How to be a Great New Employee (#221)

In this podcast episode, we discuss the types of things a person should do to be successful as a new employee. Key points made are noted below.

Help Your Boss

It is too easy to give a new employer the wrong impression. You could start working on activities that your new employer doesn’t care about all that much, or make some key mistakes and end up having your employment terminated within a few weeks.

The key to being successful as a new employee is to help your boss do his job. Or, stated another way, the supervisor has a lot of work to do and wants to reduce his work load by hiring you. So ask yourself, completing which specific tasks will make his job easier?  For example, a controller needs to complete an inventory valuation faster at the end of each month, so that he can close the books faster. This is because he’s under pressure from the CFO to issue financial statements to the management team as soon as possible.

If you know this, then all of your efforts should go toward that specific task. It does not mean creating a cool new financial analysis system for the controller, who doesn’t need it as much as a prompt inventory valuation. So, don’t try to implement something that you think is incredibly neat. Just do what your boss needs. This may sound boring, but it is how you can be successful in your first 90 days.

Take the Time to Do it Right

Another major issue is to do it right. It always takes a lot longer to correct a mistake than to do it right the first time. So, if you start a job with a series of mistakes, your new boss is not going to want to keep you around. Instead, he’s going to want to kill you. What this means is, focus very hard on avoiding errors on any tasks that you’re assigned. This may mean asking for instructions several times over, which you might think will make you look like an idiot. It’s much better to look like an idiot than to make mistakes. So in short, figure out what your new boss needs, and focus very clearly on how to do just those tasks perfectly.

Interrogate Your Boss

To make sure that you engage in the right tasks and do them correctly requires some social skills. You cannot walk into a new job and be amazing at it if you’re working in isolation. Instead, interview your boss – several times – to be absolutely certain about what it is that you’re supposed to be doing.

And, to make sure that you do it right, interview him again, or whoever the resident expert may be, to verify how to do a task. And this will require some iterations. It’s almost impossible to do something right the first time. Instead, ask to have someone sit and watch you do a task, and provide a critique right away.

And in addition, write down the work instructions. If there isn’t a procedure in place already, then make one. It takes time to memorize how to handle a task, and when you’re starting out in a new job, you shouldn’t rely on memorization. Instead, have a detailed procedure for everything.

By taking this approach, your boss will get the impression right away that you care about what you’re doing. Trust me, you will not be giving him the impression that you’re clueless. For a new employee, being clueless is a given. By asking for help, you’re giving the impression that you’re aware of your cluelessness, and want to improve the situation as soon as you can.

I’ve just stated that you need to question your boss intensively to make sure that you’re doing the right thing, and doing it in the correct way. This does not mean that you should be bugging your boss forever. As I also mentioned, you are trying to help your boss do his job, and you’re interfering with his job if you bug him too much. So the trick is to spend the time with your boss up front until you’ve completely figured out what you’re supposed to do, and then quit bothering him. After a while, your boss will see that a good chunk of his workload has been passed over to you, so he will most definitely be happy.

Ask for More Work

So let’s say that you’ve made a successful transition into a new job, and you understand the core activities. Now what? What makes for a really successful new employee? You can address this from two directions.

One approach is to go back to your boss to see if there’s any other work to take on. This approach has a couple of advantages. First, you’re offloading even more work from your boss.

And second, your boss knows what needs to be done, since he has a much greater knowledge of the business, and so is in the best position to recommend what additional items to work on. On the downside, you’re putting yourself at risk of taking on some pretty tedious work. Nonetheless, that’s the nature of a job. Not everything is fun.

An alternative approach is to dream up some entirely new activities to do. By doing so, you’re showing a large amount of initiative, and it might result in working on some really interesting projects. However, there’s a large downside, which is that your boss may not see the value of the new activities, and starts to think that you’re getting diverted on personal projects that aren’t helping the organization very much. And the boss might be right. A new employee doesn’t know enough about the company to understand which new projects are actually useful.

On the whole, I’d say a new employee should take the first approach and just ask the boss for more work. Once you’ve really settled in, it might be time to suggest projects that aren’t currently being worked on by anyone.

How Many Bank Accounts to Use (#220)

In this podcast episode, we discuss how many bank accounts to use in an acquired business, and in general. Key points made are noted below.

Identify Costs per Account

One issue is the amount of control that you’ve promised to each of the acquired businesses. If each one is supposed to retain a free-standing accounting department, then there isn’t much you can do. They’re going to need the bank accounts they already have. But let’s assume that’s not the case. Focus on the cost to keep each account open. The bank is either charging a monthly maintenance fee or it imposes a minimum balance requirement. One way or the other, there’s a cost to keeping each account open. To make things simple, I’ll assume it costs $50 to keep an account open for a month, so that’s $600 per year. If you’ve just acquired, let’s call it ten companies, and each one has two accounts open, that’s 20 accounts and they’re costing you $12,000 per year in bank maintenance fees.

That’s not a huge number, but it is a complete waste of money, especially if you plan to consolidate the accounting operations in one place. Let’s assume that the accounting operations will be consolidated. If that’s the case, the usual procedure is to go through the last few bank statements for each of the accounts, figure out what kinds of repetitive transactions are going through them and re-route those transactions to the new centralized account. Then leave the accounts open for a few more months to make sure that you’ve picked up all of the repetitive transactions, and then close the accounts.

This can be a real pain if an acquired company has arranged for all of its customers to send payments to an existing bank lockbox, and there are a lot of customers. In this case, there’s a tradeoff between the effort of contacting all the customers and of eliminating the cost of the lockbox.  It’s quite possible that it makes more sense to just leave the lockbox alone and not go through all the grief to save a few dollars in monthly bank fees.

Reduce the Account Complexity

So let’s say you’ve centralized all of the accounting in one place. How many bank accounts should that centralized location have? You might think that the ultimate is to have just one bank account, which handles everything. Maybe not. The problem is that the volume going through just one account can get pretty crazy, which makes it difficult to track. Instead, break the bank accounts down into bite-sized pieces. So have one account that just deals with payroll, so that all the employee direct deposit payments and checks run through that account. And have another account for paying suppliers. And another account just for cash received from customers. And possibly another account just for outbound wire transfers. By taking this approach, it’s easier to keep track of the cash.

Variations on the Concept

But what I’ve just suggested is not necessarily the perfect way to go. There’re lots of variations. For example, what if each subsidiary is actually an independently operated facility, where customers pay with cash or checks on the spot? For example, maybe it’s an office supply store. In this case, each subsidiary needs a bank account so that it can deposit the money locally. Or, what if subsidiaries are in different countries, so they handle different currencies? In this case, the best bet is to initially store the cash in a local bank account and then use a periodic wire transfer to shift the cash into an investment account. However, if there’re restrictions on currency transfers out of the country, then the cash has to be invested locally. But that’s a topic for a different episode on investments.

Control Issues

What about looking at it from the perspective of control? If every location has its own bank account, with local access, then this presents the risk of someone at the local level stealing cash from the account. For example, they could write a check to a friend or a spouse from the account. When going through the due diligence on acquiring a company, if there’s even a hint of fraud, then a good solution is to kill off the account and have the cash flow through a centralized account instead. Then impose really tight controls over that centralized account.

How Accounts Vary with Company Size and Complexity

Another issue is whether the number of bank accounts should increase as a business increases in size. Here are a couple of scenarios. A company only sells goods through an Internet store, and it operates from a single location, with a single distribution warehouse. In short, the operation is simple, and it can expand a lot with just this simple model. In this case, the company could have perhaps just a payables account and a payroll account as it goes from $1 million in sales to $100 million.

Let’s try a different scenario. A company develops a successful retail store operation. Sales per store can only increase just so much, so the company has to keep adding stores in order to increase its sales. Each store has one bank account for the deposit of customer checks, while payroll and suppliers are paid from a central location. In this case, you have one central payroll account, one central payables account, and potentially hundreds of additional accounts, at the rate of one per store.

Or how about this scenario. A company grows to $10 million under one business model involving the sale of computers from an on-line store, but then sales max out. So, it tacks on another strategy of also selling computers through a chain of retail stores. And when those sales stop increasing, it layers on yet another operation, which is sending service people to customer locations to fix their computers. Each of these layers of business strategy has an extra set of bank accounts associated with it, because each one is essentially a separate, free-standing business.

Parting Thoughts

So, in short, there is no ideal number of bank accounts for a business. You have to figure out the optimal number based on how many bank fees you want to pay for, whether or not the accounting operation is centralized, whether operations are in foreign locations, and also on the structure of the business.

Related Courses

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The Tax and Audit Career Tracks (#219)

In this podcast episode, we discuss whether a student should go into tax or audit in a public accounting firm, and what type of exit strategy to have. Key points made are noted below.

Personality Matching

A job in tax is quite different from auditing. You might want to consider how your personality meshes with each one before making a decision. For example, in tax, you work in a cubicle or office in one place, most of the time. In auditing, you’re nearly always working off-site at client locations. So, which do you prefer? If you like to live in the city, you may not even own a car, in which case auditing could be tough.

At the more senior levels of tax work, this can change. You may end up visiting clients to give them tax advice, so there might be some travel – but still a lot less than what an auditor goes through.

Client Interaction

Another difference is in client interaction. In tax, a lot of it is over the phone or with e-mails, where you’re just trying to get clarification about information that’s going into a tax return. In auditing, you’re constantly asking clients for information, and questioning why they did things – and it can get adversarial – which is one of the reasons why the turnover rate in auditing is so high. So if you’re a major introvert and especially if you don’t like confrontation, taxation may be better for you. If you’re an extrovert, auditing might be a better choice.

Working Hours

Another issue is the working hours. Tax is well known for having epic working hours during tax season – say, 90-hour work weeks, or more. And being better at scheduling or being more efficient doesn’t make that much of a difference, because the real problem is the clients – they usually don’t send their financial information over until the last minute, so the tax staff can’t get started until the last minute either.

However, that is during tax season. There are some other work spikes at various times during the year, but tax season is by far the worst. Most of the time, the working hours for tax people really are not that bad. In comparison, auditors routinely work long hours, but not in one massive burst, like the tax people have. Instead, extra work hours tend to be associated with particular clients, so if one client is a mess, the work level goes up. At other times, it could be a normal 40-hour week.

If you look at hours worked over the course of an entire year, I would say that auditors work more hours.

Specialization

A major difference between audit and tax is that once you’re in tax, you stay in tax. It’s a very specialized field, so even if you leave the audit firm, you’ll probably keep doing tax in the private sector. Smaller companies almost never have an in-house tax person, so that means your options are to do tax for a large company, or to be a tax consultant and do taxes for individuals or smaller companies.

An auditor, on the other hand, goes into managerial and financial accounting in the private sector. That means there’re all kinds of sub-specialties to branch out into, such as preparing SEC reports for public companies. And there’s the opportunity to work your way up to the controller or CFO positions – so an auditor can potentially go into senior management. In short, there’re more career options for someone who starts as an auditor, as compared to someone who starts in tax.

The Money You Can Earn

The other question was about exit strategies from public accounting. Before we talk about leaving, let’s talk about staying in. It’s just like any job. If you like what you’re doing, why leave? And there’s an extra inducement in the audit and tax profession, which is the amount of income that the partners earn. According to the Economic Policy Institute, it takes an income of about $400,000 to be in the top 1% in the United States in terms of income. In the Big Four audit firms, you can go from being a poor college graduate at age 21 to being in the top 1% as a partner at age 35. So if you can, stay in. It’s pretty hard to make that kind of money anywhere else in the accounting profession.

The Departure Rate

That being said, a lot of people leave the Big Four every year. Figure on your odds of being counseled out at about 15 to 20 percent, every year. So the exit strategy may be taken care of for you, whether you want to or not. But if you have the choice, the real target is to reach the manager position. If you leave an audit firm at a level below that, you’re probably going to move into a lower-paying staff job in the private sector. But as a manager, you may qualify right away to move into a controller position – which pays quite a bit more money.

It doesn’t make a great deal of sense to wait longer to make it to the senior manager position and then quit, since it doesn’t bring any additional benefit. Instead, I’d say get to the manager position, work there for a couple of years, and then move on.

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Shared Service Centers (#218)

In this podcast episode, we discuss the pros and cons of using a shared service center. Key points made are noted below.

Nature of a Shared Service Center

A shared service center is a single location within a company that handles all of its accounting. For example, if you have 10 subsidiaries, one service center handles all of their payroll, and customer billings, and accounts payable, and so on. Let’s start with the advantages.

Control Issues

First, the controls are much better. By centralizing accounting, you can impose a really solid set of controls in one place. An audit team can come through every now and then and recommend changes, which is pretty inexpensive, because there’s only one accounting system to review. If you had accounting departments in every subsidiary, it would be much more expensive to keep checking every department to make sure that the controls were adequate.

And a related issue is that it’s more difficult for anyone to engage in fraud in a shared service center, because the controls are so good.

Management Reporting System

The management reporting system is better, because all of the company’s financial information is stored in one place. Management can access all kinds of information through a dashboard system, so they can maintain better control over the business.

Staff Quality

Another advantage is that the quality of the accounting staff should be higher. That’s because the company is saving money by aggregating the accounting operations in one place, so it can spend more money on higher compensation for the accounting staff. And it really needs to, because the accounting systems are more complex, and that calls for a more senior accounting person.

Software Licenses

And here’s another advantage. Instead of paying for software licenses for a bunch of subsidiaries, you just pay for one – in the shared service center. That one software package might be high-end, because it has to handle a lot of transactions and a lot of users, but there still should be a cost savings.

Intercompany Transactions

In addition, the subsidiaries might be buying from each other, so there are intercompany transactions that have to be backed out of the financial statements. With a shared service center, the software can detect when this happens, and backs these transactions out of the financial statements. When the accounting is spread among subsidiaries, spotting intercompany transactions is not so easy.

When subsidiaries are located in different countries, the software can net out buying and selling between the subsidiaries, so there’s less need to incur foreign exchange fees for payments between the subsidiaries.

Cash Management

Yet another advantage is on the cash management side of things. The shared service center can monitor cash balances at all of the subsidiaries, and do the best job of investing it or of moving it around to cover any shortfalls within the company.

Closing the Books

And a final advantage is that it’s easier to close the books and issue financial statements. You don’t have to wait around for each subsidiary to close its books, which could delay the corporate closing for a long time. Instead, the corporate controller has complete control over the entire accounting process, and so can probably release financials in just a few days.

The Downside of Shared Service Centers

What’s the downside? The main issue is the way in which the organization is designed. Let’s say that the corporate parent acquired all of these subsidiaries through acquisitions. This means there’s an independent team running each subsidiary, and they like to maintain control over their operations. And that means they don’t want to lose their in-house accounting and finance functions.

So the corporate management team has to decide whether it’s worthwhile to annoy the subsidiary managers by taking away these functions. What happens a fair amount of the time is that only a few activities are centralized. Maybe accounts payable and treasury are centralized, and everything else stays local. This outcome is nowhere near as economical, because you still have accountants in every subsidiary, and have to manage them and monitor control systems, and there’s a greater risk of fraud. So the way in which a company was originally brought together plays a large role in whether a shared service center will ever be created.

Another issue is that each subsidiary has its own way of doing things. When you install a shared service center, every subsidiary now has to use the same policies and procedures and forms when dealing with the central accounting group, which probably varies from what they were already doing. And that can annoy people and make they resist the changeover.

And they might have a point. There could be good reasons for certain unique procedures at a subsidiary, and especially when it’s in a different line of business from the other subsidiaries. For example, the transactions that a car dealership handles are different from what a book publisher does, which are different from what a concrete plant uses. So when the subsidiaries are all in different businesses, it can be difficult to operate a shared service center.

Another concern is the management capabilities of the corporate accounting and finance group. These people have to be top notch, because they’ll be operating an advanced accounting system that requires every subsidiary to forward a lot of information to the shared service center, where it has to be processed perfectly every time. If the central accounting team screws up, then there’ll be all kinds of pressure from the subsidiaries to move the accounting back to them. And they’d be right. If the central accounting team keeps not paying suppliers, incorrectly billing customers, and screwing up payrolls, who is going to want them?

And another concern is when there are subsidiaries around the world. In this case, the shared service center has to operate 24x7, with staff on hand all the time to handle the needs of each subsidiary. It’s quite difficult to hire good accountants who are willing to work second or third shift, so the usual solution is to operate a separate shared service center for a set of time zones. So maybe there’s one center for Asia, another for Europe, another for the Americas, and another for the Pacific.

So in short, a shared service center can be a very good idea, but it depends on the circumstances. For some organizations, it’s probably not going to work.

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How to Detect Fraudulent Financial Statements (#217)

In this podcast episode, we discuss the particulars of how to detect fraudulent financial statements. Key points made are noted below.

Be aware that none of these methods will tell you for certain that the financial statements are false. What they can do is raise some red flags. And if you have a lot of red flags, there’s a good chance that there’s something wrong with the financials.

Excessively Smooth Profits

First up, reported profits are too smooth. In a real business, profits bounce around. Maybe a few customer orders are unusually early or late, maybe there were a lot of repairs this year. Who knows? The point is that these issues cause profits to be up a bit, down a bit, and maybe sometimes up or down a lot. What you should not be seeing is a great deal of consistency over time. And especially if the growth rate is about the same percentage every year. If so, earnings are being managed.

Commission Percentage is Declining

As another example, if the income statement has a separate line item for sales commissions, track it as a percentage of sales. If the commission percentage keeps going down, it could mean that management is making up fake sales. After all, why would management pay commissions on fake sales?

Deferred Charges are High

Another possibility is when deferred charges are really high. This is the prepaid expenses line item, but there could be a few other lines in the balance sheet that are similar. If management is trying to avoid recognizing expenses, it’ll stick them into some kind of current asset account. If the balances in these accounts are continually going up, the reported profit level is probably too high.

DSO Figure is Increasing

Or, what if the days of sales outstanding figure keeps getting longer and longer? It could mean that management is creating fake sales, which need to be offset with fake customer invoices. And, of course, the invoices are never paid. This is a real concern if the aging trend keeps going up, since it means that more fake invoices are being piled onto the books, month after month.

Cash Flows and Profits Differ

Another possibility is to compare the cash flows from operations figure to the net profit figure. There’re lots of valid reasons why these two numbers will vary from each other somewhat, but not that much. If the net profit figure keeps going up while the cash flow from operations number stays about the same, there may be fraud.

Metrics are No Longer Reported

This next one is a bit more subtle. A company – especially a public one – may include key metrics in the disclosures that are released along with the financial statements. Compare the most recent disclosures to the ones from prior periods, and see if any of these metrics are no longer being reported. If so, management may be trying to keep people from seeing a decline in the business.

Proportion of Reserves to Sales

Another possibility is to look at the proportion of reserves to sales. A business might have an allowance for doubtful accounts, for obsolete inventory, for sales returns, and so on. The percentage of these items to sales should be fairly consistent over time. When you see these percentages declining – and especially when they’re all declining – then there’s a good chance that management is under-reporting expenses in order to generate fake profits.

Horizontal Analysis

So far, I’ve made a few tips that aren’t related to each other. If you want to conduct a more methodical investigation, transfer the company’s financials to a spreadsheet for as many reporting periods as you can, and do a horizontal analysis. This means comparing the numbers in each line item for a lot of reporting periods. Also throw in some percentages, such as the gross margin and the operating margin. Then start scanning across the rows, looking for changes in the interrelationships. For example, if there’s an increase in sales, there should be proportional increases in receivables and the cost of goods sold. If not, why not? Maybe the sales are fake.

Another interrelationship is between the amount of inventory and accounts payable. If inventory has increased, the company should have incurred a liability to pay for it. So if accounts payable did not increase, why not? Perhaps the inventory is fake.

And at a higher level, if sales are going up, how is management funding the increase? Unless profits are really high, the chances are good that any increase in sales will require some funding for working capital, which means that the business has to sell shares or add debt. If this didn’t happen, why not? Maybe the sales are fake.

Some management teams can be really clever. They know about all of the different financial interrelationships, and so they falsify all of them, so the financials seem to hang together pretty well. If so, compare financial results to a company’s non-financial information.

Non-Financial Information Analysis

For example, for a retailer, the amount of sales per retail store really shouldn’t change that much from period to period. Or, the amount of assets per store shouldn’t change much. Or, if you’re looking at a manufacturing business, the amount of sales shouldn’t exceed the production capacity of the business, and the amount of ending inventory shouldn’t exceed the storage capacity of its warehouses. And for any business, the amount of sales per employee should be fairly consistent.

This non-financial information could be hard to come by. But if you’re really suspicious, it could be worthwhile to independently dig up this information and run a comparison against the financial statements.

A Word of Warning

And I’ll finish with a word of warning. You may see some of these issues crop up in a company’s financial statements, but it doesn’t always mean that the financials have been falsified. For example, there might be a big increase in sales and receivables go up a bunch. Your first thought might be that management has just faked some sales. But what actually happened is that the company entered into a deal with a large retailer, sold through a lot of goods, and the retailer is demanding long payment terms – so payment of the receivable is delayed. Which means that the sales figure is justified, and so is the receivable figure. In short, what I’ve been talking about are indicators – not dead certain ways to spot fraud.

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How to Create Fraudulent Financial Statements (#216)

In this podcast episode, we discuss how a person can create fraudulent financial statements. Key points made are noted below.

Sales Falsifications

The falsification that most people think about is sales inflation. How do you make sales look higher than they really are? The classic method is to keep the books open past the end of the month, so that sales for the next month are recorded in the preceding month. This one is especially common at the end of the fiscal year, when management wants to fluff up the full-year numbers a bit more. A more subtle option is to delay the recordation of sales returns and sales discounts. Just push them into the next period, so they appear as subtractions from gross sales in the following month.

What if the company sells a mix of products and services? If so, it overstates the price of the products, since those can be recognized at once. Otherwise, more of the sale would be associated with the service, which might not be completed for months.

Another option is to sell an asset and classify the sale as revenue – even though it isn’t. Or, set up a separate warehouse that’s under the control of the company, ship goods to it, and count them as sales. Then the warehouse holds onto the goods for a short time and then forwards them to a customer. This one essentially allows a company to record sales early.

And then we get into some major ethical breaches. You could enter into an undocumented side agreement with a customer to sell it goods, where the side agreement states that the customer can return the goods at any time – that’s not a sale, but the auditors won’t know that, since the side agreement is kept secret. Another possibility is round tripping. This is when the company sells goods to a customer and agrees in advance to buy the goods back at a later date. It doesn’t do anything to increase profits, but it does boost revenues. This one can be really hard to spot if the customer shifts the goods to a third party, and the company buys the goods back from the third party.

And if you really want to get sneaky, sell a business unit at an artificially low price, but require the buyer to keep buying goods from the company for a certain period of time. This means the sale price of the subsidiary has been split into the actual sale price and additional revenues.

Or, if you don’t have time for all of this deviousness, just create a journal entry that credits sales and debits accounts receivable. Presto, instant sales! This is called a topside entry.

Expense Falsifications

That’s not even close to all of the ways to falsify revenues, but let’s move on to how we can falsify expenses. One of the classics is to lower the capitalization limit, so that even minor expenses are recorded as fixed assets. This is actually considered legitimate, as long as the board of directors authorizes the change. I’ve seen this once or twice, and don’t find that it’s overly effective. For example, lowering the cap limit from $1,000 to $100 doesn’t really defer all that much expense.

You can also extend the useful life of assets, which reduces the depreciation expense in each period. Or, increase the assumed salvage value for fixed assets, which also reduces the depreciation expense.

And then we have the deliberate withholding of supplier invoices from the accounting records. Management could just sit on these and not show them to the accounting staff until the reporting period has already closed, so the expense is recorded in the following period. Or, one could not accrue an expense for various items at the end of the period. For example, if the company owes employees wages, just don’t accrue the expense, thereby shifting the expense into the next period.

Another possibility is to incorrectly keep prepaid expenses in an asset account for too long, after the assets have already been consumed. This is a common one during the fiscal year, and then someone miraculously catches up the account at year-end. In effect, this means that the reported profit in the monthly financials is always overstated.

Balance Sheet Falsification

Let’s talk about falsifying the balance sheet, and start with accounts receivable. When someone has faked a sale, that means the related account receivable will never be collected. This will eventually appear on the receivables aging report as an old invoice, which will attract the attention of auditors. The accounting staff gets around this by issuing a credit to eliminate each old invoice, and replacing it with another invoice – which has a current date, and so appears as a current invoice on the aging report.

Or, the company could sell the old receivables to a related entity, probably at full price, in exchange for a promissory note. By shifting the arrangement to a promissory note, the receivables are magically shifted to the loans receivable line item, which is not scrutinized as much.

Or, why bother to involve a third party? Just forge some documents stating that these fake customers have converted the receivables they owe into promissory notes. Same outcome, the invoices are removed from the receivables account, and re-appear in the notes receivable account – as new loans, not old receivables.

And how about loss reserves? A company might be experiencing really great profits, but knows that profits are going to start declining. No problem. Management manufactures some sort of crisis, and sets aside a nice fat reserve against future losses related to the crisis. Doing so evens out the reported profit level, so the current profits are not too high, and the reserve is used to prop up poor results in future periods.

Now, one of the prime areas for falsification is inventory. Here are a few good ones. First, double count inventory. Just record some expensive inventory twice. It doesn’t have to be for long, maybe just at month-end. Doing so increases ending inventory, which reduces the cost of goods sold, and therefore increases profits.

Or, you can delay the recording of supplier invoices for raw materials. Just record them in the next month, so that the profit in the current period is too high. Another possibility is to not record any charges for obsolete inventory – even though there may be a lot of obsolete inventory.

Let’s get a bit more devious. Expand the size of the factory overhead cost pool by adding costs that aren’t really related to the factory, and then allocate these costs to inventory. Or just artificially increase the size of the cost pool, and allocate the inflated costs to inventory. That pushes the expense recognition further out into the future. Or – increase the standard costs of inventory items, so the inventory has a higher ending balance.

Someone who is massively devious can repackage returned products as though they’re ready to ship out, and then count them as actual finished goods. Realistically, those items are probably damaged or in need of rework, and so should have a lower valuation.

Statement of Cash Flows Falsification

And let’s not forget about the statement of cash flows. The main goal of fraudulent reporting here is to increase the amount of cash flows that appear to be coming from operations. That means reclassifying cash outflows as either cash flows from investing or financing activities. It can also mean reclassifying cash inflows into cash flows from operations, even though they should be listed in cash flows from investing or financing activities. So how can someone do this? First, capitalize lots of operating expenses. By doing so, a cash outflow that should involve operating activities is now classified as an investing cash outflow. Or, acquire goods and services in exchange for a promissory note. That means the related cash outflow is considered to be the repayment of a loan, which classifies it as a financing activity.

Another possibility is to sell receivables, rather than waiting for them to be collected at the normal speed. This isn’t really fraudulent reporting, but it will increase the cash inflows from receivables.

And here’s a clever one. When you want to sell a subsidiary, don’t sell its accounts receivable along with the rest of the subsidiary. Instead, recognize the cash inflows related to the receivables as an operating activity. If you had instead just sold the whole subsidiary along with the receivables, then the incoming cash would instead have been classified as an investing activity.

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Financial Statement Fraud (#215)

In this podcast episode, we discuss the reasons why people engage in financial statement fraud. Key points made are noted below.

Reasons for Financial Statement Fraud

Financial statement fraud is when the managers of a company falsely alter the financial statements. There are several reasons for doing so. One is pressure from senior management to reach hard budget numbers. This is pretty common when the president is really aggressive, and wants to grow the company as fast as possible.

Another reason for financial statement fraud is when management can earn some major bonuses if they meet aggressive stretch goals, usually either to increase sales or profits.

Another reason for fraud is to keep from breaching loan covenants. When lending to businesses, a lot of lenders will insert covenants into the loan document, such as maintaining a reasonable current ratio. If the covenant is breached, then the lender can call the loan. If a business is heavily in debt, there’s a good chance that calling the loan will drive the company into bankruptcy, so management keeps really close track of the covenants before it releases financial statements each month, and then tweaks the numbers to make sure that the covenants aren’t breached.

A slight variation on the concept of breaching loan covenants is when someone on the management team has personally guaranteed the loans, and so could lose a lot of money if the company can’t pay up. This is usually the president. When that’s the case, you can bet that the guarantor will want to preview the financials before they’re released, and will put pressure on the controller to modify the financials if the results aren’t good enough.

Yet another reason for fraud is when a business is publicly-held, and managers own a lot of shares or stock options in the company. They have a large interest in keeping the stock price as high as possible, so that they can sell their shares or exercise their options at a good price. When the company is being followed by an analyst, the analyst may publish an expected earnings per share figure that he thinks the company will achieve. If the company reports a number even a fraction below this expected earnings per share figure, then the stock price will probably drop – by a lot. So this arrangement means that management has a strong incentive to meet a specific target earnings number, quarter after quarter after quarter. This is a particular problem when a company has just gone public, since the shares held by managers are usually restricted for the first half-year. In this case, managers will really want to keep the reported earnings level high until their shares can be sold.

We also have a reverse situation in privately-held companies that are owned by a small number of people. If the business normally earns a lot of money, the owners have an incentive to reduce the reported amount of earnings, in order to shrink the income tax liability of the business.

And finally, we come to the most pernicious reason of all for altering the financial statements, which is getting into the habit of making minor adjustments to the financials to smooth out earnings, and then getting caught up in the process. The situation is common enough. As an example, the president promises investors that earnings will be at least $100,000. At the end of the period, the controller finds that the actual profit number is $99,000, so he makes some minor “adjustments” to increase the figure to $100,000. Over time, management gets into the habit of doing this to make sure that the business always meets its numbers. In essence, managers get used to the idea that the financials can be altered.

But then there’s a month when sales or profits are substantially less than expected; so the controller makes some really serious “adjustments” to still make the numbers. This means that the management team is now becoming accustomed to some major fraud, where the new normal is to falsify a large part of the income statement. After a while, managers spend more time figuring out ways to maintain the fraud than they do running the business, so the disparity between the actual and reported results gets bigger and bigger. In essence, the fraud has taken over the business.

This situation is especially common when a growing business becomes more mature, so that its rate of sales growth declines and then levels out. When managers have been promising investors that sales will continue to growth, they get caught by this maturation in sales, and end up fabricating sales to show the old rate of sales growth – which completely falsifies the actual situation.

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Discounted Cash Flows (#214)

In this podcast episode, we discuss when to use a discounted cash flows valuation, as well as its advantages and disadvantages. Key points made are noted below.

Discounted cash flows are when you project out a stream of cash flows into the future, both incoming cash and outgoing cash, and use a discount factor to come up with a net present value for the cash flows. The net present value is what those cash flows are worth right now.

When to Use Discounted Cash Flows

There are two situations where it’s useful. The first is when you want to acquire another business. There might be all kinds of strategic reasons for doing an acquisition, but ultimately the discounted cash flows generated by the acquisition have to at least match the amount paid for the acquisition. Otherwise, you lose money on the deal.

The second situation is when you want to invest in an asset that’s going to generate cash. I’ve pointed out in some other episodes that the main point to investigate for an asset purchase is how it impacts the bottleneck operation of the business. Nonetheless, you still need to perform a discounted cash flows analysis.

So those are two situations in which it’s useful. In addition to that, the analysis is more useful when interest rates are really high. The reason is that the discount factor can be enormous in countries with high interest rates, which results in net present values for longer-term cash flows that are far lower than you might think.

In the reverse case of low interest rates, the discount factor could be close to zero, though management might layer on a few percent to account for the riskiness of cash flows. In this case, the sum total of the cash flows could be about the same as their net present value, since they’re barely being discounted at all.

In general, you should use discounted cash flows analysis whenever the cash flows are supposed to extend out into the future for more than one year. Or, if interest rates are really high, consider using it for even shorter-term cash flows.

Advantages of Discounted Cash Flows

What is the advantage of discounted cash flows?  The main point is that it gives you a reality check. There might be all kinds of other reasons for evaluating a business acquisition or an asset purchase, but over the long term the company will lose money on these purchases if it hasn’t been paying attention to cash flows.

The reason that’s always given for paying high prices is that a purchase is strategic. That usually means the price is way too high, and that the business will never earn back the investment, but that making the investment will put the company in a better strategic position. My response is that good strategy results in better cash flows. So if a purchase is classified as strategic, it should have even better discounted cash flows than normal.

Disadvantages of Discounted Cash Flows

What is the disadvantage of discounted cash flows? There’re several items. First up is how difficult it can be to predict cash flows. After a couple of years into the future, the accuracy level declines dramatically. And yet, the standard analysis always seems to run for about five years into the future. The people creating those forecasts are guessing. Sometimes wildly. The way to get around that is to do a high, medium, and low cash flows analysis, and pay particular attention to the low cash flows scenario. From what I’ve seen over the years, you should assign about a 50% probability to the low cash flows scenario, since actual cash flows tend to be lower, not higher.

And sometimes managers just lie when they’re constructing cash flow projections. They figure out the discounted cash flows figure that they need, and then adjust their cash flow projections to make sure that the calculation yields that number. This is really an ethical problem, rather than a cash flows problem. Having a code of conduct and coming down hard on the people who do this should send the right message.

Derivation of the Discount Rate

The discount rate is derived from the cost of capital of a business, which is the cost of its debt, preferred stock, and common stock. There’re so many variations on how to calculate the cost of capital that you might end up with a discount factor that’s wrong – which means that the net present values derived with it are also wrong. For example, the interest rate on just the debt part of that calculation could be based on the forecasted interest rate on the next debt issuance, or the current average rate on debt outstanding, or the company’s historical rate of interest.

The best approach is to use the incremental interest rate that’s most likely to apply to the specific acquisition you’re looking at. So, for example, if another million dollars of debt will only be taken on specifically to buy the asset being analyzed, then the cost of that specific debt should be used in the cost of capital.

The Assumed Income Tax Rate

Another issue that can result in a bad cost of capital is the assumed income tax rate. The cost of debt is its after-tax cost, so you have to figure out in advance what the marginal tax rate will be that applies to the specific transaction that you’re modeling for.

Derivation of the Cost of Capital

And to make matters even worse, the cost of capital is based on the weighted average amounts of debt, preferred stock, and common stock. But is this the targeted amounts of debt and equity that will be on the books at a later date, or the current market values of debt and equity, or the book values of debt and equity? You probably want to use the current market values of debt and equity, but there are arguments in favor of the other options.

The Risk Premium

And then, many organizations like to add a risk premium onto the cost of capital to arrive at the discount factor they want to use for a discounted cash flows analysis. If the ability to generate the cash flows is considered unusually risky, then the risk premium is higher. If the cash flows look solid, then the risk premium is lower or nonexistent. The risk premium isn’t quantified at all – it’s just a guess. And it could be used by managers to make the net present value of project they don’t like look even worse.

What I prefer to do is not use a risk premium at all. Instead, use that high-medium-low approach I noted earlier, so there’s a model that lays out the worst-case scenario.

Parting Thoughts

I’ve made a few suggestions here for how to create a reasonable discount factor, but this is still a major weak link in formulating discounted cash flows. The discount factor could be off by a lot, which results in misleading net present values. And that is certainly a disadvantage of this method.

In summary, there certainly are some issues with discounted cash flows, but it’s still one of the primary tools used to analyze larger purchases.

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The New Lease Accounting Standard (#213)

In this podcast episode, we discuss various aspects of the new lease accounting standard. Key points made are noted below.

Primary Differences from the Old Standard

The main difference from the previous lease accounting is that you now have to report a lease asset and liability on the balance sheet of the lessee. Under the old accounting, both the asset and the liability could be kept off the balance sheet, which allowed companies to look like they had less debt than was really the case. Putting this extra information out in the open is a good idea; it definitely cleans up an area where businesses used to park liabilities off their balance sheets. Unfortunately, it comes at a cost, which is the calculation of the lease asset and liability. The lease liability is calculated as the present value of the lease payments.

The lease asset is called the right-of-use asset, which, as the name implies, is the right to use the underlying asset for the term of the lease. The calculation of the right-of-use asset is more complicated. It’s the initial amount of the lease liability, plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.

Difficulty for Smaller Organizations

This will probably not be a problem for a larger organization that has a well-trained accounting staff. My concern is the smaller companies that only have bookkeeping support. There is no way I can see them getting this right. And even if they get the initial calculation right, they then have to adjust the asset and liability over time, which introduces the risk that they’ll make incorrect subsequent entries.

Lease Types

The entries depend on whether a lease is classified as a finance lease or an operating lease. You must call a lease a finance lease when the ownership of the underlying asset shifts to the lessee by the end of the lease. Or when there’s a purchase option for the lessee to buy the asset, and it’s reasonably certain to make the purchase. Or when the lease term covers 75% or more of the remaining economic life of the asset. Or when the present value of the lease payments is at least as much as the fair value of the asset. Or when the asset is so specialized that there’s no alternative use for the asset once the lease is over.

When none of these criteria apply to a lease, then it’s designated as an operating lease. When a lease is an operating lease, this implies that the lessee has obtained the use of the underlying asset for only a period of time, and then has to return it.

So when a lease has been designated as a finance lease, the lessee has to recognize the ongoing amortization of the right-of-use asset, and the implied interest expense on the lease liability, and any impairment of the right-of-use asset, and any extra variable lease payments that are on top of the regular lease payments.

If a lease is instead designated as an operating lease, the lessee has to recognize  a lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis. The lessee also has to recognize any impairment of the right-of-use asset, and any extra variable lease payments that are on top of the regular lease payments.

For both a finance lease and an operating lease, the right-of-use asset and liability are derecognized at the end of the lease. If there’s a difference between the two figures at the end of the lease, then the difference is recognized as a gain or loss. If the lessee buys the asset at the end of the lease, any difference between the purchase price and the lease liability is recorded as an adjustment to the carrying amount of the asset.

Initial Direct Costs

In addition, we have initial direct costs. These are costs that are only incurred if a lease agreement occurs. This usually means broker commissions. These costs have to be capitalized at the start of the lease, and then amortized over the term of the lease.

Options to Reduce the Workload

Luckily, there are a couple of minor options for reducing the work load. One is that you don’t have to recognize a right-of-use asset and liability if the lease term will be for less than 12 months.

Another option applies to situations in which a contract contains both a lease and a non-lease component. The standard rule is to separate out these components and account for them individually. There’s an option to not separate the components, and just account for the whole thing as a lease.

Parting Thoughts

My general thought on the new standard is that it’s absolutely comprehensive – which is good. However, there’s a difference between adopting the most theoretically correct way to do something and adopting the most practical approach. The old accounting for leases was practical, while the new approach is theoretical. Which means that the accounting for this one could hurt.

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The Future of Auditing (#212)

In this podcast episode, we discuss the future of auditing. Key points made are noted below.

More Complexity

We’re certainly looking at an even higher level of complexity as we move forward. For example, the total text of the new lease accounting standard is about 480 pages, which was close to the size of the revenue recognition standard that came out less than two years ago. And the accounting for derivatives standard is even larger.

And then we have the new initiative to reduce the accounting requirements for privately held businesses. That is fine, but what’s actually happened is that we now have two standards, one that’s simplified for private companies, and the full version for everyone else. That means the new streamlined standards are in addition to the original accounting standards – so the grand total of what the accountant needs to know just keeps getting bigger.

Changes in Compensation

So what’s the future of auditing with all of this new material? First, we can expect fewer people to pass the CPA examination, since there’ll be so much material to be tested on. However, since there’s lots of demand for auditors, the compensation packages for auditors will keep going up, so we can expect more people to try to pass the exam. A possible outcome is that we’ll have more people who’ve failed the CPA exam, but who have been hired as auditors, and have to keep trying to pass it. If they don’t pass by the time they’d otherwise be promoted to manager, they’ll be pushed out. So this could cause an oversupply of accountants moving over to the private sector.

Increased Specialization

Another prediction for the industry is more specialization. Since some of the topic areas are getting to be fairly complex, we’ll start seeing more people become experts in just one of the accounting areas, and be generalists in everything else.

For example, a person becomes completely knowledgeable in revenue recognition or derivatives, and is always called upon to audit clients who have issues in these areas. Conversely, if someone does not specialize, they could be at a disadvantage when it comes time to schedule auditors for client work. If I’m right about this, we might see colleges starting to offer separate courses in the more difficult topics. So maybe people start graduating with a degree in accounting and a specialization in revenue recognition.

Strategic Positioning

Now let’s look at auditing from the perspective of strategic positioning within the industry. A good framework for this was developed by Michael Porter in his Competitive Strategy book – which I can’t recommend enough. Porter came up with five competitive pressures that can impact an industry.

First up is pressure from customers. For example, if you’re in an industry where your main customer is Walmart, there’s going to be lots of pricing pressure, since Walmart has all kinds of pricing power. In the auditing industry, that doesn’t exist. Larger firms pretty much always pick from the among the Big Four audit firms, and those four firms don’t compete on price.

Second is pressure from suppliers. In the auditing industry, the supply is auditing recruits. And they will cheerfully sell their parents into slavery in order to get a job with the Big Four. So there isn’t any pressure there, though hiring salaries are certainly increasing.

Next is pressure from substitute products. There aren’t any. Businesses simply have to be audited, and that is that. There is no substitute – and given the risk to lenders and investors of companies not having audits done – there will never be a substitute.

The fourth competitive pressure is from potential entrants into the industry. This one is not going to happen. To enter the industry, someone starts small or acquires an existing business, but in either case, they are still not the Big Four. The Big Four audit firms are far larger than the other firms in the industry, and they routinely buy up smaller firms that look promising, so they always have more mass than anyone else.

And the final competitive pressure is from competition within the industry. The Big Four compete against each other based on the quality of their staff and services. They really try to avoid price wars, since that doesn’t help any of them.

So what does this incredibly brief look at competitive positioning tell us? In short, expect no change. The Big Four will probably still be the Big Four ten years from now, and probably in 20 years. They will all spend heavily on marketing, which improves their brand both with college recruits and with potential clients. And if any of the smaller audit firms start to get too large, they’ll buy them. In short, this is a nearly perfect oligopoly that’s guaranteed to make a large profit for a long time to come.

The Low End of the Market

So, that covers the top end of the audit market. What about lower down? I don’t expect things to change much here, either. You can always start a small audit firm and expect to have a reasonable number of smaller clients. But if the firm doesn’t add staff in order to add services, it will lose clients as they grow in size and start shifting their audit and tax work to larger audit firms.

Specialization by Industry

Having just said that there will be no change, there is an opportunity for more specialization by industry. So for example, an audit firm could decide to specialize in bank audits and nothing else, so that it has a strong competitive advantage in a particular niche. This opportunity becomes stronger as the complexity of the accounting standards increases.

Historical Changes

Even though I’m not predicting a whole lot of change, it has happened in the past. The last time was when the Sarbanes-Oxley Act was passed, which triggered the creation of the Public Company Accounting Oversight Board, which oversees the auditors of publicly-held companies. That happened in 2002. The outcome of that extra level of regulation was that a lot of smaller audit firms stopped doing public company audits, which stratified the audit industry into public company auditors and everyone else.

And – what a surprise – the prices charged for public company audits increased, since there were fewer competitors.

That kind of change is not common, but it does happen every few decades. It usually happens right after there’s been a crisis, which typically means a massive case of fraud that damaged a bunch of investors.

When that happens, the level of regulation is increased, which makes life more difficult for smaller audit firms, and drives more business toward the larger firms.

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Working Capital (#211)

In this podcast episode, we discuss working capital - what it is, how it works, and how to manage it. Key points made are noted below.

The Nature of Working Capital

Working capital is current assets minus current liabilities. More specifically, it’s usually considered to be just accounts receivable, inventory, and accounts payable.

The main point with working capital is that it can use up a lot of cash. Of those three components, accounts receivable uses cash, inventory uses cash, and accounts payable is a source of cash. When you combine the three, this usually means that working capital uses cash, because the amount of payables is far less than the amount of the other two.

When you look at the financial reasons for why a business fails, profitability is first, but the burden imposed by needing too much working capital probably ranks second. So if a business requires too much working capital, it consumes all available cash, to the point where you can’t pay suppliers or employees on time, and the business collapses.

Management of Payables

So how do we manage working capital? I’ll start with the accounts payable component. This is a source of cash, and that’s because suppliers are essentially extending you an interest-free loan. When a business starts up, it probably won’t be able to convince many suppliers to give it credit, so it won’t have the benefit of this loan. Once the company has some history behind it, suppliers will start extending credit. Do not abuse the credit and pay late, since they’ll just cut off your credit, and then you have to pay up front - and there goes the free loan. It seems as though everyone abuses their suppliers by stretching out their payments. This is a bad idea, since accounts payable has the best loan terms you’ll ever see.

Management of Receivables

Then we have receivables. This one can kill a growing company, because managers are always willing to extend credit in order to increase sales. What they never seem to comprehend is that this requires an infusion of cash to keep the company running while waiting for customers to pay their bills. So, the faster a company grows, the more working capital it needs. This is a particular problem when the margin on the goods sold is really thin.

The Impact of Gross Margins

In this case, the company has to pay for a large amount of cost of goods sold, while waiting to be paid. Conversely, if a business has really high gross margins, it’s not actually expending that much cash to pay for its products, so it requires less cash to fund the receivables. What this means is that a company with really low margins doesn’t have the cash to grow rapidly, whereas a company with really high margins can grow fast without needing that much cash to do so.

This issue can be spotted up front, during the business planning stages. If you know that margins will be low, then don’t plan for rapid sales growth. The company will just go bankrupt. And don’t think you can get around the problem by taking on lots of debt, because the interest cost will soak up all of the residual cash.

The Use of Factoring

The only case when you can legitimately take on debt to fund working capital needs is when the margins are really high. In this case, selling the receivables through a factoring arrangement will inject cash straight into the business, so it’s possible to keep growing at a rapid pace. An even though the interest expense is high, the margins are high enough to support the payments.

Shifting to New Market Niches

Another issue related to receivables is that a company presumably starts off by selling into the most profitable market niche it can find. The profits will probably support a reasonable amount of working capital. But at some point, the market niche has been fully addressed, and there aren’t any more sales to be gained in that area. So the management team decides to go after the next most profitable market niche. So the margins are a bit lower, which means that there’s less cash available to fund the related receivables. And this goes on as management keeps addressing less and less profitable niches. The end result is that working capital increases faster than sales, which creates a financing problem.

Changes to Credit Terms

A major problem arises when a customer wants to extend its credit terms, or management wants to sell to less financially stable customers that are less likely to pay on time. In either case, the company is essentially extending an even longer-term interest-free loan to its customers, and that really increases the investment in working capital. Unless the business is unusually well funded, it doesn’t make much sense to get into these arrangements.

Management of Inventory

And then we have the third component of working capital, which is inventory. This is another company killer. In fact, it’s potentially a worse company killer than receivables, because at least there’s a collections team in charge of collecting receivables. There’s no such team for inventory. Instead, the inventory investment keeps piling up at a rate faster than the sales growth rate. There’re a lot of reasons for it. For example, the purchasing department decides to buy a pile of raw materials because it can take advantage of a volume discount, and some of the materials are never used. Or, a product is discontinued before all of its components have been used up, so the components become obsolete. Or, customer demand drops, which leaves a bunch of finished goods rotting in the warehouse. And to make matters worse, converting excess inventory into cash usually involves taking a large discount from the original purchase price, so sometimes managers had rather keep the inventory than sell it and book a loss. All of these factors mean that the inventory investment tends to increase at least as fast as sales, if not more so.

Managing inventory is a tough proposition. The best bet is to never let inventory pile up in the first place, which means producing only when there’s a specific customer order to support it. At a minimum, invest in a material requirements planning system, which imposes a lot of control over the purchasing and use of inventory.

The Impact of Declining Sales

And finally, there’s the odd situation where the need for working capital has forced the owners to shut it down or at least scale back operations. A funny thing happens then. As sales decline, the cash balance shoots up – really fast. The reason is that inventory is being sold off and receivables are being collected, and there’s no need to replace them. Instead, the inventory is converted into receivables, and the receivables become cash. And when everything is done, the owners will be sitting on a pile of cash and wondering why their business failed.

The reason it failed was that they didn’t pay attention to the level of working capital required when they decided to grow sales. In short, you have to be aware of working capital when you plan a business, and understand how each individual business decision can impact the investment in working capital.

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Recovering Lifting Fees and Credit Card Fees (#210)

In this podcast episode, we discuss how to deal with short pays on electronic transfers, as well as how to collect the credit card transaction fee from customers. Key points made are noted below.

Lifting Fees

Let’s start with the short pays on electronic transfers. More than likely, customers aren’t really paying less than the amount they’re supposed to. Instead, when you send a wire transfer, the receiving bank deducts a lifting fee from the payment. If there’s an intermediary bank involved, then that one might also charge a lifting fee. Supposedly, this fee is for processing costs. This always leaves a residual account receivable balance that has to be cleared out.

A bad option is charging the customer the fee, since it’s not their fault. It’s the bank’s fault. If you do a lot of business with your bank, approach them about having the lifting fee reduced or eliminated. Chances are, they won’t do it, but you can always ask. If there’s an implied threat that you might move your banking business elsewhere, maybe it will work.

If payments are being made with a wire transfer, there’s a good chance that it’s an international payment. If so, and you do a lot of business in certain countries, consider setting up a corporate bank account over there. Then there’re more alternatives for being paid within the country, and without the lifting fee. However, at some point you still have to shift the funds back to the home country, which may involve another lifting fee.

For most organizations, the lifting fee is so small that it’s easier to accept it as a cost of doing business, and just get on with life.

Short Payments

But what if a customer is actually short paying, and there’s no lifting fee involved? In this case, the customer needs to be trained to stop doing that, which means leaving the balance in place and sending them statements that list the overdue amount. Once these amounts are really overdue, hold the delivery of any further orders. This is extreme behavior, especially if the customer is an important one. So, you have to balance the need to break a customer’s annoying habit of short paying against the possibility of losing some sales.

Credit Card Processing Fee Reimbursement

Then we come to how to collect the credit card processing fee from customers. This is that annoying fee of about 3% that’s charged to the merchant by the credit card companies whenever a customer uses a credit card to pay for something. It’s possible to charge customers a surcharge for the credit card processing fee, but there are restrictions on it, and the practice is banned in some areas. In addition, Visa forbids all surcharges in cases where the card is not present, such as online sales. There are some ways to add a surcharge under Visa’s rules if the card is present, such as in a retail store.

How can you simply sidestep the ban on surcharges? One of the more common approaches, and which is even recommended by Visa, is to increase all of your prices by the amount of the credit card processing fee, and then offer customers a discount back to the original price if they pay in cash. The problem with this approach is that all of your prices will appear to be higher than those of your competitors, which may lead to a decline in sales.

There’s also a modified version of that last suggestion. If the company receives a decent mix of cash and credit card payments, you could increase prices for everyone, but by a reduced amount, like one percent, and then don’t offer a discount at all. The increase still covers the cost of the credit card processing fee, since fewer people are using credit cards. The reduced amount of the price increase won’t make the company’s prices look so bad in comparison to the competition’s prices.

Another option is to not accept Visa credit card payments. If you only allow Mastercard and American Express cards from customers, the rules for surcharges are much easier to follow. The problem, of course, is that lots of people use Visa.

Use of Debit Card Payments

And then there’s the option of only accepting debit card payments. This does reduce the amount of the fee, but then most people are so accustomed to only paying with credit cards that they don’t like this option.

Fee Shifting

Another alternative is to shift the cost of the credit card fee into something else that’s still charged to the customer. For example, increase the shipping charge, or add a fee for faster delivery. Another possibility is to raise prices on those goods or services that don’t have a lot of direct competition, so that customers can’t compare prices. Or, raise prices for single-unit sales while still offering a good price for volume purchases.

Parting Thoughts

So in short, you can avoid the fee by restricting payments to certain types of cards, or not allowing credit card payments at all, or by being imaginative and shifting the fee into other types of prices.

What this really gets down to is strategy. If the company is competing based on low prices, it doesn’t have the option of increasing prices to cover the credit card fee. Instead, it really does need to require cash payments to completely avoid the fee. What management could do is use it as a marketing tool. That means explicitly saying that the company offers rock bottom prices, and the only way it can do that is to require payments in cash.

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Process Development for a Fast-Growing Company (#209)

In this podcast episode, we discuss the process development process within a fast-growing company. Key points made are noted below.

Typical Process Development

As a business grows, you have to keep expanding the number of processes, because the business is becoming more complex all the time. In addition, a process that might have worked fine at a low volume level starts to fall apart as the volume increases. So that’s two separate aspects of process development. Let’s start with adding to the number of processes, and begin with an example.

A small business starts out selling products directly to customers, so it has the basic processes – shipping, billing, payables, and inventory control. Then management decides to add a new type of customer, which is retail chains. The additional process that has to be addressed now is customer returns. This might have been such a tiny issue when there were only direct sales that no one cared about it. Now, the retailers ship back everything they can’t sell, which massively increases the number of returns – maybe by a factor of 10, or 20, or even 50. At this point, management considers product returns to be a major process, and the controller is told to clamp down on it with a system of return authorizations. That’s a real example, by the way. It almost bankrupted a company that I worked for a long time ago.

Inclusion in Strategy Discussions

So how do we find these additional processes early on, before they become problems? There’re a couple of ways. One is to include the controller or CFO in all strategy discussions. This gives you early warning of a potential new process before a business starts branching out into new areas.

Talk to the Staff

Second, talk to the staff. In that example I just gave, the people who knew about it were the receiving staff, who processing pallet loads of returns, and the billing staff, which was processing the credits. They know if there’s a problem before anyone else does, so cultivate contacts throughout the business.

Conduct a Process Review

Third, schedule a process review. Get the accounting staff together maybe once a quarter, and talk about which processes are working, which ones need some adjustment, and in particular which areas need processes.

And if you think processes are really a problem, then bring in a process consultant to keep examining systems all over the company and recommend changes. If the company is growing really fast, a consultant might be the best alternative, since the staff will be too buried with work to spend time on this.

Review for Losses

Another possibility is to dig through your cost variances to figure out why losses are occurring. For example, the engineering manager decides to start changing product configurations. When he does that, some older components in inventory are no longer being used, which means that the inventory obsolescence expense will start to go up. With some digging, you can figure out that some of the inventory is being bypassed by the new product configurations. The logical outcome of all that cost analysis is that an engineering change order system is put in place, where existing stocks are drawn down before a product change is allowed. Unfortunately, that’s an after-the-fact detective control, since the company is already losing money before you can find the problem and install a process to correct it.

Watch the Transaction Volumes

The second aspect of process development is figuring out when to change a process when it’s being buried by transaction volume. A key item is to watch the processing backlog. If you’re maintaining a reasonable staff headcount and the staff is well trained, and yet the processing backlog is still going up, then the process may need to be upgraded. And that doesn’t necessarily mean adding more staff to the existing process.

For example, you have a reasonably good, mid-range payables software package where the payables staff has to manually input each supplier invoice into the system. That may work fine, until the volume of incoming invoices suddenly triples. In this case, the choice may be to add more staff, but you could also look at installing a portal on the company website and requiring suppliers to enter their own invoices into the company’s payables system. Or, install an invoice scanning system that automates data entry.

For both solutions, you need to look at whether the underlying accounting system can incorporate the updates. If it can’t, then you need a whole new accounting system.

And that means that you need to plan ahead to figure out which specific system upgrades will be needed as your transaction volume goes up, and from there, figure out which accounting systems will support those upgrades.

Plan for the Most Appropriate Software Upgrade

What you’ll find is that most of the lower-end systems are largely self-contained, and don’t support those nifty labor-saving features. Which can put a controller or CFO in a bit of a bind. If you assume that growth will be fast, then you need to install an upper-end accounting system right away, before the department is buried with too much work to do a system conversion.

However, if the growth never materializes, then the company will be stuck with a terrifically awesome and amazingly expensive accounting system that it just doesn’t need. So here’s the essential problem: switching to a better accounting system needs to happen during a slack period when there’s time to install it - but there are no slack periods for a fast-growing company, so you have to correctly guess in advance that sales will increase, and install the system before they increase. But it’s hard to make that call when there’s not yet any evidence that sales will increase.

So what do people actually do? They still try to look as far ahead as possible and make the best guess for an early system upgrade, but by the time they get to it, sales will have already taken off, so they pretty much have to bring in a consulting firm to help them with the system conversion. The in-house staff just can’t spare the time to do a conversion correctly.

And in the worst case, there is no advance planning for a system upgrade, so it has to be done in a rush long after it was actually needed, which introduces a greater risk of failures because the new system wasn’t tested properly before it was turned on.

Related Courses

Accounting Controls Guidebook

Accounting Procedures Guidebook

Employee Onboarding (#208)

In this podcast episode, we discuss best practices for the new employee onboarding process. Key points made are noted below.

The Onboarding Concept

Onboarding is the induction and assimilation of an employee into an organization. Without the onboarding process, a new hire is more likely to make mistakes, since they don’t know how the company’s processes work, and their skill level may be lower than you think. In the accounting field, errors can be really expensive – and when they result in incorrect financial statements, the reputation of the whole department suffers.

A follow-on to the last problem is that new employees may not last very long. They make mistakes, which makes them look bad, and then either they leave, or the controller fires them because they’re “not working out.” In reality, the departure of a new employee might be the fault of the controller, because there was no onboarding process.

So what can be done? In short, a lot of hand holding. When a new hire walks in the door, there needs to be a more experienced person waiting for him. That person is matched up with the new hire on a full-time basis. Though that “full-time” statement requires some explanation.

The Rapid Feedback Approach

Consider using a rapid feedback form of onboarding. This means the trainer sits down with a new hire and walks him through a task, explaining every possible aspect of how to do it. Such as where certain files are located, who you have to talk to, which spreadsheets need to be updated, which approvals are needed, and so on. And then immediately have the person do a live transaction, while watching him like a hawk.

By taking this approach, the new hire gets a comprehensive feel for each task that he’s involved with, right from the start. In addition, the trainer watches how the new hire performs the task, and so can judge his knowledge and confidence level right away.

If the person is clearly stellar, then a few repetitions will be enough, and the trainer moves on to the next training item. If not, then the trainer goes back over the material as many times as it takes. At the end of the day, the trainer discusses the new hire with the controller. The discussion is about rate of progress, existing knowledge, and error rates. This gives management an immediate and solid understanding of the new recruit.

The next day, do it again with new tasks, but also mixing in some of the items that were learned the day before. This gives the trainer information about the retention level of the new hire.

Periodic Updates

Once the person has been trained in all possible areas, the trainer’s work is not done. Instead, the trainer lets the new hire conduct all aspects of the job, but also blocks out time with the person at the end of each day to talk about how the work went, and review actual transactions that the person dealt with, to look for errors or maybe whether the person is frustrated with how the process works, or possibly to see if there’re any interpersonal issues getting in the way.

After a few weeks of this, the trainer backs off to meeting once a week, with some spot checking of the person’s actual work product. After about three months, the new hire is considered to be reasonably well assimilated into the business.

Feedback About the New Hire

By going through this labor-intensive approach, you get new hires who are informed immediately if they do something wrong. This corrects bad habits on the spot, so they have fewer frustrations in meshing with their new jobs.

In addition, the trainer and the controller will know exactly what they have within a few days of the person starting work. Including the weak spots of a person, which can be counteracted with more training. This beats a more laid back system, where a person might start work and no one knows if he’s doing the work correctly until an error is found or someone complains – which might be weeks or even a few months later.

How to Find the Training Time

The only way to really have the necessary amount of spare training time is to have a slight level of overcapacity in the department. If there’re a few more people on hand than is absolutely necessary, it doesn’t take an overwhelming amount of schedule reshuffling to find the time. In addition, you can make it a requirement for senior staff to be involved in training for a certain part of each year, and include it in their annual reviews.

Another possibility is to figure out the busiest times in the annual work schedule of the accounting department, and only bring in new hires during other parts of the year. In fact, hiring during the busiest part of the year should be actively avoided, since new hires are almost certain to be under a lot of pressure to perform well.

The Need for Introductions

An additional concern is that the person does not interact with the rest of the department or develop contacts in other departments, except with those people he met during the initial training. Some companies like to have informal get-togethers, so that employees can mix; but the outcome is too mixed. A new hire might bond with one or two people, and that’s it. They miss out on a much broader range of contacts.

A possibility is for the senior staff to consider grabbing a new hire and having them come along for meetings with other departments, or other parts of the accounting department. The intent is to force them into meeting as many people as possible. And at the same time, they can learn about the subject of each meeting, so they gain a broader understanding of the issues that the accounting department is facing.

The controller can maintain a listing of which employees have been involved in which meetings around the company, and target anyone who’s not been involved much to participate more. That level of involvement by the controller might seem like an excessive amount of personnel administration, but it helps to remember that the controller job is a management position, and training up your staff is actually more important than the accounting aspects of the job.

Related Courses

Employee Onboarding

Recruiting for Accountants (#207)

In this podcast episode, we discuss the best recruiting methods for the hiring of accountants. Key points made are noted below.

Base Recruiting on the Desired Result

When figuring out the best recruiting method, first determine the result that you want to achieve. Which is not only a high-quality group of candidates, but also not having to wade through a thick stack of resumes. It’s that second item that drives me to be pretty specific about how to recruit. I really don’t like digging through masses of resumes when 99% of them are clearly not what I want, and then I have to do too many screening calls and interviews to arrive at a couple of good people.

Negative Recommendations

So here are some negative recommendations. Don’t post any accounting job on an on-line job search site. When you post a job on these sites, you’re simply going to get dumped on with masses of resumes. Instead, look for recruiting methods that cut out those candidates that won’t fit.

Tailored Recruiting Solutions

A single recruiting approach doesn’t work for everyone in the accounting department. If you’re looking for a senior position, like a controller or assistant controller, the recruiting is not the same as what you’d use for a lower-level position, like a payables clerk. The reason is that the quality of candidate needs to be very high for the senior positions, and there aren’t very many of those people around. At the lower levels, there’re many more qualified people, and they’re somewhat easier to find.

To fill a senior position, ask the company’s auditors. They may have someone in-house who wants to go to the private sector. In addition, they have connections with all of their other clients, and they may know of someone. The auditors value their relationship with the company, so they have a strong incentive not to send over the resume of a weak candidate.

Second, call a recruiter. The best ones have hundreds of contacts with people who may not even be looking for a job right now. They can match up my requirements with who they know, and pre-screen them, and then send over just a few resumes that are probably close to what I need. So this is an efficient recruiting method.

A few thoughts on recruiters. When the economy is hot, lots of new recruiting firms open up and try to get my business. I don’t use them, because they haven’t been around long enough to have built up a network of contacts. Instead, I use the recruiting firms that have been around the longest, and the people within those firms that have also been around the longest. And then I always stick with the same firm. That way, if they have someone really good, I hear about it first. That means giving them an exclusive on a job search.

I don’t contact the auditors for lower-level positions. They don’t have anyone on their staffs who would want to transfer into a clerical job, so there’s no point in contacting them. Instead, set up a referral bonus, so that everyone in the company is looking around through their networks for candidates. The people who are referred this way tend to be fairly good, since the person doing the referring is essentially pre-screening them. If there’s a company newsletter, post the jobs in there, and the employees will take over the job search.

Other Recruiting Options

Set up a jobs page on the company website. If someone is energetic enough to bookmark this page and then keep checking it, they may have the makings of a good employee – so this approach will winnow out those people who can’t be bothered to check the website. Also, don’t bury the jobs page deep down in the website. Make it one of the major links on the home page.

Use the same approach for social media sites. Post job openings on the company’s LinkedIn and Facebook pages, and issue notices on Twitter.

Once there is a pool of good candidates for a job, ask them where they heard about it. This tells you which recruiting methods worked, and which ones can be dropped.

Here are some recruiting options that are a bit less mainstream: First, if anyone has left the company who was really quite good, keep in touch. Contact them maybe every four months. These people may find that their new job wasn’t what they expected. If you’ve maintained contact, there’s a good chance you can get them back.

The same principle applies to candidates who interviewed for a job, but were not selected. If any of them looked promising, then enter their resume and contact information and interview notes in a database, and call them back if something comes up later. In this case, it helps to enter into the database the position that they’d be good at, rather than the one they originally applied for. So for example, someone was too inexperienced to be the controller, but would be a great payables manager. If so, make a note of it. This is better than conducting a new search from scratch, because you’ve already interviewed the person.

Maybe someone wants to retire. If so, offer them a part-time position. That way, they can gradually transition into retirement, and make some money on the side. This keeps you from having to recruit a new person, at least for a while.

If you need someone for a junior position, consider bringing in an intern. They need supervision and a lot of training. Even so, you have a chance to view their work and how they behave for a couple of months, so it’ll be pretty obvious if you should hire them.

Related Courses

Accountants’ Guidebook

CFO Guidebook

New Controller Guidebook

The CPA Certification for an Older Person (#206)

In this podcast episode, we discuss whether it makes sense to pursue a CPA certification later in life. Key points made are noted below.

The CPA Firm Promotion Track

The first issue is the promotion track in CPA firms. They want to hire younger people straight out of college and put them on a path that gets them a partner title by about the age of 35. A partner is then required to retire by around age 62 to 65, which creates new partner positions that can be allocated to those people who are on the normal promotion track.

This early start right out of college is important, because the new recruits don’t yet have any major impediments that might deflect their attention from the job. So, they have no mortgage, and probably no children. That means they can work long hours, and are more willing to move if the audit firm wants them to.

Let’s say that you are 10 years older than the normal accounting major going into an audit firm, which would be 32 years old. At this point, it would be reasonable to assume that you’re paying a mortgage, and there are kids to pay for, so going back to school full time is not a realistic option. Instead, you have to attend college at night to pick up the required accounting and auditing classes. Figure on about six years to do this. So by the time you’re 38 years old, you’re just ready to take the CPA exam and apply to jobs at audit firms.

Let’s say that you’re hired. You arrive at the audit firm at the age of 38 as a staff auditor, and you’re looking at a promotion track that will put you in the partner position about a dozen years later, at the age of 50.

So let’s explore some issues that might come up. First, at the age of 38, you’ve put down roots in the local community and the kids are in a school that they like, so it’s not overly reasonable to expect that you can move somewhere else if the company requires it.

That can block further promotions, and especially the final promotion to partner, since they may only have a partner position available in a different city.

Working Hours

The next issue is working hours. Energy levels are highest when you’re in your twenties, and go down from there. A reasonable question to ask is whether you want to go through the grind in your 40s to make partner, doing 60 to 80 hours per week. That can also put a lot of stress on your marriage.

The Dropout Rate

Another consideration is that, on average, the dropout rate in audit firms, especially among new staff, is about 20% per year. So you also need to consider the probability that you go through all of this work, and then wash out within a couple of years of starting the job.

The Pay Scale

And finally, there’s no pay boost for an audit staff person, just because you’re older. The same pay scales apply to everyone, so it’s possible that you’ll take a pay cut to become an auditor, in hopes of making back the lost wages if you become a partner. And not many people make it to the partner position. Even if you make it, the retirement age is likely to be 62 to 65, so there are far fewer years than usual for earning a significant amount of money.

Final Thoughts

If the intent is to get the CPA in order to just have it on your resume, then focus on getting in two years at an audit firm in order to qualify for the certification, and then move on to a corporate job. However, in that last case, prospective corporate employers will still look at your job title at the audit firm when figuring out how qualified you are for a management position. If you only worked two years for an audit firm and then got out, then that’s not enough for a more senior corporate management position.

In short, getting a late start on a CPA can be difficult. Job prospects are not as good, and the amount of time left in your career to earn much money is greatly reduced. This is not an easy decision to make.

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Synthetic FOB Destination (#205)

In this podcast episode, we discuss synthetic freight on board destination shipping arrangements. Key points made are noted below.

The Freight on Board Scenario

This situation arises when a seller is selling goods using freight on board shipping point terms, which means that normally the customer takes responsibility for the goods being shipped to it once the goods leave the shipping dock of the seller. Under FOB shipping point terms, the seller recognizes revenue on the goods as soon as the goods leave its premises.

However, the seller is also promising the customer that the seller will replace any goods that are lost or damaged while the shipment is in transit to the customer. This could be standard industry practice. At any rate, it means that the seller is effectively retaining the responsibilities of ownership until the goods reach the customer. So this means there’s a timing delay before the seller can actually recognize revenue.

Revenue Recognition for Freight on Board

The way this has worked in the past is that the seller defers revenue recognition until the estimated date of delivery to the customer. It’s really not practical to verify the actual delivery date for every customer delivery, especially if it’s hard to get a proof of receipt. So instead, the seller does an annual analysis of the actual delivery data provided by its freight carriers, to figure out the average number of delivery days.

For example, if the analysis shows that it takes an average of three days for a delivery to reach a customer, then the seller assumes that all deliveries for the last three days of the month were not received by customers during that month. So, that revenue is recognized in the next month.

The easiest way to make this work is for the accounting staff to include it as a step in the month-end closing process. First, they identify all synthetic FOB destination sales, and then they create a reversing entry that shifts the associated sales and cost of goods sold into the next month. That is how the process has worked in the past.

Impact of the New Revenue Recognition Standard

But what about the new revenue recognition standard? Under this standard, the key issue is when control over the goods changes, not when there’s a transfer of the risks and rewards of ownership. So when does the customer gain control? FOB shipping point terms can give the customer title to the goods as soon as the seller ships the goods, which means that there’s an immediate change of control. Or, maybe the customer has the ability to redirect the goods to its own customers while the goods are in transit. If so, that also implies an immediate change of control.

What this means under the new revenue recognition standard is that we really have two products for which the seller can recognize revenue. One is the goods, and the other is its coverage of the risk of loss during the in-transit period. If so, you need to allocate the selling price to each of these performance obligations. The result would probably be that the bulk of the sale can be recognized at the point of shipment from the seller’s facility. A small part of the sale is linked to the seller’s coverage of the risk of loss during the in-transit period.

To figure out the size of the second part of the revenue recognition, the simplest approach would be to calculate the historical cost of replacing goods that are lost or damaged in transit, and apply this amount to the sale transaction.

What does this mean from the perspective of day-to-day accounting? Nothing at all for individual sale transactions. Just record sales as usual. Then, wait until the month-end close, and follow these steps:

• First, take note of all synthetic FOB destination transactions.

• Second, for those transactions, calculate the amount of the revenue associated with the risk of loss.

• Finally, create a reversing entry that shifts this revenue out of the current month and into the next month.

How does this vary from the method that’s historically been used? Basically, revenue for the bulk of all sales is accelerated to the point of shipment, which means that businesses using synthetic FOB destination terms will experience a one-time bump in sales and profits that’s likely to be fairly small.

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How to Handle Auditors (#204)

In this podcast episode, we discuss how to handle auditors from the perspective of the controller, and specifically, when to push back. Key points made are noted below.

Why We Party When Auditors Leave

Controllers take their entire staffs out to lunch the day after the auditors leave. It’s a celebration of not having auditors around anymore. And that’s because it’s not a happy relationship between the two parties.

The problem comes from two sources. One is that the auditors are investigating the work of the accounting staff, so the auditors’ job is to pick apart what they find and basically make nuisances of themselves. The second problem is that some auditors see themselves as being superior to the accounting people whose work they’re investigating, because of the prestige of working for a major audit firm, and because everyone else who couldn’t get an auditing job went to work in the private sector. The second point is exacerbated when the in-house accounting staff has not worked as auditors, and so doesn’t understand the audit procedures that are being used.

Auditor Retention

There are several ways to handle auditors, which are driven by the preceding two problems. First, try to keep the same auditors, year after year. When the same group keeps coming back, that means there are fewer newbie auditors who have to be trained up in how the company operates and why the accounting is done in a certain way. This also means having a word with the audit committee before they try and switch to some new audit firm, maybe to try and lower costs. Point out that having to start over with an entirely new group of auditors requires lots of extra training time by the accounting staff.

Assign Senior Staff to Auditors

Second, do the same thing with the in-house staff, which means that only the most senior accounting personnel interact with the auditors. At most, allow just one or two junior accounting staff to work with the auditors each year, so they can gradually build up their expertise in dealing with auditors.

Minimize New Practices

Third, do not blindside the auditors with new practices. If the accounting was done one way last year, keep doing it exactly the same way this year, so the auditors won’t bug you with questions about the change. And if there’s a really good reason to change accounting methods, then have a chat with the audit manager when you’re thinking about making the change. Don’t wait until the new system is in place, because then you may find that the lead auditor doesn’t like the new approach, and will force you to switch back to the old method.

Revise the Work Schedule

Fourth, after the auditors are gone, sit down with the staff and go over the items that the auditors requested, and which annoyed the staff the most. Put those items in the work schedule that has to be completed before the auditors show up the next time. That way, a point of contention is eliminated.

Attempt to Change Specific Auditors

Now, what if there’s some major friction with specific auditors? Maybe they don’t understand auditing concepts, or they don’t know how to get along with clients, or maybe they have the accounting staff running around digging up information about transactions that’s completely immaterial. The situation is even worse when they really do think they’re better than the accounting staff. In these situations, It is acceptable to haul the audit manager into your office, close the door, and engage in some polite bitching. The trouble is that the auditors actually report to the audit committee, not the controller, so it’s not possible to absolutely, positively get rid of an auditor.

Retain Competent Auditors

The reverse side of trying to get rid of auditors is to do everything possible to keep those who are clearly competent, or at least only mildly annoying. Believe me, in this relationship, a mildly annoying auditor is a prized possession. So keep requesting that the audit partner bring these people back next year.

Fight Back on Irrelevant Proposals

What about situations where the auditors propose journal entries that you think are not needed? This usually means that something is immaterial, or just moves around the balances in the balance sheet. I fight back on these proposals, usually because they come at the end of the audit, and by then I’m getting pretty punchy. However, entering a journal entry in the accounting software isn’t really very hard, so maybe it’s better to just go ahead and do it.

Summary

In short, be as prepared as possible at the start of the audit, in order to reduce friction, and give lots of warning when there’s going to be a major accounting change. Also, try to bring back the good auditors for next year, and make it quite clear which ones are not acceptable. And finally, it’s OK to be ornery – auditors deserve a little push back. It just doesn’t seem right if the annual audit doesn’t go by without at least one argument.

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Presenting the Financial Statements (#203)

In this podcast episode, we provide tips for the chief financial officer (CFO) on how to present monthly financial statements. Key points made are noted below.

The Need for CFO Insights

The CFO deals with financial information all day, and so has a deep understanding of what’s being reported in the financial statements. No one else on the management team has that level of knowledge. So, if the CFO just hands out the financials without any additional commentary, this is doing quite a disservice to anyone reading them. They need the insights of the CFO.

The Cover Letter Approach

At the most modest level, you could prepare a standard cover letter that tells the reader how much assets have gone up or down, and how much of the line of credit is left, and so on. But that’s just a clerical enhancement. The CFO needs to provide a more in-depth view.

The Strategy Discussion Approach

To do this, it’s necessary to understand the organization’s strategy, and then use the financials as a backdrop to show management how the strategy is progressing. This is something that only the CFO can do, because the accounting staff has no idea what’s going on with the strategy.

For example, the management team has decided to direct money towards a new product line. If they were to look at the financial statements, everything associated with that product line is merged in with the results from the rest of the company, so the CFO needs to break out this information. This could include talking about how much money has been invested in the product line, as well as the sales and profits generated by the new products. But if the CFO wants to give a really detailed view of the situation, he could point out the level of returns from customers for the new products in comparison to product returns for the company as a whole. There could be a discussion of what’s happening with the accounts receivable investment, since the new products might be sold to an entirely different group of customers that wants longer payment terms. Same goes for the investment in inventory, since it might be necessary to stock more of it to meet customer demands.

The point here is that there’s always some new initiative going on, and it’s the CFO’s job to point out the financial impact. This is important, since there’s a strong chance that the initiative will fail. The CFO is in the best position to see a failure coming, and so needs to warn management as soon as the information is available.

The same goes for an outstanding success. If it appears that some product or service is suddenly selling like crazy and generating all kinds of profit, the management team won’t see it in the financial statements unless the CFO tells them. The financial statements are so aggregated that it’s not possible to see the relevant information.

The Selected Variances Approach

Another issue is that most organizations have a steady core business that doesn’t change much over long periods of time. The product line is established and profits are consistent. The CFO needs to keep a close watch over these items, too, since a twitch in the numbers could indicate the start of a major problem. This type of analysis is harder than reviewing the results of new products, since you don’t know what might happen. This means the CFO needs to look at a large number of variances, and drill down when there seems to be a pattern worth reporting to management.

The Policy Changes Approach

And then we have reporting on policy changes. For example, a large customer might ask for longer payment terms. The president doesn’t really know what the impact is, and so he agrees. It’s the CFO’s job to report on what that did to the company, in terms of longer days of receivables. This could also happen if there’s a decision to increase the number of products that’ll be stocked, which translates into longer days of inventory.

The way policy change reporting usually works out is that working capital increases in size – which is bad, since it requires more funding. So the CFO needs to be careful not to get into an “I told you so” mode when describing what happened to the company after management made a policy change. This calls for some politeness.

The Pattern Analysis Approach

And so far, we’ve only talked about what has happened. What about what will happen? The CFO may see a pattern developing in the financial statements, so it makes sense to carry the pattern forward and see what happens. So, for example, a policy decision to increase the number of days of credit to customers can be translated into a projected increase in working capital, which in turn means that the company will have used up all of its cash in three months in order to fund accounts receivable.

The Upcoming Events Approach

Another area is presenting to management some options for running things differently from what’s happened in the past. For example, the office lease is expiring soon, and if we move to the facility down the road, we can save X amount of money per year. This type of reporting isn’t really about an interpretation of financial results. It’s more about presenting an alternative view of the financials if certain things were to change.

The Need for In-Person Investigations

It is possible to write a great cover letter that highlights the main points. But to really make an impression, the CFO has to present the key points in person. That way, it is easier to expand on them.

A good presentation takes time to formulate. It’s entirely possible that you spend as much time working on the presentation as you did developing the recommendations.

So in short, the CFO should put a lot of effort into digging out just those key pieces of information in the financials that will really make a difference, and then make a persuasive presentation.

Related Courses

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High-Paying Accounting Jobs (#202)

In this podcast episode, we discuss high-paying accounting jobs. Key points made are noted below.

In what positions can you make a lot of money without being on the management track? These would be non-traditional accounting and finance positions. Keep in mind that the hours can be long, and work may start on short notice.

The Preparer of Public Company Reports

A preparer of public company reports is paid very well. Many smaller public companies don’t have enough accounting staff to do the required SEC reporting. And since the reporting activity is quite specialized, they farm it out to people who have a detailed knowledge of the reporting requirements. Someone who wants to get into this line of work needs to do it for a number of years for a larger company, as the in-house reporting specialist. Be aware that the level of precision for this kind of work is incredibly high. Mistakes are not tolerated. Also, expect a brutal work schedule, since there’ll be a few weeks when you work every waking hour. After the quarterly rush is over, there’s no further work until the next reporting period comes around. This work can be done from home.

Forensic Accounting

Another option is forensic accounting. This is usually a function within a consulting or accounting firm, where the partner dredges up a legal or insurance case that requires a detailed investigation. The work can cover all kinds of areas, like securities fraud, money laundering, and reconstructing accounting records. The work is interesting, but be aware that the work load can be bad. Projects might pop up with no warning at all. These investigations could be anywhere in the world. You may need to be an expert witness in court. So if you don’t like to be grilled by an attorney, don’t get into this line of work.

Process Consulting

Another possibility is process consulting. This could mean examining an organization’s existing accounting systems and recommending changes, or it could involve being part of a team that installs software, and the accounting processes have to be reconfigured to work with the new software. These tend to be large projects that could last for months or even a couple of years. Because of the size, they’re usually handled by large consulting firms, so you’d have to work for one of them. There will be travel on these jobs, so expect to be living out of a hotel room. A nice feature is that the client actually wants to work with you, since you’re there to improve their jobs.

Controls Analysis

A variation on process consulting is controls analysis. You can do this as an independent, but it’s more commonly found as a specialization within a larger accounting firm. And as the name implies, this is an examination of the controls that a business has in place. The outcome is a report that states all of the control shortcomings found, with recommendations for how to fix them. This tends to be one of the less stressful jobs, but this is boring work.

Tax Consulting

Another option is tax consulting. This usually means working in an advisory role to assist management, not doing tax filings. This is not a junior position. It means working in tax accounting for a long time to build up the expertise, and possibly adding a law degree onto a masters in taxation. This type of position can be found in the tax practice of a Big Four accounting firm, but it’s also possible in a larger law firm. This is really specialized. For example, it could be targeted at just wealth preservation for rich clients, or for setting up captive insurance companies, or for setting transfer prices, and so on.

Mergers and Acquisitions Consulting

A final suggestion is mergers and acquisitions advisory services. This involves due diligence on acquisition targets, figuring out pro forma results for a combined entity, synergy analysis, and so forth. These services are provided by larger firms, so you’d have to work for one. This can include investment banks, law firms, and larger accounting firms. And yet again, work tends to pop up unexpectedly, and clients expect you to drop everything and work for them for as long as it takes.

Parting Thoughts

A common thread that runs through these positions is that the perceived value to the client is high. So, for example, helping a client to win a case with some quality forensic accounting could be worth millions to the client. Or, some clever tax advice could save millions, too. Same goes for mergers and acquisitions.

On the other hand, focusing on an area where the perceived value is lower means that billing rates will be lower, too. So advising on accounts receivable collections might not justify a high billing rate. Neither would doing bookkeeping as an outsourced service. And neither would preparing tax returns. There’s lots of competition in these areas, and the value is lower, so billing rates are lower. In short, pay attention to the value being created for the client.

Related Courses

Fraud Examination

Mergers and Acquisitions

Public Company Accounting and Finance