Managing in Financial Adversity, Part 1 (#150)

In this podcast episode, we discuss how to manage through a period of financial adversity. Key points made are noted below.

This is a request from a long-time listener, and it reads, “Can you do a podcast on what companies can plan to do in the event of financial adversity.” This is a good topic, but before I get started, it also might sound familiar, and that’s because I covered cost reduction analysis in Episode 103. That one was about which expenditures to cut back on if there’s a very specific need to cut costs. This is a bit different. The question is really a strategic one, and so it requires a different type of answer.

How to Handle Financial Adversity

So to begin, you’re experiencing financial adversity. What are you going to do about it? The answer comes from how a business gets into its current bind. Nearly all companies are in existence because somewhere along the line, they figured out a core business model that made money. And after that, they drifted away from the original business model. The drift usually comes from one of three things.

The first is that the original owner of the business wanted to keep growing, and he found that the original line of business wasn’t big enough. So he kept adding side businesses, which meant that instead of that one core, profitable business, he ended up with a cluster of somewhat related businesses, and he no longer knew where his profits were coming from.

The second kind of drift is when the original business model is failing, and the company is in the middle of shifting its resources somewhere else, where it hopes to find profits again. You might say that this isn’t drift at all, but a instead a very calculated move into a new competitive space.

And the third source of drift is when the owner sticks with the original business model, but then doesn’t pay attention to expenses. So perhaps he starts adding some corporate infrastructure, or maybe he spends money sponsoring his favorite racing team. Whatever the case may be, he’s adding expenses that aren’t really necessary.

And Bragg’s first law is that all expenses will continue until acted upon by an outside force. Which means that all of these incremental expense additions keeps piling up, and none of them ever goes away.

So we’ve reached adverse times, the company is losing money, and we’re in a hole that’s caused by one of these three problems. What do we do? Let’s deal with the last one first, where there’s a bloated cost structure. And then we’ll revisit the other two options in a later episode.

Dealing with a Bloated Cost Structure

You could call a meeting and try to do a general cutback in spending. That’s hard, because everyone’s gotten used to spending all of that extra money. But remember my first law. It’s really hard to cut back on expenses. So don’t do that yet. Instead, it’s time for some historical research. Go back in the financial statements as far as you can and create an income statement that shows all expenses as a percentage of sales. And then run that calculation forward, year by year, until you have a spreadsheet that shows the percentage of sales for each expense, all the way up to the present.

Then take a ruler and look across each row to see when each percentage increased. Because, trust me, they went up, not down. When you see an upward bump that stayed up, check to see what happened. Maybe you moved into a fancier building that cost more per square foot. Or maybe you hired someone into a particular position. Make note of all these items.

These were your decision points over the years that brought you to the current financial trouble. You might make a case that those were all good decisions. But. The reason I use your earliest years as a baseline is that the beginning of the company was when you had no money, and so back then you made decisions based on what was the least expensive. Well, if you’re now facing financial trouble, guess what. Your decisions should now be based on the same issues you dealt with back at the beginning.

So the decisions now become pretty clear. Which decisions do you roll back? It’s not necessarily all of them. But you can at least ask yourself, if you could roll back all of those expenditure decisions, what would company’s financials look like? If the result looks good, then you know you can dig yourself out of this hole. If the results still don’t look good, even with the reduced cost structure, then you need to think pretty hard about shutting down the business.

Another solution was made by the listener who suggested this episode, which is that he doesn’t allow payroll to exceed a certain percentage of sales. No matter what happens, he simply will not allow compensation expense to go past that number.

That’s not a bad approach at all, if you want to draw a line on an expense and fight to keep that expense from going beyond a certain point. At a minimum, it introduces a cost orientation into the business.

Converting Fixed Costs to Variable Costs

Now, what if the business is based primarily on fixed costs? And maybe it always has been on a fixed cost basis, where revenues have to be at a certain level, or else you cannot turn a profit. In this case, your historical information doesn’t give any clues about where to cut costs. As far as you can tell, there are no costs to cut.

If so, the trick is to convert the fixed costs to variable costs. And that means altering the nature of your cost structure. So if you have a large IT department, can you outsource it? Can manufacturing be outsourced? How about payroll? Or marketing? What about hiring a part-time CFO who’s paid by the hour? And so on. It can be difficult to get into this mindset, because it’s so different. What might help is to think in terms of outsourcing virtually everything. There’s nothing left, other than a coordination function. At that point, run the numbers and see if the financial adversity you’re in will still allow you to turn a profit. If not, there’s no way it will ever turn a profit, so shut down the business.

The Outsourcing Option

But if the model indicates that the company can make money, then work through the various outsourcing options and figure out which functions can be outsourced without damaging the competitiveness of the business too much. And then run the numbers again and see if you can stomach doing this.

Now outsourcing may very well be more expensive than keeping something in-house, but as long as you structure the outsourcing deals to have a variable cost structure that changes with usage levels, it allows revenues to go down without killing the business.

Parting Thoughts

So the main takeaways from this episode for dealing with financial adversity are to look at the historical decisions that brought you to where you are today, and switching from a fixed cost structure to a variable cost structure. We’ll keep going with this topic in the next episode.

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Volunteering Overseas as an Accountant (#149)

In this podcast episode, we discuss the possibility of volunteering in a developing country as an accountant. Key points made are:

• We interviewed Neil Jennings, CEO of Accounting for International Development (AFID).

• AFID recruits volunteer accountants for small charities located in developing countries.

• AFID supports 150 charities in 28 developing countries. Locations are in west, central, and east Africa, as well as in southeast Asia, Nepal, Central America, and South America.

• They are looking for all types of accounting qualifications.

• Projects involve all types of local businesses, such as hospitals, schools, and forestry organizations.

• Targeted charities tend to have very little accounting expertise.

• The volunteer needs to assess the financial situations of their assigned charities, and then decide where improvements can be made. Most improvements are relatively simple, such as adding budgets, controls, and process improvements.

Best Practices for Accounting Reports (#148)

In this podcast episode, we cover several techniques for streamlining the reporting of information. Key points made are noted below.

Accounting is basically about two things. The first item is recording transactions, which involves the use of automation, controls, and procedures, and it’s basically what accountants do most of the time. The other activity is translating all of that information into accounting reports. Part of that reporting function involves financial statements, which we won’t address right now. There’re also a bunch of other accounting reports, and I’m going to talk about those other reports.

Types of Accounting Reports

Examples are a daily flash report that goes out to management, or the accounts receivable aging report, for the sales department. Or responsibility reports, where you list just the specific line items that a person is responsible for. Or fixed asset reports that you send to managers, where you list the assets that they’re supposed to be keeping track of.

These other reports can take up a surprising amount of staff time, since the information for them has to be collected, and checked for errors, and aggregated into a report, and distributed. What may be equally surprising is how rarely this information is used. The recipients may not believe that the information is correct, or it arrives too late to be of any use, or perhaps there’s just not much use for the information anymore. That means we have a bad cost-benefit ratio on accounting reports. So… how do we fix this?

Report Termination

We have a best practice to consider. The first step is to push back when you’re first asked to create a new report, by asking some questions. First, is when you can terminate the report. This is an interesting question to ask, because the assumption when most reports are requested is that you’ll keep producing them forever. You don’t need most reports for very long, so continually running them for years is just a waste of time. Instead, set the expectation up front that this is not going to be the case. A reasonable suggestion is to run a report for three months, and then shut it down and see if anyone complains.

Data Item Termination

The second question to ask is whether new data items can be thrown out of the report. You do not want to be collecting new data, because it takes a lot of extra time, including creating new forms and procedures and controls for the data collection. Instead, suggest using other data that you already collect.

If management absolutely insists on including new data in the report, then revert back to the first question and see if the report can be shut down fairly soon. Otherwise, this represents an incremental increase in staff time over the long haul, and that means department expenditures go up.

Reporting Frequency

The third question is about how frequently to issue a new report, and the number of recipients. Clearly, you want low frequency and few recipients, since this requires less staff time. In addition, try to set up the report for issuance during a slow part of the month, when you have extra staff available to work on it. The worst time to be issuing new reports is right in the middle of the month-end close, when there isn’t enough time for what you’re already trying to do.

So the main point so far is to take a hard, up-front look at any new report request to define it down to the absolute bare essentials. This does not mean that you’re being ornery and just refusing to issue new reports. What it does mean is that you realize staff time is limited, so the time spent creating reports needs to be as effective as possible.

Problems with Automated Reports

Some managers may try to get around these questions by saying that you can automate the entire thing. Just set up a report with a report writer, and have the accounting software automatically create the reports. Sounds good, but that doesn’t present a valid picture of what’s really going on.

What actually happens is that these automated reports keep piling up in the IN boxes of recipients – and they still have to spend time wading through them for the information they need – which may be just a single number in a large report. So, despite the automation, there’s still a problem with too many reports being issued.

Report Scheduling

Which leads me to the next best practice for reporting. Schedule in your calendar a semi-annual review of reports that are already being issued, and talk to the recipients about the reports. Do they actually make decisions based on the reports, or do they just glance at them and then throw them out?

The usual scenario is that a report is quite useful for a short time, and management actually uses the information to make changes. But once those changes are made, the reports are not overly useful anymore.

The Accountant as Curator

A reasonable outcome is that the accounting department ends up being a curator of information, rather than just an issuer of reports. In other words, the accounting staff only issues information if there’s an unexpected blip in the data that a manager needs to know about. And better yet, the accounting staff provides extra information about what caused that blip, so the recipient has enough information to take action.

Summary of Reporting Issues

So I’ve made two recommendations – to dissect a request for a new report to make it as effective as possible, and then to revisit the issue later on, to see how much of the information is still needed. These two items tend to result in a different way of dealing with reports. You start with a well-considered standard report, which will be effective for a short time. Then you review the report, pick out the information that’s really necessary, and only report these few remaining items when they fall outside of a predetermined boundary.

By taking this approach, accounting reports don’t last very long. Instead, they evolve into just a few items of information that management needs to locate problems.

Over the long term, this means you end up in a reporting cycle, where new reports are created to deal with some new condition, and they’re used until the new condition has been examined and refined, and then you chuck out what you don’t need, which leaves a small pool of items for ongoing monitoring.

This approach takes a bit more management attention to what information is really needed, but it also eliminates a much larger amount of routine information that actually interferes with the job of running a business.

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Net Present Value Analysis (#147)

In this podcast episode, we discuss the problems with using a net present value analysis to evaluate capital budgeting proposals. Key points made are noted below.

This episode is about using net present value analysis in capital budgeting proposals. I’ve already talked about every other aspect of capital budgeting analysis, so this is the last episode in that area. I know, this means three out of the last four episodes will have been on capital budgeting – which is a lot of time on one topic. Still, I’ve seen companies almost go bankrupt by investing in the wrong assets, so this is worth one last episode to really nail down the topic.

The Nature of Net Present Value Analysis

So. Net present value analysis. This is when you estimate all of the cash inflows and outflows associated with a proposed fixed asset, and use a discount rate to arrive at the present value of those cash flows. Then you base the purchasing decision on the amount of that present value. This is the traditional way to decide whether to buy a fixed asset.

You may have noticed that I keep proposing alternatives to net present value. In Episode 45, I talked about basing budgeting decisions on whether an asset was involved with increasing the throughput of a business. And then in Episodes 144 and 145, I covered the use of things like asset standardization and feature reduction. Basically, all of these alternatives are designed to give you a very precise analysis of exactly why you want a fixed asset, and what features it should have.

Problems with Net Present Value Analysis

I haven’t been focusing on net present value, because I have some discomfort with how applicable it is, and how accurate it is. Here are a few points to consider.

First, can you even trace any revenue-related cash inflows to a specific piece of equipment? In a lot of cases, there aren’t any. Instead, revenue can only be associated with a cluster of equipment, like an entire production line.

And yet, cash benefits keep appearing in fixed asset purchase proposals. Now, those cash benefits may not be related to revenues. Instead, they could be generated by projected reductions in existing expenses. For example, some automation may result in a reduction in labor expenses.

Then the question becomes, will those savings actually be realized? In a lot of cases, companies have a hard time eliminating expenses.

After all, the first law of financial analysis is that all expenses will continue unless acted upon by an outside force. I just made that up, but the point is that expenses are sticky. They’re hard to eliminate. And also, a cash projection may be based on an expense reduction that’s incremental, and which therefore can’t happen. For example, can you really achieve a reduction in cash outflows by cutting 10% of the working hours of a salaried employee? Since the employee is salaried and is therefore going to be paid no matter what, the projected expense reduction isn’t going to happen.

And then let’s look at the cash outflows. Are you really sure about the expenditure projections? Oh, sure, everyone knows what the purchase price is, but what about the costs of installation and training? For heavy equipment, did you include the cost of preparing the site? Pouring a concrete pad? Wiring? Testing? How about permits? And then, what about the cost of any delays in getting it on line? Any related working capital? In short, I’ve seen some pretty amazing cost overruns that obliterated the original projections – to the point where a healthy initial estimate of net present value turned negative before the installation had even been completed.

And then, what about that discount rate? It’s generally supposed to be based on the corporate cost of capital, or maybe the incremental cost of capital. How many companies know what their cost of capital is? For a private company that’s funded mostly with equity, the cost of capital is probably only a vague concept – and that means the discount rate being used could be off by a large amount. And if the cash flows being estimated stretch way out into the future, the discount rate can have a hell of an impact on the net present value.

These problems may not result in especially bad outcomes as long as the person preparing the net present value analysis is conscientious about forecasting reasonable cash flow information. But that isn’t always the case. Any number of managers are willing to fudge their cash flow projections to create a present value that they know will be accepted.

You can usually figure out which managers fudge their numbers after the fact, but the trouble is that it may be way after the fact – to the point where the manager no longer even works for the company.

In short, net present value is comprised of nothing but forecasted information, and those forecasts can be seriously wrong. And the longer in the future those cash flows are projected, the more wrong they can be. And yet, you have to make decisions based on something. And actually, cash flow is one of the better methods for evaluating a lot of different kinds of business decisions. So, how can we adapt the net present value concept to make it more usable?

How to Improve Net Present Value Analysis

Well, here are some suggestions. First, don’t use it for small purchases. Below a certain cutoff level, it’s not worth the time to develop cash forecast information – if it’s even available. Instead, give managers a pool of cash that they can invest, using their best judgment. This won’t represent a massive percentage of the company’s available cash, but it should make the purchasing process more efficient for smaller acquisitions.

Next, base cash flows on throughput analysis as much as you can. This gives you better cash inflow information – which is otherwise pretty difficult to obtain. If you want to learn more about throughput, please go back to Episode 45.

And then, for any remaining projects, use a high-medium-low analysis for cash flows, so you can also see the best case and especially the worst case scenarios. This is much better than using a single, middle-of-the-road case. I tend to spend more time reviewing the worst case scenario than the middle scenario.

And finally – and this is an important one – assign all purchasing proposals that contain net present values to a financial analyst for a detailed review. The same person should do all of these analyses, so they gain some experience in the issues to look for, and how these proposals can be fudged.

And even though I just said “finally,” here’s one more. When you audit expense reports, and a problem comes up on someone’s expense report, the normal procedure is to review all of that person’s expense reports in the future. The same concept applies to net present value. If you even catch a hint of someone fudging their numbers, flag them for a more intensive review from that point forward.

So, in summary, is net present value a bad thing? No. Cash flow is a useful tool. However. You really should be skeptical when reviewing cash flow projections, as well as how they’re being discounted to their present value.

If you take into account the concerns I’ve raised here, it may prevent an incorrect investment.

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Intangible Asset Impairment Testing (#146)

In this podcast episode, we discuss the new accounting standard pertaining to the impairment testing process for intangible assets. Key points made are noted below.

This episode is about a rules change for testing intangible assets for impairment. You may have noticed that I haven’t been talking much about new accounting standards for the last couple of years, and that’s because there haven’t been very many to talk about. A couple of rules changes have been issued that were too minor to bother with, but this one should actually be of interest to a fair number of listeners.

The Testing of Intangible Assets

There’s already some existing accounting under generally accepted accounting principles for intangible assets that have indefinite lives. Before the new rules change, you had to test all of this class of assets for impairment at least once a year by comparing the fair value of an asset to its carrying amount. Figuring out fair value can be expensive, since you might have to hire a valuation firm every year to do the testing.

Well, the financial accounting standards board received some rather pointed comments about this from users. They wanted an exemption if there wasn’t much of a chance of impairment actually having taken place.

And because of those complaints, things are now easier. The rule adjustment is that you can assess “qualitative factors” to see if it’s more likely than not that an intangible asset with an indefinite life is impaired. If you conclude that impairment is unlikely – which should be most of the time – then you’re done. No further impairment testing is required until the next year.

And by the way, that “more likely than not” bit means having a likelihood of more than 50 percent.

Qualitative Factors in Impairment Testing

So what are these qualitative factors? Well, they give examples of the situations that you can review to form a judgment about whether impairment has occurred. That means these aren’t necessarily the only factors to consider. Still, the factors you look at are likely to be similar to what they’ve listed.

So this is what they have. First is an increase in costs that could reduce future cash flows. The next factor is quite similar – it’s a decline in cash flows, or revenues, or profits, and especially in comparison to projected results.

This is a bit broader than the first one, since it encompasses more than an increase in costs. It could mean that revenues are going down.

The third item is regulatory or contract-related changes that could reduce the fair value of the asset. So, for example, a regulation change to increase the number of available taxi licenses would reduce the value of the existing taxi licenses.

The fourth item is non-financial changes to the business, such as losing a key employee or a key customer, or being hit with a lawsuit, but only to the extent that it impacts the fair value of the asset.

The final items are basically changes in market conditions. So this could be a general decline in the economy, or maybe the appearance of low-cost competition or new technology, or even unfavorable exchange rates.

The examples given are pretty broad-ranging, so I wouldn’t expect that you’d find some other qualitative reason that falls completely outside of these examples. If you do, you might want to run it by your auditors to see if it’s acceptable to them.

And by the way, you have the option to bypass the qualitative testing and go straight to the old-style comparison of fair value to carrying amount. Why anyone would do that, I’m not exactly sure, unless it’s so obvious that impairment has occurred that you just want to go straight to figuring out the amount of the loss.

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Capital Budgeting with Minimal Cash (#145)

In this podcast episode, we talk about how to deal with fixed asset acquisition issues when there is not much available cash. Key points made are noted below.

The last episode was about alternative ways to review a capital budgeting proposal. A listener contacted me and pointed out that there’s a scenario where you have to throw out most of the project evaluation rules and try something different. So, this episode is about capital budgeting when you don’t have much cash. This could involve a startup company, or any business that’s fallen on hard times. The chances are good that you’ll encounter one of these bad cash flow situations sometime during your career, so the following discussion might be of some use.

How to Conserve Cash Outflows in Capital Budgeting

Now, obviously, the one and only principle in this situation is to conserve cash, which is kind of hard when the very nature of capital budgeting is to spend cash. So, we need to figure out ways to get the maximum return on investment as fast as possible, while spending next to nothing. Here are some options.

First, see if you can repair what you already have, or root around in the warehouse and see if you have old equipment that can be repaired. Repairs are usually way less expensive than buying a whole new machine. Now, the machine may be inefficient, but since you’re not spending much money on it, that could be OK.

Next, see about the extending the operating hours of the existing equipment. It may be a lot less expensive to have a few people work an extra shift – even if they’re not very efficient – than to buy new equipment. Better yet, don’t just work two shifts – run the machine for three shifts. Efficiency will absolutely go down if you do this, because the machine will need more maintenance time – but it still saves cash.

Also, focus hard on outsourcing instead of capital purchases. Even if the returns are a bit worse by shifting work to a supplier, that’s still better than having to invest cash in new equipment. The situation – hopefully – will improve at some point in the future, so keep your options open for bringing production back in house. This might mean signing off on just a short-term deal with a supplier.

Another point, and which I talked about in the last episode, is putting a major focus on buying second-hand equipment. It can be so much less expensive that you may want to create a company rule that only the CEO can authorize the purchase of new equipment. Now. Old equipment may not be overly efficient, and it may be in need of repair, and it may have a short useful life. Doesn’t matter. As long as it’s cheap.

Also, take a hard look at leasing. The company may not be in very good financial condition, but it may still be possible to get a leasing company to issue a lease, since it can use the equipment you’re buying as collateral. This is worth it just to avoid an up-front cash payment.

How to Maximize Cash Inflows in Capital Budgeting

That pretty much covers the cash outflow end of things. Let’s look at the corresponding cash inflows. The focus needs to be on providing an immediate benefit – as in, cash receipts tomorrow. So if you can acquire equipment that can generate revenue in a day, that’s better than acquiring equipment that takes so long to set up that you can’t even get it operational for a month.

This also means that you have to focus on capital purchases for revenue that’s in the low hanging fruit category. In other words, to paraphrase the Field of Dreams movie, if you buy the equipment, they will come. If there’s any chance at all that revenues won’t happen, then skip the purchase. This is no time to be taking changes on speculative revenues.

Parting Thoughts

And that about covers it. You may have noticed that I didn’t talk about net present value analysis. That’s because the scenario I’ve been addressing is pure survival mode. And when you’re in survival mode, you do not worry about multi-year returns on investment. The main point is to survive for another day, so net present value is not overly relevant.

Also, I’ve kept pointing out that some of the investment choices may not result in the most efficient operations. That’s OK in the short term, but should be addressed in the long term, when you’ll presumably have more money to enhance operations.

And an additional problem is that following the recommendations I’ve laid out here could very result in a hodge podge of equipment that doesn’t work together very well. That may be OK if you’re buying used equipment, since the useful lives of these items may be fairly short.

So if you do everything right and cash flow starts to go back up, you can sell off these old machines in a year or two and use your new excess cash to buy what you wanted in the first place.

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Evaluating Capital Budgeting Proposals (#144)

In this podcast episode, we discuss a number of ways to reduce the investment in new fixed assets. Key points made are noted below.

This episode is about evaluating capital budgeting proposals. This is when someone wants to spend a lot of money on a fixed asset, like production equipment. The traditional way to do this is to make a guess at the cash flows that relate to a proposed purchase – both cash in and cash out. And then you discount all of those cash flows to the current period, and you buy it if the net present value is positive. I have some issues with net present value analysis, and that may be a topic for another episode. But for now, I’m going to talk about some other ways to evaluate these proposals.

The Bottleneck Analysis

One of them I talked about way back in Episode 45. That was about focusing your investments on bottleneck operations, so that you increase capacity only where it’s really needed. It’s a good topic, and I encourage you to go back and listen to that episode. But there are some other issues to consider, too.

Before I start in on these items, please keep in mind that what I’m going to suggest might be considered somewhat intrusive to the person submitting the proposal – because you’re going to essentially be suggesting that they reconsider what they want to buy.

Avoid Customization

For example, you can try to avoid asset customization. This means someone wants to buy equipment that been heavily customized. And they have a good reason, which is that custom equipment will be more efficient for the company. But that also means you may have to pay extra for custom spare parts, and it may be more difficult to maintain, and there may be no aftermarket for it if you want to sell it someday. This can be a tough battle, but you need to have managers look at the total life cycle cost of customized assets.

Reduce Features

As another example, what about reducing the number of features that come with a new asset? People love to buy the latest and greatest, but the greatest, with all of those extra features, is also more expensive. So if there’s old equipment being replaced by the latest and greatest, you could talk to the users and find out which features they’re actually using. Chances are, you don’t need everything, and you might be able to buy the next version down. Now, what if the manufacturer only offers one model? If it’s expensive equipment, you could call them up and see if they’ll strip off some accessories in exchange for a lower price. They might say no, but they also might say yes.

Buy Used Equipment

Here’s a third item. I just mentioned buying the latest and greatest, and was a little disparaging about buying the greatest assets. Now – let’s also be disparaging about buying the latest assets. There’s quite a good secondary market for all kinds of fixed assets, so you may spend a lot less buying second hand, and still get a lot of use out of what you buy. Some companies even ramp up their fixed asset purchases during a downturn in the economy, because they know that’s the best time to buy used equipment. In short, you might want to have a mindset that’s not to buy the latest and greatest, but instead to buy the oldest and least.

Buy in Bulk

OK, here’s a fourth item. What about always buying the same piece of equipment? Not just the same general type of asset, but the same asset. This means you can buy equipment in volume to save money, and you can stock fewer spare parts, because they’re all for the same equipment. And on top of that, the maintenance staff becomes very good at repairing the same machine all over the company. Of course, competitive bidding goes away, but there really are a lot of benefits to standardization.

Avoid Monument Assets

Next up is the monument. Other than the Washington monument or the pyramids, what I’m talking about is a large and expensive asset – usually pretty heavily automated – that everything else in the production area is designed to support. These things are super efficient, but the trouble is that there’s usually only one of them, so when it goes down, the entire facility stops working.

Even if engineering managers the world over are in love with their monuments, it’s worthwhile to talk about buying a couple of smaller and less efficient machines instead. That way, if one goes down, the company can still operate through the other one – or two, or three. And also, smaller units tend to be less complex, and so they break down less.

Extend the Asset Life

And my final point is to see if existing equipment can be extended a little longer. Sometimes the industrial engineering staff wants to replace equipment just because the manufacturer’s recommended life span has now been reached. But what if the machine is still operational most of the time, and it operates within specs, and its maintenance records look pretty good? Chances are, you can delay a replacement purchase for a while.

Parting Thoughts

Now, all of these suggestions are really pretty logical, but it’s surprising how much of a buzz saw you can run into in the way of resistance. I think the main trouble is that the administrative people are expected to just look at the numbers, run their calculations, and either say yes or no.

By asking these extra questions and really digging into a purchase proposal, it’s almost like you’re calling their competence into question. And that’s just not the case. What you are doing is exploring all of the options, so the business spends less money on equipment, or at least it spends the money more intelligently.

Still, it can take some smooth talking to get someone to seriously reconsider what they want to buy. But given the amount of money involved, it could be worth a try.

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Supply Chain Financing (#143)

In this podcast episode, we discuss how supply chain financing works. Key points made are:

• Supply chain financing provides suppliers with an early payment option at a relatively low interest cost. Buyers involve their bank in the payment process, where the bank offers suppliers early payment in exchange for a discounted payment.

• It is less expensive for the supplier than obtaining separate working capital financing.

• Supply chain financing primarily applies to open account transactions.

• The buyer sets up supply chain financing in order to give its suppliers an improved working capital position. Doing so also reduces the risk in the buyer’s supply chain that is caused by poor liquidity.

• Some software platforms are available for supply chain financing, where suppliers can pick which invoices will be paid early, and how many days early. These platforms use several banks, so that funding does not dry up. Using multiple banks also allows for some regional specialization by the banks.

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Treasurer’s Guidebook

The Dividing Line Between Treasury and Accounting (#142)

In this podcast episode, we discuss whether certain functional areas should be given to the treasury department or the accounting department. Key points made are:

• Which functions fall into the treasury or accounting departments? It depends on how the departments are organized and who has more power. Most functions are initially clustered under the controller, and then shift to treasury as the business gets larger.

• Payables and collections are heavily transactional, which accounting is better-designed to handle. Treasury tends to deal with lower transaction volumes.

• Payables, credit and collections are linked to accounting through the accounting software, and accountants are better trained to use the system.

• Controllers don’t like to give up control over payables, credit, and collections.

• The treasurer is responsible for cash management, so payables can be used to control cash outflows. Alternatively, the treasurer can have authority over the timing of large payments, to better manage cash flows.

• There is less reason for having treasury control collections, since payments are under the control of customers.

• Some companies have shifted credit to the treasury department, since it is more of an analysis role, and can be managed by altering the credit policy.

• In short, Treasury needs the information from payables, credit, and collections, but it has no particular need to manage them.

Related Courses

New Controller Guidebook

Treasurer’s Guidebook

The Value Proposition (#141)

In this podcast episode, we cover the value proposition that a business presents to its investors. Key points made are:

• The value proposition is the theme of the business; it describes the intrinsic value of the entity.

• When you have multiple divisions, it can make sense to split the business apart and assign different value propositions to each one, to maximize the total value of the business.

• Get rid of low-value operations that interfere with the value proposition.

• You need to consider the value proposition when making tactical decisions, since each one contributes to how well the business is perceived as matching its value proposition.

• You can fiddle with the value proposition to associate it with a higher-value market niche.

• Paying attention to the value proposition can greatly increase the stock price of the company.

• A muddled value proposition can reduce the market value of a business, so getting it right makes a great deal of sense.

Related Courses

Investor Relations Guidebook

Public Company Accounting and Finance

The Cost Accountant Position (#140)

In this podcast episode, we talk about how to reorient the cost accountant position to make it more effective. Key points made are noted below.

Problems with the Position

I’m bringing up this job position because there’re several interpretations of what a cost accountant is supposed to do. And if you set up the job in a certain way, it’s not very cost-effective. The basic problem is the title itself. A controller decides that he needs a cost accountant, because he wants to know what things cost. This seems reasonable, since you supposedly make decisions based on what things cost, and doing so saves the company money.

The reality is a little different. For example, what if a company has a standard set of products, and management wants to know the total actual gross margin on each product, every month. So the cost accountant spends hours and hours compiling the cost of materials and labor and allocates overhead really well – and what do you get?

Well, even if we sidestep the issue of which costs really should be included in this type of analysis, what we’re going to find is that the margins hardly ever change. Costs are built into products in the design stage. Once they’re designed, there isn’t much variation from month to month. So, management figures this out after a few months, and stops looking at the reports – and those are the reports that no one told the cost accountant to stop producing. This might sound familiar to you.

I reviewed a company that had this exact situation, and had them lay off the entire cost accounting staff, because the information they were producing had no actionable value. And that’s the key point. You can have a cost accountant churn out all kinds of costing reports. But if you don’t do anything with the information, why have the cost accountant?

Complying with the Accounting Standards

Instead of focusing on cost reporting, you can break down the job into two pieces. The first part is required costing work that you need in order to issue financial statements. This means valuing ending inventory, which, in turn, means reviewing inventory accuracy, and overseeing the month-end cutoff, and allocating overhead, and so on. Now, this is all required, but it’s not value added. You’re just complying with the accounting standards.

And that means there’s a tradeoff here. Inventory valuation needs to be right, but it doesn’t mean that you encourage the cost accounting staff to investigate immaterial items. This is essentially a cost benefit balancing act, where you have cost accountants spend just enough time overseeing inventory valuation to ensure that the result is pretty good. Not perfect, but good enough for the auditors.

Value-Added Cost Accounting

With any luck, that means there should still be enough time available for some value-added work. I’ve already talked about how compiling product gross margins is not really value added, since no one uses the information. Instead, we have to reorient the cost accounting work into areas that actually make a difference. And there are a couple of them.

First up is target costing. You might remember this from Episode 57. Target costing is about designing products to meet a certain price point and profit, which means that you have to pay close attention to the designed cost. This is perfect for a cost accountant, because you’re helping to ensure that products are going to be profitable.

Second is constraint analysis. I covered constraint analysis in Episodes 43 through 47. It involves focusing on whatever the company bottleneck is that keeps a company from generating more profit. The traditional location for the bottleneck is the production department, though I usually see it in the sales department. Anyways, the cost accountant should continually review the performance of the bottleneck, and keep suggesting ways to improve performance right there, or to route work around it.

Any improvement in a constraint has an immediate impact on profits, so there’s a clear cost-benefit involved in having the cost accounting staff work in this area.

And my third recommended task is what I’m calling the investigation of unusual stuff. You can quote me on that. It means looking into any expense item that’s out of the ordinary. I’m not referring to variance analysis, which is tracking volume and efficiency variances from standard amounts. There’re so many ways to fudge the baselines used for variance analysis that I find that whole system of analysis to be essentially useless.

Instead, cost accountants should look for any expense that jumps above the historical trend line, and investigate it. This is pretty easy. You just run a report that lists each expense monthly basis for the past year, and investigate anything that bumps above the average. And this isn’t just finding out what the amount is and reporting it to management.

A really effective cost accountant drills down to find out why the expense occurred, and if it can be avoided, and makes a complete recommendation to management. You can even take this a step further and have the cost accountant be responsible for making whatever change is needed, which really converts the position into sort of an internal consultant or troubleshooter. The reason for this extra level of investigation and pushing for changes is that department managers frequently ignore variance reports.

So instead, the cost accounting staff presents them with the problem and the solution, and even offers to fix it. And that provides value.

Summary of the Position

So let’s summarize what a cost accountant should really be doing. If a company has ending inventory, then there’s always going to be a block of time required to value it – but just enough time to avoid any material mistakes.

All remaining time should be spent on projects that are going to enhance company profits. This means getting involved in the design of products, and constraint analysis, and making sure that unusual expenditures don’t happen again.

What the cost accountant should not be doing is compiling the same old cost reports, month after month, about how much the same old products cost.

Related Courses

Constraint Management

Cost Accounting Fundamentals

Financial Analysis

A Lean System for Fixed Assets (#139)

In this podcast episode, we discuss several best practices that are designed to reduce the accounting work related to fixed assets. Key points made are noted below.

The Problems with Fixed Assets

As I’ve been pointing out in the last couple of episodes, we’re assuming that “lean” means doing accounting with minimal resources. That’s pretty tough to do with fixed assets. Consider all of the accounting you have to do. There’s setting up a depreciation calculation, and the related journal entry, and doing a fixed asset roll forward to make sure that you didn’t screw up anywhere. And when you eventually dispose of the asset, there’s a disposal transaction to figure out, maybe with some gains or losses. And on top of that, you have to review the larger items for impairment. And there may be asset retirement obligations to keep track of. And, if you’re using international financial reporting standards, you may be revaluing the assets up or down. Two problems with all of this. First, it’s a lot of work. And second, if you want to be in compliance with the accounting standards, then you have to do all of it. From the perspective of introducing lean concepts, it initially looks like you’re completely screwed.

Lean Suggestions for Fixed Assets

But that’s not quite true. Let’s look at this from the perspective of how much each fixed asset costs. If you make a list of all your fixed assets and sort them by cost, the result is going to look like a pyramid. There’ll be a couple of really expensive assets at the top of the pyramid, and there’ll be a whole pile of low-cost ones across the base of the pyramid.

Since we can’t eliminate any of the accounting work associated with fixed assets, the next best thing to do is to get rid of the assets – in particular, the ones along the base of the pyramid.

There’re two ways to do this, and you should go after both of them. First, the threshold at which you call something a fixed asset instead of an expense is called the capitalization limit, or the cap limit. You want to reset the cap limit so that it excludes all of the lowest-cost fixed assets. For example, if you’ve been capitalizing laptop computers, stop that right now. Those are office supplies. Seriously. Just taking this one step will wipe out a huge chunk of your fixed assets. Yes, it will increase the amount you charge to expense in the short term, but it’s just not that much money.

The second lean improvement involves something called base unit aggregation. A base unit is a company’s definition of what constitutes a fixed asset. So if you’re constructing a building, a lot of invoices go into a single fixed asset item. That’s fine. The problem is when you aggregate a lot of low cost items into a fixed asset that’s barely above the cap limit in total. For example, you could have a fixed asset called a group of desks. Each of those desks would normally have been charged to expense. Because you aggregated them, the group is a fixed asset. That’s bad.

What you should do is disaggregate those desks, which means you record them individually. Then they fall below the cap limit, and you won’t have to record them as fixed assets. And that gives you a more lean accounting department.

And for that matter, how do you track a group of desks? They’re going to be in different rooms, and they’re going to keep getting moved around over time. You won’t even know if they’re gone. It’s just not logical to use aggregation.

Those are my two main improvement areas for lean fixed assets. But there are some other possibilities, and they all involve doing the simplest possible accounting. If you keep it simple, there’s less room for error, and that means it’s easier to reconcile the accounting records.

First, only use one depreciation method, and make that method the straight-line method. It’s the simplest one, it’s really hard to screw up, so why not? Most of the accelerated depreciation methods are just the reverse – it’s kind of unusual not to make a mistake.

Second, don’t bother adding salvage value to the depreciation calculation unless you’re dead certain there’s going to be a salvage value, and it’s going to be material. Otherwise, you’re just going to complicate the depreciation calculations, that means it’s easier to screw up.

Next, avoid interest capitalization like the plague. It’s complicated to calculate the amount.

So if you’re only constructing an asset for a short period of time, do everything you can – legally – to avoid capitalizing any interest expense.

And finally, there’s asset classes, like computer equipment and furniture & fixtures. A lot of companies assign a standard useful life and depreciation method to all of the assets within each asset class. The trouble is that if you every move something from one class to another, you may have to change the useful life and the depreciation method. Which gets complicated.

My recommendation is pretty obvious. Just keep it simple. You should use the absolute minimum number of asset classes that you can get away with, since that way, you don’t need to worry about putting something in the wrong asset class, and then having to readjust the depreciation or the useful life to match the asset class that you should have put it into.

So what have lean concepts done for us? You should have far fewer fixed assets to track, and you should have standardized the accounting for those fixed assets that are left.

There’ll still be a few really expensive assets that require the full range of fixed asset accounting, with impairment analysis and asset retirement obligations, but those are going to be the exception. Most of the other assets won’t even be there anymore.

Related Courses

Fixed Asset Accounting

How to Audit Fixed Assets

Lean Accounting Guidebook

A Lean System for Accounts Payable (#138)

In this podcast episode, we discuss how to reduce the work load associated with the payables function. Key points made are noted below.

As I mentioned on the last episode, we’re assuming that “lean” means doing accounting with minimal resources. And again, we’re going to look at the whole process and locate those spots in the system where we can reduce the need for resources.

Recap of the Payables Process

Let’s start with a quick recap of the payables process. If you do a full three-way match, it means starting off with a comparison of the authorizing purchase order to the supplier’s invoice and a receiving report. If the invoiced price or quantity doesn’t look right, then you have to investigate further. And if there wasn’t a purchase order, then you send the invoice out for an approval. And after that, you pay the invoice.

Problems with Payables

This is a pretty crappy process, for two reasons. First, the three-way match means that the payables staff has to sort through a lot of paperwork. And there’re going to be missing documents and there’ll be variances that cause all kinds of extra work. And second, some managers are awful at returning invoices that they’re supposed to approve. So from a lean perspective, there’s too much time being wasted in accounts payable. If we want to operate payables with minimal resources, we can do so by spending less time on it. How do we do that?

Improvements to Payables

The first step is to completely avoid the three-way match. The easiest way is to have a rule that if an invoice is below a certain amount of money, no match is required. When you set that minimum threshold, do some analysis first to figure out what threshold will eliminate a bunch of invoices that aren’t too expensive.

The second step is to figure out which suppliers are completely reliable in submitting accurate invoices. If their invoices are absolutely always correct, then you don’t need to do a three-way match. Instead, audit their invoices every now and then, just to make sure that they’re still accurate.

And that is the key point. If you can train suppliers to issue perfect invoices all the time, there’s no need for a three-way match.

The impact from a lean perspective is massive, so this is absolutely worth pursuing. If you want to go down this path, it means setting up a system where the payables staff tracks which invoices went through the three-way matching process, and did not have any errors.

If you see several perfect invoices in a row, set a flag in the vendor master file to show that those suppliers are certified to avoid the three-way match. Also, if a supplier is having invoicing problems, then route this information back to the purchasing department, and request that a different supplier be used. And on top of that, start communicating directly with the supplier’s billing department to point out errors. Over time, you might be able to train them into a higher accuracy level.

If you go through these steps, there should only be two types of invoices still going through the three-way match. The first is invoices from new suppliers, who haven’t been evaluated yet. And the second type is invoices that suppliers keep screwing up – and those are the ones you want to be reviewing.

And by the way, the one thing you don’t want to do is spend a bunch of money to buy software that automates the matching process. It’s expensive, and you have to load every line item on every invoice into the system, and that requires a lot of clerical time. Instead, the lean approach is to use the system as little as possible.

Now let’s switch over to that other problem with invoice approvals, where it can be hard to get invoices back from the approvers. As you might expect, the lean view of things is to completely avoid approvals. But there are times when someone really should take a look at an invoice. So, what can we do?

One option is to automatically approve all invoices below a certain threshold amount. And again, do a study to see what threshold level would eliminate a lot of invoices from the approval process, while still leaving some approval control over the really expensive ones.

Next, if the purchasing department already issued a purchase order, then that is an approval – and you don’t need any further approvals.

Third, buy an invoice stamp that says, notify the accounts payable staff only if you do not approve. All other invoices will be paid automatically.

Use this stamp on every invoice that you send out for approval. This is called negative approval. If you take this approach, which I strongly recommend, you’ll find that almost every invoice is automatically approved. It’s really quite an event when an approver does not want to pay an invoice. So this will cover nearly all of your invoice approvals.

And finally, what if you have an invoice that’s so expensive that you just have to get an approval signature on it? Don’t send it by interoffice mail. You may never see it again. Instead, walk it to the person who’s supposed to sign it, watch them sign it, and walk it back.

Yes, this is ridiculously time-consuming, but it also absolutely guarantees that it will be approved on time. And also, you’re standing right there, so if the approver has a question about the invoice, you can answer it on the spot. And besides, this method is the exception. You’re not going to be walking invoices around the company very much.

So, what we’ve done is target the two big time-wasters in the accounts payable process, and we’ve figured out ways to avoid both of them. You may not be able to completely eliminate either one, but avoiding them 90 percent of the time should be possible.

Related Courses

Lean Accounting Guidebook

Optimal Accounting for Payables

Payables Management

A Lean System for Cash Receipts (#137)

In this podcast episode, we discuss a streamlined method for handling cash receipts. Key points made are noted below.

The Nature of a Lean System

I don’t think there’s an industry-standard definition yet for what it means to have a lean accounting system. So I’ll make up my own definition, which is doing accounting with minimal resources. Getting to minimal resources can be quite a trick. This is not a matter of just installing a best practice somewhere in the system and hoping that your cost structure gets better. Instead, you need to look at the whole process and figure out the exact spot where a system change leads to a lean system.

Cash Receipt Improvements

Let’s work through this from the perspective of cash receipts. Specifically, let’s look at creating a lean system for check receipts. Now I won’t get into the whole procedure for check receipts. Let’s just summarize the work flow. A check arrives at your business, and the mailroom staff opens the letter, does some recording of information, and then passes the check along to the cashier. This person does some more recording in the accounting records, and matches it to what the mailroom staff recorded.

Then the checks and a deposit slip go to a courier, who takes it to the bank. The bank tallies up the checks and provides a receipt, which is later compared to what the company recorded. That’s it.

So what we have is checks going through the hands of the mailroom staff, the cashier, the courier, and the person reconciling information at the end. That’s four people, and that’s four ways to screw up the process. So when you look at it from the perspective of too many people being involved, the obvious best practice to install is a bank lockbox.

With a lockbox, customers send their checks straight to the bank. The payments never come near the company premises. What does that do to the process?

Well, the mailroom staff is no longer involved. And there’s no courier. And there’s no one reconciling information, since there’s no information. Instead, all you have is the cashier looking up check images on the bank’s website each day, and recording the information in the accounting records.

That’s lean accounting. We’ve gone from four people to one. Now lockboxes have been around since about the time of Adam and Eve, so this is hardly new. The difference is that you’re thinking through the impact on the business before you figure out which best practice to install first.

Now let’s take this a step further. The objective is not really the lockbox itself. The objective is shrinking the check receipts process. And just installing a lockbox does not really meet that objective. The trouble is that there’ll continue to be a trickle of checks being sent straight to the company, not the lockbox.

So to be truly lean, you have to keep reminding customers to send their checks to the lockbox. And you may want to have the mailroom staff re-mail any incoming checks to the lockbox. And on top of that, maybe the only measurement you need for check receipts is a detailed listing of the cash that still comes through the business premises every day.

And it’s the job of the accounting department to follow up on every one of those cash receipts to make sure that they all go to the lockbox in the future.

So let’s get back to the concept of lean again. The objective is shrinking the check receipts process. You may realize now that just installing the lockbox doesn’t complete the objective. Instead, you have to do the installation, and then spend months going after every single check that still arrives at the business. As long as any check is processed within the company, you have not attained that objective, which means that the old procedure is still there, and you don’t have a lean process.

Now, what if someone says that lockbox fees are too expensive, and so don’t do it?

Well, there are other best practices that can still shrink the overall process, but it’ll still be longer than what you could do with a lockbox.

For example, you could install check scanning equipment, where you scan checks and basically e-mail a batch file of your deposits to the bank. Yes, this eliminates the courier, so the process is shorter. But checks are still moving through the company, and that means you still need to have a bunch of controls to monitor the checks.

Or, as another example, there tends to be a bottleneck at the cashier. This person may want to apply check payments to open accounts receivable, and wants to hold onto the checks until all of the cash is applied. If they have a problem applying cash, then they may not send a deposit to the bank. You can avoid this bottleneck by making photocopies of all the checks and applying cash from the photocopies. This allows the checks to be deposited faster.

Now these are two examples of ways to arrive at a somewhat more lean check receipts process. But the trouble is that you’re still accepting the fact that checks will be on the premises. And that’s the key item that has to go away.

So what do we get from this way of thinking? First up, consider the entire process flow to figure out which parts can be changed or eliminated. Then implement just those changes that allow you to alter the process. And then follow through over and over again to just beat up that implementation, so that you never have to return to the old system.

And doing it this way also means that you only have to install a relatively small number of best practices. To go back to my examples, if you revise checks receipts the right way, you only have to install the lockbox. Once there aren’t any checks running through the business, there’s no need to install check scanning equipment or make photocopies of checks.

Related Courses

Lean Accounting Guidebook

Optimal Accounting for Cash

Goodwill Impairment Testing (#136)

In this podcast episode, we discuss a new accounting standard for goodwill impairment testing. Key points made are noted below.

Background on Goodwill Impairment Testing

This episode is about the new Accounting Standards Update about testing goodwill for impairment. If you do acquisitions, this might apply to you. First, for some background. Under GAAP, you record a goodwill asset when you make an acquisition and some of the amount paid can’t be assigned to specific assets or liabilities. This happens most of the time. Then you’re supposed to test the goodwill asset every year or so to see if any of it should be written off. The way you’ve been required to test for goodwill - up until now – is a two-step process. First, you compare the fair value of a reporting unit with its carrying amount on the books, and if the carrying amount is greater than the fair value, then you go to the next step, to figure out the amount of the impairment loss. If not, then you’re done and there’s no impairment. In the second step, you measure the amount of the impairment loss, which is what you’re going to write off. I won’t get into the details of how the second step works, since the rules change doesn’t impact it.

Enhancements to the Testing Process

Now – the folks at the Financial Accounting Standards Board have been hearing some complaints about the “cost and complexity” of that first step. So they’ve decided to change the testing requirement. Under the new approach, you have the option to change the first step in the impairment testing process. Now, you can run through some qualitative factors to decide if it’s more likely than not that the fair value of a reporting unit is less than its carrying value. If so, then you still have to complete the original first step, which was to calculate the fair value of the reporting unit. And in case you’re curious, the more-likely-than-not threshold is defined has having a likelihood of more than 50 percent.

Qualitative Factors

So what are these qualitative factors? Well, the FASB is being pretty open-ended about it. What they state is what they call “examples” of events and circumstances that should be assessed. That means you should consider what they list, but you could use other factors, too.

There are seven of these “examples,” and some are pretty broad. The first is as broad as you can get.

It’s macroeconomic conditions, such as a deterioration in general economic conditions, or fluctuations in foreign exchange rates.

The second example is the same thing, but at the industry level, so now it’s a deterioration within the industry, or an increasingly competitive environment, or changes in the regulatory environment.

Then we get into cost factors, such as an increase in the cost of goods sold that negatively impacts profits.

The fourth example is a decline in overall financial performance, such as declining cash flows or a declining trend in revenues or profits.

Then they change gears and get a bit more specific in the fifth example, which is changes in management or key employees, changes in customers, new litigation, and so on.

The sixth example involves major business events, such as an expectation to sell the reporting unit.

And the last example is a sustained decrease in the share price, both in absolute terms and in relation to the share prices of competitors. This last example obviously only applies to public companies.

When you go through this analysis, you’re supposed to place the most emphasis on those factors that could affect the fair value of the reporting unit. And whatever you decide, you certainly need to document it thoroughly, since the auditors are bound to review it.

That’s how the new variation on impairment testing works.

Whenever you want to do an impairment test, this new approach is always available as an option. So if you don’t elect to use it one year, it’s still available for use in a later year.

Now, why do we bother with this new variation? Because under the old approach, you may have to hire an appraiser to determine the fair value of the reporting unit – which can be expensive. With the new approach, you can potentially avoid the expense.

And the time needed to do the qualitative analysis probably goes down after the first year, since you’ll only have to update the documentation you already created in the preceding year.

On the other hand, this can lead to some pretty mushy impairment evaluations. A lot of businesses could potentially use this approach to avoid impairment charges; so I would expect some businesses to come up with documentation for some pretty rosy outlooks.

So, the net result of all this is a reduced level of effort for impairment testing, and I would guess at a reduced number of impairment charges, too.

And by the way, this standard applies to both public and privately-held businesses. Also, this approach is only available under GAAP. It is NOT available under International Financial Reporting Standards. In fact, this creates a greater divergence between the GAAP and IFRS accounting for goodwill.

Related Courses

Business Combinations and Consolidations

GAAP Guidebook

Mergers and Acquisitions

How to Fine Tune Your Control System (#135)

In this podcast episode, we cover a number of options for altering your control system to yield better results. Key points made are noted below.

The Range of Controls

Control systems tend to be at either end of a continuum, which is practically no controls at one end, or so many controls at the other end that you choke on them. Most companies begin with too few controls, because the founders are just trying to start the business, and having the right controls is about number 500 on their priority list.

You usually get too many controls when a company hires in a controls consultant to upgrade the whole system, and they go wild. The same thing happens when a company hires in a controller who used to be an auditor, and the same thing happens – they go nuts and add controls everywhere.

In that latter case, they may be using a standard list of controls, which you might think is acceptable, especially if it comes from some well-known organization. The trouble is, that kind of a list is designed to be comprehensive, so it contains every bloody last control on the planet. And another problem is that it’s designed for some generic company in a generic industry – not for your company in your industry.

So those are the two extremes. Being in between those extremes doesn’t necessarily mean that you have a nice, balanced control system. It may mean that somebody added a few controls here and there in response to a problem, like a case of fraud, or a customer not being billed.

So, what I’m saying is that you might be at either end of the control continuum, or in the middle, and the system still may not work. You may have too few controls, or too many controls, or not the right controls.

A lot of this mess comes from the attitude that people have about controls. They think of it as an annoyance. So they only deal with it when they have to, which usually means when something breaks down or the outside auditors complain about it.

How to Improve Your System of Controls

How do you turn this around and arrive at the right set of fine-tuned controls? It helps to look at your controls from a series of different perspectives, and tweak the system based on each one of those viewpoints.

Now believe it or not, it helps to think of a control system as sort of a profit center. This may sound odd, because controls clearly cost money. So where’s the profit?

Well – first of all, please keep in mind that I’m not advocating actually creating an income statement for your control system – good luck with that. But you can quantify some of the risk that you’re trying to mitigate.

For example, let’s say that you think buddy punching is going on. This is when an employee doesn’t come to work, but his buddies punch his timecard for him. There’s a pretty clear cost associated with that, since you’re paying someone who isn’t there. So in this case, you can offset the cost of installing a biometric timekeeping system, which eliminates buddy punching, against the presumed losses from buddy punching.

So the profit center approach is going to account for some of the controls that you need.

Now let’s view this from a different perspective, which is the concept of the cost per occurrence. What if someone could get into the treasury system and wire all of the company’s cash to a foreign bank? It might only happen once every hundred years, but when it happens, the company is toast. So because the cost per occurrence is so massive, you have to add a bunch of controls involving wire transfers.

Let’s take the other extreme of that concept. What if the cost per occurrence is just a few dollars? For example, the office manager locks up the office supply cabinet to keep pilferage down. Do you really need that, or is it just irritating? If you look at controls from this perspective, there’s not much point in annoying people by protecting against a low cost per occurrence. Instead, skip the control and accept those piddly little losses.

So we’ve now viewed controls from two perspectives – profit center and cost per occurrence. Let’s view them from a few more angles.

Next up is repetitiveness. If you have certain transactions that happen every single day, then you should spend a lot of time thinking about the right controls for them. If a transaction only happens once a year, it’s quite all right to wing it and not prepare some complex system of controls for it. Though, that’s also subject to the concept of cost per occurrence. So if you only do one wire transfer per year, you still want some good controls.

You might look at repetitiveness from the perspective of a Pareto analysis. That’s the concept where 80% of the transaction volume of a business probably comes from 20% of the transaction types. What you want to do is concentrate on having goods controls for that high-volume group of transactions, and not be so concerned about the rest.

OK, let’s look at a fourth perspective. This one is about creating accurate financial statements. You want just enough controls to make it likely that the financial statements you produce contain no material errors. Some controllers really have a problem here, because they want the financials to be perfect, and that requires a preposterous number of controls. But the more controls you add to the accounting system, the more time – and money - it takes to create financial statements.

So those are four perspectives you should take when reviewing controls. But you’re not done yet. Because there might very well be overlapping controls. You might have installed one control to make the financials more accurate, and a separate control to handle a high-volume transaction, and it turns out that one control could cover both areas. So you need to look at overlaps and very selectively prune out those controls that are redundant.

Let’s bring all this together. I just pointed out five ways to view controls. And you need to use all of them to figure out which controls you need. But doesn’t that seem a little discombobulated? How do you organize this?

The first step is to document the highest volume processes you have, and the result should be a good, clean set of flowcharts. Then adopt a layering approach, where you go over those flowcharts based on each of the perspectives I just talked about. So, for example, go over the entire system from the profit center viewpoint, and then go over it again and view it from the perspective of cost per occurrence. And so on. And after you’re done, then go back and look for overlaps.

Are you done yet? No. Have the auditors look at what you’ve developed, or hire a controls consultant. You don’t want them to design your system, only to review what you’ve done. If you have them design it, they always install too many controls, without really understanding your business. So you just want them to look for holes in the system.

All of that work covers your first pass at the control system, and it might start out as a good system. The trouble is that any system starts to degrade immediately, because the underlying processes change all the time. So you need to address two more items.

The first is to arrange to be notified when any business process is altered. This usually means staying in touch with the IT staff, since they do the programming changes, or it might mean staying in close touch with all of the department managers. Whatever the case may be, you need to know when the system changes, so that you can change the controls to match the system.

And the second item is creating an error reporting database. Whenever any screw up occurs, employees have to log them into the system. And then you keep reviewing the database to see what’s happening that might be fixable by tweaking the controls.

And that covers how to fine-tune your control system. But that’s only the mechanics of how to do it. There’s also a mindset issue to consider. If you treat the control system as an annoyance, then you may go through the steps I just described, but you’ll only grudgingly do it. That’s not the way to look at it. Controls really are important. While they may seem to interfere with a lot of short-term work, they can keep a company out of a lot of trouble, and they can save money, too.

So the proper controls mindset is to block out a good chunk of time to close your door, put your feet up on the desk, and think about controls – and do it every couple of months. Even if you don’t change anything, you’ll at least get in some good meditation time.

Related Courses

Accounting Information Systems

Accounting Controls Guidebook

Adding Value to Internal Audits (#134)

In this podcast episode, we discuss how to improve the results generated by internal audits. Key points made are noted below.

When you conduct internal audits, there’s going to be a report at the end, and that report contains findings and recommendations. How do you get the greatest implementation value from that report?

Selecting the Right Topic

Well, the first issue is making sure that you have the right topic that someone wants to implement. And this is the key issue in internal auditing – planning up front to do the right projects. Now, if you listen to the outside auditors, the only role of the internal audit staff is to monitor a “robust” system of internal controls. And of course, to help them conduct their annual audit.

But does that mean you’re adding value? Well, if the internal audit staff is doing work that reduces the workload of the outside auditors, and that reduces the fees of the outside auditors, then there you go – you’re adding value. But let’s get real here. First, the audit only happens once a year, or maybe there’s a quarterly review if the company is publicly held. So what does the internal audit staff do the rest of the time?

So let’s focus on that other part of the year when there’s no audit to support. And again, we’re talking about adding value. There are a few ways to do that. One is to take a bit of a different view of controls auditing. Rather than trying to create a “robust” system of controls, which I think means an “oppressive” system of controls, what about creating a “streamlined” system instead?

A Focus on Streamlined Controls

In this case, the trick is to not overload the company with too many controls. This is not easy, since you have to judge the risk of eliminating a control. But think of what that means to the concept of adding value. It means that the internal audit staff looks at the whole company not as a system of controls, but instead as a system of business processes that it should help make as streamlined as possible.

This doesn’t always mean eliminating controls. It could mean shifting them around or automating them so that they’re less intrusive. And think of how easy it is to implement a streamlining suggestion. Of course it will be installed. And that’s a way to add value.

The Internal Auditor Liaison

Another way to add value is to assign each internal auditor to be a liaison with a department manager. If you’re an internal auditor and you’re a liaison, that means you set up a meeting on regular basis to meet with that manager. Let’s say it’s once a quarter. And your job in that meeting is to listen to the manager and find out what kinds of problems there might be that the internal audit staff can help with.

By doing this, you reorient the concept of the internal audit function. Instead of turning up unexpectedly and rooting around for problems, you are asked to come in and help with a specific problem.

Now, there will be times when you do show up unexpectedly, especially if you’re investigating a report of fraud. But the rest of the time, with this approach, adding value is easy.

Addressing Risk

But it doesn’t mean that the internal audit department turns into some kind of public service function. There are some areas where there is risk, and you need to examine those areas from time to time. So this concept of adding value to internal audits – to some extent – becomes a scheduling issue.

You need to create a mix of reviewing high-risk areas, and doing fraud investigations, and so on with the work requests being funneled back through the liaisons.

The Internal Audit Feedback Loop

And the more work the internal audit does that’s being requested by the various department heads, the more it gains their confidence, and therefore the more requests they make, so you end up with this feedback loop that keeps increasing the types of projects that add value.

But again, you need to do the other types of work too. So this is where some marketing comes in. It might be useful to have an internal audit newsletter that goes out to the rest of the company. And in that newsletter, you talk about the ways in which the department has been helping the rest of the company, and talking about projects completed, and results achieved, and so on. This means that you’re making the company disproportionately aware of the department’s role in certain activities, while still fairly quietly working on other projects, too.

Follow-Up Audits

So far, I’ve been talking about adding value through the carrot approach – which is to make the rest of the company like you more. There is also the stick approach, where you tell senior management which departments have not been implementing your recommendations, and ask to have the offending people thumped on the head. If you follow this path, then there need to be follow-up audits to see if the initial recommendations were implemented.

The stick approach is not popular, but it is still needed. There will be times when you make an unpopular recommendation, probably to mitigate a risk, and it causes extra work. So of course no one wants to implement it. Still, it has to be done, and knowing that the auditors will come back later to check on the situation is important.

So, does this carrot approach of streamlining controls and helping departments essentially turn the internal auditing department into an internal consulting department? To an extent, yes. But it’s just a matter of emphasis. The overall mission of the department remains the same, but it’s easier to add value to the work it does. And keep in mind that you need to mix in the stick approach too, to make sure that the tougher recommendations are also implemented.

Related Courses

Internal Auditing Guidebook

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.

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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

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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.

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