailing that you can track.

And there’s actually more paperwork involved. You also have to segregate the cost of each direct mail campaign in a separate cost pool, and only recognize it as an asset if you can prove that historical revenue to expense relationship – and that’s for each individual cost pool.

So, should you go through all that grief just to defer the cost of a direct mail campaign by maybe a month or two? As usual, it depends. My normal knee-jerk reaction to this kind of annoying rules-making is to say no – just charge it to expense. And in fact, that is what I recommend. Especially if the direct-mail cost isn’t that high.

But, if you’re in the direct mail business, either following or not following these rules could have a material effect on your income statement. So in that case, I suggest modeling your results both ways, and consulting with your auditors. And if you’re already following this rule, you probably want to be consistent with past practice, and just keep doing it.

Related Courses

GAAP Guidebook

Consolidation Software (#132)

In this podcast episode, we cover the basic requirements for consolidation software. Key points made are noted below.

When the request came in, I sent it along to a partner at a really large accounting firm, and she passed me along to a director who specializes in consolidation software. This seemed like a good thing. He wrote up some notes for the podcast, but then he had to have it reviewed by their legal department. And their attorneys said, no, he could not be involved. So, he passed along the notes, on the condition that I can’t say his name or the name of the accounting firm. Which was very nice of him, but just incredible that they don’t want their name involved. This podcast goes out to multiple thousands of listeners, so if this isn’t good marketing, I don’t know what is.

Consolidation Software Functional Requirements

So, let’s get on with the topic. The question was, what to look for in consolidation software. Our unnamed director listed the functional and technical requirements separately. Here we go with the functional requirements:

First, currency translation using multiple exchange rates. For example, you need the average monthly rate for the income statement, month-end rates for balance sheets, historical rates for selected investments, and management rates for budgeting purposes.

Next, we have intercompany reconciliation and elimination. This is where the intercompany balances and differences can be tracked by entity for quick resolution.

Next, alternate hierarchies. The system can provide data for multiple hierarchies, which can include statutory, management, and tax-related hierarchies.

Next, regulatory initiatives. The software should be able to do XBRL reporting for the SEC. And by the way, we talked by XBRL in Episode 108. This also means helping to do dual reporting for both the GAAP and IFRS frameworks.

Next, requirements for multiple accounting standards. This means maintaining data for local reporting purposes, and then modifying the data for the accounting standards used by the parent company.

Next, audit trail and adjusting entries. The system should provide detailed audit trails for all of the data collected, and it should generate automated adjusting entries.

Next, data categories. The system should be able to store multiple data categories, such as actuals, the budget, budget variances, and all of that.

And the last functional item is, reporting. This means a web-based drag and drop report creation system. You should also be able to set up a reporting calendar, which the system uses to create and automatically distribute reports. The system should also generate reports in PDF format.

Consolidation Software Technical Requirements

So that was the functional requirements. Next up, we have technical requirements.

First, workflow and task lists. There should be task lists for critical activities. I’ll just read this next part off his list. It says, if possible, there should be an ability to track activities that are scheduled to be completed outside of the consolidation system. For example, reconciliation of subsidiary ledgers is a critical closing activity that could be included in the task list and managed through the work flow process. Some tools offer the capability of entity-based certification from local controllers.

Next, we have the user interface. There should be a user-friendly front end for the collection and validation of data. And he notes that most consolidation packages offer interaction with an Excel front end.

Next up is data validation. There should be user-defined field validations at the point of data entry. This can be things like debits always equal credits, and net income on the income statement equals the current year profit or loss listed on the balance sheet.

Next is rule development. He’s listed this as being a self-service function, and I’m guessing this means you can develop your own macros in the system to automate some tasks.

Next is security. There should be security by module, which keeps users from getting access to data that they don’t need. This can also mean that you can read information in certain areas, but you can’t change the data.

Next is drill down capability. You should be able to drill down to the source data from the consolidation level.

Next is the allocation engine. There should be an easy-to-use allocation engine, which is used for allocating expenses across business units, regions, and so forth.

Also, there should be integration with spreadsheets. There should be quote unquote, “dynamic integration” of spreadsheets with the consolidation database.

And finally, there is system maintenance. You should be able to do system maintenance without having to log users out of the system.

Related Courses

Accounting Information Systems

Business Combinations and Consolidations

Operating without a Budget (#131)

In this podcast episode, we discuss how to operate a business without using a budget. Key points made are noted below.

In the last episode, I talked about how annoying and counterproductive the budgeting concept is. So in this episode, I’ll talk about how to get by without a budget.

The Need for a Forecast

The first issue is that you still need a forecast. Otherwise, nobody knows what’s coming. But it’s at a summary level, and it’s quick – really quick – and you update it a lot, like once a month. You don’t need to go into excruciating detail, like you would with a budget. Instead, this is simply an update on what you think might happen in the near future.

A couple of points on this. First, if you spend more than a half an hour on this each month, that’s too much time. The only way you’ll get people to issue a new forecast frequently is by making it easy to do.

Second point. How far in the future should you forecast? Only for as long as you’d use it to make decisions. So for example, if you’re building software apps, the market moves so fast that a three-month forecast is probably fine. Any longer, and you’re forecasting things that are bound to change. On the other hand, if you’re in an established industry where things don’t change much, you can extend the forecast. But not by too much. Only extend the time period out as far as the information is still useful.

Third point. Do not link it to anyone’s performance plan. If you do that, they just start messing with the numbers in the forecast to make themselves look good. All you want is a forecast that gives some warning to employees about what’s coming up in the near future. This is not designed to pay somebody a bonus.

Fourth point. You don’t actually need to revise the forecast once a month. If nothing has changed in the past month, then there’s no need for a new forecast. So in some industries where things don’t change much, just keep trucking along until something happens that warrants an update.

Ok, so a short-term forecast is the first thing you need if there’s no budget. If you have it, you get rid of all that budgeting inaccuracy that I talked about in the last podcast.

The Timing of Capital Budgeting

The second thing you need is to revise the timing of the capital budgeting process. There’s no longer a need to only review capital budgeting proposals once a year. Instead, you’ll accept proposals whenever somebody needs to buy a fixed asset. But this doesn’t mean that you eliminate the review process. Fixed assets can be really expensive, so you still need to examine the larger proposals in a lot of detail. On the other hand, if there’s a really low-cost proposal for a fixed asset, you can back off and just buy it without wasting too much time. So, there’s just a minor tweak to capital budgeting needed if you want to operate without a budget.

How to Set Goals

The third thing you need is a different way to create goals for the business. You might recall from the last episode that a standard budget is basically one gigantic set of goals. But they’re fixed goals. You’re going after hard targets that are fixed in the budget for the entire year. Instead, the new concept is that you want to do better than you did before. That’s all.

It seems pretty simple, but actually it’s a bit more complicated than that. You can use benchmarking to figure out what the best in class is for whatever you want to improve. Maybe it’s how fast you can fill an order in a distribution company, or the time required toturn around an order in a fast food restaurant, or inventory turnover. Whatever it is, just figure out how well the better companies are doing it, and set up a goal.

You don’t have to reach the goal right away, but you want to do better than you’re doing now. The reason for leaving this so vague is that there’s no reason for anyone to game the system anymore, because there’s no internally-derived target for anyone to mess with. Instead, you could say that the internal average fulfillment time for an order is five minutes, and the best in class companies can do it in three minutes. And eventually, we’d like to get there. But we don’t have to reach that goal this year. We’ll get there when we get there, but there has to be progress.

The Need for a Reporting System

And you reinforce the goal setting with a really good reporting system. So pretty much everyone in the company sees reports that show current performance, and the goal that the company is shooting for. And along with that reporting system goes more responsibility.

Who Sets Strategy

Senior management still does strategic direction work, but most of the tactical-level decisions get pushed down much lower in the organization. That way, local people know what the current performance is, and they know what the goals are, and they can decide on how to get there. And that allows them to make changes really fast, if that’s what’s needed.

Changes to the Performance Compensation System

And that brings us to the fourth and final point, which is that you have to restructure the performance compensation system. Under the old approach, there’s a specific performance agreement with each manager, under which they’re paid a bonus if they meet certain very specific targets.

What you should do is eliminate all of those performance contracts. Instead, there should be one big bonus pool for everyone in the company, which is probably based on a chunk of the full year profits. And there’s a bonus administration group that figures out who gets how much of the pie, which is based on a fairly basic allocation formula.

So why would this approach be better, and why does it work if there’s no budget? First, everyone gets involved in the performance of the company, because everyone can get a bonus. And if you think that managers come up with all the good ideas in a company, think again.

Second, if the bonus pool is based on a chunk of profits, then improving performance means there’s going to be a larger bonus pool. And also, the size of the bonus pool is only known at the end of the year, so if the company has a bad year, no bonuses. That’s quite a bit different from the traditional approach, where a company may be required to pay out bonuses even if the company as a whole did poorly; and that’s because it signed off on specific bonus agreements that promised the payment of very specific bonus amounts.

And another reason for this type of compensation. What do you think the control environment would be like if every single employee was counting on getting a bonus? I think you end up having every employee acting like an internal auditor, and they’re all making sure that operations are done right, and that money is not wasted. Kind of an interesting concept.

Parting Thoughts

These concepts might sound idealistic, but they do get around all of the issues that I described in the last episode. And some companies are using them right now.

To do it, they’ve made some pretty major changes. Senior managers have to keep their hands off of day-to-day decisions, lower-level people need to be trained to run operations themselves, and there’s a whole different way to pay bonuses that might not sit too well with those who were paid a lot before. And you have to dismantle all of that bureaucracy that went with having a budget.

So that covers budgeting. In case I haven’t made it clear enough yet, I’m not entirely happy with the traditional style of budgeting. I think it wastes an amazing amount of time, and it’s inaccurate, and it supports a top-down style of management that doesn’t work very well in a lot of companies. Instead, trying cutting loose and operating without a budget. You might like the results.

Related Courses

Budgeting

Capital Budgeting

The Problems with Budgeting (#130)

In this podcast episode, we cover the multitude of problems with budgeting. Key points made are noted below.

I talked about creating and improving budgets in earlier episodes, but have you ever considered that you might not want a budget at all? They have a lot of problems. Let’s talk about why budgets can actually harm a business.

Budgets are Wrong

The first issue is that the blasted things are always wrong. You create a budget around the end of the year, and it’s based on fairly good predictions of what will happen in the next couple of months, and then things get pretty dicey after a few more months. This can be really bad in an industry where there’s lots of upheaval, and less of a problem when you have lots of long-term contracts or the competitive environment is stable. Nonetheless, even in the latter case, the budget will eventually depart from reality. I’ve been doing budgets for a long time, and almost all of them could be classified as science fiction by the time we reached the end of the budget year.

You just cannot predict events perfectly. This has two bad results. The first is that variances from the budget keep getting bigger as the months go by, to the point where people start to ignore the budget. And second, people tend to look upon budgeted expenses as money they can spend – but what if actual revenues are lower than expected, but you’re still spending money according to the budget? Then the company loses money.

Budgets Require Revisions

Another problem with the budget is that managers get into the mindset of only doing planning once a year, for the budget. But what if the industry is changing so fast that you have to keep updating strategy every few months? If management has that annual planning mindset, it’ll keep right on using that annual budget, even though you should scrap it.

Budgets Take Time to Construct

And here’s another problem. What about the time required to construct it? You can put a bunch of people on it for months, and managers have to provide their input, too. And then you go through God only knows how many iterations to fine tune it. And, for what? If you evaluate what a company does with its budget, a lot of the time, it’s not worth the effort.

Budgets Allow for Gaming the System

And then we have the problem of gaming the system. This means that managers know they’re going to be evaluated based on how well they perform against the budget. So, doesn’t it make sense to predict really low revenues and really high expenses? That way, you’re bound to look like a hero. Of course, it also means that the budget is wildly conservative, and it also means there’s not much of an incentive to push the organization to perform better.

The Use it or Lose it Problem

But we’re not done yet with budgeting problems. I’m just getting warmed up. The next issue is the “use it or lose it” syndrome. Everybody knows that if you don’t spend every last cent in your expense budget, you’ll be assigned a smaller budget the next year. So that means managers spend money like crazy in the last month of the year, even if they don’t need to. This is why December is such an unprofitable month for so many companies.

Problems with Capital Budgeting

And then we have capital budgeting. The trouble here is that you plan for all of the fixed asset purchases for the next year during a few weeks at the end of the preceding year. So everyone submits their proposals, and the winners have their expenditures built into the budget.

OK, but what if you have an unexpected need for more fixed assets sometime later in the budget year? You’ll probably buy them, and that means you’ll spend more money on fixed assets than you expected. In fact, it means you absolutely always spend more money on fixed assets than you expected. The reason is that a pre-approved fixed asset will be bought, and it’s usually bought earlier in the budget year. Therefore, expect to need more cash than you expected for fixed asset purchases.

Command and Control Problems

And then we have the biggest problem of all, which is the command and control system. This is the very common management system where the senior management team makes all of the large decisions, and everybody else implements them. When you have a command and control system, the “control” part of the equation is the budget.

The senior management group creates a performance contract with every manager in the company, where it hands out bonuses only if managers meet their expected performance – and that performance is detailed in the budget. Now, if you think the command and control system is fine, then you’re thinking, so what’s wrong with that?

There’re several problems with that. First, there’s that gaming the system issue that I just talked about. Budgets will be conservative, so that managers can make their bonuses. Count on it.

Second, people defend their budgets ferociously, so it’s really hard to shift money into new lines of business. This means that a business with a command and control system becomes rigid – it can’t react quickly to new opportunities.

For example, what if you’re a manager, and you see a hot new opportunity. But getting the money to pursue it outside of the normal budget process requires all kinds of approvals. Chances are, you won’t bother to spend the time getting a special dispensation, and you’ll wait until the next budget year to get funding for it. And by that time, the opportunity may have passed.

And on top of all those problems, you have ethical issues. If a manager is not quite going to make his numbers, and therefore won’t be paid a bonus, do you think there’s maybe just a little temptation to bend the rules to create better results? Yeah, just maybe.

Finally, command and control systems are both expensive and self-perpetuating. You need a budgeting staff, as well as people who run around and figure out why there’re variances between actual and budgeted results, and who generally try to keep the company running in accordance with the budget. And, these people obviously have a vested interest in maintaining the budgeting system, if not expanding it. After all, if there were no budget, they’d have no jobs.

So that covers the masses of problems with budgets. In the next episode, we’ll talk about how to operate without a budget. That episode might be delayed a few weeks, since I’m trying to fit in an interview on a different topic – so, stay tuned on that one.

Related Courses

Budgeting

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Streamlining Payroll, Part 4 (#129)

In this podcast episode, we finish up with the best practices that can be applied to the payroll function. Key points made are noted below.

So, in the first three parts, we talked about cutting back on the amount of data to collect, automating data collection, reducing the number of deductions, adding self-service, streamlining payroll calculations, and using electronic payments.

The Order of Priority

What order should you use to install all of these changes? I have some suggestions that give priority to immediate, low-cost improvements. And the reason for this priority is that you want to build a reputation for being able to complete projects, so cranking out a few easy ones might give you the internal support for a bigger change later on.

I think the first item to fix is to get rid of any excess data that’s being collected.

The main reason is that there’s no new system to install. You’re simply stopping the collection of information. That means everybody throughout the company is wasting less effort on recording information. And that makes folks pretty happy, which in turn means that they may be more willing to listen when you install the next change.

And also, the impact is immediate. The company stops recording information, and the payroll staff immediately has less work to do.

My suggestion for the second most important item is error monitoring. And again, this is partially because it’s a relatively quick fix and it can have an immediate impact on the payroll department. When there’s a payroll error, it takes an amazingly long time to fix. So if you can start collecting error information and fix even a few of the underlying problems, this is really going to help.

Third in priority is payroll cycles. If you can extend from weekly to any longer payroll cycle, then do it. And furthermore, put the entire company on the same payroll cycle. Obviously, this saves the time of the payroll staff, but it takes longer to implement.

You have to convince the other managers to do it, and notify everyone, and possibly arrange for advances for some of the staff. So, it’s a good improvement, but the delay in seeing results puts it a ways down on the priority list.

After that, I suggest automating time keeping as much as you can. This means spending some money on equipment or software, and training employees in how to use everything. So, because of the investment and the time required, I put it rather far down the list. But it’s still something you should get to fairly soon.

Next up, do electronic payments. Employees love it, but the net impact on the accounting department is not that large. When you switch from checks to direct deposit, it’s not like there’s a huge decline in the payroll work load.

And finally, and really dead last, is self service. You’re going to pay for this feature, either by programming it yourself or renting it from a software provider – so there’s going to be a cost that you have to balance against the benefit of shifting some data entry outside of the payroll department. For smaller companies, this may not be an overwhelming cost-benefit tradeoff.

Now, keep in mind that you can alter priorities based on your circumstances. So if you have thousands of employees, having self service might be really cost-effective – even though it was my lowest priority recommendation. It just depends on the circumstances.

The Level of Technology to Acquire

I also have a suggestion regarding the level of technology that you buy into. And this mainly refers to timekeeping hardware and software. All of the technology you need for a nice, solid system has been on the market for years. That means you don’t need to take a chance on some new and unproven technology, and especially from a new supplier who hasn’t been in the market for long. If you buy something that’s been used for a while, and which appears to be getting good supplier support, with plenty of upgrades, then that’s a good choice. This doesn’t mean that I’m a reactionary old dinosaur; it’s just that you want to develop a reputation for successful projects, and having some technology crash on you is not a good way to develop that reputation.

And once you have a system upgrade ready to go, don’t roll it out everywhere. Instead, do a pilot test, correct any problems you find, then use a larger test, and then roll it out. Does wonders for your reputation if you only crash and burn during a small pilot test. And this doesn’t just apply to technology. For example, if you’re getting rid of some data collection, you could have just a few people stop doing it, and see how that lack of information impacts the rest of the company. And if no one complains, then roll it out everywhere else.

For example, a bunch of years back, I was paring back on data collection, so my team yanked out a couple of data items. And then found out that we had just completely screwed over someone who used that information for some pretty critical reports.

Stagger the Upgrade Projects

Another issue is to move around your upgrade projects. The reason is that people don’t want too much change. It disturbs their routines. So, if you can, implement a change in one part of the payroll department, and then deliberately give those folks a break for a few months while you do an installation somewhere else, and then come back and do another project. Makes people a lot less unhappy.

Parting Thoughts

I’ll finish with a few thoughts on how all of these changes impact the payroll staff. Under a traditional payroll system, there’s a lot of data collection and data entry – and that’s pretty boring work, to say the least. A lot of what I’ve been talking about over the past few episodes has been to either eliminate that data entry, or to have employees outside of the department do that work themselves. That means the payroll staff ends up monitoring the information that everybody else entered – and they’re looking for errors, and missing information, and so on. That means you essentially shift out of the data entry business and into the data analysis business.

It’s very likely that the payroll staff will prefer the change. The work is certainly more interesting, but on the other hand, some people may be uncomfortable with the change of focus, and you’ll have to replace them. Will there be fewer people in the department? Maybe. It depends upon how large a group you have in place already. If it’s always been a smaller group with a strong knowledge of payroll, I would expect no staff changes. But if there was a large data entry group – then yes, there will be a staff reduction, and you may also end up upgrading to employees with a higher knowledge level.

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Streamlining Payroll, Part 3 (#128)

In this podcast episode, we continue with the discussion of best practices that can be applied to the payroll function. Key points made are noted below.

So, in the first two parts, we talked about cutting back on the amount of data to collect, and automating data collection, and reducing the number of deductions, and adding self-service.

How to Streamline the Payroll Calculation

Now, let’s talk about streamlining the calculation of payroll. This is not one of the better areas for streamlining. If you have payroll software, or if you outsource it, the systems are pretty good these days. As long as you input the information correctly, then payroll processing is easy.

The Handling of Commissions

But there are still a few holes. For example, part of that calculation bit involves calculating the commissions for the sales staff. And that can be ugly. We’d all like to see a nice, easy commission percentage based on sales or cash receipts, and which never changes. What we get is all kinds of – well, I guess the sales manager would call it – enhancements to the commission plan. I call it a royal pain.

So what we see all the time is the sales manager adding retroactive commission bonuses if someone meets a quarterly sales goal, and another retroactive bonus if they meet an annual goal, and special rates for selling certain products, and commission splits. For the accountant, this is basic seventh level of Hell stuff. And especially when you have to calculate all of it within just a day or two. And especially when the sales manager finds all kinds of errors and wants you to redo everything. So, what can you do?

Well, obviously, complexity reduction is the goal, but how do you get there? One option is to buy incentive compensation software, which cranks out the commissions for you. It’s expensive, but if the sales manager really wants this kind of commission structure, you can have the CFO demand that the sales department pay for the software.

That’s one possibility, but it’s also so expensive that you won’t be able to afford it unless you have at least 100 salespeople. Another possibility is to take the pressure off the accounting staff, and just the sales manager that the commissions are too complex, and so it’s going to take an extra payroll cycle to get the payments out the door.

This does not go over too well, but it does give the message to the sales manager that the system is getting too unwieldy, and you’re not going to pay overtime to the accounting staff just because the sales manager likes complicated commission plans.

Or, another option is to charge the sales department for all of the processing time by the accounting staff. This also will not go over too well – but if the sales manager gets a bonus based on the total expenses incurred by his department, it might get his attention.

Or, perhaps the best option is good old fashioned diplomacy. Try to get on good terms with the sales manager, and point out which parts of the commission plan are really giving you heartburn, and see if you can have those pieces removed. Keep in mind, the sales manager is concentrating on increasing sales – not on keeping the accounting department happy – so don’t expect miracles.

Error Tracking

Now, the payroll person who’s responsible for all of the processing is going to find an error from time to time – and probably on a preliminary version of the payroll register. So, they correct the error and run the payroll again, and check it for errors again, and so forth. Pretty standard stuff. That’s understandable. But what they should be doing is dropping every one of those errors into a database.

This could be a simple spreadsheet. Nothing fancy. What you want to do is let those errors pile up for a while and classify them by type. Then see which types keep coming up. This means you’re not concentrating on the outliers, just on the ones that keep coming back to haunt you. Focus on fixing whatever is causing those errors. Chances are, you’re looking at maybe a half-dozen really deep-seated issues that are going to take some time to fix. But once you get them, all you have left are the outliers that don’t happen very much. And you can pick them off last.

Using a Backup Person

And one other suggestion for payroll processing. This is one of the more complicated payroll functions, so of course you have your most experienced people in charge of it. But, what about a backup person? Everybody goes on vacation sometime, and when they do, you have to drop a backup person into payroll processing – and that’s when you really see a bunch of errors.

The solution is to designate a backup person, and involve them in doing an error check on the payroll register as part of every payroll. That way, you get two things done at once – you have a second pair of eyes looking for errors, and the person doing that review will become more familiar with the payroll system, and will do a better job of filling in.

Use Electronic Payments

OK, enough on payroll processing. Let’s move on to paying employees. The main goal here is to not use checks. We don’t like checks, because they take too much time to process, and they require a lot of controls. And, because there’s a great alternative.

The alternative is electronic payments. Now this is not just paying someone electronically. We’re also talking about no longer sending them a pay stub – and for those of you who like larger words, that’s also called a remittance advice. Instead, we send employees an e-mail that directs them to a secure web site, and on that site is not only their most recent pay stub, but all of them. This means that if you have employees badgering you about getting them a copy of a pay check or a pay stub so that they can apply for a loan, you can direct them to the web site and they can get it themselves.

As for electronic payments, there’re two ways to do it. The older system is direct deposit, where payments go directly into employee bank accounts. There are two problems with it, which are not large ones. Employees have to have a bank account, so that you can put money in it. And second, because of something called pre-noting, the first payment to an employee will probably still be with a check.

You can get around both problems by using the other approach, which is a payroll debit card. This means that you load up a debit card with an employee’s net pay, and they go off and use the card. There are some concerns with this approach because of bank fees and where you can use the cards.

But basically, I don’t care. The main point is to get off of checks and onto some form of electronic payment. If you can do that, along with the improvements that I talked about in the last two episodes, then you essentially have a perfect, streamlined payroll system from beginning to end.

Related Courses

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Streamlining Payroll, Part 2 (#127)

In this podcast episode, we discuss additional best practices that can be applied to further streamline the payroll function. Key points made are noted below.

Last time we talked about shrinking the amount of payroll information you collect, and the tracking of errors, and cutting back on the number of payroll cycles. So now we’ve cut back on the amount of data to collect.

Automate Data Collection

The next step is to automate the collection of the remaining data that we absolutely have to collect. The best way to do it is either with computerized time clocks that are in a fixed location, or with ones designed for mobile users. These have been around for a while, so I’ll be quick. A computerized time clock is in a fixed location, and people run their employee badges through it to clock in or out. If you have a lot of employees in one place, you’ll either need to buy a bunch of these clocks, or stagger employee start and stop times. Otherwise, they end up forming a big queue in front of the clock, and you will hear about it. This type of clock checks every scan to make sure the employee is checking in or out at the right time, and sends the information to a central database. You can also run error reports whenever you want.

For mobile employees, you can either create or buy the same type of system, but it operates through a secure website. If employees can get access to the Internet, then you’re good to go. These generally work with smart phones, too. And there’re some variations on this concept that work through the phone system, but you get the idea. The main operational difference between the fixed and mobile time clocks is that there’s no scanner for the mobile version, so you have to enter your time by hand – and that can cause errors that you wouldn’t see with a fixed clock. So that’s a quick overview of time clocks. They have two really nice features. First, employees enter their own time, and the system flags errors.

That pretty much wipes out the pure data entry part of the payroll department. It doesn’t mean that it’s entirely gone; just that the payroll staff becomes more concerned with monitoring what other people are entering in the system. Then the payroll staff keeps track of the errors that crop up, or conducts some extra employee training, or maybe improves a procedure somewhere. The point is that data collection work is now replaced by process monitoring.

Reduce Employee Deductions

So now the detail-level payroll information is in the computer system. What else can we do in the way of streamlining?  One good place to look at is employee deductions, which we can tackle in several pieces.

The first piece is employee advances. When an employee wants to receive an advance, the payroll staff has to cut a manual check, and record it in the accounting system, and then deduct it from the next regular paycheck – and maybe over several paychecks. In short, it’s a pain. And it tends to come up with a just a few employees, who basically treat the company like their own private bank. So what can you do?

This is a tough one. You can just shut down all advances, but you might get a backlash from the employees. One possibility is to charge a fee to any department manager that approves an advance. This is an interdepartmental charge, so there’s no cost to the company as a whole. That at least makes a manager think about it before approving an advance. Another option that doesn’t work very well is to direct employees to the local bank for a loan, but they’re probably coming to the company for an advance because they can’t qualify for a loan.

Another deduction item is employee purchases. A company may get some good discounts through its suppliers, and it allows employees to make purchases through the company. That’s fine, but do not let them pay the company back through payroll deductions. Instead, make them pay for it up front.

Yet another deduction item is benefits. There can be a lot of benefit deductions, such as for medical insurance, dental insurance, life insurance, and so on. This can be quite a chore to keep track of. One option is to increase the deduction on one benefit, like medical insurance, and provide another benefit, like dental insurance, for free. If you do it right, the net impact on the company and on the employees is zero, but now there’s one less deduction to keep track of.

Or, you could work with the human resources department and create a single benefit package that has a single deduction. Now, in reality, that single benefit package will have different deductions, because the benefit cost varies depending on the number of dependents on your insurance. Still, this can cut way back on the number of deductions you need to track.

Streamline Vacation and Sick Time Tracking

And moving on from deduction tracking, have you considered the tracking of vacation and sick time? Employees are mighty particular about a mistake in their unused vacation time and sick time, and that means you spend a lot of effort making sure that it’s right. How about merging the two together, and calling it all vacation time? That cuts in half the amount of data types to track. Now, this could have some employee push back, especially if you pay employees for unused sick time. So, it depends on the circumstances.

Implement Self-Service

So, let’s move on to self-service. This is when employees enter their own information into the payroll system for things like address changes, direct deposit payroll information, and payroll exemptions. That type of self-service is called employee self-service. There’s another flavor of this called manager self-service, and that’s usually for entering changes in pay rates.

If you outsource your payroll processing, it’s quite possible that your supplier offers an internet-based self-service module. If that’s the case, they’ll charge you a monthly fee for using it. If you have your own payroll software from an outside supplier, it might be available as a separate module. In either case, it’s much easier to find employee self-service than it is to find manager self-service. And that’s because it’s more cost-effective to have employee self-service, since you can shift far more data entry over to employees.

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Streamlining Payroll, Part 1 (#126)

In this podcast episode, we discuss the first of a series of best practices for improving the payroll function. Key points made are:

I’ve talked about payroll before, but only on some specialized topics. You can find payroll controls in Episode 14, and closing the payroll at month-end in Episode 24, and Payroll metrics in Episode 26. There’s also a discussion of payroll cycles in Episode 54. But I’ve never described how to streamline the basic payroll function. We’ll take care of that right now. And by the way, this will take a couple of episodes to get through.

How to Streamline Clerical Work

The main problem with payroll is that it requires a staff that has a pretty high knowledge of payroll regulations, but which is also willing to do an amazing amount of really low-end, detailed clerical work. And that’s an anomaly. What you want to do is streamline as much of that clerical work as possible, so that the payroll staff has more fulfilling work to do. Not only does this make the department more efficient, but it probably reduces the amount of staff turnover.

So how do we do that? Believe it or not, the first step is not to spend a pile of money on better payroll software or fancy computerized time clocks – though we will get that. Instead, you need to ask a simple question, which is – what information do we want to collect? In fact, if you change that question a bit more, the question really is, what information do we need to collect?

Minimize the Data to Collect

From the perspective of the payroll department, the only information you need is the number of hours to pay, and whether or not any of those hours are overtime hours – since they have a different pay rate.

Other parts of the company may want the payroll people to collect additional information, especially job costing information. So let’s say an employee works on four jobs during the day. He has to record start and stop times for each of those jobs, and also maybe the type of activity performed. And then the payroll staff has to wade through all of this extra information, which it doesn’t need. So what do you do? Well, it’s possible that someone wanted the job costing information for a special project.

If so, the project is going to be over with eventually, and as soon as it is, stop collecting the information. Or, the intent is to keep collecting the information for internal purposes, maybe for cost accounting. If so, it’s worth mentioning to whoever is sponsoring the analysis that this type of information doesn’t change much over time, which means that the information you collect has a declining level of utility over time. And that means that at some point, there’s no additional value associated with collecting the information. Or if they absolutely insist on collecting it, then how about doing it for a few weeks each year?

The point is the additional information requires a lot of work by the payroll staff, and it may not be much good to anyone else. So – why collect it? Now, what if you absolutely have to collect the extra information? Say it’s required under a government contract, or maybe you’re using it to bill the customer. OK, so you need the information. But can you decouple it from the payroll information? In other words, let the payroll staff only collect the information it absolutely needs to pay employees, and let somebody else collect all of the other information.

So that’s a key first step for streamlining the payroll department. It’s basically a one-time decision about whether or not to collect information. And if you can restrict that information, then it’s a massive up-front labor savings for the department. And, it’s the best kind of labor savings, because it’s annoying clerical work.

Reduce Data Errors

So now we’ve reduced the amount of data entry. The next problem to work on is data errors. There can be all kinds of errors. You’ve got missing start times and missing stop times, and the wrong person listed on a time record, or incorrect dates, and so on. Tracking down and fixing these errors takes up an amazing amount of time, so you really want to cut back on errors. But the trick is to not just dive into fixing errors. Instead, what you want to do up front is create a system for collecting and classifying types of errors.

So, let the errors pile up for a while. Then assign an error type to each error, and add up the quantity of errors of each type. Then figure out the amount of time it takes to correct each type of error. Now you have what you need.

You should only be spending time correcting the errors that happen a lot, and which require a lot of time to fix. By taking this approach, you can fix large numbers of errors at one time with a single fix, which is the most cost-effective use of the department’s time.

Once a lot of department time has been freed up, you can assign the staff to fixing errors that don’t occur at quite the same volume levels, and which don’t have quite the same impact on staff time. And that, in turn frees up more staff time for more error correction work, and so on.

So by this time, you should be collecting less data, and what you are collecting should be pretty free of errors. But it’s still possible to reduce the amount of data collection by shrinking the number of payroll cycles. I already addressed this in an early episode, so – very briefly – a payroll cycle is the time period from the beginning to the end of a pay period. So if you pay employees once a week, you have a weekly payroll cycle.

Use a Longer Payroll Cycle

Now, in that case, you’re collecting information for each payroll cycle, and checking it for errors, and summarizing it, and inputting it into the payroll system, and distributing payments to employees – and you’re doing it 52 times a year. 52 times! Now if you switch to paying employees biweekly, then you just cut all of that work in half, since there’re 26 biweekly payroll cycles per year. Or you can go to semimonthly payroll cycles, which is 24 times per year. So, the trick is to switch to a longer payroll cycle, so that you can process payroll fewer times – and preferably without pissing off any employees.

And a variation on this is when you have multiple payroll cycles in the same company, such as a weekly cycle for the hourly employees and a monthly cycle for the salaried staff. Bad idea, since that’s more cycles than you need. Instead, put everyone on one payroll cycle, and then, if you can, lengthen the cycle.

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Refinancing Debt (#125)

In this podcast episode, we discuss the pros and cons of debt refinancing. Key points made are:

Is it Possible to Refinance at All?

There are a surprising number of issues to consider, and they’re not all about saving money. First, there may be a technical issue. If you’re with a large company and you’ve issued bonds to investors, then refinancing debt really depends on whether the bonds are callable, and when they’re callable. If there’s no call date in the immediate future, then you’re out of luck on the refinancing.

The Lending Relationship

The next issue, and a much bigger one, is the lending relationship. I talked a lot more about this in the last episode. You need to weigh the possibility of getting lower-cost debt elsewhere against losing the relationship with your existing lender. This has a couple of ramifications. First, if you depart for greener pastures, how do you know that the new lender will be willing to work with you as well as the old one did? Of course, that’s assuming the old lender did help you out. If the old relationship was horrific, then I’d be willing to switch to more expensive debt with someone else just to get out the relationship.

But let’s assume that the old lender was pretty good. If your company falls on hard times, the existing lender has a lot of history with you, and might be willing to be more accommodating on debt repayment, or loosening up covenants. A new lender doesn’t have that kind of history with you, and there certainly hasn’t been a chance to build up any loyalty, so you might find yourself in trouble with a new lender who’s pretty rigid in its lending practices.

The Transfer of Banking Activity

A second problem with switching lenders is if it’s a bank doing the lending, and the bank wants you to switch over all of your banking activity to them. Now if you’re a treasurer and you’re the one who has to switch over all of the bank accounts, and ACH debits, and check stock, and lock boxes, and so on, you might consider suicide before making the switch. It’s a lot of work. And that’s a serious consideration.

The Interest Rate Swap

So here’s another issue. Do you want to refinance debt, not because of the interest rate, but because it’s a variable interest rate and you want a fixed rate? Or, in a few rare cases, the other way around? If so, it might be possible to do an interest rate swap. These are usually limited to larger companies, but it may be possible. So, for example, if you have a variable rate and you want a fixed one, you can offload the risk of interest rate changes to somebody else, and keep the debt you have.

The Need for More Equity

Here’s another thought. Over time, the risk position of a company changes. Maybe when you first lined up a loan arrangement, the company had a lot of equity and some cash reserves. What if that’s no longer the case? If you try to refinance your debt, any lender will look at your financial position right now, not the way it was a year or two ago. Bottom line, you may find that changes in your balance sheet will force you to bring in more equity in order to qualify for lower-cost debt. Does the ownership of the company want to do that? Maybe not. If not, you won’t be allowed to refinance debt, even if it otherwise seems like a good idea.

When to Load Up on Debt

Now, let’s flip that concept around. What if the company’s position has really improved since you lined up the existing debt package? In that case, absolutely try to refinance. And especially if lenders seem eager to lend. The credit markets have been horribly tight lately, but that can change – and over time, it probably will.

If you have that perfect convergence of great looking financials and an easy credit market, then refinance right away. It’s kind of like the parliamentary system – you call an election when you think you’ll have the best chance of winning it. The same thing goes with refinancing. You do it when you think you can get the best deal.  Not when the old debt agreement is about to expire.

Parting Thoughts

In fact, I’d say the mark of a really great treasurer is someone who keeps a close eye on financial statements and the credit markets, and pretty much always refinances early, when the timing is just right. And not only that, but when the timing is just right, go for as much debt as you can take, and for the longest possible period of time, and with very few covenants that are easy to meet. Those conditions don’t come along every day, so if you can use the cash – take it. And keep it for as long as possible.

So you can see that there’re a lot of issues. First in priority for most companies is maintaining a long-term, trusting relationship with a good lender. If the interest rate they offer is a little high, I might try to work them down on the rate, but I wouldn’t be overly inclined to switch to a new lender if I could help it. Maybe this is old school, but I think the relationship comes first, and saving a small amount on interest expense comes second. Maybe a long way second.

But. If the conditions are right – which means great financials and easy credit - and you can make a killing on a great refinancing, then strike hard and go for four things: a low interest rate, a lot of debt, a long debt term, and really easy covenants. It’s absolutely preferable to do this with your existing lender, but if someone else offers a killer deal, you’ve just got to take it.

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Lender Relations (#124)

In this podcast episode, we discuss the best way to handle a long-term relationship with a lender. Key points made are noted below.

Set Expectations

The first point with lenders is setting the proper expectations, and that starts with the initial meeting when you’re trying to set up a relationship. When you first describe your company to a lender, try not to be too optimistic about the company’s prospects. The problem is, that if you convince the lender that you’re going to take over the market and be bigger than IBM within three years, then that’s what they’ll expect you to do. And that means that every time you send them a financial report, it’ll be below their expectations, no matter how good the performance actually was.

This is not a minor point. I’ve worked for a couple of CEOs who gave some overwhelmingly optimistic presentations, and then I had to spend time talking these excited lenders down to a more realistic set of expectations. This doesn’t mean that you’re always cleaning up after the CEO. It’s worth your time to explain matters to the CEO in advance, and try to get him to understand that setting reasonable expectations is better for the long-term relationship.

Now, a part of those initial meetings with lenders will be a discussion of the company’s business plan, or budget. The same problem arises here. If you hand over a budget that shows a massive increase in sales and profits, then not only does the lender get very excited, but he’s also going to assume that your borrowing needs are going to be astronomical, since fast growth implies the need for a lot of cash.

So – first point - be prudent in setting expectations.

Limit Lender Covenants

My next point about lender relations is to fight back on loan covenants. This is the part of the loan agreement that says the lender can call the loan if certain things happen, like falling below a certain current ratio. If the lender sets the loan covenants anywhere near where your metrics currently are, then there’s a really good chance that you’ll blow through a covenant, and then you’ll have either an unhappy lender or a lender who wants to revise the terms of the loan. If you can’t avoid the covenants entirely, then this is a good time to negotiate the most liberal covenants you can get, so you have some breathing room on the numbers.

Limit Lender Reporting

And another thing you want to set is the minimum possible amount of financial reporting to the lender. The intent here is not to keep financial information away from the lender. Instead, the point is that the average business is going to have a bad month every now and then, and that’s just the way it is. But if you send out quarterly financials, the chances are pretty good that the bad months and good months will have evened out during the quarter, so you have better odds of reporting three months-worth of decent results. And that means no surprises for the lender.

Communicate Regularly

So, once the relationship is in place, what can you do to maintain relations? Well, a key issue is constant communications, which can come in a lot of forms. For example, if you send over the quarterly financial statements, it helps to do a follow-up call to ask if you can clarify the information. Or, do a scheduled quarterly or semi-annual lunch to discuss the business in general. Or, call every now and then to inquire about purchasing some additional services.

So, to clarify what I’ve said so far, lender relations is kind of like a speech. You use a conservative forecast to tell the lender how the company is going to perform, and then you report back that you did just what you said you were going to do. If you can do that consistently, lender relations will be good.

How to Deal With Poor Results

So what about when things go wrong? Well, you still have to look at the relationship as a long-term relationship, and that means you have to talk to the lender about the problems you’re having, and as soon as possible. The worst thing you can do is use some accounting trickery to push the problems out into the future, because all that means is that the problem will be even bigger by the time you finally tell the lender about it.

And their reaction will be, why did you wait so long to tell me, you miserable bum? And also, if you dump a really big crisis on them at the last minute, how likely are they going to be to work with you to resolve the problem?

So you do the reverse, and keep them informed up front. If you take that approach, you’re keeping the level of trust as high as possible, and you’re also giving the lender some time to see if there needs to be a workaround for your debt.

Now you may say that the lender has to work with you in a crisis, because what other choice do they have if they want to see their money again? Sure, that’s true – but you have to think long-term – after you get through that crisis, the lender is going to drop the relationship for certain, because you didn’t keep them informed.

Centralize Banking Activity

On to another topic. Let’s assume that the lender is a bank. The bank will want you to shift all of your banking business over to it as soon as it extends you a loan, so that it can earn fees on all of your other banking activity. And that’s an accepted part of doing business with lenders.

If you have a lot of banking activity, you might want to consider bending over backwards to shift even more banking activity over to the lender than they expect. When you do that, the amount of fees that the lender makes from the entire relationship starts to look pretty nice. And that helps when you want better loan terms. So if you make the relationship more valuable for the lender, it might be more willing to work with you over the long term.

Avoid Playing Off Vendors

And while I’m on the topic of fees, do not try to play lenders off against each other to get the absolute best possible price, and then keep doing it over time. If you have that kind of track record, lenders won’t be interested in a long-term relationship, and they’ll back out on you just when you need them the most. Instead, give them a fair profit.

Parting Thoughts

So in summary, the best lender relationship is based on not overly optimistic expectations, lots of communications, and giving the lender a fair amount of fees. Or, to flip that around, the worst relationship is based on absurdly high projections, no meetings, and pounding on the lender to cut fees down to the last penny.

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The Controller Position (#123)

In this podcast episode, we discuss many aspects of the controller position. Key points made are noted below.

The Controller’s Job

The job description appears fairly simple. The controller is responsible for all accounting transactions and related systems, and running the department, and issuing financial statements. That’s it. You’ll be shaking your head and saying “no, there’s so much more than that” but actually, yes – those are the core functions.

And that’s a hell of a lot. A good controller absolutely needs a four year degree in accounting, and a lot of experience. In short, when you sign up for accounting classes in college, this is the job that they’re preparing you for. It requires a lot of very specialized knowledge, and a really good controller is a very valuable person.

All right, no surprises yet – you could read that on any controller job description in the Internet. But then when you start digging in a bit more, you’ll find that there’re a lot of different types of controllers - and which type you are is driven by things like the size of the company, the type of industry, and whether there’s an emphasis on a particular skill.

How the Job Varies by Department Size

First, let’s talk about size. An awful lot of accountants are hired into a “controller” position and find that they’re the only one in the department, or maybe there’s a clerk or two. Surprise! You’re in a bookkeeper position, and that’s because you’re doing everything. So if you’re spending most of your time on data entry, this is you, even if they gave you a CFO title. Very likely the systems you run are simple, the accounting software cost a couple of hundred dollars, and you have no chance of advancement, because the company has no other positions for your skill set.

I would not be surprised if half the controller positions in the world are in this category. This does not necessarily mean that this type of controller position is one to avoid. Many people enjoy this type of work, and they’re happy. A real controller is spending most of the time managing, or reviewing information that been assembled by someone else, or reviewing systems.

If you think that’s you – you’re a controller. The key factor is that it’s a position in which you use all of that knowledge you’ve picked up in college to make sure that the accounting is done right – and if you’re doing data entry, you don’t have time to check your accounting theory. This describes maybe a quarter of all controller positions.

The Combined Controller/CFO Position

And then we have the combination controller and CFO. This is where you’re doing risk management and meeting with the bank, and fund raising, and doing investor relations – on top of all your other controller activities. In this case, the company probably can’t afford or doesn’t need both positions, so you’re combining the work load. This is a good position to be in, because you’re getting lots of practice for a real CFO job later on. And this is at most a quarter of the controller jobs.

The Public vs. Private Controller

Now, we have more variations on the position. A major one is if you’re the controller of a public company, instead of a private one. If that’s the case, you probably know a hell of a lot more about public company filing requirements than you ever wanted to know, and it’s possible that you’ve even regressed into doing nothing but financial reporting – in which case you’re in danger of sliding into a financial reporting position. Functionally, you’re not a controller any more. But if you can integrate that public reporting skill set into all of your other controller activities, it’s an amazingly valuable skill to have. Though you may not like doing this kind of work – very few people do.

The Industry Specialist Controller

But we’re not done yet. There’s also the controller who’s an industry specialist. There’s some very particular accounting associated with some industries, like construction, and oil & gas, and health care. In these cases, management usually doesn’t even consider hiring in a controller who has no experience in the industry – it’s just too risky that the new hire might not know something important, and screw up the accounting.

This means that some controllers have figured out early on that a specific industry skill set is very valuable, because it gives them a huge edge in getting hired within the industry. So if you’re an auditor and want to become a controller, start specializing in a specific industry. And the same goes for anyone trying to work their way up from within a company – pick a business in an industry with the most convoluted accounting rules imaginable.

The Functional Specialist Controller

And then we have the functionally specialized controller. You may very well be one of these. For example, some companies do a lot of acquisitions. If so, the controller with the acquiring company may spend about 80% of the time on integrating the acquisitions.

And then we have the companies that compete based on cost – and that tends to produce controllers with an incredibly strong process orientation – because they’re trying to squeeze every last penny out of the accounting operations. In both this and the acquisition situation, I could make a strong case that the controller is more of a process engineer. Accounting rules play a very small part in their lives. All they think about is processes and controls.

In companies where you have several of these specializations, like acquisitions, and public company reporting, and process reviews – it’s possible that the CFO decides not to have any controller at all. Instead, there may be a whole bunch of assistant controllers, and each one is a specialist in one of those areas.

Parting Thoughts

So how do we summarize all of this? First, about half of all controller positions are really bookkeeper positions. The remaining positions are on a continuum of light controller up to one that’s really a hybrid with a CFO position. And on top of that, there’s a lot of specialization by industry, such as health care, as well as specialization by function – such as acquisitions.

So what all of this means is that it’s pretty hard to find a controller position that really fits the standard job description. Instead, there’re all kinds of niche areas in which you can specialize. As long as you’re aware of these differences, you can alter your skill set to make yourself perfect for a particular type of controller position that very few other people are qualified for.

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Fixed Asset Disposals (#122)

In this podcast episode, we discuss several reasons for keeping older fixed assets around a bit longer. Key points made are noted below.

This episode is about disposing of fixed assets – not the accounting for the disposal, but the issues you should consider before you actually do dispose of an asset. Anyway, this discussion is only about really expensive fixed assets where it’s worth your time to analyze the issues, not something cheap like a desktop computer that you’re going to swap out every few years.

When to Retain an Asset

Now, my first point is about the process you go through to buy a fixed asset. There may be a capital budgeting procedure, where someone has to formally apply to buy an asset; and you do a discounted cash flow analysis or a throughput analysis to see if it’s worth buying. But did you ever do an analysis that also includes the cost of just keeping what you already have, rather than buying a new asset at all?

In a lot of situations, there’s pressure inside a company to replace assets – maybe because there’s a bit more demand than the existing equipment can handle, or because the equipment is getting old and cranky, and the maintenance department is sick and tired of repairing it. Or maybe because it’s exceeded the recommended life span of the manufacturer.

Well, when any of these factors come into play, and the equipment doesn’t cost that much, chances are that management will just say fine – throw out the old gear and bring in the new. But what about cases where the old machinery is really expensive – or maybe it’s a whole facility that you’re thinking about replacing.

If you have a situation like this, then you need to start thinking about conducting an analysis maybe every year – and it’s mainly about what’s the cost of keeping this old clunker running just one more year? And if you’re a little short on capacity with that old asset, what’s the cost of turning away some business or outsourcing some production? This is a worthwhile discussion, because the cost of prolonging what you already have is usually way less than the cost of buying all new gear.

And if you think the risk of an old machine failing is all that great, you might want to measure the failure rate to see if it’s really as bad as you think. In a lot of situations, an old machine is really just very well broken in, and it doesn’t fail very much. In fact, you may find that the break in period for a new machine makes it less reliable than the old machine, at least for a few months.

Why Not to Throw Out Replaced Equipment

Now let’s say you’ve gone ahead and ignored my advice and bought new equipment. Even now, do you really want to sell off that old machine? After all, it may have some utility left, and chances are, you won’t be able to sell it for much. In a case like this, you may want to keep some reserve capacity on hand, just in case the new equipment breaks down. And if the new equipment is more automated than the old equipment that it’s replacing, there’s a pretty good chance that all that extra complexity is going to cause a failure.

In particular, if you like to focus on throughput, it makes a lot of sense to keep some excess capacity lying around, especially if it’s upstream from your bottleneck operation. If you want to learn more about throughput, go back to my episodes 43 through 47.

And here’s another thought. You may have to incur more cost to eliminate an asset than you would if you keep it. In particular, what if there’s a fair amount of environmental remediation cost involved? In cases like this, it may be more economical just to delay incurring those extra expenses a bit longer by hanging on to the asset.

Who Questions Fixed Asset Acquisitions?

So there’s a few things to consider. Now, who should be doing all of this questioning? The CFO should. In fact, the CFO is probably the only one who can. You see, the problem with capital budgeting is that an asset purchase builds its own bureaucratic momentum after a while, where there’s a pile of paperwork that everyone reviews and signs off on – and it has a sponsor somewhere who’s pushing it along. And here you are, trying to slow down the process and make people really think about whether it makes sense to keep using what you have, rather than buying that really neat, high-speed whatchamacallit.  It takes a CFO with some clout to do this.

Of course, since the CFO needs to be involved and the CFO is busy with other things, this means that he or she can’t get involved very frequently – so you have to make those few times count.

Therefore, to be efficient, the budget analyst or cost accountant needs to spot those situations where an asset is going to be disposed of, and where there may be a good reason to keep it. They notify the CFO and supply a complete set of backup information, and then the CFO goes into battle.

So why am I spending time beating on this topic so much? The reason is that if you can avoid a really large capital expenditure even once every year or two, that could mean a savings of millions of dollars.

Parting Thoughts

And by the way, what I’m talking about here is not black and white, like you proceed with a project or you kill it. What might very well come out of the discussion is a decision to scale back on a purchase to something less expensive, while also keeping the existing machine. And this outcome can still save a pile of money.

And that last point is worth chewing on a bit. The outcome is that you keep an existing asset and also make a reduced capital expenditure. What this does is give you two assets capable to doing the same thing, which gives you greater total capacity, but which has the added benefit of still giving you some capacity even if one of the machines breaks down. And means you’re averting the risk of a production stoppage by keeping the old machine.

Related Courses

Capital Budgeting

Fixed Asset Accounting

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