When to Write a Procedure (#161)

In this podcast episode, we discuss when to write an accounting procedure and when to avoid doing so. Key points made are noted below.

Characteristics and Usage of Procedures

The core issue is, do you write a detailed how-to-do-it procedure for every conceivable activity in the department? On the plus side, this is a really good training tool if you have a lot of inexperienced new hires, and they just don’t know how processes work. It’s also good from a controls perspective, because auditors like to see that there’s a written procedure in place, and that you’re following what the procedure says. It also tends to improve the consistency of processes.

Those are the good points. Then we have a lot of downsides. Systems are constantly changing, so you have to spend time updating whatever’s been documented, as part of the process of changing the systems.

Also, if you decide to write a massive number of procedures, that’s going to take a lot of time by either senior staff or consultants. Either way, there’s a fairly large cost associated with it. And on top of that, updating the procedures is expensive.

The next problem is issuing updates. If you have lots of people who use the procedures, and especially if they’re in multiple locations, you may have to send out either complete replacements for the procedures manual, or a lot of minor updates to three-ring binders. In the latter case, the recipients have to keep swapping out the old pages and putting in the new pages. So the updating process requires a lot of time by the people using the procedures.

Next issue. Just sending out an update to a procedure isn’t enough, since you can’t really expect people to figure out the exact nature of the change. Instead, there needs to be training that goes along with the written procedure. Again, we’re racking up a lot of cost and staff time.

But we’re not done yet with procedure problems. The next issue is rigidity. If every last conceivable process step has a written procedure for it, then bureaucracy sets in. This means there’s a specific, approved way to do everything. By default, that means every other way is not allowed.

The end result tends to be way too much reliance on a massive procedures manual, where the response to every question is – I don’t know, let me go look that up. And by the way, the largest complete set of corporate procedures I’ve ever seen was three feet thick.

And speaking of bureaucracy, a massive set of procedures also calls for a full-time staff to support it. Which does not strike me as being a very good idea from a cost perspective.

And one more issue with bureaucracy is that the use of best practices pretty much disappears. Instead of thinking of better ways to conduct a process, a written procedure just locks it in where it is right now. And that means the efficiency of the department stops improving.

When to Create Procedures

By now, you may have figured out that I’m not exactly advocating having a lot of procedures. Instead, you need to figure out that fine line between too many procedures and too few. So here are a few guidelines to consider.

First, is a process highly repetitive? If so, you need a procedure, because every transaction should be completed in exactly the same manner, and a procedure can control that. Otherwise, there’ll be just enough variation that the auditors will call you out on having processes that aren’t being followed consistently.

Second, is there a significant risk of loss? For example, something like a wire transfer. Even if the volume is low, a single screw up could cost a lot of money. In this case, write a procedure. And again, this is exactly the place where an auditor is going to look for a procedure, and they’ll expect the procedure to be followed perfectly, every time.

Third, what’s the nature of the business? If you have a highly repeatable business, like a retail store, then most processes should be handled in the same way in all locations. This is one of those cases where having a fairly large procedures manual is expected.

And fourth, is the process really complex, with many steps? If so, even an experienced person could screw it up, so it makes sense to have them walk through every step, every time, just to make sure that they get it right.

And that pretty much covers the cases where you need procedures. In all other cases, I suggest that you do not have formal, written procedures. And by avoiding procedures, you’re also giving the staff a certain amount of leeway, which may result in some imaginative thinking about how to do things better.

So in summary, in most cases, you should have a relatively small procedures manual that only covers the most high-volume, risky, or complex processes. This allows you to easily swap out the manual when there’s a procedural change, with minimal staff time and not much expense. And it also means that you avoid getting bogged down in those dozens or hundreds of minor processes that really don’t impact the department or the company all that much.

Related Courses

Accounting Controls Guidebook

Accounting Procedures Guidebook

The Soft Close (#160)

In this podcast episode, we discuss the nature of the soft close and how to do it. Key points made are noted below.

Characteristics and Usage of the Soft Close

The soft close means that you close the books at the end of each reporting period, but not with all of the usual closing steps. You might even skip nearly all of the closing steps, and just go ahead and print the financial statements. Now, obviously, if you skip a bunch of closing steps, you’ll save loads of time, but the financials will also be less accurate. The question you need to ask yourself is, under what circumstances does it not matter that the financial statements are a little off? Let’s work through this.

First of all, we’ll assume that your company gets its financials audited at the end of each year, so those year-end financials will require a complete closing process. OK, that still leaves 11 months of financials for which you could use a soft close.

Next, a publicly held company gets its financials reviewed at the end of each quarter. So for these companies, you still could use a soft close for eight months out of the year. Well, that’s not bad. You could save a bunch of time on your closing process two-thirds of the time. And that’s the worst case.

Now, how much time can we save with a soft close? There’s no hard and fast number. Instead, think of this as a continuum, where you could have no closing steps whatsoever, but a high risk of inaccuracy at one end, and at the other end, you have lots of closing steps and a low risk of inaccuracy.

You need to decide how much risk you want to have in the financials. This isn’t a qualitative judgment, where you just make a wild guess as to how many closing steps you can avoid. Instead, take a look at the size of the adjusting entries that you’ve made as part of the closing process for the past couple of years. Chances are, only a couple of them are really large. Everything else is so puny that you could either skip them entirely, or just copy the same entry for multiple months.

Soft Close Techniques

Let’s go through some examples, so you can see how this works. First, how about depreciation. It changes a little from month to month, but not much.

What you could do is load a standard depreciation entry into the accounting software, and set it to run automatically for the next six months. At the middle of the year, it’ll probably be off a bit, so check the underlying depreciation calculations, and set a revised entry to run through to the end of the year. Then adjust the year-to-date figure to actuals, so the full-year results will be accurate.

Here’s another example. The allowance for bad debts. You could go through all sorts of analysis to guesstimate what the allowance should be on a month-to-month basis, but let’s face it. This is a reserve account. That means you can never get it exactly right. So don’t try – or at least, don’t try every month. Instead, record a reasonable bad debt expense each month, to load up the reserve account, and then let it run for a while.

However, this doesn’t work if you have a small number of large invoices outstanding, because if even one of those is a bad debt, your allowance could be way off. So it depends on the circumstances. If there’re lots of small invoices, adjusting the allowance at long intervals is probably fine.

Here’s another possibility. What about the wage accrual? If the company has mostly salaried employees, who cares about the accrual? It’s just not for that much money. On the other hand, if practically everyone is paid on an hourly basis, you could seriously screw up the financials by not including the accrual. It just depends on the circumstances.

Let’s keep going. What about commission accruals? A lot of controllers go through this incredibly painful process of calculating the exact commission owed to every salesperson before they close the books. Why bother? If the overall commission percentage doesn’t change much, then just accrue the overall percentage of sales as commission expense, and get on with life.

And here’s a favorite for controllers – what about overhead allocations? In most companies, the amount produced in each month doesn’t vary much, and the overhead cost pool doesn’t vary much. So why allocate overhead at all? You could skip what is sometimes an amazingly convoluted exercise, and just wait until the auditors show up at year end, and then do it once.

And here’s one you may struggle with. What about account reconciliations?

Any reasonably cautious controller wants to know what’s in every single balance sheet account, because it’s possible that some of those balances should be charged to expense. Well, you don’t have to reconcile all of them. Instead, look through the accounts, and decide which ones are so small that even if they’re completely wrong, will correcting them really impact the financials all that much? Chances are, you’ll only have a couple of accounts left that really require a reconciliation. The others can all be checked at much longer intervals.

Now, I’ve just pointed out that you can drop or at least scale back a bunch of closing activities that some controllers would consider religiously important. I only consider one closing activity to be absolutely mandatory. And that activity is to print a preliminary version of the financials, and scan it for anomalies. There’re bound to be a few, and those will require an investigation – though only if they’re large enough. A small variance isn’t going to bother anyone, so don’t worry about it. Chances are, the small stuff will probably self-correct in the next month’s financial statements.

Now, all of this may sound like an awfully laid-back way to deal with what is, realistically, the most important product of the accounting department. True enough. But it can also save a bunch of staff time. You need to make the decision to adopt a soft close or not. And if you do, then keep in mind that you still need to conduct a full and very detailed close – just at longer intervals. By doing so, any minor problems can be found and corrected before they become so large that they’re causing major errors in the financials.

So in short, the soft close can be a major labor saver – but you need to figure out for yourself just how much of a soft close you can tolerate. It might be the elimination of just a few closing steps, or you could strip away most of the closing process, in exchange for a bit more variability in the results that you report. It’s you call.

Related Courses

Closing the Books

The Soft Close

The Year-End Close

The Liquidation Basis of Accounting (#159)

In this podcast episode, we discuss the details of the new liquidation basis of accounting. Key points made are noted below.

When the Liquidation Basis is Used

Liquidation basis accounting is basically about preparing your financial statements in a different way if the business is about to be liquidated. The official term is, “when liquidation is imminent.” You can consider “imminent” to mean when it’s unlikely that the business won’t be liquidated, or that liquidation is being imposed on the company – such as through an involuntary bankruptcy. And by the way, liquidation means the business is shutting down and paying off its creditors. Liquidation does not mean when a business is being acquired. Otherwise, a lot more companies would be using this.

Presentations Under the Liquidation Basis

Hopefully, you’re not in an imminent liquidation situation. But if you are, the basic rule of presentation is to include in the financials the amount of expected cash proceeds from the liquidation, and the expected expenditures needed to settle all remaining liabilities. This means the accounting is different from what you’d normally see in a couple of areas.

First, you can recognize any assets that had not previously been recognized, but which you expect to either sell in liquidation, or use to pay off liabilities. And that means you can recognize internally generated intangible assets – which would not normally be the case. The main point is that you can only recognize these items if they’re actually worth something in liquidation. And only when you’ve also accrued expected disposal costs for the assets.

Another point. In liquidation accounting, you’re measuring assets at the estimated amount that you can sell them for – which may or may not be their fair market value. If the liquidation is a bit of a rush, this could mean that the estimated selling price is less than fair market value.

Also, and this is no surprise – you’re supposed to accrue every expense that you expect to incur as part of the liquidation – such as legal fees. What is surprising is that you’re allowed to accrue the income you expect to earn during the liquidation period.

For example, let’s say there’s a plan to completely shut down a plumbing business in one month. You should estimate the amount of income expected from the remaining customer orders, and accrue that income right now. And yes, this means the business is recognizing income before it’s earned the income. This goes against GAAP in a big way, but then liquidation accounting no longer assumes that the business is a going concern. Instead, the main focus of attention is – as the name implies – to see what the company is worth in its liquidated state.

Now these rules changes don’t mean there’s a complete accounting free-for-all, where you can completely recast the balance sheet. In particular, you’re not allowed to anticipate being released from a liability until the release actually happens.

Another point is that you don’t discount disposal costs to their present value, and there’s no discounting of any accrued income. And that’s because there’s really no point. If the entire business is about to be liquidated, it won’t be around for very long, so the amount of any discount should be immaterial.

So, what if the company doesn’t liquidate just yet, and in fact drags along for a few reporting periods? Well, in each period, you’re supposed to remeasure the assets and liabilities and adjust them in the accounting records to their liquidation values as necessary.

And of course, you have to disclose all of this – the plan for liquidation, measurement assumptions, when liquidation should be completed, and details about the income and costs that you’ve accrued.

Additional Statements to Present

There’re also a couple of new statements to present. There’s the statement of net assets in liquidation, which shows the net assets available for distribution at the end of the period. There’s also the statement of changes in net assets in liquidation, which is just what the name implies – it shows only the changes in net assets during the reporting period.

Parting Thoughts

And finally, the liquidation basis has had a few references in the accounting literature in the past, but this is the first it’s been directly addressed. And it’s only been referred to in passing in the international standards. My guess is that this is not the last we’ve heard of the concept, and that more will appear in the international standards, too.

Related Courses

Essentials of Corporate Bankruptcy

GAAP Guidebook

Intercompany Accounting (#158)

In this podcast episode, we discuss the mechanics of intercompany accounting. Key points made are noted below.

• Intercompany accounting is a subset of consolidation accounting.

• It involves the accounting for transactions between entities that are owned by the same parent, usually with a payment arrangement.

• An intercompany account is used to identify these transactions.

• There must be intercompany entries on the books of the companies on both sides of a transaction, which is easier to enforce when they use the same software.

• The managers of assets received from another company tend to argue for lower asset values, to minimize subsequent depreciation and write-offs.

• Both entities need to agree in advance on what to record for the intercompany entry.

• Regulators could challenge outstanding receivables as capital contributions, if they are not settled.

Related Courses

Business Combinations and Consolidations

The Senior Accountant (#157)

In this podcast episode, we discuss why the senior accountant title should not be used, and how to replace it. Key points made are:

When you’re in public accounting, it’s pretty universally accepted that an introductory auditor position works on things like confirmations and bank reconciliations, and then you move up to inventory and equity accounting as a senior-level auditor. So if you switch to another auditing firm, they can tell from your title what you’ve been doing.

How to Become a Senior Accountant

That’s not true in the private sector, where there’re three different ways to become a senior accountant. One approach is just seniority based. If you’ve been with a company long enough, you get the senior accountant label. Or, if you’re supervising people, you’re considered to have that title. Or, if you’re a real specialist in a certain area, then you receive the same tag. So you could be classified as a senior accountant if you’ve been with the company for maybe 10 years, or if you supervise the collections team, or if you’re the designated general ledger accountant.

Problems with the Senior Accountant Title

I don’t like these reasons. Any of these reasons. In fact, the basic problem with the senior accountant title is that it can mean so many things that it’s essentially meaningless. And therefore, you shouldn’t use it. Here are my reasons.

First, if someone simply has a lot of seniority but not enough skill, this is really a pay grade adjustment, not a title change. There’s no reason to ever alter someone’s title if the underlying skill or training level hasn’t changed.

Next, if someone supervises staff, then say so. They might be an accounts payable supervisor, or a collections supervisor. If so, call them a supervisor, not a senior accountant. If you call someone a senior accountant who’s really a supervisor, you’re doing them a disservice, because they have to explain on their resumes how that title translates into what may be quite valuable supervisory experience.

And then there’s the specialist. If someone is a specialist in inventory, then call them the inventory accountant. Or if they do nothing but general ledger work, then call them the general ledger accountant. It’s specific, so there’s no question about what a person with a more specific title is supposed to do.

So what if you have employees who all have the senior accountant title, but who individually received the title for a different reason. One of them has been with the company a long time, another one is a supervisor, and another one is a payroll specialist. Well, there’s no way to compare the positions. So for comparative purposes, the title is useless.

So when can you call someone a senior accountant? There’re two circumstances. One is when you add it onto a more specialized title. So someone with a lot of inventory experience could legitimately be called a senior inventory accountant. It reflects a superior level of knowledge.

The other situation is in a small department where you have several accountants on staff who are multi-purpose – each one may be involved in any number of activities. In this case, you could use the senior title to differentiate the most experienced of this group, without going so far as to designate them as a supervisor or an assistant controller. Realistically, this should be called a general accountant, senior grade.

But I can’t think of any circumstances at all when you’d just call someone a senior accountant. It’s too vague and tells you nothing about the position. So, the recommendation is to abolish the title. Instead, if someone is a really good specialist, add “senior” to the front of their title. If they supervise, then say so. And just having lots of years on the job doesn’t qualify someone for any special title at all.

Related Courses

Accountants’ Guidebook

Changes in CPE (#156)

In this podcast episode, we discuss changes to the continuing professional education rules, and how they will impact the CPE industry. Key points are noted below.

CPE Requirements for CPAs

If you’re a certified public accountant, then you need to earn at least 40 hours of CPE per year. If you’re not a CPA and don’t plan to become one, then you can tune out this episode right now. But if you are a CPA or want to become one, this discussion contains some information that you likely did not know about.

But first, some actual advertising. We’re now offering on-line CPE courses. So if you go to accountingtools.com/cpe, there’s dozens of CPE courses listed, which you can take on-line, and at your own pace. And that includes taking an on-line test and receiving a completion certificate by e-mail. So if you need CPE, go to accountingtools.com. There’s also a link to the CPE at the top of every page on the site.

The Governing Body

Now, getting back to the topic. The governing body that sets the standards for CPE is NASBA, which stands for the National Association of State Boards of Accountancy. NASBA has changed some of the rules regarding CPE recently, and this is going to cause a ripple effect through both the CPE industry and the publishing industry.

What I’m going to talk about isn’t something that you’ll see anywhere else, because I may be in the best position to see the impact of what NASBA has done. I deal with the CPE distributors, and the course developers, and NASBA, and one of the big publishing houses, so I have a pretty broad view.

The first change is that NASBA no longer allows a book to be the basis for a course. In the past, a CPE distributor bought accounting books in bulk from the major accounting publishers, and hired local CPAs to develop course materials for the books, like course objectives, and question and answer segments at the end of each chapter, and of course the final exam.

Ramifications of NASBA Rule Changes

But because NASBA wants a course to look like a course, and not like a book that’s been adapted into a course, you can’t take that type of course any more. This has way more ramifications than you might think. First, some of the distributors are still issuing courses in book form, which is now illegal.

If you buy a course and they send you a book with some extra course materials attached, you need to buy your CPE somewhere else.

Second, the CPE distributors who were offering books as courses just had their business models destroyed, so they’re scrambling to find new content that’s structured as an actual course. If they don’t succeed, they’ll probably go out of business, so expect some consolidation in the industry.

And third, the CPE distributors are no longer buying books from the publishing houses. Since I see book royalty statements from both the publishing side of the industry and the CPE distribution side, I estimate that roughly a third all accounting book sales for books that are also sold as courses have now disappeared.

This means that the publishing houses now have a drop in sales that they never expected. And because sales have dropped so low, they’re now activating a clause in their contracts with authors, where they switch to print on demand, rather than printing in large batches of books. This has a major implication for the authors of accounting books, because the royalty for print on demand books is only 5%, versus 15% for books printed in batches. So the accounting book authors are having their royalties cut by two thirds, in those cases where book sales are low. I’m now seeing the 5% rate take effect in as little as two years after the publication date. And that drives authors out of the book writing business.

This means that you’ll still see authors writing one or two accounting books, but then they’ll stop writing, once they understand how low their royalties will be. And overall, this means there’ll be fewer accounting books being published.

Also, because book sales go down, there’ll be very few second editions of any books coming out. At this point, I would expect only very established books with a long history to still go into multiple editions.

Changes to the CPE Standards

Now, let’s go back to those NASBA changes. They’ve also ratcheted up the standards for what has to go into a CPE course. This involves some very specific use of course objectives that have to be reflected in the final examination, and a table of contents, and an index, and a glossary. These aren’t massive changes, but they require more work by someone who’s developing a course.

So if a course developer had been planning to make money by publishing a book and issuing a course, now the book publishing avenue doesn’t look very profitable, and it takes more time to create the course. The end result is probably going to be fewer people wanting to create courses, because the profit just isn’t there.

On the other hand, there won’t be any real impact on existing courses, since it’s not that difficult to retrofit a course to the new standards. So you’ll still see the old courses, just not as many new courses.

And here’s another NASBA change. When a course was developed, a CPE distributor used to put it into what they called pilot mode and made it available for free to their customers for a short period of time. The customers were supposed to take the course and render an opinion on how many CPE hours should be assigned to the course. Once the distributor had this information, it stopped the pilot phase and started selling the course based on the number of hours recommended by the testers.

This meant that some CPAs were getting their CPE for free. NASBA has now created a word count formula that CPE distributors can apply to a course, and they can determine the number of CPE hours from this formula. That means they don’t need the pilot mode anymore, so there’s no longer a need to offer free courses. I’ve noticed that a few of the CPE distributors still offer course pilots on their websites, but you should expect this to go away fairly soon.

And in case you’re wondering how many people were taking pilot courses for free, it was a decent number. Usually about 20 people pounce on these courses when they’re in pilot mode, and that’s at each of the distributors.

Competitive Pressures

And another issue that I alluded to earlier is that the number of CPE distributors will probably decline. At first glance, it appears fairly easy to get into the CPE market, but there’re several barriers to entry. First, NASBA is amazing slow at certifying anyone to offer courses. Also, if a distributor wants to offer courses, the annual NASBA fee is pretty high, and you also have to maintain an infrastructure for taking on-line courses. And, if you’re issuing course catalogues, there’s the cost to buy CPA mailing lists, and printing and mailing the catalogues.

So it isn’t that easy for a new course distributor to turn a profit. This means I’d expect some churn at the low end of the market, as people try to get established as distributors, and then fail.

And also, there’s some pretty serious price discounting by some of the CPE distributors, to the extent that the better course writers refuse to do business with them. And that means course writers are starting to refuse to distribute their courses with anyone but the established companies. And that means a new player can’t even attract any content to offer to CPAs.

So, in short, expect fewer CPE courses in the future, and fewer accounting books, and not so many CPE distributors. It’s not a pretty picture, but that appears to be the direction in which we’re headed. And the reason for these changes was essentially an interest in tightening the standards so that higher-quality courses would be issued. The result may not be quite what was intended.

Reporting of Other Comprehensive Income Reclassifications (#155)

In this podcast episode, we discuss the new accounting standard for disclosing the effects of a reclassification of other comprehensive income. Key points made are noted below.

Rules Change for Other Comprehensive Income

This episode is about a new accounting standards update that’s called “reporting of amounts reclassified out of accumulated other comprehensive income.” The update number is 2013-02. This is a minor update, but since a lot of organizations report other comprehensive income, I thought it might be useful to bring up the change.

The rules change basically says that, if GAAP requires an entire amount to be shifted from other comprehensive income to net income, you have to report the effect of the reclassification on the line items into which the amounts have been shifted. Also, in cases where the amount reclassified does not go directly into net income, you now have to cross-reference other GAAP disclosures that describe these changes. So, for example, if a reclassification goes into the balance sheet, you’d have to cross-reference the disclosure. The reason for requiring this information is so that someone reading the financial statements of a business fully understands the effect on the statements of these reclassifications.

All of this information was already required to be disclosed, but it was scattered around in the financial statements. Now, the information is assembled into one place.

Also, the disclosures are required for all financial statements issued by a publicly held company, and for the annual financial statements of privately held companies.

That was the overview. Here are a few more detailed points.

You have to present the information separately for each component of other comprehensive income. Also, you can present the information on either a before-tax or an after-tax basis. And also, you can present the information either on the income statement, or as a separate disclosure in the notes to the financial statements.

If you choose to present the information on the income statement, it’s presented in parentheses next to each line item that’s affected. This also has to include the aggregate tax effect of the reclassifications on the income tax line item.

An example of this type of presentation would be a parenthetical disclosure next to an expense line item that says, “Includes $10,000 of accumulated other comprehensive income reclassifications for net losses on cash flow hedges.” That’s a pretty bulky form of presentation that can clutter up the income statement, so I’d suggest not using it, unless you’re only including this type of information for just one or two line items.

If you choose to present the information in the notes to the financial statements, then present it for each component of other comprehensive income, along with subtotals for each component. In terms of readability, I think you’d do better by disclosing this information in the notes.

So for example, the header for the footnote disclosure might be called “Reclassifications out of Accumulated Other Comprehensive Income.” The first column in the table might have a subheading for gains and losses on cash flow hedges, with individual line items for things like interest rate contracts and credit derivatives. And then you could have additional subheadings for things like unrealized gains and losses on available-for-sale securities, or maybe a separate classification for insignificant items.

Then the second column contains the numbers for each of these line items, and a third column lists which line items in the income statement are affected.

And that covers the new accounting standards update. Overall, I don’t think they should assemble this information in the income statement, since it really will clutter up the presentation. Aggregating everything into a footnote disclosure could put some useful information in one place, and the tabular format is a good way to present it - but this is not what I’d call critical information for the users of financial statements.

Related Courses

GAAP Guidebook

The Income Statement

Managing in Financial Adversity, Part 4 (#154)

In this podcast episode, we discuss the things not to do when a business is confronted with a period of financial adversity. Key points made are noted below.

How Not to Deal with a Bad Financial Situation

In the first three episodes, I talked about how to correctly handle situations where a company’s financial situation declines. And that leaves room for one more episode about how not to deal with a bad financial situation. What I’m going to describe this time, you’ve probably seen or will see at some point in your career. I know I have.

Doing More With Less

The first way to not deal with bad finances is the concept of doing more with less. Also known as firing a bunch of people and spreading the load among the remaining lucky few. From the viewpoint of management, the remaining few are lucky, because they still have jobs. But because management didn’t redesign the business to pare away parts of the company, the work load can be enormous. And that leads to some bad effects.

First, there’s no longer any corporate culture. Because the work day is longer and the work load is larger, there’s no time for employees to mingle. And there’s no time for company-sponsored events. In short, all of those subtle reasons that make a work place enjoyable go away, which increases employee turnover.

Second, there’s employee burnout. Work days get longer, and weekends become work days. After a while, people start making mistakes because they’re always rushed. Efficiency improvements disappear, because no one has time to think about installing best practices anymore. And, employees are more likely to become sick, but they need their jobs, so they come to work anyways. For all of these reasons, productivity declines.

But we’re not done yet. Some of the extra work is being dumped on people who don’t know how to do the work, because the people who used to specialize in that work have been let go. And there’s no time or money to conduct training in the extra work. This means productivity goes down and error rates go up. And, because the remaining employees know they’re not doing a good job on these new tasks, their morale goes down.

Eventually, the best employees will find work elsewhere or shift into different careers.

That means the “A” level employees are gone, which leaves the B and C grade employees behind to run the business. And that means the productivity level declines even further.

So. The end result of just laying people off and spreading work among the remaining staff is burnout and lack of initiative, which leads to bad morale, reduced productivity, and losing your best employees. And yet, this is what managers do all the time. They call a staff meeting and look sorrowful, and declare that everyone has to pitch in together to pull through the crisis.

If the only thing a manager can do is a great sorrowful imitation, then they’re going to get what they deserve, which is a failed company. As I’ve been saying in the first three episodes of this series, a smart manager should very carefully reconfigure a company so that it can operate normally at a reduced level of expenditure. And that does not mean laying lots of extra hours on the remaining staff.

The Impact of Fairness in Cutbacks

Another scenario is when management decides to be “fair” to all parts of the company in a financial downturn, and decides to require the same percentage of expense cutbacks all over the company. This is another mistake, for a couple of reasons.

First, some department managers are better than others at controlling their expenses, so a tightly-run department could be devastated by a mandatory expense reduction. Meanwhile, someone who’s been very loose in managing another department may find that it’s quite simple to accommodate a cutback, since there’s so much excess spending already going on in the department.

And, a side effect of this situation is that managers learn to maintain a buffer of excess expenditures that they can unload during the lean times. And that means the company is maintaining too high a rate of expenditure all the time.

Second, some parts of a business are more important than others. Do you really want to impose a mandatory, across-the-board cutback on areas like R&D, or sales? If they’re driving revenue growth, that could be a really bad idea.

And we have one final scenario, where you think that the financial downturn will be a relatively short one. In this case, what may appear to be a prudent and humanitarian decision is to spread the pain around the entire organization, and impose a temporary pay cut on everyone.

This approach may actually work if there’s a reasonable expectation that the situation will improve soon. In that case, paring back wages allows you to retain talent, and it can build trust with employees. The problem is that it doesn’t work very well if management is simply hoping and praying that sales will improve. There may be no basis for such a belief – the industry may not be cyclical, so sales probably won’t come back. In this case, cutting back on wages has a couple of negative effects.

First, it means the sole method by which management is dealing with the crisis is by cutting wages. That isn’t exactly proactive. From a competitive perspective, it’s not good, because the management of a competitor may be reacting differently. They may be restructuring their business model, so they can really pound away at their competition – which, of course, will make matters even worse for the first company, which simply imposed a pay cut.

And the second negative effect is that no one knows how long the pay cuts will be in effect. So, if sales don’t increase, and time goes by, then look for the A level employees to leave the company. And maybe to go work that more proactive competitor that I just talked about.

So imposing an across-the-board pay cut is not always a good idea. If you’re going to impose one on an organization, then at least set up a mandatory review date that’s not too far in the future – like a month off. When that date arrives, make a realistic assessment of the situation, and decide whether to prolong the pay cuts to another review date, or to take more decisive action.

My main point in all of these discussions about dealing with financial adversity is that it takes quite a bit of analysis to understand exactly where costs can be reduced. In most cases, a broad reduction in expenditures is not warranted, and it may damage the company.

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Managing in Financial Adversity, Part 3 (#153)

In this podcast episode, we discuss how to manage through a drop in profits when a company has many products and subsidiaries. Key points made are noted below.

I had talked about three ways in which a company can get into financial trouble. Episode 150 covered how to retrench when you haven’t been paying attention to controlling expenses. Episode 151 covered how to manage a situation where you’re trying to shift from one failing business model to an entirely new model.

Managing Through a Complex Scenario

And that leaves us with one more scenario, which is what to do if the company is in financial difficulties right now, and the business has lots of products, or product lines, or subsidiaries. Basically a tangled mess. The goal is to sort through the mess and figure out what can be pared back right now in order to keep the company out of bankruptcy.

This is a case where you really can save a business with cost accounting, because the main point is to use direct costing to figure out the incremental cost of – well – just about everything. Direct costing is when you only assign variable costs to cost objects. A cost object is anything for which you want to separately measure the cost. Since I don’t want to sound too theoretical here, let’s do some examples.

The first example. A business has fallen on hard times, and it produces an enormous number of products. Management might ask, how about if we save money by cutting back on some of these products? Each of the products is a cost object. What we want to learn about is what specific costs will go away if we cancel some products. We use direct costing and figure out that nothing but the direct material costs will go away if we cancel products. So, unless the products are selling at below the cost of their direct materials, which is not likely, then it doesn’t make much sense to cancel any of them. I talked about this back in Episode 92.

This doesn’t mean that you can’t cut costs in the area of products. But rather than cancelling products, use direct costing to figure out the margin you’re actually earning on each unit sold of each product, and then emphasize selling the ones with the highest margins. The low margin stuff only gets produced last, if there’s some remaining production capacity available for it.

Here’s another one. Move the whole concept up a notch, to a product line. They’re all produced out of a single manufacturing facility, where the same set of production equipment makes a dozen different models. In this case, the logical cost object is the entire facility and everything produced in it. So, you’d use direct costing to figure out the incremental cost of this entire bundle, which means the product costs, the facility, and any associated materials management staff, and salespeople, and management, and so forth. If the entire bundle loses money, kill it.

Cost Object Analysis

Now let’s talk about some other cost objects besides products. What if you’re running a retail chain? The cost object appears to be at the store level, so you use direct costing to figure out if there’s actually a savings associated with shutting down a store. There may not be, and in fact, every time you shut down a store, the overhead cost of the distribution warehouse for that region is now spread over fewer stores. So the real cost object may be an entire cluster of stores, including the warehouse. And, for that matter, the regional store manager and any related administrative staff. This means you analyze the situation based on which costs go away if the entire region is shut down.

Let’s shift to sales channels. I’m talking about selling through distributors, versus retail stores, or a web site, and so on. Each one can be considered a cost object. So. Accumulate incremental costs for each sales channel, and see what you find. For example, you might find that the company is spending a mint developing a web store, and isn’t making much money from it. If so, an option is to cancel the website, and the marketing budget for it, and the programmers, and so forth.

And one more cost object. What about customers? This can be a tough one to analyze, because the staff always bitches about certain customers who seem to chew up an inordinate amount of staff time. They’re probably right. But the question is, if you refuse to do business with a customer, what costs really go away? Will you really eliminate staff positions? Unless it’s a really large customer, the answer is – probably not.

Now all of this discussion of cost objects comes down to, which ones do you chop, and which ones do you keep? There’s really no waffling around on this. It’s a binary solution. You save the most money if you completely eliminate a cost object. If you try to keep it, but at a lower expenditure level in order to keep your options open, then you don’t save as much money. In short, you need to be decisive about completely cutting out entire cost objects and all of the costs associated with them.

Now this may sound like I’m advocating attacking the business with a battle axe. That’s basically correct. But. If you do it properly, chunks of the business are taken away that were holding back the rest of the company. That means a proper expense reduction might not even touch the most profitable parts of the business. In fact, you could reallocate funds from the areas being eliminated and use them to increase spending in the most profitable areas.

The sad part about all of this is that a business with a cluttered mess of products, and subsidiaries, and so forth should be conducting this analysis even in the good times. Management should always know where the business makes and loses money. It should not be a last-minute rush to find out these things only when the bank account is running dry.

So the main takeaways from this episode are to review costs at the cost object level, and take out entire cost objects to save money.

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Changes to Other Comprehensive Income (#152)

In this podcast episode, we discuss changes to the reporting requirements for other comprehensive income. Key points made are:

• The method of presentation of other comprehensive income has been changed because of the increased level of complexity of the information being reported.

• There used to be three options for reporting other comprehensive income, which were stating it at the bottom of the income statement, or in a separate statement, or in the statement of shareholders’ equity.

• The last option is no longer available; it is considered better to associated other comprehensive income with the income statement, and not hide it in equity.

• Evidence shows that presenting other comprehensive income in equity appears to have been more useful to investors.

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Managing in Financial Adversity, Part 2 (#151)

In this podcast episode, we talk about how to save a company while switching away from a failing business strategy. Key points made are noted below.

Shifting to a New Business Model

In the last episode, we talked about dealing with a bloated cost structure. In this episode, we’ll talk about a situation where you know that the original business model is failing, so you’re trying to save the company by shifting to a new business model.

This means that profits are falling, or maybe they’re long gone, and you’re just trying to hang in there until profits from a new revenue source begin to appear. This is a really common scenario, and it results in bankruptcy a lot of the time. Chances are, management already knows the company is in serious trouble, and is doing everything it can to cut expenses and keep the company running long enough for the new revenues to kick in.

The real question is, will the new profits appear in time, and can you afford to wait that long? If not, you need to shut down the company right now, before it burns through any more cash. Otherwise, you’re just throwing away the cash that should go to creditors or investors.

This may not sound like very optimistic advice, but let’s face the facts. Businesses shut down all the time, because they do not have sustainable business models. They can either keep going until the last minute and have a messy collapse, or they can shut down early and in a more orderly manner.

Which Information to Collect

So how do you make the decision to keep going or to shut down? The central issue here is to collect the right information for making the decision.

First, you need the cash burn rate, to see when the company runs out of money. This calls for a detailed cash forecast, not just an average rate of cash usage, so that you know exactly how much time is left. This establishes the time period over which you have to decide what to do.

The next step is to collect information about the new business model that you’re trying to implement. Chances are, there’re very few hard facts available, so the way to approach this is to focus on the key data items that indicate success or failure.

For example, if you’re trying to relaunch a business as a website that sells Google advertising, the main information items to track are the trend line for page views and the ad revenue per page view. With those two items, you can estimate future revenues.

Or, what if you’ve decided to open a retail location, rather than using distributors? Then the questions revolve around sales per store location and the cost to operate each store.

These are open questions, and if the company stays in business long enough, you’ll eventually get the hard data you need to make a decision. The trouble is that the hard data may not arrive for a long time. So how to make decisions without the hard data in the short term?

What you do is build a table that itemizes all of the information you need, along with where the information needs to come from, and especially any substitute sources of information. The substitute information is key, because it may be all you have in the short term.

For example, you’ve launched the web site that’s supposed to survive on Google ad revenues. After a month, the Google ad reports tell you what the ad revenue per page is, so you can run a breakeven calculation to figure out how many page views it will take for the company to stop losing money. Then compare this figure to your competitors to see if anyone is generating that many page views right now. If no one is, then your obvious decision is to shut down the company, because the model doesn’t work.

If it appears that the model will work, then your next question is how long it will take to generate the required amount of page views. You can estimate this by seeing how long it took competitors to reach the required number of page views. This is good substitute information, and you can augment it with your own data as time goes by.

I’m going to keep beating on this concept of substitute information. This means that you use information generated by a similar business in a similar situation as though it were the results of your own business. Adjust this substitute information to most closely match your own estimated results, and then use the adjusted information to make decisions until your own business generates its own information.

Now let’s look at the other example, for a retail store. The main issue is sales per store location. Initially, you have no idea about what this will be. But, you can estimate it by looking at similar stores operated by competitors. You’ll have to adjust this substitute information for factors like differences in marketing, and customer service, square footage, merchandising, and so on.

Over time, you’ll start to pick up your own data from actual store operations, and you can then swap out the substitute information and use this in-house data instead.

If the business can survive for a year or so, chances are that you can swap out all of the substitute information with in-house information, which is way more reliable. The trick is surviving that long.

So, if you listened to the last episode, about cutting back on costs, you can see that this scenario calls for a completely different response. In the last episode, I recommended a historical cost analysis to figure out which expenses to reduce. In this case, the main issue is uncertain information, so the recommendation is to be very precise about the information you need to make decisions, and then carefully specifying the types of substitute information that you can access to make the decision. And the decision is to either attempt to continue the business or to shut it down now.

Additional Concerns

A couple of warnings about these concepts. First, business owners are very optimistic people, and they’re also deeply attached to their companies. And that means they usually believe in only the most optimistic projections. You can get around this by maintaining both optimistic and conservative forecast information, and giving each one equal presentation time with the owners.

The second issue relates to substitute information. You’re almost certainly going to have to use it. Be aware that it does not perfectly relate to your business, and so it’s somewhat unreliable. Therefore, when you’re using substitute information, write down the reasons why the company’s own results may differ. For example, there may be differences in target markets, price points, product quality, and so on that create different results for a competitor than what your business will experience. These can result in major differences between substitute information and your own results.

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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.

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