Sales and Use Tax Audits (#230)

In this podcast episode, we discuss sales and use tax audits. Key points made are noted below.

The state government may send a team of auditors to a business, to see if it’s been remitting the correct amount of sales and use taxes. If it hasn’t, the business not only has to pay the missing amount of taxes, but also interest on the unpaid amount and penalties.

Your Chances of Being Audited

Who is most likely to be audited? Look at it from the perspective of the government. Audit teams are expensive, so they need to be targeted at businesses that are most likely to end up paying more in fees and penalties than the cost of the teams. This means larger firms are more likely to be targeted. In addition, if an audit team finds a significant problem, the business will probably be put on a watch list, and so is more likely to be targeted again in the future. This does not mean that a small business will never be audited, but it is less likely.

Another possibility is that a company will be audited as the result of an audit of someone else. For example, a supplier is audited, and the auditors note that the company wasn’t charged sales tax on a large invoice. They then target the company to see if it paid use tax on that invoice. Use tax compliance tends to be much worse than sales tax compliance, so this kind of investigation can be easy money for an audit team.

How Auditors Find Errors

How does an audit team find sales and use tax errors? They send a notification to the targeted company, stating which time periods they want to look at. When they arrive, they select a sample of the customer billings and supplier invoices from these periods, and see if there were any cases on these invoices where sales or use tax was not paid. When no tax was paid, the auditors see if there was a valid sales tax exemption certificate that was the basis for the nonpayment. The auditors also check to see if all sales and use taxes were remitted to the government, both in full and by the required payment dates.

The auditors may go even further, and investigate whether any sales made to dispose of old assets had sales taxes charged on them. After this work, the auditors compile a list of all exceptions found, and forwards them to the company controller for review. At this point, keep in mind that the business is assumed to be guilty unless it can prove otherwise, so the controller has to make a valid case for why sales or use tax was not paid.

The Error Rate Extrapolation

If the controller cannot make a persuasive case to the auditors, then the exceptions are included in an error rate extrapolation. What this means is that the auditors extrapolate the error rate percentage they found in their sample to the full population of customer billings and supplier invoices.

For example, if the auditors find that $100 of sales tax was not collected in a sample that comprises ½% of a company’s total sales volume, it will extrapolate this finding to the rest of the company’s sales – which in this case results in a total charge for uncollected sales taxes of $20,000. And then, the auditors add a late payment interest charge onto the extrapolated amount, plus penalties. The result can be a startlingly large amount that has to be paid.

Pursuing Customers for Sales Taxes

It is technically possible that a business could go after its own customers for sales taxes that it never charged them, but this is not likely, either because it damages customer relations or because the sales occurred so far back in time that collecting the amounts due is impossible. So instead, the company has to pay the entire amount.

Damage Mitigation

How can we minimize the damage caused by one of these audits? First, conduct a periodic review of the Department of Revenue’s listing of what is and is not exempt from sales tax. This is most applicable when the company currently is able to not charge sales tax, since that exemption could go away. Second, if customers have submitted sales tax exemption certificates, make sure that they’re up-to-date and completely filled out. If not, the certificates are not valid and sales tax must be charged. Third, make sure that there’s a solid process in place for calculating and paying use tax. This is an area that’s usually quite weak. And finally, conduct your own internal audit to see if any exceptions crop up. If they do, figure out how the process broke down, and fix it.

How to Treat Auditors

An additional issue is how to treat auditors when they show up on the premises. As an overall guideline, these people are professionals, so treat them with respect and give them a decent amount of office space to work in. That being said, there are a few guidelines for minimizing the damage they can cause. First, have them work in an area away from the rest of the employees, so that they don’t overhear conversations that might cause them to expand their audit. Second, have just one point of contact between the auditors and the rest of the company, and have this person carefully review everything submitted to the auditors. Doing so keeps the auditors from ever receiving inaccurate or misleading documents. And third, minimize communications between the auditors and the rest of the company. It is not helpful for the auditors to walk around, quizzing everyone about what they do and trying to dig for more information. So, talk to the accounting staff before the auditors show up, and tell them to only respond to direct questions and to not volunteer information. And finally, don’t volunteer to give them a tour of the company. If they get a tour and then see some large and expensive equipment on the premises, they may want to investigate whether sales or use tax was paid on it.

Parting Thoughts

In general, the key to surviving a sales and use tax audit is to have solid systems in place already, so the auditors won’t find much of anything to include in their error rate extrapolation. This means that charging sales tax to customers should be your default method of operation. Any sales tax exemption certificates from customers should be well-organized and reviewed on a regular basis. There should be a solid use tax calculation system in place. And finally, make sure that sales and use taxes are paid on time, every time.

Related Courses

Sales and Use Tax Accounting

Sales and Use Taxes (#229)

In this podcast episode, we discuss sales and use taxes. Key points made are noted below.

Sales Tax Basics

Sales tax is charged when there’s a sale of tangible personal property, which is to say, most anything but real estate. And it can also be imposed on the sale of some services. The seller collects the tax and remits it to the government, which in the United States is usually the applicable state’s Department of Revenue. That much seems simple, but then things get more complicated.

The seller only has to collect sales tax if it has nexus, which means that it has regular and systematic contacts in an area, usually through its employees or property. That means the seller has to collect sales taxes if, for example, it maintains a warehouse in a state, or its salespeople travel to a state to solicit sales, or it uses its own vehicles to transport goods into the other state. If this is not the case, then the seller does not have to collect sales tax. Instead, the buyer has to pay the government the sales tax, except now it’s called use tax. Also, the use tax is paid to the government where the buyer is located, not to the government where the seller is located.

So in other words, some sort of a tax is always paid, except that the name of the tax may change, and the government to which the tax is being paid may also change.

Sales Tax Exemptions

But of course, the situation gets even more complicated. Then we have sales tax exemptions. Each state has its own list of exemptions where you don’t have to pay sales tax. And it’s a long list. I looked up the exemptions list for the State of Colorado, and it’s 20 pages long. For example, no sales tax is due when selling firewood or propane for residential use. Or, alteration services are not taxable, as long as they’re billed separately from the sale of clothing. Or – and I like this one, it nearly defines what a bureaucracy does for a living - water sold through a pipeline is not subject to sales tax, though bulk water sold in tanks is subject to sales tax. Go figure.

The point is, there’re many exemptions from sales tax, so you have to check the rules that apply to wherever you have nexus. And on top of that, some buyers have sales tax exemption certificates.

These certificates authorize a buyer to not pay sales tax, either because of the manner in which it’s using acquired goods, or because of the nature of the business. For example, the purchases made by a farmer are usually tax-exempt, because the purchased goods are then used to grow crops. Or, the raw materials bought by a manufacturer are tax exempt, because they’ll go into finished goods that will then be sold, and the buyer of those goods will pay sales tax. Or, the nature of the business may allow an organization to avoid paying sales tax. This usually means governments, religious institutions, and non-profits.

When the seller receives one of these sales tax exemption certificates from a buyer, the seller needs to keep a copy of the certificate, in case its books get audited by the government and it needs proof that it acted correctly. If the exemption is out of date or was only partially filled in, the auditors can declare the certificate invalid, in which case the seller is now liable for the full amount of the sales tax that it didn’t charge the buyer.

And it gets better. Even when the seller has received an exemption certificate, the seller is not necessarily off the hook for sales tax liability.  The seller has to use his best judgment to see if a sale falls within the restrictions imposed by the exemption certificate. If a buyer tries to buy something that’s outside of the exemption range, the seller is supposed to figure this out and charge sales tax. And that really means that the sales clerks who are taking care of these sales have to be trained in how to deal with exemption certificates – which they probably aren’t. Instead, it’s quite likely that they’re relying on what the customer tells them, which may not be accurate.

Layers of Sales Taxes

But of course, it gets even better. Sales taxes can come in multiple layers. There’s the state-level tax – except for states that don’t have any sales tax – and there’s the county-level tax and the city-level tax, and there’re probably one or two special tax districts inserted in there somewhere, too. An example of a special tax district is one that’s intended to pay for a new sports arena that the taxpayers voted for. Once the bonds are paid off, this type of special district goes away. Other districts, like transportation districts that pay for a subway or light rail line, are more likely to be permanent. In total, there’re about 10,000 government entities in the United that can charge sales tax. The clear champions for tax districts are Texas, with more than 1500 of them, and Missouri, with more than 1200.

Each of these tax districts gets to charge its own tax, which is piled on top of the sales taxes from the other tax districts to create the aggregated sales tax that a person or a company actually pays when making a purchase. If any one of these districts changes its tax rate, that changes the tax rate that the seller charges when it sells goods. As you might expect, tax rates usually go in only one direction, which is – up. Therefore, if the seller doesn’t keep up-to-date on the latest sales tax rates and keeps charging the old rate to its customers, it may find that it’s been under-collecting sales tax. And when this is the case, the seller has to come up with the shortfall.

Overcharged Sales Taxes

In those rare cases where the seller has been over-charging sales tax, it cannot keep the overage. Either it returns the excess to the customer or it forwards the excess to the state government.

Private Letter Rulings

What if an organization is in an unusual line of business that doesn’t seem to be covered by any of the sales tax regulations? In that case, you can request a private letter ruling from the state government. To do that, you send them a letter that describes your circumstances – along with a fairly hefty fee – and they send back a ruling. You can usually rely on this ruling in deciding whether to charge sales tax.

In addition, the state government then deletes all identifying information from the ruling and then posts the letter on-line for everyone else to see. The private letter ruling can only be relied on by the business that asked for it, but everyone else can use the ruling to make an estimate of how the letter pertains to them. I strongly suggest bookmarking the page on your state’s website where these rulings are listed, and checking it every now and then to see if any new rulings have been posted that might apply to you.

Use Taxes

Let’s switch topics, to the use tax. How do you calculate it? The most labor-intensive approach is to review every single supplier invoice to see which ones don’t contain a sales tax and aren’t covered by an exemption certificate, and then accrue an expense for the use tax on the remaining invoices.

To save time, create a report in the accounting system that aggregates all invoices coming from out-of-state suppliers. Then include a flag in the vendor master file for all of the out-of-state suppliers that still charge the company a sales tax, and use this flag to exclude those suppliers’ invoices from the report. Then use the same approach to flag suppliers that only ship goods that are exempt from sales tax.

After you’ve completed these refinement steps, the total use tax due on the final report should be fairly accurate.

Sales Tax Payments

And one final comment. Sales tax payments usually – but not always - go to the state government, which turns around and allocates a portion of each payment to the applicable county, city, and special tax districts. This makes the remittance of sales taxes fairly easy for the seller.

This is not always the case for the payment of use taxes. You may need to make separate use tax payments to each one of those entities. That means a separate use tax payment to the state, and the county, and the city, and each one of the special districts.

In short, I think you can consider the sales and use tax regulations to be a sort of full employment guarantee for accountants.

Related Courses

Sales and Use Tax Accounting

The Best Practices Trap (#228)

In this podcast episode, we discuss the best practices trap. Key points made are noted below.

Problems with Best Practice Installations

Installing every possible best practice is not always a good idea. In fact, it can be a trap if you go too far down the best practices road.

Installing best practices involves a mindset of wanting to reduce costs and be more efficient. And that mindset works great in accounting, because the accounting department is clearly a cost center. That is, the department consumes costs and it really doesn’t create any significant revenues. Therefore, any reasonable controller or CFO is going to want to reduce costs within the department as much as possible. And to do that, they employ best practices, like altering process flows to make them more efficient, or automating the payroll system.

There’s a positive feedback loop that occurs when you install best practices, because costs go down. This looks great to senior management, so there’s a natural tendency to keep looking for more best practices to install. That means controllers and CFOs get caught up in searching the literature and going to conferences to find more best practices. And they spend the rest of their free time supervising best practice implementations.

Cost Eliminations from Best Practices

So what kinds of costs get eliminated from the accounting department as a result of best practices? Look at the department expense report, and you’ll find that most of it is labor. Which is to say, wages, payroll taxes, and benefits. So as best practices are installed, it’s pretty likely that the department headcount goes down.

So let’s work through the scenario as far as it can go. If the department is focused on best practices, there’ll be fewer and fewer employees in the department. Ultimately, there may only be a small number of process experts who oversee a bunch of highly automated processes. What could be better, right? The problem is that the accounting managers are viewing the value added by the accounting department to the rest of the company only in terms of cost reduction within the department.

Headcount Reduction Problems

If this is your viewpoint, then costs can be reduced to a certain point and the department is staffed with process experts who have no expertise in anything else. In essence, the unending focus on cost reduction has narrowed the skill set of the department too much and has eliminated its ability to deal with additional projects. The accounting department no longer has the ability to assist the rest of the organization in any other ways.

For example, there’s no one to provide due diligence work on a prospective acquisition. Or, there’s no one to do a financial analysis of an asset purchase to see if it makes sense. Or, a process is changed somewhere else in the company, and there’s no one left in accounting to provide advice on the controls that should be used for the revised process. In other words, the advisory and analysis roles of the department have been purged.

This is not good, because the decisions made by the senior management team may be the wrong ones, due to the lack of in-house advice. The result is costs being incurred that are much higher than the cost savings that the controller or CFO created by eliminating staff positions. For example, there are too few accounting staff on hand to deal with the due diligence work on a possible acquiree, so the senior management team decides to go ahead with an acquisition without the due diligence – and then incurs massive losses when the acquiree’s sales turn out to have been faked. Which is something that the accounting staff would have spotted.

Problem Mitigation Actions

So what can you do? After all, there’s usually ongoing pressure to cut costs, so it’s not easy to advocate retaining extra staff.  There’re a couple of possibilities. One is to make a list of every best practice that you still want to install, and list next to each one the amount of expected cost savings. Then sort the list in declining order of cost savings. There’s a good chance that the projected savings will start being pretty slim once you get just a short ways down the list, so consider pausing the best practices effort after those first few big cost savings projects are completed. It’s a good bet at that point that ladling out advice elsewhere creates more value than continuing to push for more best practices implementations.

Another possibility is to build a case for retaining a core group of advisory staff. You can do this by creating a comparison of the cost of this group to the savings they’ve generated for the company over the past few years.

This analysis is not that easy, since it may involve situations where the accounting department kept the company from making a bad decision – which is difficult to quantify.

In short, best practices are a good idea, but keep in mind the bigger picture of helping out the entire organization before you gut the department to reduce expenditures.

Related Courses

Accounting Information Systems

Lean Accounting Guidebook

Cleaning up Messy Books (#227)

In this podcast episode, we discuss how to handle a situation where the books are a mess. Key point made are noted below.

This is a fairly common problem, especially if you’re in the bookkeeping business and a new client has basically been operating out of a shoe box. In short, there really aren’t any accounting records, there are just source documents. Or, someone might have tried to keep the books, but they had no idea what they were doing, so the accounting records are incredibly bad.

Stop Any Further Damage

So, the first step is to stop the damage from occurring from this point forward. That means routing all of the new, incoming source documents through a reliable bookkeeping system. This presents a bunch of problems. First, is the original bookkeeper still going to be involved? That might be bad, because the person clearly hasn’t demonstrated any ability to keep the books so far. This is going to be a judgment call. If the person is clearly incompetent, then remove him from the accounting operation immediately. If the person simply didn’t have any training, then it may be possible to correct his behavior.

Take Control of the Source Documents

The next issue is taking over control of the source documents. Make sure that all supplier invoices and employee expense reports are being routed straight to you. The same goes for payroll records and customer billings. It’s impossible to keep the books if the paperwork is scattered all over the company.

Enter Transactions Properly

Then set up a chart of accounts in a simple accounting software package and start entering the accounting transactions the way they’re supposed to be entered. The emphasis is on getting an operational system running as soon as possible. What this does is give you a functional general ledger from the current day forward. With just this information, you should be able to construct an income statement without too much trouble. The problem is that it’s impossible to create a balance sheet without the prior records – and that brings us to the second step, which is using the old source documents to construct general ledger transactions for prior periods. And this presents another bunch of problems.

The first problem with reconstructing the old records is that you may not be able to load them into the new accounting software that you’re now running the business on. Some of these packages don’t allow you to create accounting periods prior to the current period. If so, you’ll need to initially store these old transactions on an electronic spreadsheet. When you’re done researching the old records, you may need to start up a brand new accounting software package and load in both the old accounting records and the new records that you’ve been maintaining since you took over the books.

An alternative that’s less messy is to initially set up the earlier reporting periods in the accounting software and leave them empty, and then start recording entries in the current period. Then re-open the earlier periods when you have transactions to record in those periods.

Determine What to Record from Prior Periods

The next problem is figuring out what to record for the prior periods. There are two key principles to follow. One is that every transaction has to be verified, which means that there must be a source document. If you record an accounting transaction and it’s not based on a source document, then, if you’ll excuse the expression – you’re just making shit up. The other principle is to verify every transaction you’re recording through the company’s bank statements. There’re actually some situations when a source document doesn’t appear in the bank statements, which I’ll get to in a minute.

The bank statement is the best possible record of what the business has been doing, since it shows all cash inflows and outflows, and the bank should have an online image scan of every check and deposit that was processed through the account – which is valuable evidence.

So, based on these two principles, the reconstruction of prior period accounting records involves coming at the work from two directions. You can start with the source documents in that shoe box and verify that they happened by checking them off on the relevant bank statement. Once you’re sure it happened, create a double entry journal entry for it in the correct reporting period and then move on to the next source document.

Then turn the situation around and trace all items that have not yet been checked off on the bank statements back to the source documents. This might result in clear evidence of a cash payment or receipt, but no source document, in which case you may have to dig around for it, maybe by contacting a supplier or customer for the relevant document.

At this point, you’re probably going to have a set of supplier invoices that didn’t trace through to the bank statement, and that’s because they haven’t been paid yet. These are recorded as accounts payable. And, along the same lines, there’ll be customer invoices that don’t appear in the bank statements, and that’s because they haven’t been paid yet. Those are recorded as accounts receivable.

As you might expect, this is a slow and incredibly painful process. The longer the books have been a mess, the longer it will take to conduct a complete clean up. At some point, a reasonable question to ask is whether it’s really worthwhile to keep going further back in time.

Complete Financial Statements and Supporting Reports

After going back to the beginning of the current fiscal year, you’ll be able to put together some semblance of a balance sheet, and you’ll have sales and profit figures for the entire current year. And, if the rollback work was for at least three months, you’ll probably have reconstructed something pretty close to the actual aged accounts receivable and aged accounts payable reports.

With this information available, the business is operational. So, depending on the circumstances, you can then restart the general ledger as of the beginning of the year and load in all of the earlier transactions. Or, if you initially set up the general ledger with a bunch of empty earlier reporting periods, then you should have now populated those periods with transactions.

Switch to the Accrual Basis of Accounting

Here’re another consideration. When someone is operating out of a shoe box, they are probably operating on the cash basis of accounting, which means that they record revenues when cash is received and expenses when bills are paid in cash. This would be a good time to switch the company to the accrual basis of accounting, since you’re putting their books through a complete overhaul anyways. And THAT means going back into the accounting records to record accruals for the prior months that you’ve reconstructed, so that each month now has accrued expenses on the books. By doing that, the reported profit levels are likely to be more consistent in the earlier periods, rather than gyrating around, depending on the dates when cash came in or went out.

Related Courses

Bookkeeping Guidebook

Closing the Books

New Controller Guidebook

The Learning Process (#226)

In this podcast episode, we discuss the continuous learning in which an accountant can engage. Key points made are noted below.

Accounting Standards Updates

This is a large topic, because it’s so broad. Let’s start with just accounting learning. Most people are going to find that, for their chosen industry, the accounting doesn’t really change that much. To stay on top of anything that might impact you, go to the accounting standards updates that the Financial Accounting Standards Board posts on-line. If you check the updates maybe once a quarter, you should be fine.

A larger problem is how to advance your overall knowledge. As you become more senior, other people are going to start judging you based on your knowledge and also on your opinions. So if you stop trying to educate yourself, outside of the occasional accounting standards update, you may find that people stop considering you for higher-level positions – because you don’t behave like someone who deserves to be in that kind of position.

News Sources

There are a couple of ways to deal with this. At the most minimal level, it helps to be generally aware of what’s going on in the world. My main source of information for a quick scan of the headlines is Google News. I check it first thing in the morning when I get up, just to see if there’s anything that I should know about. I might click on one or maybe two of the articles and spend a few seconds to see what’s going on. The intent is to appear reasonably informed if the people I deal with bring up a news item. If I don’t spend five minutes on this scan each day, I’m going to appear ignorant.

Podcast Sources of Information

There’s lots more learning that I do, but a major consideration is how much time it takes. As you’re going to find out as you advance in your career, there’s nowhere near enough time in the day. So one thing I do is sign up for podcasts that I can listen to when I’m in the car. A good one is The Economist Radio podcast. They put out maybe a half-dozen episodes per week, mostly short ones, where they talk about business and politics. Another possibility is the HBR Ideacast. It’s put out by the Harvard Business Review magazine, which I’ll get back to in a minute. The Ideacast comes out once a week and each episode is about 15 minutes. I find that these can be a little too professorial and abstract, so maybe one episode in three is really informative.

Another podcast that’s quirky and really informative on odd topics is Planet Money, which is produced by National Public Radio. The general scope is absolutely anything involving business or money. For example, recent episodes were about the old monopoly on cheese in Switzerland and interviewing some of the staff at Wells Fargo about the issues that were going on over there during the recent scandal. Those episodes run about 20 minutes.

Another possibility is the Entrepreneurial Thought Leader series, which is produced by the Stanford Business School. They bring in business leaders, usually very senior-level managers or investors, to talk about business startups. Every episode is good, but they’re also long. These run for an hour.

And my last podcast recommendation is The World Next Week, which is produced by the Council on Foreign Relations, which is a Washington think tank. You get doctorate-level people talking about the most important foreign events – and it’s just great. Their perspective is not conservative or liberal. It’s more from a practical or maybe a pessimistic viewpoint about what’s going on in the world.

Travel as Education

I happen to like The World Next Week because I think the greatest education is traveling all over the world. Once I spend the time to really get to know a country, I remain interested in it for life. So far, that means I’m always digging through the news to learn more about the 36 countries that I’ve visited – so far. I try to add on a couple of countries every year.

I also find that experience is the best form of education, because those lessons really stick. The next best form of education after experience is a really deep dive on a specific topic – something that runs for several thousand words, and which comes from a reputable source.

Recommended Magazines

Which brings me to the next form of continuous learning, which is magazines. And when I say magazines, I also mean their on-line sites. First, business magazines. I’ve subscribed to Fortune, Forbes, and Business Week at various times, and eventually dropped Fortune and Forbes, and kept Business Week. The problem with all of these magazines is that some of the articles seem to have been written by the public relations departments of the companies that are being spotlighted. There’s some investigative journalism, but not a whole lot. So I keep Business Week around just to be informed at a modest level about the most current business topics.

I also subscribe to the Harvard Business Review. The articles are always well-written and they go pretty deep on business research topics. Each edition has a different theme, so one edition might have nothing but product development topics in it, while another one might have nothing but marketing articles. By and large, I really like what they do, but that’s partially because I write business books and they’re a good source of ideas. Some people may find that HBR is too much information. It may not be for everyone.

Another source of deep information is not a business magazine at all. It’s the New Yorker. A good thirty pages of each edition is about local New York activities, which may not be of much use. However, there are usually one or two amazingly detailed articles in the middle of the magazine that make the entire thing worthwhile. For example, they just ran a long article about the political situation in the Philippines, and the week before that they did the same thing for Venezuela. So if you have an interest in foreign affairs, the New Yorker is a good bet.

ProPublica

This may seem like a lot of good sources of information, but actually things have gotten a lot worse over the past few years. Newspapers are not profitable, so they’ve laid off many reporters, which means that the quality of reporting has gone down. And this is where I’m putting in a plug. There’s a nonprofit website called propublica.org. They’re based in New York, and at the moment they have 45 reporters who all do investigative reporting. They’ve already picked up three Pulitzer prizes, so they’re good. They’re also non-partisan, so they will investigate anything. You’ve probably already read their stories, since they have dozens of partner news organizations that distribute their articles. Take a look at propublica. If you like them, consider sending them a donation. I send them money every month.

General Impact of Learning

I’m going to finish up by describing how this lifelong learning has impacted me by talking about – Turkey. I traveled pretty extensively through Turkey years ago, met a lot of people, and have a very high opinion of the country. I’ve rarely seen that level of hospitality anywhere. Since that opinion was experience-based, I’m probably going to keep it for life. It also means that I’m quite interested in what goes on there.

A couple of years ago, Wikileaks posted a massive number of State Department reports on its website. Even though I’m not a great fan of WikiLeaks – separate story – I went to the site and looked up what they had on Turkey. There was an amazingly detailed analysis of Prime Minister Erdogan that spotlighted his personality and how he might react to opposition, and lots of other things. Since this was a deep analysis and it came from a reputable source, that affected my opinion – not of the country, but of its leadership.

And then there was the coup attempt a short time ago, where now-President Erdogan cracked down all over the country and also demanded that the United States extradite a cleric who was based in Pennsylvania, but who he claimed had initiated the coup. Having read the earlier State Department report, I was skeptical about the claim.

But then the New Yorker put out another one of its great articles about this Pennsylvania cleric, and it turns out that there might be some truth to Erdogan’s allegations. At a minimum, there are a couple of very large egos battling each other.

So what does that example have to do with the continuous learning experience for a CPA? On the face of it, nothing at all. But what you should be getting out of my story is the process I went through. I initially formed an opinion based on personal experience and then added to that opinion based on some very solid information sources. I did not rely on those one-paragraph news snippets that you see so much of these days.

Now this does not mean that I’m an expert in everything – I’m probably just an expert in accounting and nothing else. But what I do have is a fair amount of learning on topics that interest me. And if anyone wants to hear my opinions on those topics, then I can hold forth pretty well.

Now, remember what I said earlier about how people will judge you based on your knowledge and your opinions. If you follow the path I’ve described – going out and getting experience, as well as learning from the best news sources – you’re going to come across as a much more interesting person – and probably a more influential person – and that will most definitely help you in your career.

The Reserve for Obsolete Inventory (#225)

In this podcast episode, we discuss the reserve for obsolete inventory. Key points made are noted below.

The Need for the Reserve for Obsolete Inventory

This reserve means that you recognize an expense in advance for inventory that’s already on hand, and which is likely to be thrown out or disposed of in some other way. The presence or absence of a reserve can be a big deal when a company has a large amount of inventory on hand and it’s not doing a good job of managing it. In this case, who knows how much of the inventory is obsolete? A quarter? Maybe a third? No one knows. From my experience, the proportion is frighteningly high. But that doesn’t mean you need a reserve in all cases.

Where a reserve is needed is when the inventory turnover level is low, the investment in inventory is medium to high, and there’s not a good system for tracking it. When those conditions are present, there’s bound to be a lot of old inventory that should be eliminated.

Now, just turn around those conditions to figure out if you don’t need a reserve. The inventory turnover level is high, so the inventory is being flushed out rapidly, and doesn’t have time to become obsolete. The investment in inventory is low, so even if there is obsolete inventory, the write-off is minimal. And third, if there’s a good inventory monitoring system in place, then management already knows which items are getting stale and is taking steps to eliminate them.

So let’s assume you’re in the first group, so there’s likely to be obsolete inventory mixed in with the other inventory. In this case, there’s something else to think about before you go anywhere near creating a reserve for it – which is that the management team routinely denies the truth and claims that there’s no obsolete inventory. They do this because creating a reserve triggers a hit to profits. In essence, they can put off recognizing a loss until next year, so let’s just leave things the way they are.

How to Set up a Reserve

This is a real problem if you’re the accountant and you’re trying to do the right thing and set up a reserve. Your best bet is to get the auditors on your side and have them demand the reserve. Even then, management is going to press for a really small reserve, but at least it’s a start.

Now, how do you figure out the amount of the reserve? There’re a couple of ways to do it. One is to have an experienced group of users examine the entire inventory on an ongoing basis and figure out exactly which items are obsolete. Then estimate the amount that the company could earn by dispositioning the inventory in the most profitable way. The difference between the book value of this inventory and the proceeds from dispositioning it is the amount that the company is going to lose. That’s the amount of the reserve.

But there are a couple of problems with this approach. First of all, it assumes that there’s a well-organized system in place for figuring out which inventory is obsolete and how much it can be sold for; which may not be the case.

As another issue, consider that a reserve is really intended for losses that you don’t yet know about. Which is to say, once the obsolete inventory is identified, would it make more sense to write down its value to its disposition price right away, rather than messing around with a reserve?

To take that concept one step further, a precise identification of obsolete inventory is probably going to fall short of the actual total amount of obsolete inventory, since there’s always some amount that will be unknowable. So keep these shortcomings in mind.

An alternative approach is to just make an estimate. To do so, compile the cost of the obsolete inventory that you’ve disposed of in the past year, and divide it by the average cost of the total inventory for the same period. And that’s your obsolete inventory percentage, which is the basis for creating a reserve. This approach works pretty well, but only if you’re tracking charge-offs due to obsolete inventory.

If you’re not, and people are just throwing away old inventory, then there’s no way to make the estimate. Instead, the lost inventory just means that the ending inventory valuation is now lower, which means that the obsolescence losses are being dumped into the general cost of goods sold expense. To get around this problem, set up a system for charging off the cost of these throwaways to a special account for obsolete inventory losses. After a few months, you should have a reasonable idea of the cost of this inventory.

But – and it’s a large but – only if management is willing to part with the inventory. If the warehouse staff is under orders from management to never throw away anything without their express consent, then you may find that the cost charged to this account is really small – if not zero.

Accounting for a Reserve for Obsolete Inventory

Despite the issues I’ve just noted, using a general obsolete inventory percentage as the basis for setting up a reserve is usually the best way to go. So let’s assume that you want to set up the reserve. How do you do that? Create a contra account that’s paired with the inventory asset account. That means the contra account has a natural credit balance, so that its balance offsets the natural debit balance in the inventory account.

Then charge the initial reserve amount to the contra account – which is a credit. The offset is an expense, which can be to the general cost of goods sold account, or a special expense account that’s just for obsolete inventory. Then, when you actually have obsolete inventory, write its book value down to the value the company can earn from its disposition. That’s a credit to the inventory asset account. Meanwhile, the debit is to the reserve account, which reduces the amount of the reserve.

What all of this means is that recognition of the expense is accelerated, rather than delayed if you were to just charge it to expense when something is eventually identified as obsolete.

So, what about dealing with the reserve on a going forward basis? The reserve amount as a percentage of the total inventory valuation should be kept fairly consistent, unless there’s a significant change in the underlying obsolete inventory amount that needs to be reflected in the reserve. Otherwise, you just need to make minor adjustments to the reserve on an ongoing basis to keep it at the right size.

Dealing with Management Opposition

I’ve kept mentioning that management wants to oppose this process. Even if you manage to create a reserve and it’s initially of the right size, expect management to push for a smaller reserve over time, so that they can delay the recognition of an expense into a later period. There is a way to combat this. Prepare an annual schedule that compares the size of the reserve as a percentage of the total inventory valuation, and run it back for a bunch of years. Then give it to the auditors when they show up for the year-end audit. They can then use this information to make inquiries regarding why management wants to have a smaller reserve.

Related Courses

Accounting for Inventory

How to Audit Inventory

Inventory Management

Construction Industry Accounting (#224)

In this podcast industry, we discuss the accounting for the construction industry. Key points made are noted below.

Unique Construction Issues

The construction industry is unusual in several ways. Pretty much every project is unique, so it varies from the usual business, where there’s a standard product. Also, the level of demand can go from really high to really low within a few months, so a construction company tends not to keep too many people on staff – instead, it relies on subcontractors for a lot of the work. And it can be difficult to schedule the subcontractors. It’s also hard to track resources, because specialist workers and specialized construction equipment may be moving among several job sites. All of these factors make it easy for expenses to get out of control fast.

To make matters worse, contracts with clients may be on a fixed fee basis, so the contractor has to absorb any cost overruns – and that means it’s unusually easy to lose money on a construction project.

Change Orders

To deal with these conditions, the accounting staff tends to be unusually large. It has to closely track the work hours of the staff, and the hours being charged to jobs for equipment usage. And an item unique to this industry is change orders, which are adjustments to the baseline contract for alterations to a project. The accounting staff needs to compile the cost of each change, give input on what kind of price to charge for the change, and then negotiate with the customer to have the change accepted. And then bill the change. If change orders aren’t handled properly, the company will almost certainly lose money on a job. These activities take a lot of time, which is why construction requires so much accounting labor. It’s also difficult to streamline the process, because each job is unique. In fact, a larger job may require its own accounting staff.

Cost Tracking

And then we have the cost tracking. There needs to be a job cost ledger, which is a subsidiary ledger that feeds into the general ledger. The job cost ledger compiles all of the costs for each individual job. The accounting staff makes sure that each cost incurred is assigned to the correct job. In addition, each client may have different rules for what types of overhead costs are allowed to be charged to their job, in cases where they’re being billed for the costs incurred. So the accounting staff needs to maintain a separate cost allocation calculation for each job.

Equipment Ledger

There may also be an equipment ledger. Each piece of construction equipment has its own account in the equipment ledger, so that costs incurred can be charged to each piece of equipment. You need this information in order to figure out what hourly or daily equipment rate to charge to each job.

Revenue Recognition

And then there’s the revenue recognition. For the longer-duration projects, the percentage  of completion is calculated, which can be based the proportion of costs incurred to date, or the proportion of labor hours incurred, or some similar measure. Based on this percentage, the accounting staff determines what percentage of job revenues and costs it can recognize in the reporting period. If the amount actually billed is less than this amount, then the contractor recognizes an asset called costs and profits in excess of billings. If the reverse is the case, where the amount billed is more than is indicated by the percentage of completion calculation, then the contractor recognizes a liability, which is called billings in excess of costs and profits.

And in case the situation already sounded complex, let’s get back to those change orders. The contractor may also have a bunch of claims that it wants the client to pay, and which the client hasn’t agreed to yet. For example, maybe the client had agreed to have a portion of the job site cleaned up by the time the contractor sent in a work crew, and it wasn’t – so the work crew had to spend time unexpectedly doing cleanup work.  So the project manager files a claim with the client to have this cleanup cost reimbursed. There can be a mass of these claims percolating in the background throughout a job, and they may not be settled for a long time, as the parties bicker about who is responsible for payment. You can’t recognize the revenue associated with claims, because payment is too uncertain, so the accounting staff is always pushing for resolution. Which means documenting claims and attending meetings with the client to go over these items.

Estimated Project Profitability

The accounting staff also has to run an ongoing estimate of the project profitability, based on the percentage complete and the amount of costs incurred to date.

If this analysis results in a projected loss, then the loss has to be recognized right away. This can require some pretty detailed cost estimating work, especially early in a contract when most of the costs haven’t been incurred yet. This analysis also puts the controller under quite a bit of management pressure, since they don’t want to recognize any losses, and especially well before a job has even been completed.

Retention

And yet another item is the retention. This is a percentage of the contract price that the client will not pay until after the job is complete and it’s accepted the job. The amount of the retention is usually in the range of five to ten percent, which can be a lot of money that’s not coming in to pay bills. So, the accounting staff needs to track the amount of these retentions and factor them into the cash forecast. And then to complicate matters further, the contractor might do the same thing to its subcontractors and impose retentions on them – which calls for splitting out the retention amount in accounts payable and figuring out when these items are supposed to be paid – which is a manual tracking process.

Construction Controls

Construction also needs a bunch of controls that you just don’t find anywhere else. For example, fixed fee bids have to be accurate, or else you either lose a project because the bid was too high, or lose a lot of money because you incorrectly bid too low. To counteract this, contractors use a cost checklist to make sure they didn’t forget to include any costs, as well as multiple reviews of the initial bid.

As another control example, construction equipment is frequently rented, and the daily rental rates are high. This equipment may be used on multiple job sites, so it’s easy to lose track of where it is, which means that the contractor keeps piling up rental fees. So, there’s a control to monitor where equipment is located and whether it’s being used.

Yet another area for controls is the job cost ledger. A job needs to be shut down in the ledger as soon as the job is finished. Otherwise, costs for other projects might be coded into this old job, which incorrectly makes other jobs look more profitable than they really are. Some project managers look for these old, open jobs and stuff expenses into them in order to make their own projects look better.

Another good place for controls is the job site. It’s fairly easy to steal materials from a job site unless you fence it in and maybe use a security guard.

And finally, a great place for controls is change orders. There should be a change order log that’s used to track the approval status of every change order, as well as a change order committee that meets regularly to discuss and approve change orders. Otherwise, there’s a real risk for the contractor of losing money on unapproved change orders.

Related Courses

Auditing Construction Contractors

Construction Accounting

Real Estate Accounting

New Controller Stories (#223)

In this podcast episode, we discuss several stories relating to being a controller for the first time. Key points made are noted below.

Don’t Piss Off Anyone

When I first became a controller, the previous controller had been fired the preceding Friday and I started work the next Monday morning. The company president didn’t like the job she was doing, and also thought the accounting staff wasn’t very good. So, he wanted me to show up, call a meeting, and tell everyone they sucked. You can imagine how this would have gone if I’d actually said that. Luckily, the president wasn’t sitting in the meeting, so I managed to put a more positive spin on things and just pointed out that we were going to clean up the systems. That’s a lot less personal. So, lesson number one – don’t piss off anyone on your first day.

Clean Up

After that, I asked the president about exactly why he didn’t like my predecessor. Turns out, she kept a very messy office and took between three and four weeks to issue financial statements. I inherited her office, which had probably a thousand pounds of paperwork in it. So, from the first day through about two months later, I spent the end of each day rooting through the paperwork to see what could be thrown out or archived. Most of it I threw out. At the end of that time, I have a big office with next to nothing in it. I kept a stack of paper that weighed maybe five pounds. So, lesson number two – clean up the mess, so you can focus on what’s really important – which is usually only a few items.

Produce Financials Faster

The paperwork cleanup was an ongoing issue, so then I met with the staff one on one. The assistant controller was really good, and the rest of the staff was anywhere in the range of adequate to good. So despite what the president was saying, the staff was actually OK. What was bugging the president more than anything was late financials. Since we were coming up on the end of the month, I decided to get the financials out really fast. However, this was a manufacturing company, and they were bursting at the seams with too much inventory. And the inventory records were not very good. So I ended up spending a lot of time in the warehouse to figure out what was going on with their systems. At this point in my career, I was already something of an inventory specialist, so word got back to the president that the guy in the suit actually knew how to run a warehouse. So about a week after I started, the president gave me the warehouse to run.

The Problem is the Systems

I can’t really recommend being given an extra department this early in the game. There’s just too much work to do already. Nonetheless, I took over the warehouse. And found that the warehouse staff was unusually good. The problem was in the systems. Which brings us to lesson number three – the problem is usually not the people. It really is the systems. If you can get people to trust you, it’s possible to mutually figure out what’s wrong and keep it from happening again.

That first month, we closed the books in something like three or four days. Which was taking a risk, because the inventory record accuracy was really awful, so the cost of goods sold figure was shaky. But there were still a bunch of months to go before the year-end audit, so there was time to keep improving the accuracy, which meant we’d have time to perhaps write off more inventory losses later in the year. As it turns out, the numbers were actually pretty close in that first month. So, when we issued financials so fast, and they were accurate, the president stopped complaining. Unfortunately, he also gave me the purchasing department to run. That was at about the end of the first month.

Limit Your Areas of Responsibility

I did not have time to run purchasing, because it had problems too. That brings me to lesson number four. Do not go around trying to grab additional responsibility when you’re just starting out. If you’re good enough, it will come to you. If you’re not good enough, you’ll sink under the weight of all the responsibility. So don’t try to run everything.

Identify Ethical Problems

But there’s more. I needed to meet the rest of the management team. Which meant talking to everyone – the sales manager, production manager, engineering manager, human resources, and so forth. This was a good group. But I got the impression very quickly that the president had major ethical issues.

He pushed the staff to do all kinds of things, like shipping goods without customers having placed orders yet, shipping goods well past midnight on the last day of the month, fudging inventory records, and so on. The reason was that the company had been partially acquired by a major international company, and the new owner was offering big bonuses if profits could be increased by a lot.

So this became an ethical strain as we got closer to the end of the year. The profit goal was about double what the company had made the year before, so the pressure was intense to jack up profits, no matter what. This had an interesting effect on the management team, which was really a decent group of people. We worked together to push back as much as possible, but the president was on everyone, every day. And he worked that gray zone pretty hard – where the decision to record revenue could have gone in either direction. We had Big Four auditors, and I ended up being much more on their side than the company’s in order to keep things honest. And at the end of the year, the president got his bonus – just barely.

When to Bail Out

Which brings me to lesson number five. No matter how good the staff is and even if the bulk of the management team is OK, you need to get out if the senior management group wants to stretch the rules. And from what I’ve seen and heard, that’s a lot of senior managers. So take the time to get the measure of those people. If it’s clear that you can’t trust them to be honest, then start looking for a new job. Otherwise, that company will earn a bad reputation, and it’ll be on your resume for the rest of your life.

So, to summarize. As a new controller, you’re ignorant of the company and the people who work there. So, be quiet and get to know everyone. Then figure out a quick win to gain a positive reputation – in my case, issuing financial statements. Next, don’t assume that employees are incompetent; in most cases, you cannot fix a problem just by firing someone. And finally, step back from the day-to-day activities and try to see what’s going on at a higher level. If there’re ethical issues, start planning your exit. And yes, I left that company after being there a couple of years – the experience was great, but the main lesson I learned was not how to be a controller – it was how to tell right from wrong.

Related Courses

Behavioral Ethics

New Controller Guidebook

Unethical Behavior

Data Presentation (#222)

In this podcast episode, we discuss the best ways to report performance measurements. Key points made are noted below.

Identify Actionable Items

Always pinpoint the underlying goal for reporting the measurements. It should be to tell the recipient about actionable items. That means you give the person some information, and he acts on that information. So let’s play with this concept for a bit.

First, narrow down the presentation to a few actionable items. The trick is to set change thresholds for reporting the measurements. There’re usually two thresholds, one on a percentage basis and one on a currency basis. For example, you might have a trigger that reports on changes in the amount of office supplies expense if it exceeds a 25% unfavorable variance or a $1,000 unfavorable variance. If the change is less than that, don’t report the variance.

But that’s not enough. The trouble is that some changes, even if they’re quite small, could be key indicators of bigger problems. For example, what if a measurement is the percentage change in products being returned? I don’t want to wait to see this information if it has to increase by 25%. I may want to know if it increases by just 1 or 2%. So what this means is that the threshold may change, depending on the measurement. You may not want to see an unfavorable office supplies variance unless it’s a seriously large one, because – most of the time – who cares?

But a very small change in things like the cost of goods sold, the order backlog, or product returns could be a good reason for people to run around pulling their hair out.

Consider the Baseline

The next issue to consider is the baseline. We’re talking about only reporting something if it exceeds a threshold, which is calculated as the change over a prior period. But which prior period? What if the immediately preceding period was also an odd month? For example, a major supplier invoice is lost in the mail in April, and no one notices, so the expense appears in May. So the calculation of the variance is based on the percentage change of the number in May – which was high – over April – which was low. In reality, there is no variance, because there was a timing problem. A good way to get around this is to base a percentage change over the average for the past three months. That way, the monthly anomalies are reduced through averaging, so there should be fewer big variances to report.

Watch the Trend

But that’s not all. Sometimes measurements have a way of creeping up on you, maybe at the rate of a fraction of a percent per month. So if you’re only spotting items based on their changes within a short time frame, you might never report on it, even though it’s actually pretty important. For example, if the cost of goods sold percentage is going up by a half a percent a month, it might not appear significant. But over a full year, that’s six percent, and that might put you out of business. So the way to get around that problem is to also compare the measurement to what it was 12 months ago. If there’s a significant year-over-year difference, then report it.

After spotting an issue, write up a report, sit down with the recipient, and go over it in person. The report length should be one page. That is the best way to convey performance measurements.

Simplify the Report

If you want to just lay out the performance measurements, then at a minimum, only report quarterly results plus the most recent month. By doing that, you’re dropping down from 12 data items per year to four or five, depending on the situation. Once you’ve reduced the number of data items, round off the numbers. Showing something to the third digit really doesn’t help. Just round up the number to a reasonable level. For example, a performance measurement is the total monthly sales for a product line, and let’s say the actual number is $14,326,820, you can probably report it as $14.3 million. As long as the rounding is still within about 1% of the actual figure, no one is going to care. And it’s way easier to read when you use rounding.

Alternative Presentation Formats

What about using diagrams and charts? For me, the answer is no and no. I prefer the straight numbers, and so Excel is what I use. But that is also my preference. It works for me, because I deal with numbers all day. What you might want to do instead is ask the recipient what he wants. If he prefers to see horizontal bar charts or pie charts, than give him that. If I absolutely have to report information in a chart, I use vertical bar charts. Again, it’s a matter of preference. I find them to be less vague than other forms of presentation.

When done right, PowerPoint is a great presentation tool. Doing it right means keeping the number of slides down to a tiny amount – like ten. Or less. And having just a couple of points on each slide – which it seems that almost no one can do. Instead, there are way too many slides and vast amounts of information crammed onto each one.  If you really want to try PowerPoint, just keep in mind that a clean, simple presentation probably took hours and hours to put together. And it may have started with quadruple the number of slides and then took about 20 iterations to boil it down to the essentials. So my comment in regard to PowerPoint is to avoid it unless you absolutely, positively have to give a presentation, and then block out a whopping amount of time to prepare it.

Related Courses

Business Ratios Guidebook

Key Performance Indicators

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

Corporate Cash Management

How to Audit Cash

Optimal Accounting for Cash

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.

Related Courses

How to Conduct an Audit Engagement

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.

Related Courses

Accounting Controls Guidebook

Accounting Information Systems

Accounting Procedures Guidebook

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.

Related Courses

Fraud Examination

Fraud Schemes

How to Audit for Fraud

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.

Related Courses

Fraud Examination

Fraud Schemes

How to Audit for Fraud

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.

Related Courses

Fraud Examination

Fraud Schemes

How to Audit for Fraud

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.

Related Courses

Capital Budgeting

Financial Analysis

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.

Related Courses

Accounting for Leases

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.

Related Courses

Business Strategy

How to Conduct an Audit Engagement

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.

Related Courses

Working Capital Management