Accounting for Mining (#261)

In this podcast episode, we discuss some aspects of the accounting for mining. Key points made are noted below.

Mine Exploration Activities

One issue with the accounting for mining is that a mine operator first has to engage in exploration activities in order to even figure out where to develop a mine. Then it has to decide whether it would be economical to build the mine, and only then can it begin developing the property. In these early stages, there isn’t necessarily any prospect of having a viable business, so all of the expenses incurred have to be charged to expense as incurred.

Mine Development

The situation changes when you actually start to develop the mine. At this point, management has decided that commercially recoverable mineral reserves actually exist, and so has decided to proceed with construction. There can be a lot of development costs, such as building roads to get to the mine site, and sinking shafts, and removing something called overburden, which is the rock or soil that lies on top of a mineral deposit. All of these costs are capitalized during the development stage.

Sustainable Production Phase

That development stage ends when sustainable production begins. At that point, you can start amortizing the costs that were capitalized during the development stage. The amortization method used is the units of production method, which is not used all that much elsewhere. Under this approach, you estimate the total output expected from the mine, and then amortize the proportion of the total output actually mined.

So, if the capitalized amount of development costs is $1 million, and the mine has just produced 2% of the total amount of expected ore, then you can charge 2% of that $1 million to expense in the current reporting period. If there’s no production from the mine, then there’s no amortization.

Inventory Valuation

The next phase in the life of a mine is the production phase, which should last a fairly long time. The most unique accounting issue in this phase is inventory valuation, because it isn’t necessarily all that precise. For example, a mine could engage in something called heap leaching. This means the company has laid out some sort of impermeable pad and dumped a massive amount of low-grade ore onto it.

Then it drizzles some fairly nasty chemicals onto the heap, like sulfuric acid or cyanide, which dissolves out the metals being mined. The dissolved metals are then collected and subjected to further treatment in a processing plant. The accountant recognizes an inventory asset from the ore stacked on the pad by measuring the size of the heap and then factoring in the proportion of expected metal recovery. Or, a mine could simply pile up its output into a stockpile. For example, coal from a coal mine could be heaped up into a stockpile. If so, the accountant needs to measure the pile to determine the amount of inventory to recognize.

Royalty Payments

Yet another inventory issue is that the mine might very well have to pay a royalty to the owner of the land. If so, the cost of the royalty should be capitalized into inventory, so that it gets charged to expense when the inventory is sold.

Asset Retirement Obligations

And the final unique accounting issue for a mine is the costs that arise towards the end of its useful life. There are two of them. One is any asset retirement obligations, should as landscaping an open pit mine after it’s been closed. This can be a massive cost, running well into the millions of dollars. The mine needs to accrue for a liability for this cost as soon as it has a reasonable understanding of the amounts involved. This number is likely to change, as the closure date of the mine approaches and the company clarifies just how much it’ll need to spend; so the related liability will also change. The accountant may find that this is the largest liability on the balance sheet, so it pays to keep close track of the amount of the liability, and how it’s been calculated.

Environmental Obligations

The other cost that can come up later in the life of a mine is environmental obligations. If there’re any environmentally hazardous conditions at a mine site, the mining company may be seriously liable under a bunch of federal laws. If so, it may be responsible for things like feasibility studies, cleanup costs, legal fees, and restoration costs. The accountant needs to accrue for an environmental obligation if it appears that the business bears some responsibility for a past event, and it’s probable that the outcome will be unfavorable for the business.

It’s not that easy to figure out the amount of this cost, because the mining company might end up sharing responsibility for the obligation with other parties. For example, a mining company buys a mine from another mine operator, and then the Environmental Protection Agency declares the area a Superfund site. In this case, both the current and former owners share responsibility for the cleanup.

In this case, you need to estimate the likelihood that the other party will pay its fair share of the liability, because if it doesn’t then your company may be tagged with the full amount of the cleanup. Consequently, the amount of the environmental cleanup obligation will vary not just based on the latest cost estimate, but also on the ability of the other responsible parties to pay for their shares of the bill. This is a moving target for the accountant, who can expect to issue revisions to this accrued liability on a very regular basis.

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Money Laundering (#260)

In this podcast episode, we discuss how money laundering works. Key points made are noted below.

Money laundering is all about making money that you shouldn’t have look legitimate. If it looks legitimate, then the government won’t take it. That seems like a worthwhile goal for someone involved in illegal activities, so how can we do it?

Money Laundering Process

The basic money laundering process involves three steps. The first is to get the money into a bank. By doing so, you’ve converted bills into digital money, which is way easier to move around. Though it is possible to smuggle the money overseas and deposit it in a foreign bank, the usual approach is to break up the cash into small amounts and deposit it all over the place. This can mean setting up lots of bank accounts at different banks, and then spending your day driving from bank to bank, making small deposits everywhere. The reason for the small deposits is that a bank is required to send the government a Currency Transaction Report if it receives at least $10,000 of cash in a single transaction.

So, assuming the cash is now in a bank, you need to move it around, perhaps to banks in other countries that have bank secrecy laws. By doing that, an investigator can’t follow the trail of wire transfers past the first foreign bank. So, if you keep splitting up the amounts and wiring it around to different banks, there’s no way for anyone to figure out where the cash went.

And the final step is to convert the cash into assets that you can use, such as real estate or maybe buying a legitimate business. So, the intent is to take dirty money that you can’t explain and shift it into a new form that you can now use.

Loaning Yourself Money

Of course, there’s still a problem with having more assets than it appears that you can justify, given your apparent income. For example, a politician who accepts bribes may only be making $50,000 a year, and yet somehow owns a $1,000,000 house. People might ask questions. Luckily for the money launderer, there are a few methods for improving the situation. One is to loan yourself the money. Let’s say that you’ve shifted cash into a foreign shell corporation. You can apply to a bank for a big loan, and have that shell company put up the cash for collateral against the loan. Then you use the loan to buy a local business, and use the cash flow from the business to pay back the loan. In essence, you’re loaning yourself the money, by way of a banking intermediary that makes the loan paperwork look nice and clean. And on top of that, you get a tax deduction on the interest paid on the loan.

Selling a Business to a Fake Buyer

And to take the concept one step further, let’s say that you’ve used the cash flow from the business you bought to pay back the entire amount of the loan. Now you can set up a fake buyer for the business, and pay yourself from the fake buyer to acquire the business from you. Now you legitimately have the sale price of the business sitting in your bank account – nice and clean. And you still own the business, though now it’s through an intermediary. Just don’t set too high a price, or you’ll have to pay taxes on the gain from selling the business.

Use of High-Cash Flow Businesses

Now let’s get back to that business you bought. Money launderers like to buy businesses that deal with lots of cash, like used car lots, and restaurants, and night clubs. When you own a business like that, you can fake lots of additional sales and pay for them with money from your pile of cash. On the books of the business, it just looks like you’re having an unusually good year. An extra benefit is that the business can pay you a salary, so you have some legitimate income to report to the tax authorities. And on top of that, you may be able to run your business from the premises. Like running a gambling operation from the basement.

Fake Invoicing Schemes

Let’s try a different angle, which is fake invoicing schemes. A money launderer owns two businesses that supposedly sell goods or services to each other. One is in the United States, and the other is overseas. If the money launderer wants to move money out of the United States, he creates a fake sale from the overseas corporation to the local business, and overbills for whatever is being sold. The local business pays the bill. By doing so, the excess amount paid represents a transfer of cash out of the country.

It’s quite possible to do the reverse, where the invoiced amount is underpriced. In that case, the overseas company is transferring value into the United States in the form of the goods shipped, which means that money is flowing into the country.

Black Market Peso Exchange

And here’s another scheme – a really clever one. It goes by the name of the black market peso exchange, and it was created by the Colombian drug cartels, which needed a system to bring their dollar profits from the United States back into Colombia. Let’s say that a drug cartel earns $1 million dollars from drug sales in the U.S. It contacts a Colombian peso broker, which offers to buy the dollars in the United States, minus a commission, and to pay the cartel in Colombian pesos in Colombia. This means that the dollars are still in the U.S. and the pesos never leave Colombia.

The broker then uses a group of associates to break up the $1 million into smaller amounts, and deposits it in a bunch of bank accounts – still in the U.S. Next, the broker lines up some actual, legitimate Colombian businesses that want to buy goods from companies in the United States. With these orders in hand, the broker goes ahead and buys them from U.S. companies, acting as the middleman. This means that the U.S. companies who are selling the goods are paid from that stash of $1 million that’s still sitting in the U.S. Meanwhile, the Colombian companies have paid the broker in Colombian pesos – in Colombia. That stash of pesos is now available for the next time the broker wants to buy dollars from a drug cartel.

In short, the money in this scheme never crosses a national border, which makes it so difficult to spot. Instead, there’s a flow of goods between the two countries that represents the actual flow of value out of the U.S. and into Colombia.

The Hawala System

Let’s do one more. This last scheme is really about shifting money out of the country in an undetectable manner. It’s not really about shifting the cash back into the country at a later date, though that may happen. This approach involves an informal money transfer system. It’s generally called the hawala system, but it goes under different names, depending on where you are in the world. In essence, you go to your local hawala broker, who usually operates out of a small storefront, and ask to send money to somebody somewhere else in the world. The broker takes your money, and then calls a contact close to where your recipient is, and asks that the broker on that end deliver the money as requested. The two brokers can settle up later, maybe with a wire transfer, and maybe by sending goods to each other that are priced in favor of whoever is owed money. This is actually a legitimate system. It’s mostly used to send money between family members. But it can also be used to launder money, simply by paying the money to a broker and having the broker arrange for payment at the other end to an associate. The brokers usually only keep enough records to make sure that they settle up with each other eventually, and after that they may chuck out the records, which makes it incredibly difficult to track down these kinds of money transfers.

Summary

In general, the most successful money launderers are the ones who use multiple methods to hide their cash, and who use accountants and lawyers to help them set up new schemes all the time. The ones who are caught are usually the small-time operators who aren’t so sophisticated.

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Screening and Interviewing Techniques (#259)

In this podcast episode, we discuss screening and interviewing techniques for new hires. Key points made are noted below.

Screening Activities

First off, screening. The intent here is to minimize your investment in interviews by talking to job candidates on the phone first, to figure out as quickly as you can whether someone is worth the effort of a full interview. There are a couple of areas to really dig into during a screening call that can help with this. First, clarify exactly what they’re doing in their current job. In quite a few cases, what they’ve stated on their resume is an inflated version of their actual job, so it can help to walk through what they do in a typical day. By doing this, you can get around an inflated job title and figure out, for example, that someone is not really a controller, but instead is actually a bookkeeper.

It also helps to talk about the scale of the person’s employer. If they’re quite small, like a $10 million company, then chances are, the person doesn’t have enough experience in some of the more advanced topics that you might see in a much larger company, like accounting for derivatives or pension plans.

In addition, if you need a very specific skill set, like someone with a deep knowledge of inventory accounting, then talk through every possible aspect of that area, until you’re satisfied that the person meets your basic criteria.

And finally, this is a good time to talk about salary expectations. If the person wants a compensation level that’s well above what you can pay, then this pretty much shuts down the person as a viable candidate.

So, screening is designed to focus on the minimum criteria that a candidate has to have. It’s not a wide ranging interview, and this is not the time to sell the candidate on company benefits or anything like that. This is not a sales job, it’s a weeding out job.

Interviewing Activities

And then we have the actual interview. Let’s start with red flags. These are statements made by a candidate that could be indicative of problems. For example, he blames his last boss for everything. Sure, the last boss could have been awful, but it’s more likely that the candidate shared some of the blame, and is not willing to take responsibility. Expect more of the same if you hire him.

A slight variation is when the person acts like a victim, always having been put upon by others. Chances are, he has a very low capacity for dealing with adversity. This is the kind of person who will not take the initiative on the job, and who could quit suddenly if there’s any kind of dispute.

Or, probe carefully to see if the person is just looking for a job change in order to make more money, and nothing else. You can consider this person to be a mercenary, who’s only going to stick around for one or two years and then move on to an even higher-paying job with someone else. The obvious indicator is having been through many jobs, with a short tenure in each one.

Another red flag is complaints about the number of hours worked in previous jobs. If you know that the open position is probably going to call for a fair amount of overtime, then focus on this during the interview – a lot – the person might decide not to continue with the interviewing process, in which case that’s one less person to evaluate.

And here’s one that bothers me more than anything else, which is passiveness. There’s no indication of any substantial accomplishments in the person’s background, or even outside of work, like being a competitive cyclist or writing novels on the side. This may be someone who simply shows up for work, without displaying any aggressive behavior to improve the business. If you hire someone like this, expect them to complete their assigned tasks and then dawdle on their computer, rather than coming to you to ask for more work.

Other than red flags to watch for, the rest of the interview is mostly about what I would call essay questions. The objectives are to see how a person thinks, what level of knowledge he has, how much initiative he has, and how well he’s likely to get along with other employees. So for example, a question targeted at how a person thinks might be:

“Let’s say that we acquire another company with messy books. How would you go about cleaning up the situation?”

Or, a question targeted at a person’s level of knowledge might be:

“What types of controls would you like to see in an accounts payable operation?”

Questions about a person’s initiative are more difficult. You could ask about their prior accomplishments, which is one of those standard questions that they’re probably prepared for. It might be more fun to catch them off guard with a different kind of question. For example:

“This position involves running the collections department. Let’s say that I want you to improve the effectiveness of the department in driving down bad debts. Go ahead and grill me with questions about what’s going on in the department right now, and then give me recommendations for what you’d improve.”

Now, that sounds pretty rough for an interview, but how else are you going to find out if the candidate actually has what it takes to improve your operations? In other words, you need to involve the person in current company problems to see if there’s any chance that he has enough knowledge to figure out viable solutions.

And then there’s the issue of figuring out how well the candidate will get along with other employees. This is another tough one, since he’s obviously on his best behavior during an interview. You might be able to gain some insights by poking around with some situational questions. For example:

“Let’s say that the financials have to be completed over the weekend to secure financing, and your general ledger accountant wants the weekend off to deal with a sick parent. What do you say to the accountant?”

Or, “Let’s say that one employee accuses another one of theft, and the accuser is a friend of yours. How do you handle it?”

Or, “Let’s say that you’re competing with someone else in the department for a promotion, and you get the promotion. What do you say to the other person?”

None of these questions are designed to have an easy answer. The point is to put the candidate on the spot and just see what he does. This gives you much richer information that can then be used to make a hiring decision.

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Property Management Accounting (#258)

In this podcast episode, we discuss property management accounting. Key points made are noted below.

The Property Manager

A property manager is an independent manager of properties that does so on behalf of property owners. For example, a vacation property has a hundred condominiums in it, each of which is owned by a different family. They all rent out their condominiums when they’re not using the units, and the property manager for the entire complex does so on their behalf. The same situation occurs for an office building – where perhaps a pension fund owns the building and contracts out the property management to a third party. The property manager takes care of everything on behalf of the property owners, which includes advertising, maintenance, risk management, and accounting for the results.

The property manager acts in a fiduciary role on behalf of the property owners, which means that the manager has to act with proper diligence in managing the property, and in reporting the results of its activities back to the owners. As an agent for the owners, the property manager is usually required by state law to maintain accurate accounting records for each of the properties under management. This means that a separate set of accounting records is maintained for each property owner. Given that there could be a lot of property owners, it makes sense for the property manager to maintain exactly the same chart of accounts for each property, though this may not always be possible if a large property owner demands that its chart of accounts be used instead.

Property Management Chart of Accounts

The chart of accounts used by a property manager mostly differs in the area of revenue tracking. The manager may want to separately identify income from rent, late fees, utilities, laundry, vending machines, storage units, parking, and even renter assistance payments from the government.

Property Management Accounting Entries

So, what kinds of accounting entries is a property manager likely to make? There will certainly be entries for rent payments and security deposits, as well as withholdings from security deposits to pay for damage to rental units. Property owners may also be required to make reserve payments, which are accumulated to pay for major property repairs. There may also be pass-through charges, such as when the property manager pays to have the carpeting cleaned in a rental property, and the cleaning fee is then passed along to the tenant. Another possibility is an entry for contingent rent, which is usually based on the future sales or profits of the tenant. This arrangement is most common for retail stores, where part of the rent is a percentage of a store’s sales. And of course, the property manager charges a fairly substantial monthly management fee to each property owner.

Funds Held in Trust

When a property manager is handling money on behalf of a property owner, these funds are considered to be held in trust. For example, rent payments and security deposits cannot be mixed in with the funds of the property manager. Under most state laws, trust funds have to be held in a bank account that’s identified as a trust account, which makes it more difficult for a property manager to inadvertently misappropriate the funds.

Pooled Trust Account

One problem with using separate bank accounts is that the property may need to deal with a massive number of bank accounts in situations where there are many property owners. To get around this problem, the property manager can use a pooled trust account, where all property owner funds are kept in a single bank account, with the accounting system being used to identify the funds held by each property owner.

This doesn’t necessarily mean that just one pooled account is being used for a property. There may be three. One is the operating account, which handles incoming rent payments, and which is used to pay for most day-to-day expenses. The second is the security deposit account, which – obviously – contains all of the security deposits paid in by tenants. And the third is a reserve fund account, which contains funds that will be used for capital expenditures, such as repaving the parking lot or replacing the roof. This money comes from the property owners.

Property Management Reporting

Property managers are expected to periodically issue a reporting package to property owners. There’s no standard report configuration, but it usually includes a rent roll, which is a detailed listing of the rent earned from each property. There is usually also a summary of operations that matches expenses against revenues, so that owners can see the net income from operations. Owners also want to see a summary of the activity in the reserve account, so that they can see the amount of funds that have been added, the amount taken out to pay for various items, and the ending balance.

The information for the rent roll comes from the rental ledger, which stores a complete set of information about each tenant, including balances owed, payments made, security deposits, and pass-through charges.

Operating Expense Ratio

Property owners will probably calculate the operating expense ratio for their properties. This is operating expenses divided by gross income, and is a good measure of the ability of the property manager to keep expenses under control. However, it can be also misleading, since operating expenses go up over time, as a property ages. Also, the ratio doesn’t differentiate between fixed and variable operating expenses. This is not minor, since variable expenses will probably change along with the occupancy level, while fixed expenses, such as property taxes, will still be incurred, even if a property is completely empty.

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How to Present Cost Control Information (#257)

In this podcast episode, we discuss how to present cost control information to management. Key points made are noted below.

How to Select Costs for Reduction

Reporting on cost control means presenting an argument to cut expenses. My general rule on presenting any argument is that you should spend 25 percent of your time compiling the information, and 75 percent figuring out how to make a persuasive case. So, let’s say that you’ve identified a way to control costs. In fact, let’s say that you’ve identified several dozen ways to do so. Which is quite likely. There can be cost control opportunities all over the business. Your first step is to sort through them all to see which ones should be presented – which implies that not all cost control activities are a good idea.

For example, consider the company culture. It may have been designed to foster employee interaction, maybe through offering a beer bash on Friday afternoons, or expensive bonuses for the goofiest ideas to make fun of the company president. Sure, these could be cost reduction opportunities, but they’re also an essential part of the underlying structure of the business. If you suggest that these costs should be cut, you’re going to look like a clueless idiot who’s out of touch with the rest of the organization.

As another example, consider the company strategy. It’s quite possible that management wants to spend lots more money in areas where it wants to expand the business. From the perspective of the accountant, this could look like a profligate use of funds, but from the perspective of management, these are necessary expenditures. For example, the commission rate on new sales might be doubled for a new sales territory, because there’s a push to expand into new geographic areas, and management wants to give the sales staff an incentive to sell in these new areas. The doubled commission rate might look crazy from a cost control perspective, but it’s perfectly rational from a strategic perspective.

As yet another example, consider production capacity. The production manager might be keeping a number of old machines lying around unused, and it just bugs you that this equipment could be sold off right now to generate some cash.

But from the perspective of the production manager, those old machines could be brought back into use if sales exceed production capacity – which makes perfect sense, especially if those additional sales would otherwise be lost.

Based on these examples, you can see that presenting cost control information to management first requires a fair degree of knowledge about how the business operates and how it intends to compete – which may mean that you don’t report anything for a while, until you’ve built up some background information about the business.

Consideration of How Suggestions Are Received

And then it’s time to think about how your suggestions will be received. Most managers have protected areas that they don’t want to go after, as well as areas that they’re more than happy to cut back on. Maybe they want to deliver a hefty expense reduction to announce at the next shareholder meeting. Or, maybe it’s time to shave back those bastards in the marketing department. And, maybe they have a built-in aversion to certain types of expense cuts, such as doing layoffs. The way to learn about these tendencies is to spend some time getting to know the person who’s going to receive your recommendations.

This could mean having lunch with them on a regular basis, or attending the same meetings, or pretty much anything that allows the manager to chat in a general way about what he wants to do, and how he views the company. With this information in hand, you can tailor your recommendations to the manager. By doing so, what you recommend is much more likely to be implemented, because the manager is seeing cost management proposals that he inherently wants to implement.

Building a Case for Cost Reduction

Now, making recommendations in this manner also means that you’re leaving out all kinds of perfectly good cost reduction suggestions. That’s because you need to take a more circuitous path with those other ideas to gain acceptance. For example, let’s say that there’s a clear problem with a new product that also just happens to be a manager’s pet project. He doesn’t believe that it can possibly fail, even though you have solid information that it is. How to proceed? It depends on how the manager reacts to having a core belief jumped on. In a lot of cases, he will shoot the messenger, and since you’re the messenger, this can be painful.

There’re a couple of ways to deal with the situation. One is to gradually build a case over a period of time. During one meeting, you could mention that you’re going to evaluate all product sales, and in the next meeting, present a report that shows sales for all products, which just happens to include his favorite product. When he complains that the sales figures must be wrong, come back with a detailed sales analysis, and regretfully point out that the numbers are correct. The intent here is to engage in a gradual let-down, so that the manager gets used to an idea that he might reject if you just hit him with it all at once. Call it managing your manager.

Of course, this approach takes time, and if the expense situation is getting out of hand, you can’t afford to wait. If so, another option is to present several cost control suggestions, and mix it in with the other items. Then walk the manager through every item on the list in a fair amount of detail. By doing so, the manager will be so buried in information that he’s less likely to react negatively to that one specific issue. But, be aware that this approach doesn’t focus the attention of the manager on that one specific issue, so there’s a risk that you have to keep bringing it up.

Focusing Attention on Proposed Cost Reductions

No matter how you choose to make a cost control suggestion, it’s critical to only bring up a few at a time – maybe just one or two. That focuses the manager’s attention on thoroughly implementing those specific suggestions. It also means that you can spend more time developing additional information to back up your position, so that the case for implementation is overwhelming.

After the implementation is complete, you can dole out one or two more suggestions, and so on. It might seem like this approach is painfully slow, but the rate of successful implementation is actually higher than if you had dumped a massive 20-point list on the manager’s desk. In the latter case, the manager would have probably just picked a couple of items from the list and ignored everything else.

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How to Derive a Product Cost (#256)

In this episode, we discuss how to derive a product cost. Key points made are noted below.

Problems with Developing Product Costs

Coming up with a product cost doesn’t sound all that hard – or is it? There are a bunch of issues to consider. First, a cost accountant can’t begin to do this alone. You have to talk to the engineering department about the components that supposedly went into the product. They should have a bill of materials that goes along with the design drawings, but that list may not be entirely correct. Still, it’s a good starting point. Then, take that bill of materials over to the materials management staff and have them verify it. They have to order the parts or have them made in-house, so they should have a pretty good idea of what goes into the product.

Bill of Materials Verification

Or, do they? In some companies, fittings and fasteners aren’t included in the bill of materials. Instead, these items are bought in bulk and are available in bins on the shop floor for anyone to use, so no one thinks there’s any need to record them in the bill of materials. So, you have to look into that. If you miss it, your product cost will be too low. If you have to adjust the bill of materials for these missing items, take it back to the engineering department and have them verify it. There’s a fair chance that there’s still something wrong, so the extra meeting is worth your time.

Cost Identification by Volume

So far, you’ve only identified the components – there’s no costing associated with them. Now for the fun part. Unit costs vary by volume, so you need to identify at what point the unit cost goes up or down, depending on how many units are purchased. For example, a widget that goes into a product might cost a dollar if you buy it in quantities of at least a thousand, but it costs three dollars if you buy it in smaller quantities. So, your next trip is to the production scheduler, to talk about production volumes.

Volume Purchasing Considerations

So, let’s say that the production scheduler thinks that 2,000 of those widgets will be needed in the next year. Does that mean you can automatically assume that the product cost will include one dollar’s worth of a widget? Not necessarily. It’s possible that the purchasing department plans to buy in smaller quantities in order to reduce the inventory investment. Or, maybe they want to buy in really large quantities, because that widget can be used in multiple products. If so, they could be able to buy the widget for a lot less than a dollar per unit.

If this sounds like a lot of interviewing to do, you can cut through everything and just look up the supplier invoice to see what unit price is being charged to the company.

Impact of Future Decisions

Another point to consider is that the unit price might change depending on future decisions. For example, if management intends to push this product really hard in the marketplace with a big ad campaign, it might be useful for them to know that the product cost will decline if unit sales increase past a certain point.

The Need for Multiple Versions of Product Costs

So, what all of this means is that you really need to come up with a couple of variations on the product cost. The main one is for the production volume that everyone expects, and you might want to consider deriving a cost that applies to a low level of production, as well as to a high level of production. As the production volume declines, the unit cost will increase, and as the production volume goes up, the unit cost will drop.

Consideration of the Scrap Rate

Of course, we’re not done yet. There’s also a scrap rate to build into the product cost. This can be difficult when you’re using components that have never been used before, since there’s no history for them. That means you may have to make an educated guess at the amount of scrap, and then come back after one or two production runs to see if the estimated scrap rate turned out to be correct, or if you need to adjust it. In general, you probably ought to issue a preliminary product cost, and then discuss it with the production manager after there’s some experience with actually manufacturing the product, and decide whether another version of the costing should be issued.

Fixed Nature of Labor Costs

And then we have labor. It can be considered a fixed cost, rather than a variable cost, like materials, because there usually has to be a minimum crew size to man a production line, no matter how much volume runs through the production line. That being said, I’ll assume that you’re adding the cost of labor to the product cost.

There are a couple of problems with deriving a labor cost. The first issue is that the cost of the labor itself keeps changing. The people working on a product may be getting paid at different hourly rates, based on their seniority or skill level, and the people assigned to producing the product may change, even within a single day. The usual solution is to use the average hourly rate for everyone in the production area. The next issue is that labor rates tend to increase over time, as people gradually get bumps in pay, so you have to go back from time to time and see if your average labor rates built into the product cost are still correct.

And a third issue is that the industrial engineering staff is always looking for ways to automate parts of the production process, so it’s entirely possible that the total amount of labor hours assigned to a product will gradually go down.

My main points in regard to labor cost are that you need to use an average labor rate, you need to update the calculation of that rate on a regular basis, and you need to update your assumptions regarding how many hours it still takes to make the product.

Overhead Costs

And finally, we have the cost of overhead. No matter how well you try to refine the allocation of overhead to a product, keep in mind that it’s still an estimate. And on top of that, the overhead may still be there even if the product is never manufactured, so there’s a pretty reasonable argument that you shouldn’t even include it in the product cost.

But let’s say that you do. If so, break it out from the rest of the cost. For example, put the materials cost in a subtotal that’s in bold and maybe in a bright color, so that management knows that this is the real variable cost of the product. Then layer on a line item for labor, which is a reasonably valid inclusion. And then insert a couple of blank rows to really give it some separation, and then state the assigned overhead cost. Just trying to put the costing emphasis where it belongs.

Summary

In summary, product costing is more complex than you might initially think. It can vary by production volumes, it needs to be adjusted over time to account for estimates and cost changes, and some of the elements in the report maybe shouldn’t even be there, depending on how you intend to use the information.

Related Courses

Cost Accounting Fundamentals

Accounting for Vineyards and Wineries (#255)

In this podcast episode, we discuss the accounting for vineyards and wineries. Key points made are noted below.

The Basis of Accounting

In the United States, a farm is nearly always allowed to use the cash basis of accounting, no matter how big it is, and a vineyard is classified as a farm – so, vineyards usually use the cash basis of accounting. Doing so allows them to somewhat defer the recognition of income, so they can delay paying income taxes. A winery is not classified as a farm, since it’s more of a production operation, so wineries usually use the accrual basis of accounting. This difference means that a vineyard and a winery are set up as two separate entities, with the vineyard using the cash basis and the winery using the accrual basis. So, the accountant for a combined operation needs to be conversant with both approaches, and will need to maintain two sets of books.

Expenditure Capitalization

Even though a vineyard is on the cash basis, it needs to capitalize quite a lot of its initial expenditures. The problem is that it can easily be a half-decade – usually longer – before it begins to produce grapes in commercial quantities. That’s because it takes time for a site survey to figure out how to configure the vineyard, and decide on what types of vines to plant, and then extract rocks, and grade the land, and possibly fumigate the soil, and add fertilizer, and drill wells, and lay down an irrigation system – and that’s before planting any vines. And then there’s vine planting, and setting up windbreaks, and installing a trellis system, and training the vines to grow on the trellis system – and so on. The up-front investment is pretty incredible, which is why mostly rich folks own vineyards. At any rate, most of these expenditures are capitalized, up to the point when commercial production begins.

Winery Operations

Which brings us to the winery. So, a winery has four main operations. There’s the crush phase, where the grapes are crushed. Then there’s the cellar operation, where the juice is kept in tanks to let the sediment drop out, followed by fermentation, and then bulk aging in oak barrels or stainless steel tanks. The next step is bottling, which involves filling the bottles and adding labels and a cork or a screw-top cap. And finally, the bottles are left in storage for a period of months for further aging. Of these four steps, the crush and bottling phases are quite short, while the other two can be very long.

Cost Accounting Issues

This makes for an interesting cost accounting situation, since the various products spend differing amounts of time in the cellar or bottle storage. For example, a white wine or a red wine with lower production values could spend far less time in the process than a high-grade red wine. So, logically, a high-grade red wine should accumulate a lot more indirect costs than a product that spends less time in the winery.

And there are a lot of indirect costs. There’s the depreciation on the production facility and equipment, and the labor by the winemaster and the rest of the staff, and utilities, and production supplies, and testing expenses, and so on. So, the wineries have come up with a variation on activity-based costing, where they assign expenses to each of the functional areas in the winery, and then allocate the costs of these functional areas to what they call gallon/months of each wine product. So, for example, if 1,000 gallons of Merlot are aged in barrels for six months, then that is 6,000 gallon/months of Merlot. And, if the cellar operation accumulates a half million dollars of costs in a year, that cost is assigned to the Merlot based on its proportion of the total gallon/months of wine kept in the cellar. The same approach works when allocating the cost of bottle storage.

So this can get a little complicated. And it gets worse, for several reasons. First, wines could be kept in storage for more than one year, so you have to allocate costs not just to several types of wine, but also to several vintages of each varietal. And on top of that, the winemaster might decide to engage in blending activities somewhere in the production process, which mixes wines together, and, of course, complicates the cost accounting. And, there can be wine shrinkage, where the wine evaporates while it’s aging in the oak barrels. And furthermore, the winery may choose to sell off some wine in bulk before it reaches the bottling process, so that a good chunk of the wine volume never makes it to the end of the process.

Now, you might ask if this cost accounting is a little excessive. No, it’s not. For two reasons. First, most wine sales go through distributors, who demand some really aggressive pricing deals, to the point where a winery will probably only make a 20% gross profit on its distributor sales. This is opposed to the much smaller sales volume a winery generates through its tasting room or wine clubs, where the gross margins can be in the 70% range. So, because of the crappy profits on distributor sales, the winery really needs to know how much its products cost.

And the second reason for a good cost accounting system is that the Internal Revenue Service demands it. The IRS wants to see the profit levels for each product sold, and proof for the calculations. And on top of that, the IRS wants wineries to allocate interest costs to wine when the production process takes at least two years, so there’s another cost accounting step.

And if you think that’s enough cost accounting for one day, no – not even close. The wineries prefer to use last in, first out costing to value their ending inventory, since it matches their latest costs against revenue, which should lower their taxable income. The trouble is that calculating LIFO is kind of tough on a per-unit basis. So, what they do is use the dollar-value LIFO system, where the ending inventory valuation is based on a conversion price index. This index is based on a comparison of the base year cost of the inventory and the current year cost, which is then converted into a percentage and used to value the ending inventory.

This is a fairly complicated calculation, so the wineries want to limit it to just two types of inventory, which are bulk wine and cased goods. The IRS doesn’t think that’s good enough, so they want to see separate calculations that are broken down into more groups, such as by the type of wine, the source of the grapes, the length of the aging process, and even the size of the storage containers being used. This can result in a small war with the IRS if a winery gets audited.

Sales Tax Exemptions

Of course, there are other accounting issues that are specific to vineyards and wineries. For example, there are sales tax exemptions for oak barrels, and for wine labels and fertilizer, since these items are all involved in either the grape growing or production processes. The assumption is that the final consumer will pay for the sales tax on these items, not the winery.

Charitable Donations

Here’s another issue – charitable donations. Wineries are always being asked to contribute their wine to charity auctions. The simplest way to account for these donations is not to do anything at all. The donated bottled are just not in stock at the next physical inventory count, so they’re charged to the cost of goods sold at the end of the month.

Depletion Allowance

And a final topic is the depletion allowance. Wineries sometimes offer a discount of a certain amount for each case that their distributors sell through to retailers. This is a depletion of a distributor’s inventory, which is where the name comes from.

The problem is that the distributors have to report the amount of cases sold back to the winery, usually in the form of a bill-back, so the winery ends up paying the distributor. This is an issue at month-end, when the winery is closing its books, since distributors may not report back about the number of cases sold for several weeks. And if you’re trying to close the books, this means that the amount of the depletion allowance has to be accrued, and it’s pretty much a guess. And if you’re wrong on the accrual, then the adjustment falls into the next month. Which introduces some inaccuracy into the financial statements.

Related Courses

Accounting for Breweries

Accounting for Vineyards and Wineries

Merger Integration for the Accounting Department (#254)

In this podcast episode, we discuss the integration process for the accounting department after a merger has been completed. Key points made are noted below.

Issues Relating to Merger Integration

There is no best way to integrate two accounting departments. You don’t necessarily have to go through a long and involved process of working towards two accounting departments that exactly mirror each other. It all depends on the intent of the acquiring company’s management team. If the intent is to let the acquired company operate on its own, then there isn’t a great deal to do. On the other hand, if the intent is to buy a bunch of companies and basically make each one an exact copy of the corporate parent, then there’s a lot of work to do, since you have to rip out and replace the existing systems.

The Low-Integration Option

So let’s start with the assumption that the acquiree is going to continue to operate with minimal interference from the parent. If so, the only critical integration item is making sure that every account in the acquiree’s general ledger is matched up with specific line items in the parent’s financial statements. This is called mapping, and it’s needed to make sure that you can add the acquiree’s financial statements to the parent’s financial statements to generate consolidated financial statements.

There are a couple of related activities. One is to have the acquiree notify you whenever they add another general ledger account, so that you can map the new account to the parent’s financial statements. Another item is to agree on a standard set of definitions for each account, so that each firm is recording the same types of transactions in the same accounts. Otherwise, there can be problems with account names looking the same, but the contents of the accounts are different. And if the corporate parent does a lot of acquisitions, there isn’t much debate about those definitions – whatever the parent says is the official account definition is going to be the definition. There’s just no time to argue with each new acquiree about it.

Another item to address is accounting policies. Both the parent and the acquiree should be dealing with transactions in the same way. For example, both parties should have the same capitalization limit, so that each one accounts for an asset purchase in the same way. And depreciation methods should be similar.

And they should deal with revenue recognition issues in the same way. And so on. Ultimately, the accounting policies should be so similar that each subsidiary of the business will deal with a transaction in exactly the same way.

Another integration item is accounting controls. You really can’t afford to make an expensive acquisition and then have it leak money because some key controls are missing. Those controls don’t necessarily have to be the same as the ones used by the parent company, since the processes used by the acquiree may be different. The main point is just to have a solid set of controls.

And the final really essential integration item is making sure that the acquiree understands the parent company’s month-end closing schedule, so it knows when information is supposed to be submitted and what information will be provided.

Believe it or not, that’s all you need for the simplest possible accounting integration, and it should only take a week or so, along with some occasional follow-up.

The High-Integration Option

Integrations can be monumentally more difficult when the intent is to use the same accounting system across the entire organization, since this involves loading the acquiree’s accounting records into the new system, as well as training everyone to use the new system. The real question is, is it really necessary to do this?

It might be warranted in some very specific situations. For example, if the accounting department of the acquiree appears to be fairly weak, using a central system allows the corporate parent to keep a close eye on what they’re doing. Or, if the parent wants to save money by cutting administrative costs, it can probably do so by centralizing as much of the accounting as possible. And another reason is to have tighter controls by centralizing everything. Of course, those reasons sound good, but is the parent company willing to spend some really serious money to make that happen? You might need to work through a cost-benefit analysis to see if it’s worthwhile.

Cold Turkey Integration

If senior management still wants to centralize accounting, then you have three choices for how to do it. One is the cold turkey approach, which means you turn off the old system and turn on the new system on the same day, and really, really hope that the new system works as planned. This is usually a bad idea. Sometimes, it can be in the really bad idea category, because there’ll be some unanticipated problems that no one sees until the new system has gone live. Management tends to push this approach because the conversion appears to cost less than the other alternatives – at least until everything falls apart.

Parallel Processing

The next option is parallel processing, where you run both the new and the old systems at the same time. This means that the accounting staff has to enter every transaction in both systems, which is wildly inefficient. On the plus side, you can compare the results coming out of the two systems and see if they match. If not, keep tweaking the new system until it works properly, and then shift entirely to the new system. This approach is much less risky and much more inefficient.

Convert One Module at a Time

A midway approach is converting over one accounting module at a time. For example, you could switch just the payroll module to the new system, and then payables, and then billings, and so forth. This approach chops up the conversion process into smaller pieces, which makes it easier to handle. However, the process as a whole takes longer, and also you need to write lots of custom interfaces. The problem is that each accounting module shares information with the other accounting modules, so when you switch to a new module on the new accounting software, you have to write interfaces from that new module back to the remaining modules in the old accounting system, to keep the information sharing going.

Selective Standardization

A variation on these concepts is to convince management that only a few accounting functions need to be standardized, and only concentrate on them, leaving everything else alone. For example, if there’s a centralized treasury department, they may want to control every bank account in the business, so that they can centralize funds for more efficient investing. If so, there can be an implementation process for converting an acquiree’s bank accounts to different ones at the parent company’s preferred bank. This means that only a few, very specific accounting areas are of importance to the parent company, so only those few are addressed. Everything else is left alone.

Concluding Thoughts

In general, I advocate using just those few integration steps that I mentioned at the beginning. Doing so addresses the main goal of the parent company, which is to produce consolidated financial statements.

If management really wants to conduct a massive accounting overhaul at every acquiree, try to convince them to focus on just one or two areas, which greatly reduces the effort.

After all, management always has the option to come back in later years and re-address the integration issue, if it wasn’t completely addressed right after the acquisition. And there’s a side benefit of engaging in a brief set of integration activities, which is that it gives the parent company the ability to move on to another acquisition within a few weeks. And if the parent is trying to roll up a bunch of acquisition targets, that could be a good reason to go easy on the comprehensive integration strategy.

Related Courses

Accounting Information Systems

Mergers and Acquisitions

Switching from Accounting to Solo Consulting (#253)

In this podcast episode, we discuss the issues associated with switching from an accounting career to solo consulting. Key points made are noted below.

The Switch to Consulting

This is a common wish for senior managers who’ve been in the same type of position for years, and the job just doesn’t seem that exciting anymore. Even with a different company, you can count on engaging in pretty much the same activities, over and over again. And, in a corporation, the pressures on a manager can be intense, especially when the company is publicly-held. So consulting can seem like nirvana.

Problems with Consulting

It’s not quite that easy. The first obstacle is marketing. How are you going to get the word out that you’re available for consulting projects? Just setting up a website is not good enough. Instead, you need to be targeting your specific area of expertise, which means figuring out where your ideal group of customers is, and then going out and meeting them. That could mean networking at industry events, or giving speeches at those same events. It means handing out business cards all the time. It will probably not be enough to just call a few friends and expect to have high-end consulting work drop into your lap. It doesn’t work that way. Instead, you’re going to be looking at a lot of your time in marketing drudgery. Many accountants are introverts, so this is monumentally hard for them.

Service Aspects of Consulting

If you feel confident that you can handle the marketing end of things, then it’s time to consider the flexibility aspect of consulting. In short, when a client calls, you answer. The consulting business is all about service. So if a project needs to be done right away, expect to cancel that vacation you’d already planned. If the client needs a report by tomorrow morning, expect to work some long hours to finish it. In other words, expect some periods when you’re under a lot of pressure.

The Highest-Value Services

Now, what about targeting an area that can make you a pile of money? The highest paying consulting work is value priced, which means that you’re not charging by the hour, but rather by the outcome. A good example of this is in the legal profession, where lawyers know that a client will pay them whatever it takes to keep them out of jail. So, if you apply the same thinking in the accounting field, that means targeting outcomes that are really important to the client. For example, provide consulting services for taking a company public, or assist with a bond offering, or provide advice about buying a public shell company for a reverse acquisition. In all three cases, the client is trying to raise money – probably a lot of it – so helping them raise the money can translate into a major consulting fee.

The same goes for mergers and acquisitions. These are major events that can make or break a company, so management needs the best possible advice in lots of areas. For example, you could provide due diligence services for acquisitions, or maybe in specific areas of the due diligence, like whether the target company has an adequate system of controls. Or, the area of emphasis could be in negotiating acquisition deals, or maybe in the fund raising needed to pay for an acquisition. Another option is to assist with searches for possible acquisition targets.

Another possibility is working on acquisition integration after the deal is done, like merging the accounting systems of the buyer and the target company. But, keep in mind that all of these high-value services usually have a short timeline on them, so expect to work some serious hours within a short period of time.

Less-Valuable Services

Now, let’s move down a notch to somewhat less valuable services, where you’ll probably have to bill by the hour. These services are more competitive, because there are more people out there with similar skills. For example, there’s reviewing the system of controls for any weaknesses, or writing accounting procedures, or helping to install accounting software, or helping to set up an inventory tracking system. It’s especially hard to break into the software installation business, because all of the large consulting firms consider this to be one of their core areas of expertise. At best, you might end up working as a contractor for one of the other consulting firms. The billable rates for these “lesser” activities can actually be quite good, but they also call for very specific skill sets, which a senior-level manager may not have.

Another concern is that the target market for consulting services is not smaller firms. They just don’t have the money to pay for a lot of consulting, so you might find yourself spending all kinds of time marketing to them, and then find that the resulting project is only worth a few thousand dollars. Instead, the sweet spot in the consulting market is larger firms. Unfortunately, all of the other consultants know that, too – so they’re all trying to sell to a fairly small number of potential clients.

This can be a real problem in a smaller city where there aren’t many large companies. In that case, you may find that your target clients are located a long ways away – so be prepared to spend a good chunk of your consulting career living in a hotel room, and only getting home on weekends.

Summary

I’ve made the situation look pretty grim. That doesn’t mean it’s impossible, just that there’s a lot more work involved than you might think, because of the marketing and the rush nature of the work. It’s quite uncommon for someone new to the business to immediately land a consulting contract, sit around all day ladling out advice, and get back home for an early dinner with the family. Instead, it may be months before you get any work at all, and it’ll be more likely that you end up subcontracting through a larger consulting firm, probably with no benefits.

My advice is not necessarily to avoid consulting, but to think through exactly how you’re going to do it, how you’re going to market yourself, what services to offer, how much to charge, and how much you’re willing to be away from home. An old friend of mine is a classic example of a consultant, who believed that if you weren’t interest in traveling, you shouldn’t be a consultant. It turned out that his next project was in Egypt – and he stayed there for years – a long ways from home.

The Compilation Engagement (#252)

In this podcast episode, we discuss how a compilation engagement works. Key points made are noted below.

The Full Audit

Most people are familiar with the full audit, since lenders usually require that a borrower have one each year. A full audit is quite detailed, and involves an examination of the client’s books and control systems. A review is a notch down from an audit, and mostly concentrates on analytical procedures, which means comparing financial and operational information to see if it makes sense. If it doesn’t make sense, the auditor has a discussion with management about it. Reviews are mostly used by publicly-held companies, which are required to have a review at the end of each fiscal quarter, plus an audit for the full year.

The Compilation Engagement

And then we have compilations, which are really just a service to assist a client in preparing its financial statements. The auditor doesn’t engage in any of the audit work that’s found in a full audit or a review, so there’s no examination of controls, or walk-throughs of transactions, or tracing account balances back to the supporting documentation. In short, a compilation isn’t designed to provide any assurance about the information contained within the financial statements.

Compilations don’t have to be for a complete set of financial statements. They could be just for a portion of the financials, such as the income statement, or for a budget or a forecast, or maybe just for a supporting schedule, such as a royalty schedule.

Compilation Activities

What does the auditor do in a compilation, since so far I’ve only mentioned what the auditor doesn’t do. First, the auditor reads the financial statements, checking to see if they’re in the correct form, and whether there are any obvious misstatements. This means the financials should be free of mathematical mistakes and errors in how the accounting standards are applied.

The auditor can also go down into one extra level of detail, and scan the supporting trial balance for unusual items. The same goes for the general ledger, where the auditor looks for things like unusual journal entry descriptions, or unusually large transactions, or one-time transactions, or recurring entries that seem to be missing in a few periods.

In other words, the auditor is looking for anomalies that don’t make sense. If so, there’s a discussion with management. Depending on the outcome of that discussion, the auditor can propose some adjusting journal entries. Once those changes are made, the auditor takes another look at the financial statements to see if they meet the requirements of generally accepted accounting principles, or international accounting standards, or whichever other accounting framework is being used.

Next up, the auditor reads the disclosures that accompany the financial statements, and makes improvement suggestions whenever there appears to be a missing disclosure or when something isn’t entirely clear.

If this examination uncovers an issue where the financial statements depart from the reporting framework, then the auditor needs to decide whether this departure is being adequately described in the disclosures. If not, the departure may need to go into the auditor’s compilation report.

Now, as the auditor works through this process, she may find situations in which records are incorrect or incomplete, or where the judgments used by management in regard to accounting issues are not correct in some way. If so, these issues have to be brought to the attention of management, along with a request to correct the situation.

Another possibility is that the auditor may find that the client can’t continue as a going concern, which is to say that it may go bankrupt. If so, another suggestion has to be made to disclose this possibility in the financial statements, since they’ll otherwise be misleading.

Material Misstatements

If an auditor starts a compilation engagement and begins to suspect that the financial statements may be materially misstated, she should investigate further, to see if this is the case. If it’s not possible to obtain the needed information, then the auditor should withdraw from the engagement. Or, if the auditor has proposed revisions to the financial statements that the client didn’t make, then it’s also a good idea to withdraw from the engagement.

Compilation Reporting

Once the financial statements have been completed, the auditor writes a report that the client should attach to the financial statements, which points out that this was not an audit or a review, so the auditor is not expressing an opinion about the financial statements, and is not providing any assurance that the financial statements are correct. The report can also point out any cases in which the financial statements depart from the related accounting framework.

Reasons Why Clients Want a Compilation

So why would a client want a compilation? Because it’s cheap. Or, knowing how expensive auditors can be, let’s call it the least expensive option. However, the users of a company’s financial statements might not want a compilation, because it doesn’t give them any assurance that the financial statements are correct. So, from the client’s perspective, it makes a lot of sense to check with the users to see if they’ll go along with a compilation. There’s a good chance they won’t.

Summary

In summary, to view a compilation from a high level, it’s essentially a consulting engagement for the auditor, who conducts a modest inspection of the books to see if any anomalies pop up. The auditor can then make suggestions to management for improving the financial statements; if management decides not to do so, then the auditor has grounds to pull out of the engagement.

Related Courses

How to Conduct a Compilation Engagement

How to Conduct a Review Engagement

How to Conduct an Audit Engagement

Accounting for Oil and Gas (#251)

In this podcast episode, we discuss the accounting for oil and gas operations. Key points made are noted below.

Reporting of Reserves

In this industry, the real value generated by a business is underground, which means that the main focus of attention is on the amount of reported reserves. In general, reserves are considered to be the amount of commercially recoverable oil and gas. Within that general concept are two subdivisions, which are proved reserves and unproved reserves. The main focus of attention from an accounting perspective is proved reserves, which are those oil and gas reserves that can be reasonably estimated to be commercially recoverable from known reservoirs. In other words, you know it’s there, and it’s cost-effective to extract it at current market prices.

The reported level of reserves keeps changing. It’s not that the amount in the ground keeps changing. When a reservoir is first discovered, there’s a certain amount of oil and gas in there, but not all of it is recoverable. The situation differs by reservoir, but let’s say that it’s only feasible to extract half of what’s in a reservoir at the current market price. But then if prices go up, it becomes cost-effective to use more expensive techniques, like injecting steam into the ground. So as the price goes up, a larger proportion of the reservoir becomes available – maybe that brings you to 60% that can be extracted. Or, someone invents a new technique for extracting oil, such as fracking. Whenever something like this happens, even more of a reservoir becomes accessible – maybe the accessible portion goes up to 70%. So what all of this means is that reported reserve levels can fluctuate – a lot.

Depreciation, Depletion, and Amortization

Another unique thing about oil and gas is the concept of DD&A – which stands for depreciation, depletion, and amortization. In this industry, there are lots of tangible assets, like wells, and pumps, and storage tanks – but there are also intangible assets, like the cost to lease mineral rights from a property owner. So, someone figured out years ago that they’d lump all of these assets together and use a standard depletion calculation to charge everything to expense. And therefore, we get the term DD&A, since it combines elements of depreciation, depletion, and amortization.

The way it works is called the unit of production method, where you divide the capitalized cost by the total estimated amount of the reserve – there’s that reserve concept again – and multiply by the number of units produced. So basically, the amount amortized in each period is directly related to the amount produced, so if the production level increases, so does the amortization expense.

But of course, it’s not that simple. There are two schools of thought regarding which expenses to capitalize. Under the successful efforts method, if you drill a dry hole – which means you didn’t find any oil or gas – then the costs associated with that well are charged to expense right away. That’s nice and conservative, since expenses are more likely to be recognized up front.

The other approach is the full cost method, which takes the position that you can’t drill successful wells without also drilling some dry holes. And based on that logic, you pretty much capitalize everything, even if you’re suffering through a string of dry holes. So as you might expect, a business using the full cost method will have more assets on its books than another firm that’s using the successful efforts method.

Asset Impairment

Which brings up the issue of whether these assets can ever be impaired. The main concern is with companies using the full cost method, since they tend to overload their balance sheets with assets. The solution is called the ceiling test, which starts with the present value of future cash flows from the firm’s producing properties, and then subtracts out the cost or fair value of those properties, along with income tax effects. The result is then compared to the net book value of the assets being tested, to see if a write down is needed. So it’s a bit different from the impairment testing system used in other industries.

Impairment is a very big deal in the oil and gas industry, because projected cash flows can vary all over the place. For example, cash flows can drop catastrophically along with the usual gyrations in the prices of oil and gas. Or, the government that controls the drilling production process decides to alter tax rates, or it alters the requirements to restore well sites after production is done. What this means is that an oil and gas firm could appear to have perfectly reasonable asset levels in one year, and finds itself writing off a good chunk of those assets in the next year.

Severance Taxes

And then we have the interesting issue of severance taxes. These are taxes on production that’s levied by the government. So, you produce a $1,000 of gas, you have to pay a portion of that to the government. The main problem is that a producing property usually has more than one party that gets paid for the revenue from a producing well, so the government could be faced with the collection of severance taxes from a bunch of entities.

For example, the Smith family owns the mineral rights underneath a property, and they lease out those rights to an oil and gas firm in exchange for a royalty. And on top of that, the oil and gas firm needs to raise money to pay for drilling wells, so it sells half of its interest in the lease to someone else, in exchange for cash. That means there are now three parties that owe severance tax to the government.

There are two ways to make this more efficient. One is that the buyer of the oil or gas pays the government, so it’s essentially acting like an agent, withholding the amount of the tax from what it would otherwise have paid to the interest owners. The second option is that the operator of the property is paid the entire amount by the purchaser of the oil or gas, and then the operator pays the tax to the government on behalf of the other interest owners. In a way, these arrangements are somewhat similar to how sales taxes are handled in other industries.

Revenue Recognition

And there are lots of issues related to revenue. For example, what if a well site extracts oil or gas and then turns around and uses some of it to power the machinery at the well site? How do you account for that? Turns out, you don’t – the government doesn’t tax it, and the interest owners don’t receive a royalty, on the grounds that you otherwise would have had to bring in the fuel from somewhere else, which counterbalances the lost revenue.

But then things get more complicated. What if you then shift that oil or gas to a nearby property and use it to power the equipment over there? That other property may have different ownership percentages, and perhaps some of the interest owners over there aren’t even the same folks as the ones involved with the first property. So now, you have to record the oil and gas coming out of the source well as revenue, and pay royalties and taxes on it, and then charge it to expense at the receiving site.  It’s issues like this that keep accountants employed.

Another revenue issue is take-or-pay arrangements. This is where a pipeline owner commits to taking a minimum amount of gas from a well site each month. But it may not take the gas during the warmer months, when gas demand goes way down. In that case, as the name of the arrangement implies, the pipeline has to pay the producer anyways. The accounting treatment for these payments is that they’re recorded as a deferred credit, which is used to reduce the amount of payments made in other months when the pipeline takes more gas from the well site. Once again, full employment for accountants.

Interest Capitalization

And a parting thought. On top of what I’ve mentioned here, oil and gas companies also capitalize their interest on drilling projects, and they can potentially have massive liabilities for asset retirement obligations, like restoring drilling sites to their original condition. All of these issues mean that oil and gas accountants have to deal with the full range of accounting issues, practically on a daily basis. In short, this is one of the more technically challenging accounting areas in the world.

Related Courses

Oil and Gas Accounting

The Burn Rate (#250)

In this podcast episode, we discuss the burn rate. Key points made are noted below.

When We Use the Burn Rate

The burn rate measures the amount of cash being used up per month, which you can then use to estimate the amount of time it’s going to take for a business to spend its remaining cash reserves – and then presumably go out of business. This is an important concept for a startup company, which has been given a fixed amount of cash to get things going, and only has a certain amount of time to create a product and start generating sales, before the cash is gone. This isn’t just a financing issue. It’s also a concern for the auditor, who needs to figure out if a business is a going concern. Because if it’s not, that’s kind of a major disclosure issue.

Example of the Burn Rate

The burn rate is based on the amount of negative cash flow per month, which is divided into the amount of cash on hand. For example, if a business’ bank account balance is dropping by $50,000 per month, it’s said to have a burn rate of $50,000 per month. If it has $1,000,000 of cash in the bank, then it should be able to last 20 months until its cash runs out.

Issues with the Burn Rate

Of course, things are never quite that simple. The first issue is that the burn rate is not the same thing as expenses. So, a startup company might have operating expenses of $50,000 per month, but it’s also paying for computers for its staff, and rent deposits, and office furniture – none of which are classified as expenses. Those extra items are all classified as assets. So when figuring out the burn rate, you have to look at every possible kind of expenditure being made.

The second issue is that companies are a lot looser with their expenditures when they’ve just received a pile of funding, and a lot stingier when the last few dollars are about to be drained out of the account. That’s for two reasons. One is that a company needs to spend more money up front when the business is just getting starting, to pay for things like legal expenses, just to get properly organized. The other reason is psychological. When there’re many months remaining before the cash runs out, people tend to worry about it less than when the whole enterprise is about to close its doors.

So when the cash is nearly gone, management tends to scale back on purchases, lays people off, cuts pay, and so on. And that makes it a lot more difficult to figure out the burn rate over a long period of time, because the amount of cash being used tends to decline a lot when the end is near.

Another issue is the likelihood of obtaining additional funding. If the business is about to launch a promising new product, there’s some chance that it can line up an additional round of funding and keep things going longer. If management expects more cash, then it’ll be less inclined to scale back its expenditures when the cash balance drops, and instead is more likely to keep going full speed ahead – and might even increase its expenditures, so that the burn rate goes up over time.

This is why you occasionally see a startup company crash and burn very suddenly. They’re hiring more staff right up until the last minute, and then the funding doesn’t come through on time, and it collapses. But that’s still not the only issue with the burn rate. It’s quite possible that management has made promises to its employees and suppliers to hang in there just a bit longer until the next round of financing has been lined up, and then it’ll pay them for amounts owed.

The problem is that the people supplying the next round of financing are doing so based on an extension of the current burn rate. And they’re not too happy when the new funding goes into the company’s account and then there’s an immediate decline in the cash balance in order to pay off those overdue amounts. In essence, what just happened is that management has been disguising a higher burn rate than initially appears to be the case, because of the delayed payments.

And there’s yet another issue, which is whether the burn rate is a valid figure if the founders decide to cut their losses early, shut down the business, and take out their cash. This is based on a review of how well the company’s product development work is going, as well as a realistic review of whether or not it’s possible to get an additional round of financing. If the answer to either one is not good, then it can make sense to lay everyone off and liquidate the business, even though there’s still cash in the bank.

So far, I’ve been talking about additional funding as though that’s a realistic possibility. In many cases, it’s not. There’s going to be one funding round, and if the company can’t get its operations going with that specific amount of cash, then the game is over. And maybe that’s why venture capital folks have a term called the Death Valley curve. It’s a declining curve that shows the amount of remaining cash. At some point, the business runs out of money, and it dies in Death Valley.

The Burn Rate Applied to Older Companies

The burn rate concept is most applicable to new companies, but it can also be useful when an older business has a persistently negative cash flow. In this case, it needs to come up with some sort of strategic or tactical change in order to turn around its cash flow situation. In this case, burn rate is quite useful for telling management just how much time it has in which to make those changes.

But it’s not quite that simple, because the burn rate is supposed to represent a fairly consistent amount of cash being used up each month. And for a business going through a turnaround, that’s just not the case. Instead, it spends a lot of money up front on severance pay to let people go, along with paying for the things it needs to launch it in a new direction. Which may include payments for branding, like advertising to reposition the public image of the company. These payments tend to be lumpy, so the burn rate could vary a lot by month.

A Reason Not to Use the Burn Rate

Which brings me to my final point, which is that maybe the burn rate isn’t such a good measurement to rely on. Instead, it can make more sense to maintain a fairly detailed cash forecast that runs a good ways out into the future, and only tack on the burn rate for periods beyond what’s covered by the cash forecast. That way, you get the best possible visibility into when you’re going to run out of cash.

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Accounting for Films (#249)

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

Film Production Costs

The main issue with films is what happens to the production cost. For example, a studio pays an author for the rights to a book or a screenplay, which it can then adapt into a movie. For example, Amazon recently paid $250 million to the Tolkien estate to bring a Lord of the Rings prequel to television.

The cost of the film rights is capitalized. And so is the cost to adapt the story into a screenplay. And then, the actual cost to produce the film is capitalized. That includes the cost of the actors, the construction crew that builds the sets, the camera crew, and so on.

So, what about a situation where a scene has to be reshot? For a recent example, you might remember the film All the Money in the World, which was about the kidnapping of J. Paul Getty III. Kevin Spacey played the role of J. Paul Getty, but because of sexual misconduct allegations, Christopher Plummer was brought in as a replacement just a month before the film was scheduled for release. The reshoot reportedly cost somewhere between $6 million and $10 million. That cost would have been capitalized.

So let’s say you’ve completed the production work, and you’ve accumulated all of these costs into an asset. Now what? Then the amortization begins, where you charge the asset to expense over a period of time. They use quite a unique method, called the individual film forecast computation method. The calculation of the amortization rate is to divide current period actual revenue by the estimated remaining ultimate revenue as of the beginning of the year.

Ultimate Revenue

So I’ll stop here and go over a few items. First, what is ultimate revenue? Sounds like a video game, but it’s actually the estimated total revenue expected to be generated from a film, from all sources – which includes things like exhibition fees, sales of spin-off products, and foreign licensing. The estimation period usually runs for 10 years from the film release date.

Second item – let’s assume that the ultimate revenue figure is a perfectly accurate estimate. If that’s the case, then the amortization charge essentially matches the revenue that’s been generated in the current period. So, if actual revenues in the period turn out to be 40% of the total amount expected, then you amortize 40% of the production cost of the film. This sounds great, since there’s good matching of revenues to expenses, and the profit percentage should be the same in every period.

There’s just one problem, which is my third point. What if the ultimate revenue figure is wrong? Which usually means that the movie bombed. For example, if you do a search on biggest movie failures, you’ll find that the movie John Carter may have lost as much as $213,000,000, and the loss on the Lone Ranger may have been as high as $200,000,000. Those two are just the largest – there are several dozen movies that have lost at least $100 million – each.

So, let’s say that a movie has gone in and out of the theaters, and a cheap licensing deal with Netflix is the only remaining option. In that case, the ultimate revenue figure is revised downward – a lot. Since most of the revenue has already been earned at this point, the next amortization calculation is pretty much going to require that the rest of the production cost be written off right away. This is essentially the same as an impairment calculation, but the method used to get there is a bit different.

Asset Impairment

Which doesn’t mean that a production company doesn’t have an asset impairment process. They do, though the criteria for judging whether a film asset may be impaired are a bit different. For example, indicators of impairment for a film include things like production delays, a change in the roll out plans to a smaller number of theaters, and not having enough funding to complete a film.

Of course, that’s just to decide whether an actual impairment test should be conducted. The actual impairment test involves making estimates of its discounted cash flows, which are based on some pretty unusual metrics. For example, cash flow projections can be based on the public perception of the underlying story – or, the historical results of the people involved with the film – or, the run time of the film. I assume that a shorter run time is better, but that’s a guess.

In the end, though, no matter how the loss is calculated, a production company has a fairly high risk of taking a bath on each film it produces, so impairment testing is a big deal in the film industry.

A different form of asset write-off occurs when work is begun on a film, but it’s never released. In this case, the production company has three years to either get the project ready for production, or write it off. A good example would be acquiring the film rights to a book, and then deciding that the movie is too difficult to produce. In that case, the studio can sit on the acquisition cost for three years, and then has to write it off. Or, it could sell the film rights to someone else, and use the proceeds to reduce the amount of its write-off.

The Television Series Asset

But that’s just films. What about a television series? The cost of multiple seasons of a television series are rolled up into one big asset, and then amortized by comparing actual revenue to the ultimate revenue figure for all of the produced seasons of the show.

And what if the producer doesn’t directly make any money from airing a particular television series, or film? For example, HBO doesn’t accept advertising, so it can’t tie revenues to specific shows, like Game of Thrones. In this case, they just have to make estimates of how much to amortize as a film or series is exhibited – which is weak, but what else can they do?

Here’s another issue. Let’s say a major actor negotiates compensation that’s a percentage of the gross revenues generated by a movie, which is what Robert Downey Jr. does in his Ironman and Avenger movies. This participation cost is accrued over time, starting with the release of the film, and is charged to expense at the same time as the related revenue is recognized. Again, this means that the film generates a fairly consistent profit percentage.

The Overall Deal

And here’s another accounting issue that’s quite unique to the film industry – the overall deal – which is an arrangement under which a studio pays compensation to a producer in exchange for the use of that person’s creative talents. Under this arrangement, anything developed by the producer stays within the studio. For example, Ryan Murphy just signed an overall deal with Netflix for somewhere between $250 and $300 million dollars over a five-year period.

The main point is how do they account for these payments? If part of the cost can be associated with a specific film project, then it’s accumulated into the capitalized cost of that film. When there’s no way to do that, the remaining cost is charged to expense.

Exploitation Costs

But we’re still not done. Then there’re exploitation costs. This sounds vaguely illegal, but it just means the cost to distribute and promote a film, like advertising and promotions. These items are charged to expense as incurred. Since they’re basically sales and marketing costs, that’s not unexpected.

The Accountant Movie

And a final point, the movie The Accountant was released in 2016. The production budget was $44 million, and its worldwide revenue was $155 million. Which just proves that being an accountant can be profitable. Though, to be fair, the movie was really about a hit man. Which is not what most of us do.

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Revenue Management (#248)

In this podcast episode, we discuss several revenue management concepts. Key points made are noted below.

Revenue Management Principles

Proper revenue management is based on a few underlying principles. One of them is that customers love a discount and hate to be charged a premium. For example, a hotel could quote you a price for a more expensive room, and then point out that, for a reduced price, you could get one of their standard rooms. This is exactly the same as the hotel starting off with a low-priced quote for a standard room and then pointing out that, for a premium, you can get one of their better rooms, maybe with an ocean view. The difference is that, in the first case, it looks like the hotel is looking out for your best interests by offering a discount, even though both deals are exactly the same. Studies have shown that when people are offered a discount, they’re more likely to upgrade, so the seller makes more money by presenting prices using the discount approach.

Let’s turn the situation around and do it from the perspective of an airline. Years ago, the airlines used to present their prices using bundling, which means that everything they did was contained within one price. Then they switched to unbundling, which means that most airlines now charge for everything individually, such as the flight, the baggage fee, seating upgrades, change fees, food, and so on. Obviously, they did this to make more money, but the effect was that everything involving an airline requires paying a premium over the base price. And as I just noted, customers hate to be charged a premium. And so, by and large, people hate airlines.

The funny thing is, the airlines did not unbundle their prices for people in business class, who pretty much still pay just one lump sum. That’s because the people in business class are the most profitable customers, so the airlines can’t afford to piss them off, like they do with everyone else.

Revenue from Incremental Customers

Which brings me to the second underlying principle of revenue management, which is that incremental pricing adjustments are usually made to bring in new customers who are not the core customers of a business. Which is to say, when a business runs some sort of a discount program, it doesn’t want its core customers to take advantage of the program. After all, this group is already paying full price.

Rate Fences

The trick is to offer deals that have rate fences built around them. A rate fence is some sort of rule or restriction that segregates customers based on their needs or willingness to pay. There’re all kinds of rate fences. For example, consider a rebate. Rebates are really pretty awesome from the perspective of the seller, because it looks like they’re available to everyone, and the seller can advertise the price of whatever is being sold, net of the rebate amount. But what actually happens is that full-price customers almost never go to the trouble of filling out the paperwork and mailing in the rebate. Instead, only those shoppers who are really sensitive to prices will go to the trouble – and this group may not have been attracted unless the rebate was offered. Therefore, a rebate is subtle kind of rate fence.

Another rate fence involves student pricing. You have to show a student ID in order to buy something at a seriously reduced price. The intent here is to sell to people who might buy the product again later on at full price, when they’re employed and maybe can pass the charge through to their employer. Because a student has to show an ID, people who normally pay full price can’t take advantage of the special discount.

And one more example of a rate fence is when a resort hotel offers discounted rates to locals. The prices never appear on the hotel’s website, and you have to show a driver’s license that identifies you as a local. This is useful for filling hotel rooms during the off season, and tourists have no way of knowing that the discount exists, and couldn’t take advantage of it even if they knew.

So let’s assume that some sort of rate fencing is in place. How do you maximize profits by offering special deals? This involves figuring out how many customers are willing to pay full price, and how that compares to the available capacity. The easiest example is an airline. Let’s say that a flight has 100 seats, and the historical sales for the flight will include 25 people who are willing to pay full price at $500 each. So that leaves 75 seats that can be sold at a lower price. The airline offers the remaining seats at $250, but there’re some catches. The payment is nonrefundable and it has to be made more than three months prior to the flight. These rate fences are designed to keep business travelers away from the lower-priced seats, since business people usually have to travel on short notice, and may have to change their reservations at the last minute. And on top of that, the airline might decide to only offer the discounted seats on a separate website that’s run by a discounter, so that business people will never see it.

The Booking Limit

This method of setting aside a certain number of seats at a discount price is called the booking limit. When enough passengers finish buying up that block of 75 seats, the booking limit has been reached, and at that point only the more expensive $500 seats will be available. But this introduces a problem from the revenue management side of things, which is what to do if more than 25 people want to buy the higher-priced seats. In this case, you want to maximize revenues, so the system invokes what’s called a nested booking limit, which allows higher-priced ticket sales to intrude on the block of lower-priced seats. So if 30 people buy the higher-priced seats, this automatically cuts the allocation for lower-priced seats down to 70 seats. It would be theoretically possible for 100 full-fare passengers to buy out an entire planeload of seats, which means that no discounted fares are offered at all.

Overbooking

Another revenue management tool is overbooking. Everyone hears about overbooking on airlines, but that’s not the only place where it happens. A hotel can overbook rooms, a restaurant can overbook seats, and even a retail store can offer something for sale without having enough units to back up the sales. These are all cases of overbooking. The main overbooking scenario that annoys everyone is the airlines, so let’s take a closer look there.

On average, a flight experiences a non-show rate of 10%. So on a flight with 100 seats, the airline can expect 10 seats to not be filled that it had expected to fill. That’s a pretty major opportunity to increase sales. The airline maintains a record of the no-show percentage for every flight for every day of the year, so it can estimate the amount by which it can overbook each flight. Of course, the actual no-show rate is going to vary from expectations on almost every flight, so the airline won’t get it exactly right. Which brings up the problem of denied boardings.

Strangely enough, customers sometimes like it when the airline pays them to get off a flight, so airline approval ratings can increase as the result of a voluntary denied boarding. When the denied boarding is involuntary, though, an airline can earn an enemy for life and get a lot of bad publicity. And by the way, involuntary denied boardings currently run at about 1 person for every 10,000 passengers.

So, revenue management in regard to airline overbookings is a pretty complex process of applying historical trends to the present and having a system for paying off anyone who’s kicked off a flight.

Overbooking can be a pleasant experience in a hotel, since it usually means that they bump you up into a more expensive room for free. In the rare cases when there’s absolutely no room, they get you a spot somewhere nearby, which isn’t anywhere near as big a problem as being kicked off a flight, since it only involves a short drive to another hotel.

Restaurants also overbook, but you may never notice it. If a time slot is unexpectedly filled up, you end up waiting a few minutes, and get inserted into the next time slot. Eventually, somebody does not show up for a later booking, which eliminates the wait.

And when a retailer overbooks, it can either issue a rain check to a customer, or it states up front that quantities are limited. In the first case, the customer has to wait a bit longer for the goods to be backordered, but the retailer still makes the sale. In the latter case, customers tend to queue up at the beginning of the sale period in order to make sure that they get one of the units that’s available at the discounted price.

This was only a brief view of revenue management, but you can see that there’re lots of ways to tweak the amount of revenue, and hopefully generate more profits.

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Fraud Schemes: Payables (#247)

In this podcast episode, we discuss fraud schemes related to accounts payable. Key points made are noted below.

The Stolen Check Scam

A business can lose a lot of money if it doesn’t keep tight control over its payables, because there are several ways for employees to redirect cash through the payables system. One of the easiest scams is for an employee to steal unused company check stock and write a check to himself. Or, since a bank reconciliation will spot the employee’s name on the check, to write a check to a business that’s owned by the employee. If the name of the party being paid is generic enough, no one may question the payment. Still, these amounts tend to be on the smaller side, in order to avoid notice.

Another element needed to make a stolen check scam work is access to the signature stamp being used to sign checks, or the perpetrator may just have a good ability to counterfeit the signature of an authorized signer. This problem can be stopped fairly easily. You have to lock up the check stock in one location, and lock up the signature stamp in another location – otherwise, if someone can break into a single location, he’s hit the jackpot, because he can steal checks and sign them with a valid signature stamp. Of course, the controller can’t leave the keys to these locations sitting in her desk drawer – which is all too common. In short, you need to exercise some prudence.

The Concealed Check Scam

A slightly more clever approach to the same fraud is the concealed check scam. This involves creating a check through the payables system, with a reasonable amount of fake supporting documentation. Then insert the check into a stack of other checks that need to be signed, and give the stack to the authorized check signer. If the signer has a reputation for signing anything without question, it should be easy to get a valid signature on the check, which the clerk can then cash. Obviously, blocking this fraud requires the check signer to be diligent in reviewing supporting documentation for checks. But sometimes even the best check signer is in a hurry, and blasts through a pile of checks without looking too closely at what’s being signed.

And furthermore, if the perpetrator creates supporting documentation that’s convincing enough, the check signer may fall for it and sign the check anyways. Even worse, the check signer may get used to seeing the same supplier name appear in the stack of checks, and will continue to sign off on these checks – which means that the concealed check scam actually gets easier through repetition.

The Duplicate Payment Scam

There are some additional variations. One approach is to create two payments to a supplier “by mistake” for the same invoice, then issue one to the supplier to cover the actual supplier invoice, and cash the other check into an account that’s in the name of the supplier, but which is owned by the payables clerk. This approach is a bit limited, since there’s a good chance someone will spot a large number of duplicate payments after a while.

The Intercepted Check Scam

Another approach is to fake a supplier invoice from a real supplier and cut a check to pay for that invoice. The check signer will be taken in by the name of the supplier, and so is more likely to sign the check. The payables clerk then intercepts the signed check and deposits it into an account that’s in the name of the supplier, but which is owned by the payables clerk.

You can mitigate these types of fraud by not allowing the payables clerk access to signed checks. Instead, they’re mailed as soon as they’re signed. This is not a good solution in a small business, where there aren’t enough employees to properly segregate responsibilities.

These kinds of fraud are an even worse problem when the person engaging in the fraud is an authorized check signer, such as an in-charge bookkeeper or a controller. This person obviously has access to the check stock, and no one will question the checks being issued. The situation is especially bad if the person sets up fake suppliers, so that she can submit fake invoices, and then signs the checks to pay for her own invoices. This class of fraud can involve some major losses, so the basic rule is to keep check signing authority out of the accounting department.

Expense Report Fraud

And then we have expense report fraud. There are so many ways for an employee to file an expense report that contains false expenses. When the company reimburses the employee for an expense report, the employee is essentially stealing funds. So here are some ways to pad an expense report.

You can make multiple copies of a receipt, and submit these extra receipts in successive expense reports, so that one expenditure is reimbursed multiple times. A variation is to submit several different types of support for the same expense in successive expense reports. For example, you could submit the itemized detail for a hotel room on one expense report and the credit card receipt for the room on the next report. Another approach is to charge an item to the company credit card and then claim reimbursement for it on your own expense report, using the purchase receipt.

And there are plenty of other ways to mess with an expense report. For example, you could characterize a personal expenditure as company business, and run it through the expense report. Or, adjust the amount on a receipt to make it larger, and then submit a photocopy instead of the original that’s deliberately fuzzy, so no one can detect the change. Or to be really artistic, create entirely fake documentation, with an official-looking form and a fake company logo. This last approach is not worth the effort unless you’re going for a really large reimbursement.

But, we’re not done yet. You could enroll in a class at a local college and submit the receipt for reimbursement – and then cancel the class and get a refund. Or, if you’re on an extended business trip, submit grocery store receipts for your grocery purchases – and then collect grocery receipts from other shoppers, and submit those receipts, too. By the way, I saw an audit manager do that one. For an easy reimbursement upgrade, try overstating the number of miles actually traveled on company business, and get reimbursed for the larger amount. Or, if you’re taking a cab ride, ask for a blank receipt from the cab driver, and fill it in with whatever number you want.

I’m not trying to turn this episode into a how-to guide for how to steal from your company – but you can see how easy it can be, especially with expense reports. Now let’s turn it around and look at the situation from the perspective of the company. How do you keep employees from padding their expense reports? It might seem like the only option is to view every expense report with deep suspicion, and spend an hour or so digging through each one – but that’s not very practical. A better option is to conduct an occasional in-depth review of an expense report. If you find something dubious, then that employee’s prior expense reports are all examined in detail. In addition, that person is flagged in the system as a problem employee, so that all future expense reports are subjected to a detailed audit. Of course, at some point you fire these people.

Another possibility is to make employees use a company credit card or a corporate travel agency, so that the company directly pays for all travel expenses. This eliminates most reimbursements, though it’s still possible for someone to run personal expenditures through the company card.

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Switching from Private to Public Accounting (#246)

In this podcast episode, we discuss the issues with switching from private to public accounting. Key points made are noted below.

Employee Sourcing for Audit Firms

The main source of employees for audit firms is people coming straight out of college. They’ve just gotten their accounting degrees and are more or less ready to sit for the CPA exam, so they’re a good source for filling the lowest-level audit positions. The second most important source of audit staff is poaching the auditors of other audit firms. These people are expensive, since it usually takes a significant pay raise to lure them away. But it’s worth it, because they already have experience, usually coming in as senior staff or managers.

Notice the difference in the slots being filled. People coming straight out of college go into the lowest positions, and people hired away from competitors move into higher slots. That’s pretty obvious, but hang on a minute.

This brings us to the third source of audit staff, which is trained accountants coming from the private sector. These people have accounting degrees, but they probably earned those degrees a few years ago, and so may be weak in some areas that they haven’t used since college. And on top of that, their practical knowledge of auditing is probably limited to taking requests from the auditors who show up for their annual audits. And that’s pretty thin experience.

Problems for Auditors from the Private Sector

This leaves people from the private sector residing in sort of a no-man’s land between the other two groups. They’re more experienced than new college graduates, but not in auditing, which is what really matters. So they won’t be hired into senior staff or manager slots. Instead, they’ll be hired into junior audit staff positions, because that’s the kind of work they’re capable of performing.

My first point in regards to a course of action is to get used to the idea that you may very well be taking a pay cut to switch from the private sector to the public sector, so decide up front whether it’s worthwhile to earn less money.

My second point is that some major brushing up will be needed to get ready to sit for the CPA exam. Don’t forget, this is all fresh knowledge for someone coming straight out of college, but that’s not the case for someone who’s already been working for a few years. This is not a minor point. Audit firms are famous for getting rid of their lowest-performing staff at least once a year, so if you don’t perform as well as the new college grads on the CPA exam, you may be kicked out of the firm. So my third point is to decide whether you can take the financial risk of quite possibly not making it in the audit industry. And don’t think it won’t happen to you. 80% of all recruits do not last.

Advantages for Auditors from the Private Sector

But – it’s not all doom and gloom. Someone coming in from the private sector has more real-world experience than a new college graduate, and so might become a better auditor over the long term. And on top of that, the private sector accountant is older and so is presumably more mature, and so is better able to deal with clients and other auditors. These aren’t minor advantages, but the real risk – again – is not making the initial cut as an auditor. And so my fourth point is to grind it out as hard as you can up front to learn how auditing works, because from then on, you might be in an advantageous position.

Another point in regard to being a bit older and more experienced is that you might be promoted more quickly, maybe shaving a year off the normal progression to partner. But don’t get too excited, since very few people ever make it to partner.

The more likely outcome, even for someone who succeeds as an auditor, is that you’ll make it up to the manager level and then get hired right back out of the firm by a client. But that’s OK, because the position you’ll be hired back into is probably going to be a controller or CFO, which presumably means a pretty hefty increase in pay over whatever you were making when you switched to auditing.

The Age Disparity

Another thought is to consider what it will feel like to start out in an audit firm where you’re the oldest person among the audit staff. This can be tough, so there’s sort of an informal cap on how old people tend to be who get hired in as new auditors. Very few people do it once they’re more than 30 years old. The age disparity is just too great.

An Additional Employee Source for Audit Firms

And a final comment is that there’s actually a fourth source of audit staff for an audit firm, which is people they’ve already hired, but into other parts of the business. So you may see a trickle of transfers from the tax and consulting sides of the business, and sometimes from the administrative staff. No matter where they come from within the firm, they already know the work schedule and they know the culture, so they usually have a higher success rate than people coming in from the outside. And from the perspective of the audit partners, these people are already a known quantity, which is always a plus.

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Fraud Schemes: Inventory (#245)

In this podcast episode, we discuss fraud schemes relating to inventory. Key points made are noted below.

Theft of Inventory at Receiving

The intent behind inventory fraud is to steal the goods and then sell them, though a person might want to keep stolen inventory for his personal use. One approach to stealing inventory is right at the receiving dock. It usually doesn’t make much sense for a receiving person to steal a box right there at the dock, walk it out to the parking lot, and dump it in the trunk of his car. That’s not entirely subtle.  A more discrete way to do it is to come to an agreement with the delivery person who’s bringing goods to the receiving dock. Have that person park somewhere out of the way and extract the goods in private, and then deliver the rest of the goods in the normal manner. The receiving person signs off on the full amount stated on the packing slip, so the company pays for the full amount. The delivery driver and the receiving clerk then split the proceeds from the sale of the inventory.

This scheme falls apart when the warehouse staff keeps finding shortages in the received goods that they’re putting away in the warehouse. To find out what’s going on, they can trace missing inventory back to the person who signed for the goods. However, if the receiving clerk is clever, he’ll forge the signatures of other people in the department on the receiving documents, which muddies the water.

Quality Assurance Collusion

Another possibility is when a warehouse clerk colludes with someone in the quality assurance department. The quality assurance guy can designate inventory as not meeting quality standards, so it has to be scrapped – even though it’s actually good product. The warehouse person then intercepts the inventory and records it as having been scrapped. This approach can result in some pretty significant losses. It’s especially possible when there really are quality problems, so some stolen goods can be slipped in with all of the other quality issues being reported.

Finding this kind of theft calls from some trend analysis. See if there’s been a spike in the amount of scrapped inventory lately. And as usual, see if most of the scrap designations can be traced back to one person.

Accounting Department Collusion

Another form of collusion is for someone in the accounting department to create credit memos for supposedly returned goods from customers. The accomplice in the warehouse then writes off the supposedly returned goods as being damaged, and steals them. This approach will cause a spike in the amount of returned goods, which would hopefully trigger an investigation by the product design staff, to see what’s wrong with the product. Another indicator is that the credit memos will appear in the customer receivable records, which might prompt some questions from the customers.

Order Entry Clerk Collusion

Another collusion scheme is for an order entry clerk to enter a fake sales order into the system that triggers a shipment to an address where the inventory can be redirected. If a billing clerk is in on the scam, no invoice is ever logged into the accounting system, so there’s no record of a sale. Of course, the shipment is still listed in the system, so a reconciliation of shipments to billings would spot the missing invoice. So all of these are collusion schemes.

Theft from the Warehouse

It’s also possible to simply steal inventory items right off the shelf in the warehouse. A warehouse person can cover his tracks by writing off these items as being damaged and thrown out, or just inventory counting errors. This is really easy, and it’s tough to spot, especially if the warehouse staff is careful, and only steals a few items at a time. This doesn’t mean that detection is impossible. You could track who is entering write-down transactions in the inventory database, though – again – a warehouse person could log in as several different people to record the transactions. Another option is to put video recording equipment in the warehouse, though that can get somewhat expensive.

And along the same lines, even more opportunities are available if the company has overflow inventory that’s stored in trailers near the warehouse. In this case, an employee can break the lock and make off with the inventory, without bothering to hide the theft with some paperwork shuffling. Since the inventory was taken from a location outside the building, the theft could be blamed on an outsider.

Scrap Payment Theft

But that’s not all. Some inventory really is scrapped, and it’s thrown into a bin, which is picked up periodically by a scrap dealer. The dealer may pay cash on the spot, in which case anyone – but probably someone in authority – intercepts the cash, so it never appears in the accounting records. This is really easy to do, since scrap is maybe the least controlled asset in a company.

You can get rid of this problem by having the scrap dealer only pay with a check, which it sends to a bank lockbox. Doing so keeps the cash off the premises. Another option is to set up a pickup schedule for the scrap dealer, so you know when to expect a payment. And yet another option is to track the amount of these payments on a trend line, to see if the total amount is declining, or there are gaps in the payments.

Indicators of Inventory Fraud

So, what are some of the signs that inventory fraud is occurring? One item is that inventory count variances are always unfavorable – which means that you’re always writing off inventory as the result of a count. With normal inventory counts, there’s more likely to be a mix – a few items are written up, and a few are written down.

Another sign is that inventory-related documents keep disappearing. There may be missing packing slips, or shipping receipts, or physical count sheets. If so, employees are stealing the documents to hide their thefts.

Yet another sign is that the signatures or initials on inventory-related documents are completely illegible. Now, some people just write that way, especially when they’re in a hurry. But when lots of documents have illegible scrawls on them, it’s possible that one person is fudging the signatures of multiple people.

And here’s another one. Employees in the warehouse are always bringing baggage into the building. Sure, it could be their lunch, but what if there’s enough room in there to jam in some inventory?

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The Numismatic Industry (#244)

In this podcast episode, we discuss accounting in the numismatic (coin collecting) industry. Key points made are noted below.

Inventory Tracking

A lot of a reseller’s business is conducted at auctions and trade shows. This means that their coin inventory can be scattered around, waiting for auctions to be conducted. And on top of that, they sometimes send coins to customers who might be interested in buying them. So their first issue is keeping track of the inventory, which could potentially be in dozens of locations. To do that, each coin is assigned a unique identifier code, which is what they use to track inventory in their database. And of course, they use the specific identification method, where costs incurred are assigned to specific coins.

Sales Taxes

A second issue is sales taxes. Coins aren’t necessarily sold from a single, fixed location. In fact, there may be no physical store front at all. Instead, a sale could occur at any number of locations, such as at an auction or at a customer’s location. So there may or may not be a need to charge a sales tax, depending on the local laws regarding whether nexus exists, and whether the sales tax applies to coins. This can get complicated.

Pooling of Cash to Buy Coins

A third issue is that some of these coins are very expensive. So expensive that a single reseller may not to bear the risk of purchasing a coin. To get around this, a couple of resellers will pool their resources to buy a coin. When this happens, one company pays the entire purchase price and is then reimbursed by their partner in the deal for part of the purchase price. The coin is shipped to the primary reseller.

Restoration and Evaluation Services

The primary reseller then pays for any restoration and evaluation services associated with the coin, and eventually sells the coin to a customer. At this point, the accountant for the primary reseller has to total up the original purchase price that it paid to the seller, subtract out the amount received from the partner, and add in all the other fees incurred, to arrive at the total net cost of the coin. Then the accountant subtracts all these costs from the revenue earned from selling the coin to figure out the profit, and then splits the profit with the partner.

Supplier Invoices

This is pretty complicated. It seems to be designed to make life difficult for the accountant, especially when you figure that some of these coins won’t be sold for a long time, so the supplier invoices may pile up for months, and could get mixed in with the charges related to other coins. And on top of that, it’s not unlikely for some supplier invoices related to evaluation services to arrive after the reseller has already sold a coin to a customer. This means the accountant has to use a checklist to make sure that all supplier invoices have been received before calculating the profit split with a partner. Or, if that’s not possible, he may just have to wait a while for the bills to arrive, which runs the risk of annoying the partner.

Billing Issues

A final issue is that the billing systems in the industry aren’t exactly world class. Instead, a sale at a trade show is usually documented on a hand written invoice. So you have to remember to log the invoice back into your system, in the correct amount, for the correct identifier code, in order to have an accurate record to match against all the associated costs.

Additional Issues

There are a few high level issues associated with the industry, too. One is that transactions are pretty much on a cash basis. Accrual basis accounting doesn’t really seem to have taken hold. Another concern is whether to write down the value of a coin if the market price declines. I would imagine that very few resellers even consider that option. After all, each coin is unique and the market is rather thin, so how could you even prove a write-down in the value of a coin?

The Hotel Industry (#243)

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

Cost Tracking and Capacity Usage

What is so special about hotels that they present a challenge for the accountant? The main issue is not any special accounting standards – there aren’t any. Instead, it’s all about tracking costs and capacity usage. For example, a lot of hotels are located in tourist areas where there’s a lot of seasonal variation from month to month. The accountant needs to separate out the fixed and variable costs of the hotel, and report on the fixed cost base for every month of the year. By doing that, management can figure out if it might make more sense to shut down the hotel during the off season.

Or, knowing the breakeven point of the facility, they can decide just how low they’re willing to drop prices during the off-season in order to pull in enough cash to offset their monthly operating costs. This is not a minor issue, since a hotel can easily go out of business if there isn’t someone available who can monitor the flow of revenues and expenses from month to month.

Discounts Granted

The accountant is also probably going to report on the discounts being given from the standard price for a hotel room. This standard price is called the rack rate, and it’s the price quoted to customers who request a same-day reservation without having made a prior reservation. This rate is usually discounted for people who reserve in advance, or who are preferred customers, or who buy rooms through a discounter. There can be a lot of discounting, since there’s not much variable cost associated with someone renting a room for a night. The price is nearly all profit, so there’s a temptation for the hotel manager to offer some pretty deep discounts in order to fill up the hotel. The accountant needs to keep track of the balance between offering discounts to attract customers, and being able to pay for all the fixed costs each month. So the accountant can maintain a model that shows how extra discounts increase the room utilization rate, but don’t generate as much revenue per room. This model should show a sweet spot where the prices are set at a level that maximizes profits, which probably also results in some rooms not being booked.

Ratio Analysis

The accountant can keep track of a few ratios that will give management a good idea of the hotel’s performance. For example, there’s the paid occupancy percentage, which  states the portion of rooms sold in comparison to the number of rooms available for sale. Another measure is the average room rate, which is the total room revenue for the day, divided by the number of rooms sold. Or, the accountant could keep track of the complimentary occupancy percentage, which tracks the number of rooms occupied for free, divided by the number of rooms available for sale. I never seem to get those rooms.

Labor Cost Tracking

Another issue for the accountant is to track labor costs being incurred during the day. Hotels tend to need a lot of labor during very specific times, usually during check-in and check-out, and for room cleaning in the morning. The rest of the time, management needs to know when it can let employees go for the day, so that the hotel doesn’t rack up unnecessary labor expenses during low-activity periods.

Profit Center Tracking

And yet another issue is that the accountant needs to track the performance of every profit center within the hotel. It’s not a single, monolithic entity that earns a profit. Instead, there’re profit centers for the vending machines, and in-room movies, and the hotel restaurant – if there is one – and for any stores located within the facility.

Unusual Financial Statement Line Items

In terms of what’s different in the financial statements, a hotel can have separate line items on its income statement for sales related to rooms, and food, and vending, at least. The expenses can look a bit different, too, and may include line items for things like cable television fees, cleaning supplies, grounds and landscaping, laundry, linen, and uniforms. And, of course, consumables – that’s those little bottles of shampoo and conditioner in the bathroom.

Payroll Accounting

And then we have the accounting for payroll. In the hotel industry, nearly everyone is paid wages, not a salary. Wage tracking takes much more time than paying a salary, so payroll is a disproportionately large part of the work in the accounting department.

Fixed Asset Tracking

Fixed asset tracking can also be much larger than usual, for obvious reasons. It’s not just the construction cost of the hotel facility. There’re also fixed assets in the restaurant area, and the massive amount of furniture and fixtures in all the rooms and common areas. And on top of that, there are land improvements that need to be tracked. And, as the hotel ages, a lot of these assets are retired and replaced with new ones, which also have to be tracked as fixed assets. And on top of everything else, constructing a hotel takes months or years, and during that time the cost of the interest associated with the funding for the hotel can be capitalized.

Maintenance Tracking

A hotel is going to need maintenance – all the time. The facility is being heavily used, so equipment and fixtures will wear out. The accountant needs to keep track of the incoming maintenance requests, classify them in terms of what’s critical, and then recommend to management which issues can be fixed right now. In some cases, the cash flows of the hotel just won’t allow for immediate maintenance, so some issues have to be delayed. And this is not just a cash flow issue. In a high-end hotel, the facilities are supposed to look great all the time, so delaying maintenance can lead to reduced bookings, which reduces cash flows, which makes it even more difficult to keep up on the maintenance.

Fraud Issues

There can be a few fraud situations that are unique to hotels, and they’re most likely to occur when someone pays cash for a room. For example, the clerk at the front desk could charge a customer the room rate for a better room, check him into a lower-priced room, and then pocket the difference. Or, the clerk could pocket the cash from a customer payment and then charge the person’s room to a corporate account – which works pretty well when there’s a lot of volume running through the corporate account, so that no one will notice an extra charge or two.

Summary

So in short, the main issue with hotel accounting is that you’re optimizing the use of a massive asset. The accountant needs to assist in tracking costs, prices, and utilization levels, which can vary a lot by time of year. The job is like a giant balancing act, trying to work with lots of variables to keep the hotel profitable.

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Crowdfunding (#242)

In this podcast episode, we discuss new ways to sell shares through crowdfunding. Key points made are noted below.

Crowdfunding Regulations

First, the bad news. Regulations. The Securities and Exchange Commission issued Regulation Crowdfunding in 2016, which places a few restrictions on the process. A business can only raise a million dollars a year, which includes all other fund raising within the same period. This amount is inflation adjusted, so the fund raising figure for 2017 is $1,070,000, and that number will presumably keep going up. Nonetheless, that is not a lot of money, so crowdfunding is probably going to be restricted to small startup companies. Any organizations larger than that will need more money.

Funding Levels

The second bad item is that individual investors can only invest a relatively small amount of money. I won’t get into all the restrictions, but it’s basically ten percent of their annual income or net worth, which is reduced to five percent if the person’s income or net worth is less than $107,000. And again, this figure is inflation adjusted. This rule was put in place so that investors wouldn’t lose too much money if the investee goes bankrupt. From the company’s perspective, it means that they’re going to need a lot of investors to meet the maximum annual investment cap – probably around 200 of them.

Reporting Requirements

And then there’s the third bad item, which is reporting. Any business that wants to sell stock through crowdfunding has to file a Form C with the Securities and Exchange Commission, which is estimated to take 50 hours to complete.  In addition, the firm has to provide its tax returns if it’s raising a small amount of money, and reviewed financial statements if it’s raising a mid-range amount, and audited financials for amounts near the top of the allowed range.

Auditing Requirements

Audits are expensive and time-consuming, but if you want to raise at least $535,000 per year on an ongoing basis, then the audit must be completed – in advance. There’s also some reporting to be done while the fund raising is being conducted, as well as the annual Form C-AR, which has to be filed in each of the next three years, depending on the circumstances. Figure on spending a total of 200 hours on the Form C and then the three Form C-ARs.

Stock Registration

And for a final bad item, the shares that are sold will still have to be registered with the SEC if the company’s assets ever exceed $25 million. I talked about registering shares back in episode 93. The brief version of that episode is that stock registration is expensive, time consuming, and frustrating.

Investor Issues

So far, I’ve only mentioned the bad side of crowdfunding from the perspective of the company. There’s also a bad side for the investor, which is that the level of disclosure made by a company is relatively light, compared to a full initial public offering. Also, the investors who invest through a crowdfunding deal are less likely to be sophisticated investors. Put those two issues together, and you get people investing in stock offerings that may not be overly likely to pay off.

Crowdfunding Benefits

So, how do I balance all of this grim news with the benefits of crowdfunding? The main benefit is that a small startup company may have very few possible sources of funding, or at least, that aren’t rapacious – so crowdfunding gives them another option. In addition, if a business plan is really risky, a crowdfunding campaign might still raise money, whereas a more traditional investor wouldn’t consider investing. And finally – and not a small item – a business no longer has to be physically located near one of the main fundraising centers, like Silicon Valley or New York. Instead, since the fundraising is conducted on-line, the company could be located pretty much anywhere.

Crowdfunding Summary

So in summary, I haven’t really painted a favorable picture. Selling shares through crowdfunding could be useful for some smaller companies, but not all that many.

Regulation D

But don’t give up hope, there is an alternative, which is Rule 506-c of the SEC’s Regulation D. The quick summary is that Rule 506-c is pretty awesome, because you can raise an unlimited amount of money.

The downside is that stock sales can only be to accredited investors, and the company has to confirm that they’re actually accredited investors. An accredited investor is someone who has a net worth of at least $1 million dollars or annual income of at least $200,000 individually or $300,000 of joint income with a spouse. That’s the short definition – there are some other options.

This accreditation rule means that the pool of possible investors is reduced – a lot. People who qualify as being accredited constitute only about 3% of the population. On the other hand, there’s no cap on the amount you can raise from each one, so this restriction may not be much of an issue.

The way to use Rule 506-c is to go to a fundraising portal, which is a registered website that handles crowdfunding stock sales. The portal may have already investigated a pool of investors to see if they’re accredited, so that takes care of the legal requirement for reviewing investors. The fundraising portal posts the sale opportunity on its website, and investors can review the materials to see if they’re interested. Examples of these websites are crowdfunder.com, fundable.com, and microventures.com. And there’re many others.

The only real downside of this rule applies to investors, which is that the shares issued are not registered with the SEC – and that means the shares can’t be resold to someone else. So if you buy shares under Rule 506-c, you might have a hard time liquidating the investment later on. This usually means that you either hope that the company will be sold, or you pressure the company to register the shares with the SEC – which, as I already noted, is not easy. And even if the shares are registered, there may not be much of a market for them, so it could still be difficult to sell the shares.

So in summary, Regulation Crowdfunding is only good for small amounts of money and requires a fair amount of reporting. Rule 506-c is better all around, because you can raise much more money.

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