A Real Case of Fraud (#281)

In this podcast episode, we discuss how to recover from fraud. Key points made are noted below.

Details of a Fraud Case

The topic of this episode comes from a listener, and it involves an actual case of fraud. It appears that criminal charges were filed, so I decided to let this one sit for a year before putting it on the podcast. I’m also not going to mention any names. What you hear next is going to be a mix of the listener’s e-mail to me, and a few comments I have on the situation.

His email begins as follows: “Good morning, I’m a young business owner who made a terrible decision with a woman I hired last year, and it’s erupted into total chaos trying to clean up the mess I was left in. While trying to rebuild the books and payroll system, I figured what I’ve been going through could be a good podcast for your listeners. A quick background on the company, I founded it while in college working toward a degree in finance, working in electrical contracting. By the end of 2017, we grossed $330,000 in revenue and around $100,000 in profit. At the end of 2018, I decided to sign a lease on office space to expand operations. I knew I’d have my hands full running the business and starting my junior year of college, so I decided to hire a contracted controller who would also oversee all of our human resources. What came to follow blows my mind to this day. I later found out that she lied on her resume, had limited accounting experience, and the list goes on. Since her removal from the company in May of 2018, I’ve been doing my best to keep everything together, but the challenges are ongoing and I’m surprised the business hasn’t folded yet. Here are the highlights of what happened:

• She set up a Quickbooks accounting system and locked everyone else out of the system.

• She set up a Paychex account and locked everyone else out of the system.

• She took out a $15,000 loan and forged my signature on the application.

• She wrote over $33,000 in checks to herself.

• She threw out 90 percent of the receipts for all purchases.

• She paid “reimbursements” to her brother, who also worked for the company, that were actually wages.

• She stole proprietary information from the company and then started a competing company, and solicited all of my employees to work for her.

It looks like the district attorney will end up sending her to jail, but that doesn’t help me in putting the finances back together. After being a victim of fraud, having to let go all but two employees, and needing to get the books in order with limited source documents and little money to find professional help, I’ve been having to do it all myself. Based on my situation, I have a few questions that I, and your listeners, might find useful in a similar situation. First question: How do you book a transaction when there’s no supporting documentation?”

Booking Transactions Without Documentation

Before I respond to that, let me just say, holy crap! Talk about being taken. This was a case of both massive incompetence by the controller and a comprehensive lack of ethics. Anyways, when there’s no supporting documentation, I wish I could give you a magic solution, but there just isn’t. When all you know is that cash has been withdrawn from the business, then all you can do is charge it to an expense account. I suggest setting up an account with a name like “Undocumented expenses,” just to clarify the situation, but in this company’s case, there’s no way to be more refined about it.

Forensic Best Practices

Second question: “Are there any best practices for doing forensic work to isolate questionable transactions?” The point of this question was for the owner to save time in cleaning up the books by focusing on specific transactions. The answer is, not really. When one person has total control over the books, as was the case here, anything and everything could be screwed up, so there’s no way to reduce the amount of investigative work. To go into a bit more detail here, you can either keep things at a high level and just write off every outgoing payment as an expense, or go into lots of detail and try to track down check recipients and company suppliers and try to get their side of each transaction. Which can take a long time, and it may not be worth the effort.

Wages Paid as Reimbursements

Third question: “How to treat reimbursements paid to employees that were actually wages.” This one is not too difficult. In this company’s case, the owner could notify Paychex of the situation and record the payments in the payroll system after the fact, paying payroll taxes a few months late. This also means that the government will be notified of the increased compensation on the employees’ year-end Form W-2.

Recording Cash Receipts Without Paperwork

Fourth question: “How do you book a cash receipt when there’s no supporting paperwork?” Same answer as for question one, except that now we’re talking about revenue. You can either record these receipts in an undocumented revenue account, or call it a revenue suspense account, if you think you can figure it out at a later date, and then move the money from the suspense account to a more specific revenue account.

Penalties for Engaging in Fraud

Final question: “To what extent of liability or jail time can an accounting professional face by doing these things, and what level of detail should they be concerned about to keep them in the clear?” That is the most interesting question of all. So in essence, what is the difference between someone acting in a fraudulent manner, and someone who’s just royally incompetent? There’s no legal answer that I’m aware of, but I would say that if the person screwing up the books is not personally benefiting from doing so, then it would be difficult to prove fraudulent behavior. I would say that if you’re not too certain of your accounting skills just yet, then rely on the company auditors for advice or use their connections to find someone more competent than you, and ask for help. And always, always document every accounting transaction, so that you can prove why you did what you did.

Getting back to the case that started off this episode. I can totally see why the circumstances led to the hiring of this controller. The owner was desperate for support, needed it right now, and so probably hired her without spending enough time on background checks. When bringing in a new controller, this is the one position where you absolutely, positively have to be sure that the person is a professional, so if there’s any question about a candidate, keep looking for someone else.

Related Courses

Fraud Examination

Fraud Schemes

How to Audit for Fraud

Strategic Planning (#280)

In this podcast episode, we discuss the role of accounting and finance in strategic planning. Key points made are noted below.

From the perspective of the accounting and finance employees, there might not appear to be any connection with strategy, but that’s not really the case. Accounting and finance are linked to strategy in two ways, one in its formulation, and the other as a feedback loop. I’ll start with the second one, since that might seem a bit more familiar.

Strategy Feedback Loop

When management decides on a strategic direction, like launching a new product category or expanding into a new country, or using a new distribution channel, the amount of cash flow related to it is being monitored by the finance people, while the related revenues and expenses are being monitored by the accounting folks. Ideally, accounting and finance should be giving feedback to the management team about how their initiatives are working out. That doesn’t always happen, since accounting and finance may not even know what the strategy is – that’s pretty common. But if management clues them in on what’s happening, then they can look at the financial results and report back about the success or failure of the strategy.

For example, let’s say that a company is based in the state of New York, which has a fairly large population, and it’s been doing pretty well with a business product that requires a fair amount of salesperson hand-holding. Management’s new strategy is to roll out the product across the rest of the country. Since it takes a lot of salesperson time to make these sales, it’s a fair bet that initial sales might not be very good in states where the headcount per square mile is fairly low, like Wyoming or Montana. That being the case, it makes sense for the accounting staff to monitor revenue by state, matched up against selling expenses by state. But unless there’s interaction between management and the controller about this strategy, the accounting staff might not even collect revenue and expense information by state, which makes it more difficult for anyone to see if the strategy is going to work.

As another example, a start-up company has to develop software, and it’s projected to take a year before anything is ready for sale. The finance department needs to keep track of how fast the company is burning through its cash reserves, and estimate how many more months the company can last before the cash is gone. For this feedback loop to work, finance needs to be kept aware of the progress of the programming work, and be talking to management all the time about the resources needed to complete the product. That’s the only way to keep management properly informed about how much time is left.

So, what I’ve been talking about so far is accounting and finance being in data collection and feedback mode, where it hands out information about someone else’s strategy. But they can also be involved in the actual formulation of strategy.

Strategy Formulation

Consider the types of strategy that are out there. One of the main ones is cost leadership, where the goal is to be the low-cost provider in the industry, so that the company can set lower prices than anyone else, which allows it to grab market share. To do this, the company has to be incredibly aware of its cost structure at all times, and of what it has to do to lower its costs even more, like building a higher-capacity factory or repositioning its distribution warehouses to minimize distribution costs. And, for that matter, lowering the costs of the accounting and finance departments. Basically, every function in the company has to be figuring out ways to lower costs, because that’s the whole purpose of the company.

Another strategy – and one that applies to a lot more businesses – is differentiation, where the objective is to develop unique products for different customer segments. In this case, accounting can provide input about the cost to develop these products, while finance can weigh in on what the related cash flows are likely to look like. Based on their input, it’s quite possible that management will choose not to pursue products where the market niche is just too small. So in this role, finance and accounting are engaged in something of an advisory role, pointing which options might work better or worse.

And another strategy is blue ocean strategy. I recommend reading the book by the same name – it was released in an expanded edition in 2015, and it originally came out back in 2005. The authors advocate searching for a niche that no one else is serving, and which is new and unique, and then structuring the organization to serve it as perfectly as possible. That’s fine, but the part that relates to finance and accounting is their second recommendation, which is to find unique ways to cut costs by massive amounts, so that the resulting profits are really, really high.

For example, have you ever seen those insurance company cars that come right to your house after a car accident, inspect the damage, and pay you a settlement on the spot? It might seem like they just want to provide great service – well, that might be part of it – but also, consider what just happened from an accounting perspective. They handled the bulk of the accounting for that accident up front. There’s almost nothing left to do, so their total accounting costs just went down.

What this means is that whenever management is considering a radical strategy along the lines of the blue ocean concept, consider whether there’s an entirely different way to handle the associated accounting or finance. Here’s a real-life example from the perspective of finance. Do you remember when touch free car washes were added to the back of practically every gas station in the country? If it seemed like that happened everywhere, all at once, that’s because that’s exactly what happened. I ran across a couple of guys who originally came up with the idea of doing nothing but setting up low-cost leases, so that all of those station owners could afford their own car washes. In this case, it was the financing that drove the entire business model.

And one more example relating to finance. Most people don’t buy the solar panels that are installed on their homes – they lease the panels, because otherwise, they couldn’t afford to buy them outright. In this case, yet again, financing is what drives the entire strategy. Arguably, it supports the entire solar panel business model.

So in short, yes – there is a role for accounting and finance in strategy. Any company should be using them at least as a feedback loop, and in many cases, they can have a surprising amount of input into the formulation of strategy.

Related Courses

Business Strategy

Law Firm Accounting (#279)

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

The Basis of Accounting

A law firm is not in the business of spending a lot of its resources on accounting, so the smaller ones use the cash basis of accounting, to keep things as simple as possible. Larger ones that have a decent-sized accounting staff usually switch over to the accrual basis of accounting.

Client Billings

Next, the essential ingredient in law firm accounting is billings to clients, which is hours worked, multiplied by the billing rate for each person on staff. To calculate billings, each employee has to charge his or her time to a charge code, which at least identifies the client, and probably also a specific activity, so there might be a sub-level charge code for trademark work, and another charge code for dealing with specific lawsuits, and so on. For a detailed listing of codes, you might want to look up the Litigation Code Set online, which provides codes for things like fact investigation, and pleadings, and oral arguments.

The coding can also be separated by practice group within a law firm. In a larger firm, there could be upwards of 30 practice groups, such as arbitration, franchise law, and securities law, so this could be an important differentiator in a larger firm.

So, getting back to the billing process. It’s not actually as simple as multiplying hours worked by the billing rate. They also consider the efficiency of the people conducting the work, and the value of the services provided. The result might be a billing amount that exceeds the standard rate that would normally be charged, but more likely it’s a reduced billing. If the billing exceeds the standard rate, the difference is called over-realization. If the billing is less than the standard rate, the difference is called under-realization.

And then we have the timing of billings. One approach is to require a retainer, where clients pay in advance for services that will be provided at a later date. This approach wipes out any cash flow issues for the law firm, but clients might not be too happy about it. A more common approach is progress billings, where billings are issued immediately after month-end, based roughly on hours worked during the month. And finally, there’s the single billing at the end of work, which is what it sounds like. Single billings are usually confined to very short projects – otherwise, the firm might not be able to support the related negative cash flows.

Billing is the single most important accounting issue. But, it also makes sense to group employee compensation by practice group. The reason is that you can then construct income statements by practice group, where billings and compensation cover practically everything.

Compensation Reporting

And then there’s compensation reporting. Since this is by far the largest expense of a law firm, it makes sense to view it as many ways as possible, to see if there’re any anomalies to investigate. For example, you could track average compensation for groups of employees, based on the number of years since they graduated from law school, to see if there’re any outliers. Or, track the cost of time not charged to clients, or the cost of any people not assigned to specific practice groups.

Reimbursable Costs

Another topic is reimbursable costs. Law firms tend to incur costs on behalf of their clients a lot more than in other industries, so they need a good system for identifying and recording these costs by client, as well as to bill clients for reimbursement. For example, they may need reimbursement for travel expenses, filing fees, and court costs. When a law firm incurs these costs, it records them in a client disbursements receivable account, which is an asset account. When clients reimburse the firm, the payments offset the receivable, so these payments are not recognized as revenue, and there’s no impact on the reported amount of profit or loss. The only exception is when a client refuses to pay back the firm, in which case the unpaid amount is charged to expense.

Distributable Income

And then we have the concept of distributable income. From the perspective of a law firm partner, the main financial statement line item is not net income, but rather the amount of distributable income. This is the amount of net income that’s available for distribution to active partners. This amount is usually less than net income, where the difference is the amount paid out to former partners in the firm.

Types of Receivables

Moving on to receivables. In most industries, there’s just trade receivables. In a law firm, though, there’re three types of receivables. The most obvious is fee billings to clients, which are billable hours that have been formally assembled into an invoice and issued to a client. In addition to that, it has unbilled fees, which are hours charged to client matters, but which have not yet been billed. At month-end, this could be a fairly large amount, depending on billing practices. And finally, there’re client disbursements receivable, which are costs incurred by the firm on behalf of clients, and which have been billed to the clients.

Reserves for Receivables

If a law firm uses the accrual basis of accounting, this triple receivable situation means that it needs to maintain a more complex set of reserves for receivables. There should be an allowance for doubtful accounts, which is the usual reserve against billings for which the firm never receives payment. Nothing new there. But, it may also need a reserve for estimated unrealizable amounts. This is for when the partners decide not to include some billed hours in the billings that are eventually issued. This might be because the partners don’t want to exceed a certain amount of billings with certain clients, or perhaps because they feel that the work was inefficiently performed. In these cases, the reserve is set aside for estimated unrealizable amounts. This approach is totally unique to professional services firms.

Both reserves can be difficult to estimate, for several reasons. First, a client is less likely to pay the entire amount of a billing if its relationship with the firm is fairly weak, or if it’s new to the relationship, or it’s having financial difficulties. And, the reserve for estimated unrealizable amounts is hard to determine when the firm has a large proportion of new associates and paralegals, who are more likely to be inefficient.

Partner Accounts

The final accounting issue is partner accounts. Each partner has a capital account, which is used to track the net investment balance of the partners. This account involves pretty much what you’d expect for a partnership, which begins with the investments made by the partners, with additions for profits made by the law firm, and reductions for payments made to the partners.

Management Reports

And then we have the management reports. I’ll point out a couple. Of course, there’s the unpaid billings report, which is a receivable aging report that’s usually broken down by the responsible partner. Partners spend a lot of time on this one.

Next, we have the chargeable hours report, which compares the actual chargeable hours by employee to either an historical average or some sort of budget figure. Partners use this for capacity planning, since low chargeable hours might trigger a layoff, and high chargeable hours is a warning flag to hire more people.

Another possibility is the lawyer leverage ratio, which compares the number of partners to the number of all other lawyers in the firm. The partners make more money if they have a large base of legal staff, but if they run up that ratio too far, then the staff won’t see a clear path to partnership, and they’ll leave.

And finally, there’s the realization rate. This’s the proportion of billable hours at standard billing rates that’s actually billed to clients. This rate can be broken down by employee classification, since junior employees tend to be less efficient, so fewer of their billable hours are billed to clients. This can be a major driver of profitability, so partners tend to keep a close eye on it.

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Law Firm Accounting

Fiduciary Accounting (#278)

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

Trust Accounting

Trust accounting is about the record keeping for a trust arrangement. You have a trust when a trustee holds assets on behalf of one or more beneficiaries. The trustee is responsible for managing the assets, and also has to issue periodic reports to the beneficiaries. These same activities apply to an estate, where a fiduciary has the same responsibilities to whoever is inheriting the estate of the person who has died, who’s called the decedent. The accounting concepts that apply to estates and trusts are about the same, so I’m going to lump them together and call the whole thing fiduciary accounting.

The Uniform Principal and Income Act

Fiduciary accounting is not covered anywhere in Generally Accepted Accounting Principles, or in IFRS, and that’s because there’s no single accepted way to do it. Instead, the overriding rule for the handling of a trust or estate is that you follow the rules laid down in the will of the decedent, or in the trust agreement, regarding which funds go where, and how to treat specific transactions. If there are no instructions, then you might follow the rules stated in the Uniform Principal and Income Act. In this Act, the key word is Uniform, which means that Congress passed a law that’s intended to be uniformly applied to trusts and estates in all 50 states, but only if those states accept the Act, which not all of them have done. Or, they can modify the rules stated in the Act. This means that fiduciary accounting not only varies by will or trust agreement, but also by state. So as I go through the rest of this episode, just keep in mind that there is no one, universal way to do the accounting. In fact, a professional fiduciary might be overseeing ten different trust arrangements and estates, and the accounting for each one of them is unique.

Objectives of Fiduciary Accounting

When setting up an accounting system, a fiduciary has to deal with two offsetting objectives. One is to keep the accounting simple enough to avoid imposing an unreasonable expense on the estate or trust; that’s because the fiduciary is acting on behalf of the beneficiaries, so creating an awesome accounting system that’s really expensive cuts into the funds available to the beneficiaries. On the other hand, the second objective is to produce some fairly in-depth reports for the beneficiaries, which of course requires at least a moderately detailed level of record keeping. So, the fiduciary has to strike a balance between the spending on the accounting system and the level of detail to include in beneficiary reporting.

Cash Basis of Accounting

Next, the basis of accounting is the cash basis. There is no accrual basis in fiduciary accounting. All you care about is cash inflows and cash outflows, which are called receipts and disbursements. The types of transactions you’ll record are things like cash receipts from dividends or bond interest, gains or losses on the sale of assets, distributions to beneficiaries, and disbursements for fiduciary expenses.

Income and Principal

And then there’s probably the single largest issue in fiduciary accounting, which is income and principal. Income is the money that a fiduciary receives as a current return on an asset, while principal is property that’s being held for distribution to a remainder beneficiary – which I’ll get back to in a second.

Trusts and estates have two classes of owners, which are those with an interest in the income and those with an interest in the principal. The first party is the income beneficiary, and the second party is the remainder beneficiary. For example, Mrs. Smith dies, and states in her will that the income from her estate will go to her daughter until the daughter reaches the age of 21, after which everything left in the estate will be given to a designated charity. In this case, the daughter is the income beneficiary, and the charity is the remainder beneficiary. This means there’s an inherent conflict between the beneficiaries, because a receipt that’s paid out to an income beneficiary is cash that won’t be paid to a principal beneficiary, and vice versa. Because of this built-in conflict, it’s reasonable for the fiduciary to deal with accusations from the two types of beneficiaries that they’re being shortchanged, depending on how individual transactions are being accounted for.

The rules for deciding between whether a receipt or disbursement should be charged to income or principal are pretty detailed. Here’re some of the rules listed in the Uniform Principal and Income Act. First, you have to figure out if a receipt is periodic. It’s classified as periodic if it’s paid at recurring intervals, such as a monthly interest payment. When that’s the case and a due date is prior to a decedent’s death, the receipt is allocated to principal. But, if the due date is after the decedent’s death, then the receipt is allocated to income.

What if a receipt is not classified as periodic? When that’s the case, it’s considered to be accruing on a day-to-day basis. For example, an estate could be getting an income tax refund, which is clearly a one-time event. The amount that’s accrued prior to the decedent’s death is allocated to principal, while the amount accruing afterwards is allocated to income.

Here’s another one. A property is taken by the government through eminent domain proceedings. The proceeds are usually classified as principal. But, if a portion of this payment represents lost profits or future lease rentals, then that portion is allocated to income.

And another rule relates to the proceeds from property insurance. When proceeds are received from an insurance policy that insures against property damage, then it’s classified as principal, since it offsets property damage.

And then we have rent receipts. All rent receipts are allocated to income. But, refundable deposits are allocated to principal, from which they’re deducted when the deposits are eventually returned. If a deposit is forfeited, this amount is reclassified as income. And as another variation, when part of a rent payment includes a capital improvements reimbursement, the reimbursement amount is allocated to principal.

Any my personal favorite, lottery winnings. When ongoing payments are coming in from a lottery win, the amount received should be allocated 10% to income and 90% to principal. Conversely, if the fiduciary had exchanged a winning lottery ticket for a lump sum payment, the entire amount received is allocated to principal. What is the logic for this rule? I really don’t know. But, the 10%/90% allocation keeps coming up. For example, the net receipts from the sale of minerals is allocated 10% to income and 90% to principal. And so on. When there’s no clear rule for how to allocate a receipt, the default is to allocate it to principal.

There’re dozens more rules like this, and some really arcane ones when you have receipts coming in from the sale of timber or water. But, you get the general idea, which is that fiduciary accounting is not principles-based – it’s most definitely rules based.

In general, it looks to me as though a lot of these rules were the result of a series of lawsuits, and whatever the courts decided ended up being included in the Act as the accepted way to conduct fiduciary accounting.

Reporting to Beneficiaries

So, getting back to the responsibilities of the fiduciary, what goes into a report to beneficiaries? The exact contents will vary by – well, everything – the requirements of the individual probate court could apply, or what the applicable judge wants to see, or it can even be stated in the trust agreement or will. Usually, though, the report includes separate schedules for receipts, disbursements, distributions, and gains and losses, as well as a listing of assets on hand.

The fiduciary generally wants to be pretty detailed with this reporting; otherwise a beneficiary could claim that information was being withheld, and then sue the fiduciary personally for damages. This is not an issue that accountants usually have to deal with in other industries.

There’s a lot more to this topic, but the general issue is obvious – the rules are entirely separate from the normal accounting frameworks, so you really have to be a specialist in order to do this type of accounting.

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Fiduciary Accounting

Governmental Accounting: Part 4 (#277)

In this podcast episode, we discuss the comprehensive annual report in governmental accounting. Key points made are noted below.

Comprehensive Annual Financial Report

The comprehensive annual financial report is a government’s official annual report. It starts with a management’s discussion and analysis section, which introduces the financial statements and provides a summary-level analytical overview of the government’s financial activities. This part is sort of like what you’d find in a public company’s annual financial statements. It covers things like an analysis of the transactions associated with individual funds, budget variances, debt activity, and any conditions that might have an impact on the government’s financial results.

Basic Financial Statements

And then there’s the basic financial statements, which may not seem so basic, once you figure out that they could run for a couple of dozen pages. It contains financials for the government as a whole, as well as for individual government funds, proprietary funds, and fiduciary funds. The types of statements presented are different from a normal set of financials. I’m not going to cover everything, but there’s the statement of net position, which is somewhat similar to a balance sheet, though it doesn’t have an equity section. There’s also the statement of activities, which approximates an income statement, though there’s no profit, just a change in net position. Another one is the statement of cash flows, though it only applies to certain types of funds – and some of the cash flow categories in the report are different. I’m only drawing rough parallels here, to link some of these reports to classic financial statements.

Combined and Individual Fund Statements

And then there are the combining and individual fund statements. A combining statement by fund type is presented when a government has several internal service funds, fiduciary funds, or other types of funds. Or, an individual fund statement might be presented when the government has just one non-major fund of a particular fund type.

It also contains required supplementary information, as well as schedules that contain things like revenue sources, taxes receivable and long-term debt. This part can be pretty long.

Disclosures

And there’s lots and lots of disclosures, some of which are quite a bit different from the disclosures you normally see, such as disposals of government operations, landfill closures, special revenue funds, net position restricted by enabling legislation, and service concession arrangements.

Budgetary Comparison Section

There’s also a budgetary comparison section, where the government shows how well it’s been able to match its actual performance to both its original and final budgets. The final budget is the original budget, adjusted for all subsequent reserves, transfers, allocations, supplemental appropriations, and so forth.

Statistical Section

And finally, there’s the statistical section. This can be massive. It presents comparative information for multiple time periods, sometimes covering a decade or more. It can contain a lot of non-financial information, too, such as assessed valuations, population data, and tax rates. The statistical section is broken up into five categories, which are financial trends, revenue capacity, debt capacity, demographic and economic information, and operating information.

To focus on a couple of key points, the revenue capacity information shows the different types of taxable property, such as residential, commercial, and industry property, and the applicable tax rates, which could cover things like property taxes and sales taxes. The intent is to provide users with a feel for the government’s ability to raise cash through its property base and tax rates. Another key area is the debt capacity information, which is targeted at the government’s debt obligations and the extent to which it can issue additional debt.

The analysis also itemizes the principal property taxpayers in descending order. This part can be critical, since you can skim down the list and make your own determinations about whether a business might leave the jurisdiction, which impacts its ability to generate tax revenue in the future. And the analysis goes further, to state the principal employers in the jurisdiction, again so that you can decide whether they might not be around in the future.

The analysis also shows the headcount employed by the government on a trend line, and broken down into general categories, such as community services, finance and administration, and planning and development. This can be useful for understanding the number of personnel needed to run operations, and how it might change in the future.

They also report on capital asset statistics, which covers things like acres of developed parks and open space parks, miles of streets, the number of fleet vehicles, and even the number of street lights.

Summary

In short, the amount of information jammed into the comprehensive annual financial report is incredible. It actually exceeds the amount of reporting required for a public company’s annual financial report. And when you consider the amount of work required to produce something like this, you might have a bit more respect for the accounting staff at your local city hall.

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Governmental Accounting

Governmental Accounting: Part 3 (#276)

In this podcast episode, we discuss the budgeting aspects of governmental accounting. Key points made are noted below.

The Need for Detailed Budgeting

It’s absolutely critical for a government to have a detailed budget for each of its funds, because the supply of cash is strictly limited. Once you use up the cash, there isn’t going to be any more.

Durations of Budgets

Government budgets usually have a duration of one year. Once a budget is prepared, it’s forwarded to the legislature for further discussion, and then it’s converted into an appropriation bill. That appropriation lays out the maximum amount that can be spent over the budget period.

There’s also the long-range budget, which usually goes for a period of four to six years. This is more of a planning document, so that everyone has a better idea of how much cash is needed in the future, so that they can start figuring out how to finance it.

Flexible Budgets

When I talk about having a fixed pool of cash available, that’s generally true, and most government budgets are considered to be fixed. But – in a few cases a flexible budget can be used. A flexible budget contains formulas that alter the amount of a budget line item, depending on the activity level. The most likely candidate for a flexible budget is a proprietary fund, which as you might recall from two episodes ago, covers the business activities of a government, like a state park or an airport. Proprietary funds tend to have a more variable revenue level, so expenditures need to change in conjunction with the sales level.

Budgetary Control

The main point about government budgets is budgetary control. There are several types of control. One is the appropriated budget, which is created when an appropriation bill has been signed into law. This appropriation begins with the original budget that was submitted to the legislature, and which has then been adjusted for all kinds of things, like supplemental appropriations, transfers between funds, and reserves for various contingencies. This is the strictest level of control.

The Non-Appropriated Budget

A different level of control is associated with the non-appropriated budget. This one is not subject to appropriation, because it’s been authorized by statute. This is a lower level of control, because it can’t be touched. For example, a portion of your state-level sales tax might be automatically set aside for school funding. Or, a chunk of your gasoline tax might be set aside for road maintenance. Those are examples of a non-appropriated budget.

Budgetary Execution and Management

There’s one other type of budgetary control, which is called budgetary execution and management. This is basically everything else, and it involves adjusting the budget to make it fit reality. It might involve setting up contingency reserves, funding transfers between funds, deferring funds, and basically whatever is needed to put money where it’s actually needed. In short, the appropriated budget represents the big picture level of funding, while budgetary execution and management is at the most detailed level of deciding where to place the cash.

The Budgetary Account

A unique feature of budgeting for governments is the budgetary account. This is an actual entry into each fund, showing the amount of the budget assigned to that fund. These accounts are reversed at the end of the year, so they don’t have an effect on ending balances – but they’re quite useful for monitoring the amount of available funding for each fund.

Encumbrances

And then we have encumbrances. An encumbrance is a commitment related to an unperformed contract for goods or services to a government. It’s used to ensure that there’ll be enough cash available to pay for the supplier invoices associated with those contracts. An encumbrance is usually recorded for larger contracts, just to make sure that the government has set aside enough cash to pay for it. So for example, if a city government enters into a contract to pay out $100,000 for tree trimming services, then it also sets aside, or encumbers, $100,000 to make sure that the supplier’s bill can be paid.

It’s quite possible that a contract will run past the end of the year, so the associated encumbrance can still be outstanding at year-end. If so, it basically indicates the amount of cash set aside to pay for the rest of the contract. And once the associated contract has been completed and paid for, the encumbrance linked to it is removed from the accounting records.

Summary

In short, budgeting is a very big deal for governments. I’ve talked in some of my books and articles about how budgeting might even be harmful for businesses in general, since they tend not to be overly accurate once you go a few months into the future, and they tend to make decision-making too rigid. But that doesn’t really apply to governments. They simply cannot run out of cash, so they have to watch every penny. Hence, the need for appropriations, and budgetary accounts, and encumbrances.

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Governmental Accounting

Governmental Accounting: Part 2 (#275)

In this podcast episode, we discuss the basis of accounting and the measurement focus in governmental accounting. Key points made are noted below.

In this episode, we go a little deeper into the fund accounting concept, and talk about the basis of accounting and the measurement focus. You probably already know about the basis of accounting. A business might use the cash basis of accounting, where revenue is recorded when cash is received, and expenses are recorded when payments are made. Or, a business might use the accrual basis of accounting, where revenue is recorded when earned and expenses are recorded when incurred. And you might have thought that those were the only two options.

Modified Accrual Basis of Accounting

No. In fund accounting, we also have the modified accrual basis of accounting. This involves a lot of tweaks to the accrual basis of accounting. For example, revenue is recognized when it becomes susceptible to accrual. I always thought that susceptible meant being susceptible to the common cold, but in this case, the meaning is a little bit different. Instead, revenue transactions have to be available to finance the planned expenditures for the period. The “availability” concept means that the revenue should be collectible within the period or right after it, so it can be used to pay the bills. In addition, the revenue has to be measurable, which is a bit of an odd concept in governmental accounting. A government can accrue revenue even when it’s not exactly sure about the amount to be collected. So, a revenue accrual could be based on historical collection patterns from prior years.

For example, you could accrue as revenue those property taxes that are expected to be collected in the current period. Or, you could accrue grants expected from other governments, or inter-fund transfers, or maybe income taxes where the taxpayer’s liability is pretty well established, and the probability of collection is fairly good. Obviously, revenue recognition under the modified accrual basis is a bit different, which can make someone raised on the other two methods a bit uncomfortable. So, to make things a bit easier, it can be more practical to recognize miscellaneous revenue items when cash is received – in other words, using the cash basis of accounting. For example, parking fee revenue might be recognized on the cash basis, rather than the modified accrual basis.

So what about the recognition of expenditures? They’re accrued in the period in which the associated fund incurs a liability. This approach normally applies to any liability that’s paid in full and in a timely manner from current financial resources. Examples of the types of liabilities that are recognized like this are employee compensation and professional services. That sounds easy enough, but not every expenditure is treated that way.

For example, the employee of a city government has been piling up sick time for years, and hasn’t yet used it. The city’s policy is to pay out unused sick time only when an employee leaves the employment of the city. Therefore, the liability associated with the sick time isn’t accrued until the employee actually leaves the city. To extend the example a bit more, let’s say that the government has a fiscal year end of June 30. If the employee were to stop working for the government the next day, on July 1, the city would not record a liability or an expenditure for the sick time in its June 30 financials. But, if the person had instead left one day sooner, on June 30, then the city would have to recognize the full amount of the payment, since it’s due within the fiscal year. In short, when dealing with expenditures under the modified accrual basis, the key point is whether and to what extent the associated liability has matured.

So far, we’ve been talking about the basis of accounting, which is all about when transactions will be recorded. In governmental accounting, there’s also the concept of the measurement focus, which is what transactions will be recorded.

The Measurement Focus

The focus used by governmental funds is the current financial resources measurement focus. This means that the focus of these funds is on assets that can be converted into cash and liabilities that will be paid for with that cash. When there’s an increase in spendable resources, this is reported as revenues or a source of financing. When there’s a decrease in spendable resources, this is reported as an expenditure or a use of financing. Or, stated another way, the balance sheets of governmental funds don’t include long-term assets or any other assets that won’t be converted into cash to settle current liabilities. This approach is only used in governmental accounting.

A proprietary fund, which is used to account for the business activities of a government, uses the economic resources measurement focus. This approach focuses on whether a proprietary fund is economically better off because of transactions occurring within the fiscal period being reported. In this case, there’s no consideration of whether there are current financial resources, so a proprietary fund will include long-term assets and liabilities on its balance sheet. When there’s an improvement in the economic position of a proprietary fund, this is reported as revenue or a gain. When there’s a decline in the economic position of a proprietary fund, this is reported as an expense or a loss. Out of the two, the economic resources measurement focus will sound more familiar, since this is what a commercial business uses.

Concept Usage in Government Entities

How are all of these concepts used within a government entity? Governmental funds, such as the general fund and the permanent fund, use the modified accrual basis of accounting and the current financial resources measurement focus, while proprietary and fiduciary funds use the accrual basis of accounting and the economic resources measurement focus. And on top of that, when preparing government-wide financial statements, you should use the accrual basis of accounting and the economic resources measurement focus.

Another way of looking at the situation is that long-term assets and liabilities are recorded in the government-wide financial statements, but they’re not recorded in the general fund or any of the special revenue funds.

As you can see, these concepts can be pretty confusing, especially because which concept is used depends on the type of fund for which you’re doing the accounting. Why would anyone adopt such a complicated system? The easy answer is that we’re accountants and we always take the most complicated approach. And if you don’t believe me on that one, just look at the accounting rules for derivatives!

But the real reason is that governments are working with a fairly fixed amount of available cash, and so they have to produce financial statements that show them exactly what resources are available to provide the funding for expenditures in the current period, as well as what has to be paid in the current period. They’re less concerned with longer-term assets and liabilities, because they have to pay the bills now, and the financial reports have to assist with these shorter-term issues. And that’s why these complicated rules are used.

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Governmental Accounting

Governmental Accounting: Part 1 (#274)

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

Governmental accounting is quite a bit different from the accounting used by for-profit organizations, because the priorities of a government are completely different. It’s not supposed to earn a profit; instead, it’s supposed to provide services in a cost-effective manner. And, because specific amounts of cash are targeted at different service activities, a government uses the concept of funds to channel cash toward specific programs. I’ll get back to that in a moment.

Governmental Accounting Standards Board

Because the accounting is different, there’s also a different organization that sets the accounting standards for it, which is the Governmental Accounting Standards Board. This is the sister organization to the Financial Accounting Standards Board, which sets the accounting standards for most other types of organizations.

Fund Accounting

The core concept in governmental accounting is fund accounting. A fund is an accounting entity with its own set of accounts that’s used to record financial resources and liabilities, as well as operating activities. It’s also segregated in order to carry out certain programs or attain certain objectives. This does not mean that a fund is a separate legal entity – it’s only a separate accounting entity.

A government uses funds to maintain tight control over its resources, with particular attention to how much money is left to be used. By tracking the remaining amount of cash, a government is better able to monitor resource usage, which reduces the risk of overspending, or of spending money in unauthorized areas. A government could have dozens or even hundreds of these funds, which it then rolls up into its financial statements at the end of each reporting period.

So what types of funds are there? The default fund category that’s used to account for all the activities of a government is the governmental fund. This is the primary operating fund. The main point when accounting for governmental funds is to measure the financial position of the fund and its changes in financial position. This means that a governmental fund has a separate balance sheet, and a statement of revenues, expenditures, and changes in fund balances – which is kind of an income statement.

There are a bunch of different fund types within the governmental fund category. One of them is the capital projects fund. This one is used to account for financial resources that have been set aside for capital outlays. There might be a separate capital projects fund for each individual capital project, or you might have a single fund for all capital projects.

Another type of governmental fund is a debt service fund. This is used to account for financial resources that have been set aside to pay for principal and interest on debt. Debt service funds may be required by a bond indenture agreement, so that investors can have more clarity about whether the government can pay the interest on its bonds and eventually redeem the bonds.

And then there’s the permanent fund. This one is used to account for financial resources for which only the earnings can be used to support a program. It’s usually set up when a government receives an endowment, so the endowment is recorded within its own permanent fund, and investment proceeds from it are used to support, for example, a city zoo.

There are also special revenue funds.  These are used to account for the proceeds from specific revenue sources, where there’s a commitment for expenditures other than capital projects or debt service. For example, a city government receives a federal grant that has to be used for road safety, and parks the money in a special revenue fund for that purpose.

And finally, there’s the general fund, which is used to account for all financial resources not being reported in any other fund. This is the main operating fund of the government. There’s only one general fund in each government, though there may be lots of the other types of funds.

Now that’s a lot of funds to take in. Here’s an example of how you might see some of them being used. A city government levies several types of property taxes, each of which can only be used in a certain way. All property taxes are initially received into the city’s general fund. The funds are then distributed to other funds, where they’ll eventually be expended, based on the operating instructions for each fund.

Here’s another example. A state government has a revenue-sharing arrangement for the use of state-owned land, where the government receives a usage royalty.  Of the amount received, three-quarters is directed toward the funding of affordable housing projects, while the remainder is held in trust for a third party land conservation fund. In this situation, two separate funds may be used to store the incoming funds, or the entire amount can be stored in a single special revenue fund.

So now we’ve covered the different types of governmental funds. Then there’re proprietary funds. These are used to account for the business-type activities of a government. They emphasize operating income, financial position, changes in net position, and cash flows. And as you might expect, there’re several types of proprietary funds. The first is the enterprise fund. This is used to account for any activity for which users are charged a fee for goods and services. Sometimes, a government will set up an enterprise fund just to have information about the total cost of providing a service, like running a municipal golf course or running a vending operation at the local stadium.

For example, a state government operates an enterprise fund for its lottery operations. The fund is used to account for the ongoing operation of the lottery, including the distribution of lottery proceeds to other funds.

Another proprietary fund is the internal service fund. This is used to account for activities that provide goods and services to other funds, as well as to departments of the primary government, or to other governments. For example, a government could set up an internal service fund for data processing, or for purchasing.

A third category of funds is fiduciary funds. These funds are used to report on assets held in trust for the benefit of organizations or other governments that are not part of the reporting entity. In this type of fund, the reporting emphasis is on net position and changes in net position. There are four types of fiduciary funds. The first is an agency fund, which is used to report on resources held in a custodial capacity, where funds are received and then remitted to other parties. For example, a state government could collect sales taxes on behalf of a city government, and temporarily stores the funds in an agency fund until they’re forwarded to the city government.

Another fiduciary fund is the pension and employee benefit trust fund, which is used to report on assets being held in trust for pension plans and other types of employee benefit plans. In short, the name of this fund pretty much describes what it does.

Yet another fiduciary fund is the private-purpose trust fund. This one is used to report on trust arrangements where other parties are the beneficiaries. For example, a state government receives unclaimed property and holds it in a private-purpose trust fund until the rightful owners eventually claim their property.

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Governmental Accounting

Customer Service and the Accounting Department (#273)

In this podcast episode, we discuss the role of the accounting department in customer service. Key points made are noted below.

This episode is based on something that happened to me a couple of weeks ago, and I thought it provided a good lesson about how accounting can improve relations with customers, or screw them up.

The Need for Customer Service

But first, for the general concept. Some organizations focus almost exclusively on customer service, because their main interest is in the lifetime value of a customer. They don’t just want to generate a profit from the current transaction – they want customers to keep coming back, over and over again. And on top of that, they want customers to be so happy with them that they keep sending out recommendations to their friends. In short, their target is to have such over-the-top service that customers are completely amazed by it.

There aren’t very many companies that really attain this level of service, but you probably have a few of your own. I like to focus on airlines and hotels. So, Thai Airways and Singapore Airlines are awesome, and if I have a choice, I fly with them. But the real champion for me is the Mandarin Oriental hotel chain. They’re fabulously expensive, so we can’t stay with they very much, but the service level is incredible. Just one example out of at least a dozen is what I like to call the grape wars.

We were staying at the Mandarin in Bangkok, where there was a complimentary fruit bowl in the room. So, I ate all the grapes in the fruit bowl – and then went downstairs to see what my wife was up to at the pool – turns out she was having a complimentary ice cream sundae. And then I went back to the room after an hour, and found that the grapes had been replaced. So I ate them again. And then went out to lunch. When we got back, the grapes had been replaced – again. And so on. All day long. As near as we could tell, as soon as we left the room, ninja housekeepers snuck in through the ceiling, slid down on silk ropes – because that’s what ninjas do – and replaced the grapes. There’s no other reasonable explanation. Based on that level of service, we routinely check to see if there’s a Mandarin Oriental hotel anywhere near where we’re planning to travel. Which is exactly what they want, of course.

Now I know what you’re thinking. Isn’t this podcast about accounting? Or maybe, why didn’t I eat some other fruit in the fruit bowl? As for the first question, we’re getting there, there is an accounting point. As for the second question, oranges are messy.

Now, for the more specific customer service experience. My wife and I have been scuba diving for many years, and decided to finish up after just one more trip, for medical reasons. My wife has gotten at least 15 ear infections from diving, and I’ve started having trouble equalizing my ears underwater. So for our 30th and final trip, we decided to go to Wakatobi, which is a resort located in Indonesia, and which is routinely listed on surveys as one of the best dive resorts in the world. To be accurate, we actually bypassed the resort and went straight onto their liveaboard dive boat, which is the Pelagian, and which is routinely on the top ten lists of best dive boats in the world.

And the customer service was first-rate. A good way to see how successful they were is that, of the nine divers on the boat, six were returning for at least the second time, and every one of those six was scheduled to transfer back to the Wakatobi resort and stay there for another week. Which is pretty much unheard of.

Which brings us to the event. We finished up a week of really great diving and returned to the Wakatobi resort, where we disembarked and went over to their restaurant facility for breakfast, while they transferred our luggage to the pier. Which is where they dropped my suitcase into the ocean. The one with my laptop inside, that contained a few hundred underwater videos from the trip. Or to be more precise, they put the suitcase down on the pier, but made the mistake of putting it down on all four wheels. So while no one was watching, it rolled away on its own and went over the side. This was obviously a perfectly honest mistake, and I can’t really fault them for it. It’s not like they were having an Olympic hammer throwing event and trying to see how far they could chuck everyone’s luggage off the end of the pier.

Once they fished the suitcase out of the ocean, their customer service function really got into high gear. They had a staff person parked on top of the laptop, blow drying it with a hair dryer – no luck, it was dead. They pulled all of my wet clothes out of the suitcase and ran them over to their cleaning facility, which returned everything in a half an hour, cleaned and pressed, and even in a Wakatobi tote bag. And two managers apologized profusely, and offered to pay for a new laptop. And at the end of a nearly three-hour flight back to Bali, they had another person waiting for us at the gate, who apologized again. This is all pretty amazing customer service – and overall, I definitely have to recommend them to anyone who wants great service and an excellent diving experience.

The Involvement of Accounting in Customer Service

But that still leaves the accounting issue. I bought a new laptop and e-mailed Wakatobi a receipt for it. Through this point, I’d only been dealing with their customer service staff, which was obviously quite good. The trouble is, their accounting department was responsible for reimbursing me, not the customer service department. And so far, I’ve been waiting 10 days for payment. Now, international bank transfers can take some time, but even so, it’s pretty apparent that there’s not the same sense of urgency in their accounting department.

So, enough of my combination of mostly complimenting and somewhat bashing Wakatobi. The actual point of this podcast is that the accounting issue I’ve just described is probably nearly universal. The only goal of the customer service department is to delight customers, while the accounting department is more concerned with keeping costs down and being as efficient as possible. This means that any payments promised to customers for things like refunds and reimbursements will probably be delayed in order to be more efficient, which drives away customers.

Customer Service Activities for Accounting

What would work better? Probably a different measurement system for the payables department, where the expectation for making payments to customers needs to be in minutes, not days. That means dropping everything and issuing a payment on the spot. If the customer is still on the premises, then hustle over and pay the customer in cash, right there. If it’s a check payment to an off-site customer, then using an overnight delivery service should be the required approach. Now that might seem expensive, but let’s get back to the concept of the lifetime value of a customer. Interrupting the normal workflow of the payables department and paying an overnight delivery service are really minor inconveniences, compared to the prospect of losing a customer.

The other point of interaction between the accounting department and customers is obviously collections. This is a tough one. You want to get paid, but without taking the more extreme steps of getting really aggressive with customers on late payments. There isn’t an ideal solution. When the lifetime value of customers is a major focus of the business, you’ll probably want to back off of being too aggressive, and might accept a larger bad debt expense instead. On the other hand, if customers rarely come back to make repeat purchases, any collections technique at all might be considered acceptable.

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Effective Customer Service

Review Engagements (#272)

In this podcast episode, we discuss the nature of review engagements. Key points made are noted below.

Types of Audit Activities

There’s a range of audit activities. 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, which also means that it’s less expensive. Anyone who’s a CPA already knows what a review is, so I’m going to focus instead on what you can expect from a review as a client.

Activities in a Review Engagement

There is no examination of company controls, no confirmations go out for receivables or loans, there’s no physical inventory count or fixed asset count, and the auditors don’t go digging around through your accounting records, looking for backup evidence – which is also known as substantive testing.

Analytical Procedures

It doesn’t sound like they do much of anything, which is not entirely true. What they do perform is analytical procedures, which involves comparing different sets of financial and operational information, to see if historical relationships are continuing forward into the current period. In most cases, they do – for example, if your days of receivables figure has been around 45 days for the past few years, then chances are it will still be somewhere fairly close to 45 days in the current period. If so, great – the auditors will assume that your reported numbers are probably about right. But if those relationships change, then there’s a possibility that the financial records are incorrect, which might be due to errors or some kind of fraudulent reporting activity.

There are different types of analytical procedures. As I just pointed out, the auditor might choose to compare the current period’s ending account balances or ratios to prior periods. So, they might look at the current ratio, or days of inventory, or the debt/equity ratio over the past few years, or maybe the gross profit percentage or the net profit percentage. Or, they could do some comparisons of financial to nonfinancial data, such as revenue per employee, or sales per retail store. And, they might compare your actual results to your budget – though that relationship can be weak if you don’t have much of a history of accurately projecting future results. And as another example, they could do an historical analysis of sales by individual product, or sales region, or distribution channel, basically just looking for significant changes.

What does the auditor do with all this analysis? They’ll set some thresholds for what to investigate and what to ignore. It’ll depend on the size of the company, but maybe they decide to investigate any variance of more than 20%, and which is greater than $50,000. The type of investigation of these variances is pretty simple – they just ask management. If the responses don’t seem reasonable, then the auditor could take additional steps to investigate further, maybe by making additional inquiries with other people.

Other Review Inquiries

In addition to that, the auditor will make other inquiries. It’s a standard checklist. I won’t go through it all, but they’ll ask about things like whether there have been any asset impairments, or issues with loan covenants, or maybe hedging activities, or any new revenue recognition methods, or restructuring charges, or any off-balance sheet transactions. Basically, they’re looking for anything out of the ordinary. They’re also going to make inquiries about fraud – things like whether you have any knowledge of fraud that involves management, or any allegations of fraud by anyone. And, they’ll ask about any hanging issues from the last review, such as what you did with any misstatements found the last time around.

In short, it’s a pretty thorough discussion of anything that might impact the financial statements. And they might walk the same questions around through several people on the management team, just to see if they uncover any inconsistencies in the responses.

After all that, they’re going to compare the information they’ve found to what’s stated in the financial statements, to see if it all makes sense. They could also compare the financials to the ending balances in the general ledger, just to make sure that the financials accurately reflect the accounting records. And finally, they’ll see if there are any misstatements that should be corrected, and whether any disclosures should be added or expanded upon. 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 discussion is whether to disclose this possibility in the financial statements, since they’ll otherwise be misleading.

Grounds for Withdrawal

If the auditor keeps making pointed suggestions about revising the financial statements and you don’t want to, then the auditor is perfectly justified in withdrawing from the engagement. If the revisions are made, then the auditor will issue a review report, which clarifies the exact nature of the work that was done, and which specifies that it wasn’t a full audit.

When to Use an Audit

Why would you want a review instead of an audit? Because it’s much less expensive. It’s impossible to say exactly how much, because there’s still a minimum of overhead involved in working with any client, and because some organizations are just more complex than others. Still, at a very rough guess, a review is maybe a quarter to a third as expensive as an audit.  If you’re in startup mode and need to preserve cash, a review could be a reasonable way to go.

Another benefit of a review over an audit is that the auditors will be on-site for far less time, which means that they won’t be taking up your staff’s time anywhere near as much as they would in a full audit. And that may not be a minor consideration when you’re under staffed.

However – the users of a company’s financial statements might not want a review, because it doesn’t give them any real assurance that the financial statements are correct. So, you need to check with your investors and lenders first, before signing up for a review, to make sure that it’s OK with them.

Also, there’s one case where you have to have a review – and on a quarterly basis. This is when the company is publicly-held. In that case, the SEC requires that there’s a review following the end of the first, second, and third quarters, followed by a full audit at the end of the year.

Summary

In summary, to look at a review from a high level, it’s essentially a consulting engagement for the auditor, who conducts a reasonable inspection of the books and makes inquiries to see if there’re any anomalies. 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.

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How to Conduct a Compilation Engagement

How to Conduct a Review Engagement

How to Conduct an Audit Engagement

Getting Your Career Back on Track (#271)

In this podcast episode, we discuss the decisions you can make to get your mid-life career back on track. Key points made are noted below.

The person making the request is having trouble jumping from a staff position into a management one, and is not sure what to do next. The general concept happens to a lot of us, and it certainly doesn’t just apply to the accounting profession.

Whether to Become a Manager

There’s no clear answer for how to make that critical move into a management position, but let’s work through some questions first, which might point us in the direction of an answer. First, am I a manager at all? Some people just slide right into the role, while a lot more people have trouble with it. It involves a lot of changes. You need to stop doing the hands-on work yourself, and spend lots of time convincing other people to do the work instead. And dealing with other managers. And planning, and budgeting, and helping everyone else do their jobs. Are you sure you want to do that? A great many people might not see any value in what they do as managers, so they – go off in a different direction. Such as – not trusting anyone else. They want to review everything, so they end up spending massive amounts of time in the office, they never hand off any work to subordinates, and they become the chief bottleneck in the department. And maybe in the entire company. Other evidence of not trusting people is installing all kinds of policies and procedures, tracking what everyone is doing all the time, and basically badgering people.

Are you one of these people? If so, making the leap into management could be a very bad idea, and one that you’d regret for a long time. Just as an observation, there’s this view in the accounting profession that you have to become a CFO, and preferably of a really large corporation. Or, an audit partner, preferably of a Big Four audit firm. Have you ever considered that almost no one makes it that far? And, that those people might be so overworked in those jobs that they’d rather not be in them? When I was a CFO, I almost always worked on Saturdays, because that’s what it took to do the job.

Probability of Becoming an Audit Partner

The latest number I’ve seen for CPAs is that there’re 665,000 of them just in the United States, and 2.1 million in the world. How many end up in those top positions? There are about 15,000 partners in the Big Four audit firms just in the United States. If you extrapolate that out for the world based on the proportion of CPAs in the US to the number of CPAs worldwide, then there’re maybe 47,000 partners in large audit firms. Throw in the CFO positions for the 10,000 largest firms in the world, and that’s still only 57,000 people, out of a base of 2.1 million CPAs. That means your odds of getting into a dream job are 37 to 1. And as I just pointed out, the job may not be that easy. There are a lot of audit partners who would agree with me on that. So, is it reasonable to aspire to that sort of position? I can’t answer that question for you, but it seems like kind of a long shot to me.

Exploratory Solutions

Maybe a better way to deal with that mid-life quagmire is not to look quite so far ahead. Instead, try for a lower-paying management position in a smaller firm, and see if you like it. And, just as important, do they like you? It’s quite possible that you think you’re doing a good job, but no one else thinks so.

It can be really hard to find out the opinions of other people on this – and it needs to be someone you work with – not your friends and certainly not your spouse. They haven’t seen you in action, so they don’t know if you’d be a great manager or a terrible one. Instead, you need to cultivate your co-workers, and gently probe for opinions. Which will not be easy to come by, because no one wants to tell you bad news. Ever. Only a really great friend – or, for that matter, an enemy – will really tell you the truth. It can help to talk to both. Sometimes it’s just the barest hint of a suggestion. When those come up, don’t ignore them. Pursue any hint you get, because that is gold.

You’re simply looking for the truth about how other people think you’re performing as a manager. If the feedback is good, and you like the work, then keep trying. If not, it really is acceptable not to be a manager. You might be much more comfortable in some other job, and maybe that’s what you should pursue – possibly for a long time.

Dealing with a Firing

What about those really uncomfortable situations where you’ve just gotten a management position for the first time – and then you were fired. Do you back off and never try for a management position again, or decide that your boss was a jerk and try again somewhere else? Again, no easy answer. The first step is figuring out why you were fired, which your old boss may not be too interested in talking about.

Instead, you may need to call up any remaining contacts at your old employer and ask them. There has to be some information lying around somewhere. But, if you don’t feel comfortable calling any former contacts, that could be your answer right there. A key part of being a manager is building up contacts all over the company, so if you didn’t do that, maybe a non-managerial position would be a better bet for you.

But, it could also be that your boss was a jerk. It does happen. Some people who are in management positions really don’t belong there, and especially when it’s a family-owned firm and they’re part of the family. Those people might not normally qualify as janitors, but – they’re vice presidents instead. If you think this is the case, then by all means – try again.

But, if you keep trying and failing in management positions, it’s more than likely that the main fault lies with you, not the employer. In which case, it’s time for some major soul searching to decide whether this big career leap is really for you.

When the Career Path is Not Working

Which brings up the question of whether you want to retreat into a non-management accounting position or try something else entirely. This is not uncommon. I’ve never seen any statistics for how many CPAs give up their certifications and leave accounting entirely, but it must be several times larger than the number of current CPAs.

A lot of them try consulting, some start up their own businesses – I know one person who bought a lawn care company. And of course, in my case, I went from being the CFO of a small public company to writing accounting books. Which most people would find incredibly dull, but it works for me.

Summary

In short, there’s no correct answer. Ending up in a powerful corporate or audit firm position sounds great, and it does pay well – but those positions are draining, and they’re very definitely not for everyone. If you’re stuck in that mid-career quagmire, it might take you a few years to figure out what really works for you, so take your time, gather information, and think about it.

Accounting for Software as a Service (#270)

In this podcast episode, we discuss the accounting for software as a service. Key points made are noted below.

Software as a service is when a customer accesses software over the Internet, as needed. This discussion can come from both sides of the equation, which is from the perspective of the customer and the service provider. From the customer’s side of things, there’s some fairly new guidance that only covers the fees paid by the customer in a cloud computing arrangement.

Relevant Accounting Guidance

In case you want to look it up, this is Accounting Standards Update 2018-15, which was issued by the Emerging Issues Task Force. The EITF is a group within the Financial Accounting Standards Board that issues guidance on some fairly narrowly-defined topics. According to the EITF, if the arrangement includes a license for internal-use software, which it usually doesn’t, then the customer recognizes an intangible asset for the software license and amortizes it over time. If there is no software license, then the customer instead accounts for the arrangement as a service contract; which means that the customer charges the monthly hosting fees to expense as incurred.

Another issue for the customer is what to do with the cost of implementing the arrangement when it’s been classified as a service contract. Training and data conversion costs mostly have to be charged to expense right away. Any costs related to application development are capitalized, depending on what they are. And, any costs incurred during the preliminary project and post-implementation stages are charged to expense. That advice is probably not going to apply to most software as a service arrangements, because there is no application development.

But if it does happen and these costs are capitalized, they have to be amortized over the term of the hosting arrangement, beginning when the hosting arrangement is ready for its intended use, which is when all substantial testing is completed. The term of that arrangement is the initial non-cancelable period, as well as any extension periods, as long as the customer is reasonably certain to exercise it. There’re some other variations on the term of the arrangement, but that’s the most likely scenario.

Even though there are some capitalization possibilities here, in most cases, from the perspective of the customer, the bills from the hosting provider will probably be charged to expense as incurred.

Subscription Revenue Accounting

Now, let’s turn things around and look at the situation from the perspective of the seller. First, subscription revenue accounting. The accounting for customer payments will depend on the terms of the underlying contract, so I can only talk in general about how this might work. Let’s say a customer makes a large up-front payment, and in exchange the service provider commits to provide services for the next year. If so, the up-front payment is initially recognized as a liability, and you can flip it over to revenue at the rate of one-twelfth per month. Or, maybe you gave the client two months of free services up front, so that up-front payment is only for months three through twelve. It doesn’t matter. You’re still providing 12 months of services, so divide the up-front payment by 12 and recognize one-twelfth of it in every month. There can be so many variations on this that I can’t possibly address them all.

Customer Cancellations

A variation on the revenue theme is customer cancellations. Again, how you account for it depends on the terms of the underlying contract. If the customer can back out at any time and get its money back for any subsequent periods, then revenue recognition ends when the arrangement is officially cancelled. Or, if the cancellation just means that the customer doesn’t plan to renew its annual contract, then there is no special accounting. You’re presumably already recognizing revenue over the term of the original service contract, so just keep doing it through the end date of the contract.

Multi-Part Arrangements

Another revenue variation is multi-part arrangements, where the provider is also providing other services, such as training. Once again, it depends on the terms of the contract, but you’ll probably need to split apart the amount of the revenue and allocate it to each element based on its market value, and then recognize each part separately. This can be a big deal when some of the services are being provided up front, like training, because the revenue for those elements can be recognized sooner.

Over-Budget Implementations

A second topic is over-budget implementations. There could be some different positions taken on how a service provider accounts for the implementation of each of its customers. The most conservative approach is that these expenditures are an element of selling costs, and so would be charged to expense as incurred. Which means that, when an implementation goes over budget, there is no special accounting for it, because you’re still charging it to expense as incurred.

A less conservative approach is that the implementation cost is initially capitalized and then amortized over the life of the underlying contract. In this case, you’d want to set a budget for each implementation and charge off whatever expenses go over the budget, as an unexpected variance. This requires a lot of accounting work to accumulate and then amortize implementation costs, so if implementations aren’t very expensive, it could make sense to ignore the whole issue and charge everything to expense as incurred.

Software Development Costs

And finally, we have software development costs. This is covered in two entirely different parts of GAAP. Section 350 of the Accounting Standards Codification covers software that’s developed for internal use, while Section 985 covers software that’s developed for external use. There is a reason why they split it up, which is that internal-use software is considered an intangible asset, which is what Section 350 is all about, but it’s still confusing. For our situation, we only need Section 985. Under Section 985, the capitalization of software development costs can take place when technological feasibility has been proven. If not, you have to charge it to expense. And, once development is complete and the software has been made available for release to customers, then you have to stop capitalizing. After that, all remaining expenditures are assumed to be ongoing maintenance and support, which have to be charged to expense as incurred.

So, what is technological feasibility? It’s been established when – and I quote – the business has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications, including functions, features and technical performance requirements. End quote. This requirement applies even if you’re paying an outside party to develop the software.

So, there’s obviously some documentation needed to prove to the auditors that you’ve established technological feasibility. To do that, you’ll need either a detailed program design or a working model that’s ready for customer testing. In the latter case, that can mean that you’ll end up charging a very large part of the development costs to expense as incurred, because GAAP isn’t allowing all that large of a window for capitalizing expenditures.

And what about ongoing update work on the software? Unless it involves an entirely new feature, charge the cost of those activities to expense.

Related Courses

Accounting for Software

Accounting for Breweries (#269)

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

Overview of the Brewing Process

I assume you’re generally familiar with how beer is made, so here’s just a short overview. The first step is malting, where barley or other grains are run through a process of heating, drying out and cracking, where the goal is to isolate the enzymes that are needed for the next step. Which is mashing, where the grains are soaked in hot water, which activates the enzymes in the grains that cause it to break down and release its sugars. The result is a sweet, sticky liquid called wort.

Next up, the wort is boiled, while hops and other spices are added. Hops add bitterness to balance out the sugar in the wort. After boiling, the wort is cooled, strained, and filtered. After that is fermentation, where the wort is put into a fermentation vessel, where yeast is added. During this time, the yeast eats the sugar in the wort and converts it into alcohol and carbon dioxide.

And finally, we get to bottling and aging, where the beer goes into cans, bottles, or kegs, sometimes with artificial carbonation. If there’s no artificial carbonation, then it may be aged for a while, to give it time to naturally carbonate. At this point, the beer production process is complete, but there’s also a lot of waste, which is called spent grain. Most breweries donate their spent grain to farms for animal feed, but it can also be used as compost, or as ingredients in baked goods, or even used to produce methane, which is then used to power the brewery.

Chart of Accounts Issues

So, what are the accounting issues? First of all, the chart of accounts is a bit different. Raw materials inventory is broken down into a bunch of accounts, including raw materials for malt, and hops, and chemicals, and packaging materials. Then finished goods might be broken down into pack types, such as packaged and kegged. And then on the income statement side of things, the main issues are to have separate accounts for every type of revenue and the cost of goods for each type of revenue, so that you can figure out the gross margin for each one. This means having separate accounts for things like kegged beer, packaged beer, growlers, and taproom sales. And in case you don’t know what a growler is, it’s a refillable jug used to transport draft beer. And if you don’t know what draft beer is, it’s beer served from a keg.

Marketing Expenses

A brewery is likely to have a lot of marketing expenses, one of which is somewhat unique to the industry. They usually have a line item for festivals expense, which is a great place to acquaint walk-by customers with the company’s beer offerings. Incidentally, marketing expenses can be anywhere from 20 to 30 percent of the total expenses of the brewery.

Merchandise Accounting

Another accounting issue is merchandise. The brewery probably buys T-shirts, hats, glassware, and so on from a supplier, and sells them on the premises. This is pretty much guaranteed profit, so it makes sense to set up a separate profit center to track it in the accounting system.

Taproom Accounting

And speaking of profit centers, there’s the taproom. It’s the area within a brewery where it serves beer to its customers. This can be a seriously profitable area, so it needs separate reporting. Which brings up an accounting issue. If you transfer beer from the brewery to the taproom at cost, then the taproom is going to report massive profits, while the brewery doesn’t get to report any profits at all. To get around this, some breweries transfer beer to the taproom at its wholesale price, which allows the brewery to participate in some of those profits.

Cost of Goods Sold

And what about the cost of goods sold? I won’t get into the usual materials and labor and overhead topics, but here are a couple of issues that are unique to breweries. First, there might be stale beer on the premises. If so, it’s charged to expense right away, through the cost of goods sold. Second, stale or unused beer may be returned by distributors, in which case it’s also charged to expense through the cost of goods sold. A larger brewery might even accrue for expected amounts of stale beer, which brings up one of the best account names ever, and I am not making this up – accrued stale beer.

Another interesting cost of goods sold item is yeast. It can be used over a number of batches, so theoretically its cost could be allocated out over those batches. But, since it’s not that expensive, a lot of breweries just charge it to expense as incurred.

As for the costing system used, production is usually valued with either a standard costing or average costing system. And for a smaller brewery with not much accounting support, it may use a modified system that’s really simple. In short, ending raw materials are valued at their most recent purchase costs, while work in process and finished goods are valued using a standard cost.

Outsourcing Issues

And to complicate matters, a brewery might outsource some of its production to another brewery, in which case the accountant needs to track the transfer of ingredients to the other party, and pay for the production costs billed back to the brewery. In some cases, the brewery may commit to using a certain percentage of the other party’s brewing capacity, which can involve paying extra fees for the capacity.

Fixed Asset Accounting

So, moving along to fixed assets, there’s lots and lots of equipment in a brewery – things like boil kettles, conditioning tanks, grain storage silos, keg washers, and water purification systems. There aren’t any special capitalization or depreciation rules here – just different types of assets.

One unusual type of fixed asset is kegs. A brewery may sell its beer to distributors and retailers in kegs. If so, it collects a refundable deposit on each one, which it pays back when kegs are returned. This means that the deposits appear on its balance sheet as a liability. Also, kegs can have hard lives, and so may be damaged. If so, the brewery will have to write them off – which doesn’t happen with most fixed assets.

Excise Taxes

And then we have excise taxes, which are charged straight to the brewery, not to customers. The brewery has to pay the federal government an excise tax on each barrel of production, and usually another excise tax to the state government. The state rates are wildly different, with some states like Wyoming charging next to nothing, and Alaska charging super-high rates. The main reporting issue for the accountant is the Brewer’s Report of Operations, which has to go to the Alcohol and Tobacco Trade and Tax Bureau – that may be a more important report for the accounting department than the financial statements. This report is used to track the amount of beer flowing through the brewery, and to impose the federal excise tax.

Distribution Channels

Another issue is distribution channels. In some states, breweries are required by law to sell through distributors, who take a massive cut from the retail price. Meanwhile, taproom sales can be quite high, and if direct distribution to retailers is allowed, then the brewery has a price point for them that’s somewhere between those two extremes. So, it makes a lot of sense to structure the financial statements to show profitability by distribution channel. It’s quite possible that a big increase in sales might have a minimal impact on profits, because the sales were through the least profitable distribution channel.

Brewery Metrics

Moving along to metrics, there are a couple of unique ones, such as revenue per barrel, which is watched pretty closely. But the one I like is keg cycle time – great name. This is the period of time during which a keg is in use, starting when it’s filled and ending when its later refilled. A brewery usually owns its own kegs, so compressing the cycle time for its kegs means that it has to invest in fewer kegs, which improves its cash flow.

Financial Statement Disclosures

And then there are financial statement disclosures. Larger breweries may enter into really long purchasing contracts for their ingredients – like, ten year contracts for hops – so that has to be disclosed as a long term commitment.

Related Courses

Accounting for Breweries

Accounting for Vineyards and Wineries

Suggested Readings (#268)

In this podcast episode, we discuss a variety of readings that are definitely outside of the accounting area. Key points made are noted below.

Please keep in mind that there is absolutely nothing about accounting in this episode. Instead, my focus is on just giving you a broad knowledge of what’s going on in the world today. In the earlier episode, one of my recommendations was to read Business Week. That is no longer the case. Though I liked the magazine, they had a horrible time delivering it, where I was getting it maybe one week in three.

The Economist

So, in looking for a replacement, I decided to try the Economist, which has turned into my main reading source. I read probably three-quarters of it every week. It’s absolutely loaded with news about business and politics from all over the world, and it references research papers all the time, so you’re also getting the latest thinking on scientific research. They also run a special in the middle of the magazine that hits a broad range of topics in more detail.

Which is, that I score the Economist a 9 on a scale of 1 to 10. This is being picky, but I have two small issues with it. One is that, while they do produce some really amazing charts that must have taken a lot of time to compile, every now and then there’s a real head scratcher. I’m probably just stupid, but sometimes I have no idea what they’re talking about. Maybe the chart description needs to improve, or maybe they should just run their charts past the janitor before putting them in the magazine – just to see if a normal person understands them.

My second point is that their book review section at the back seems like a lot of wasted space. Either you’re a news magazine or you’re not, and sticking a half-dozen pages of book reviews at the end doesn’t seem like it’s worth the paper. More on that topic in a moment.

Foreign Affairs Magazine

My second recommendation is Foreign Affairs magazine, which is put out by the Council on Foreign Relations. This magazine comes out every other month, and I get it downloaded automatically to my Kindle. Foreign Affairs does exactly what the name implies. They ask experts to talk about various foreign affairs issues. Sometimes the topics are all over the place, and sometimes they focus on one theme, like the rise of China. The articles are very well-informed, and they come from major academics or senior people in the government.

If there’s a problem with Foreign Affairs, it’s that you can get so depressed from reading it. The commentary is generally from the perspective of what the United States could do better with its foreign policy decisions, and there’s a lot that can be done better. Nonetheless, if you want some really good, well-considered opinions about what’s going on in the world and how to make it better, Foreign Affairs magazine is a good place to start.

However – Foreign Affairs is not just about the essays. It also contains a massive listing of book reviews at the back of each edition. Unlike the Economist, the Foreign Affairs editors are taking the position that the magazine itself can’t possibly cover all the topics that are out there, so here are all these extra books you might want to read.

Specific Book Recommendations

Sometimes, it seems like I’m just trying to survive the essays in order to get to the book reviews –because this is my number one source for books to read. I buy at least a dozen books every year just based on their book recommendations. And – they’re all over the place. As a few examples of recent purchases, I bought Pandemic 1918, about the Spanish flu, Where the Party Rules, about the Chinese communist party, Tunisia – An Arab Anomaly, which is pretty much explained by the title, Brave New Arctic, about global warming, Putinomics, about the economics of staying in power in Russia, and Saudi, Inc., about how Saudi Arabia is run as a business. In short, Foreign Affairs does an incredibly good job of sorting through book releases and recommending some really fine nonfiction.

How to Search for Lessons in What You Read

I have one further recommendation, which builds on those Foreign Affairs book listings, which is to search around within a book for additional points that the author was not necessarily trying to make as his or her main point. By doing so, I find that I’m really paying attention. That’s a pretty vague recommendation, so here are a couple of examples.

One Foreign Affairs recommendation was The Saboteur, by Paul Kix, which was about the exploits of a French Resistance fighter during World War II. The author’s main point was to just follow along behind the resistance fighter while he did all the usual things, like blowing up railroad tracks. But then he also mentioned, at different places in the book, that 2% of the French population were in the resistance, while 20% of the population collaborated with the Nazi occupiers. And this is in France, arguably the proudest country on earth. Makes you wonder about how easy it is to subvert a population.

Or here’s another one. In The Fate of Rome, by Kyle Harper, the author’s main point is that some really massive plagues swept through the Roman empire and wiped out millions. But interspersed between the points being made is that several times over the life of the Empire, a massive volcanic eruption did exactly the same thing. They ejected enough dust into the atmosphere to lower crop yields, which starved an incredible number of people. And today, we might be about to stop a pandemic – after all, we have the World Health Organization and the Centers for Disease Control – but how do you protect subsistence farmers from the after-effects of a major eruption? I’m not sure we can.

And my final point – which is a long one - comes from a book called Where the Party Rules, by Daniel Koss. It’s a very difficult read, but it’s basically about anomalies in membership levels in the communist party across China. Which sounds dull – and it really is dull. But, the author made this incredibly interesting point that I’ve started to see elsewhere quite a bit. His point was that the Chinese communist party is much more highly represented as a percentage of the population in areas that were under the control of the Japanese army during World War II. Initially, this was because the communist party was active behind enemy lines during that time, and fought back against the Japanese pretty hard – and that is something that the local population doesn’t forget. So they kept on supporting the communist party for years afterwards. And this is where it gets interesting, because he calculated that the statistical half-life of this anomaly appears likely to last for 80 years. Which implies that the impact of supporting the local population will have a statistically significant impact on communist party membership for a total of 160 years.

In short, the lesson to be learned here is that memories are long. Really long. Knowledge gets handed down from one generation to the next, and it has an impact on decision making for far longer than you would imagine is possible.

This same effect comes up in Tunisia: An Arab Anomaly, by Safwan Masri. It’s one of the best books I’ve read in the past ten years. It’s all about what makes Tunisia a success when most of the Middle East has been comprehensively screwed up for decades. The author points out that Tunisia has mandated a secular education for everyone since the 1950s, where there’s an emphasis on critical thinking. Everywhere else in the Middle East, there’s a much higher infusion of religion into the educational system, which results in lots of people having a narrow view of what is right and what is wrong.

So in Tunisia’s case, because of the educational system, which results in a more broad-minded population, they’ve been able to construct an economy and a political system that just functions better. This does not mean that Tunisia is a paradise – they have all kinds of problems – but they at least have a chance of success. So how does this tie into my earlier point about long-term effects? The author specifically points out that success has been based on an educational system that’s been in place for seven decades. It takes that long to develop multiple generations of a population that aren’t going to go tearing off in a religious fundamentalist direction.

And a third supporting source is an article that just came out in the Economist, about voting patterns in southwestern Germany – right where I went to school during a semester in high school, by the way. It turns out that this area has consistently voted in the most conservative manner out of all parts of Germany for a very long time, and the reason appears to be that the population there has experienced the least population turnover in the country. People from elsewhere just don’t go there to live. In essence, it means that voting patterns stay the same across multiple generations. So once again, memories run far longer through a population than you would think is humanly possible.

This issue does suggest a foreign policy direction for the United States, which is that it doesn’t make a whole lot of sense to introduce democracy into a country and assume that it will take root right away. You need to keep up the educational process for fifty years, a hundred years, who knows? Can the United States realistically do that? Probably not. But what it can do, and has been doing for a long time, is maintain the best possible university system, and encourage foreigners to come here and learn about – everything. How Americans think, what we value, and how the system works. If they take that knowledge back home and use it to make positive changes – then, great.

Which means that the United States needs to massively support its system of higher education, and also offer visas to pretty much anyone who wants to come here to get an education. The long-term effects could be quite acceptable, and this is an approach that’s easy to support over the long term.

So how does all of this relate back to accounting? It doesn’t, of course. But by reading the Economist and Foreign Affairs, and digging through the Foreign Affairs book recommendations, you can develop a really deep view of how the world works – and being a more well-rounded person strikes me as being quite a good goal to shoot for.

Activity-Based Management (#267)

In this podcast episode, we discuss the activity-based management (ABM) concept. Key points made are noted below.

Overview of Activity-Based Management

ABM is all about using activity-based costing information to improve the operations of a business, usually through an ongoing process of fine-tuning existing processes. I talked about activity-based costing in the preceding episode.

So, how does ABM work? It can be rolled out in several ways. One of the better ways is to get rid of non-value-added activities. Examples of non-value-added activities are product rework, paperwork approvals, material movements, batch setups, and inventory counts. They don’t do anything to enhance value. There are a lot of these activities in the typical business, and paying attention to them can really reduce expenditures.

Time Reduction with ABM

For example, an insurer might want to cut down on the amount of time required to process an insurance claim. So, it commissions an activity-based costing study that identifies every activity associated with the claims processing staff, calculates the cost of each activity, and how heavily those activities are used. Now that the ABC information is available, ABM is used to create some results. You could examine the list of activities to see if any are unrelated to the basic task of processing a claim. Whenever there is one, such as moving paperwork to another person for more processing, that’s non-value-added move time and queue time, and it should be eliminated, or at least reduced. By doing so, the claims processing staff will have more time available to work on claims, which increases the capacity of the business while at the same time reducing the costs associated with those non-value-added activities.

As another example, an ABC analysis finds that the production staff is spending a total of $10,000 worth of time filling out timesheets. Management decides that the resulting information is pretty useless, and so changes over to a simple in-and-out timekeeping system that uses bar coded employee badges. The time saved increases the effective capacity of the production staff.

Cost Reduction with ABM

Another possible use is just general cost reduction. An ABC analysis might discover that a lot of the activities in the production area are associated with the rework of returned goods. The company has some very sophisticated products with lots of features, and customers tend to break them. So, an ABM analysis concludes that the company can eliminate most of the rework activities just be creating simpler products that don’t have so many complicated features.

Another possibility is that it costs a lot of money to fill each individual customer order. The activity cost is just really high. When this is the case, a logical outcome is to encourage customers to place a smaller number of larger orders, rather than a lot of small orders, maybe by rewarding them with volume purchase discounts.

As another example, an ABM analysis finds that the order entry department is expensive; it uses a lot of resources. If so, a possible option is to set up an online order placement system, so that customers can enter their own orders directly into the company’s production planning system. A small discount might be offered to anyone who uses the new system. The outcome is reduced order entry expenditures.

Or, let’s look at ABM from the perspective of the sales department. An analysis finds that its very expensive to have the sales staff visit customers in person. So, change the type of sales calls made to customers to a lower-cost form, such as switching from an in-person meeting to a phone call. A variation is to increase the interval between sales calls, or to mix in-person contacts with phone calls.

Let’s try another one. An ABM analysis finds all kinds of costs associated with expediting orders through the production process, since it lays waste to the orderly flow of work. Since the analysis comes up with an actual cost associated with expediting, management now knows how big a fee to impose whenever anyone wants to expedite another order through the company.

Profit Enhancement with ABM

ABM is really useful when a company is producing a mix of really complicated and quite simple products, because there’s a good chance that too many costs are being allocated to the simple products and too few to the complicated ones. This means that the profits associated with the simple products are probably being reported lower than they should be, with the reverse being the case for the complex products. By using ABM to figure out which products are actually consuming activities, you can either stop producing some of the more complicated products, or at least raise their prices.

It might also be possible to encourage customers to shift their purchases from lower-profit to higher-products, perhaps with coupon offers or some adjustments to prices.

Customer Service Improvements with ABM

Another way to use ABM is to focus on customer service. This usually means compressing the time required to complete a customer order. So, the emphasis is on analyzing every activity involved with taking a customer order, scheduling production, ordering materials, storing completed goods, and shipping them out. By focusing on eliminating or streamlining every activity in this process, customers can receive deliveries much sooner than had previously been the case. So the emphasis here is not on cost reduction, but rather on time reduction.

Summary of ABM Benefits

In short, this analysis can pick up enormous savings. Even when you think a process is pretty efficient, there’s a good chance that an ABM analysis can strip out another 20% of the cost. This analysis can generate some major results throughout the organization – in accounting, production, sales, product development – everywhere. Some organizations use this one tool as the basis for most of their cost reduction activities.

Problems with ABM Analysis

While ABM might sound like the perfect tool for increasing profits, it can cause an expectation that costs will be reduced when that’s not actually what happens. The trouble is that overhead costs are usually incurred as step costs, so that it takes a large activity reduction to yield any actual cost reduction – though when it occurs, the cost reduction comes in a big lump.

For example, management might figure out that it can reduce the number of phone calls being handled by the customer service department, maybe by eliminating some issues with its products. And by doing so, it manages to actually reduce the number of incoming phone calls by 2%. The problem is that there’s no way to eliminate a customer service staff position unless the number of income phone calls can be reduced by 3%. In the meantime, there aren’t any savings. The activity volume has dropped, but not by enough to trigger a staffing reduction. So unless there’s a way to reduce phone calls even more, the company won’t save any money. This can happen a lot with ABM projects, so be aware of the volume of activity reductions needed to trigger an actual cost reduction. Otherwise, there’ll be lots of disappointment.

Related Courses

Activity-Based Costing

Activity-Based Management

Activity-Based Costing (#266)

In this podcast episode, we discuss activity-based costing. Key points made are noted below.

Overview of Activity-Based Costing

As the name implies, this is the concept of tracing costs to specific activities within a business. Now, why would you do that? Consider that a business normally tracks its costs at the level of expense type, such as rent expense, or utilities expense, or compensation expense. When you’re trying to improve the performance of a business, just looking at an income statement with these expenses listed on it doesn’t really provide you with any information about how the business actually operates. So, if you decide to arbitrarily decrease one of these expenses, such as compensation, you really don’t know what impact that will have on the business.

But if the existing system for tracking expenses doesn’t give us much actionable information, then why do we use it? The main reason is that the typical accounting system is designed to accumulate data as quickly and easily as possible, in order to produce financial statements. The emphasis is on doing accounting at the lowest possible cost.

This is where ABC comes in. The emphasis is entirely on producing actionable information, where you can tell how much it costs to engage in any of a large number of activities within a business. And there can be hundreds of activities, such as making sales calls, or processing customer orders, or scheduling production jobs, or maintaining equipment, or training employees. Or, just within the accounting department, examples of activities are issuing customer invoices, processing cash receipts, and processing supplier invoices.

The Effort Needed for an ABC System

If you really want to accumulate the cost of each of these activities, the cost is monumental, because there has to be a tracking system for each one. For example, just tracking the cost of the sales call activity means having everyone in the sales department start logging their hours associated with sales calls, plus travel expenditures just for this specific activity. If you were to expand this level of activity tracking to every significant activity within a business, you could be looking at expanding the administrative work within a company by many multiples. Which is why you don’t hear about a whole lot of successful ABC installations. Someone in management gets enthusiastic about the concept and tries to roll out a company-wide system, which could take years. Because setting up the data collection systems takes so long, pretty much everyone gets frustrated with the project, and it gets dropped before it ever has a chance to produce any information that management can use.

How to Make an ABC Project Succeed

This does not mean that ABC is a bad idea. Far from it. You just have to be careful to target it very specifically, so that the existing data collection systems don’t have to be adjusted all that much, and in a way that doesn’t interfere with the normal work of employees. That means a successful ABC project might only involve a couple of extra data collection activities.

To make the project even more likely to succeed, it should be initially set up as a short-term project, where there’s data collection, and a final report that summarizes cost information – and that’s it. The data collection is then stopped and the project ends. By doing it this way, ABC is not considered to be a long-term administrative burden on the company. Instead, it’s expected to last just a few months, which most people will find tolerable. For example, management might want to look at which customers are taking up too much activity to be profitable, so the cost accountant tracks customer usage of activities like the processing of returned goods, the processing of bad debts, and customer service calls. And after that she delivers a final report that identifies a list of customers that should either be dropped or have their prices increased. The company may not need to revisit this topic for another five or ten years, so the project is terminated.

That does not mean that every ABC project has a short life. If management finds that the results from a particular project is giving it actionable information over a long period of time, then the data collection systems associated with it need to be made permanent, which means installing some automated data collection systems, and adding formal procedures and revising job descriptions to embed the process into the company. But this is rare. You can expect that if a company runs 20 ABC projects, maybe one of them will end up being part of the permanent systems of the organization.

Cost Object Analysis

So, moving along – management has targeted a focused project area, and there’s a cost accountant collecting data about the cost of activities. Now what? This is where the concept of a cost object comes in. A cost object is any item for which a cost is compiled. There’re lots of cost objects in a business, such as products and services, one-time projects, distribution channels, sales regions, and customers.

Ultimately, the whole point of an ABC project is to figure out how much each cost object is costing the business, so a request from management will probably not be to figure out, for example, the cost of each customer service call – which is an activity. A more likely management request is to figure out the total cost of each customer, of which customer service calls are only a small part. Therefore, the cost accountant receives a request from management to determine the amount of a cost object, and then determines which activities need to be tracked, so that the cost of these activities can be traced back to the cost object.

Data Collection Activities

This means that yet more data collection needs to be performed, to determine activity usage by cost objects. For example, the cost of a manufactured product includes ten minutes of machining at a computerized lathe. The cost accountant has to track a bunch of things to arrive at the cost of the activity, which is machining time, and then has to track the amount of time required to run the product through that activity. Only after both steps have been taken can we arrive at the final cost assignment for the product, which is the cost object.

Project Setup Decisions

When setting up one of these ABC projects, the cost accountant needs to make a few additional decisions, which could make the project either more or less complex. When making these decisions, the accountant has to balance the additional amount of work required against how valuable the incremental improvement in information will be.

For example, the accountant needs to decide how many activities to track for an ABC project. Let’s say that the full range of activities associated with a distribution channel cost object is 30 activities. That’s a lot of activities. The accountant might throw out half of them, because the data collection is too difficult, or it may not even be possible to collect the data, or the data collected will be too unreliable, or maybe there’s not enough funding for a full-blown project. This is a significant issue, so the accountant may spend a lot of time sorting through the various activities and deciding which ones to keep and which ones to throw out.

Summary

And that’s it. My intent was to give just a taste of what ABC is about, because it’s a complicated process, and delving into it in detail could take hours. A major takeaway is that ABC is useful, but only if it’s precisely targeted. Conversely, it’ll probably fail if you try for a broad, company-wide rollout of the concept.

Related Courses

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Accounting for Franchises (#265)

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

Overview of Franchising

A franchise is a privilege granted to a third party to market a product or service, usually under a trademarked name. The franchisor is the party that grants business rights related to a franchise to the franchisee, which is the party that commits to operate the franchised entity. In return, the franchisee pays a fee to the franchisor, which is usually based on a percentage of the sales generated by the franchisee.

There may be a single unit arrangement with a franchisee, where the franchisee becomes the hands-on manager of a franchise that covers a specific geographic region. The agreement may be for a specific period of time, such as ten years. If the franchisee wants to renew at the end of the current contract period, it will need to pay a renewal fee. Or, there may be an area development franchising arrangement, where the franchisee gets the right to develop a certain number of units within a specific territory, such as a county or a state. This entity then enters into a separate arrangement with the franchisor for each unit constructed within that territory.

A variation on the concept is the master franchising agreement, where the franchisor grants the master franchisee the right to sub-franchise to an additional level of franchisees. A master franchising agreement tends to cover a larger region than you normally see for an area development franchise.

There are several ways to build a franchise operation. One approach is for the franchisor to provide the franchisee with a turnkey solution, where the franchisor finds a location, builds it out, stocks it with inventory, and then hands everything over to the franchisee. In return, the franchisee pays quite a large up-front fee to the franchisor. A variation is for the franchisor to also operate the unit for a period of time, and then hand it over to the franchisee, just to make sure that everything is running properly.

Yet another approach is for the franchisee to be directly involved in the development process, with the oversight of the franchisor. This approach increases the risk of failure, since the location of the unit is untested. A final possibility is for a pre-existing, independent business to enter into a franchisee relationship, where it agrees to operate under the logo of the franchisor. In this last case, the franchisee already knows that the selected location will succeed, since it’s already been in operation for some time.

Business Development Expenditures

So, as you might expect, these arrangements can trigger some accounting issues. First up is what the franchisor is supposed to do with its business development expenditures. It might spend millions developing its franchise concept. Even though these expenditures might lead to lots of franchising revenue somewhere down the road, they’re still considered to be research and development costs, and those costs are charged to expense as incurred.

Facility Construction

Next, let’s assume that the franchisor is constructing facilities on behalf of its franchisees, with the franchisees paying advances as the work proceeds. In addition, the franchisor may charge the franchisee a fee to manage the construction process. The franchisor records these incoming payments in a development fund liability account, which the construction billings are then charged against.

Franchise Fee

After that, there’s the accounting for the continuing franchise fee, which is based on a percentage of the franchisee’s sales. When the franchisor incurs expenses related to these continuing fees, it should charge them to expense as incurred. These expenses include pretty much every operating cost of the business, such as general, selling, and administrative expenses.

Cooperative Advertising Fund

A franchisor might require its franchisees to pay into a cooperative advertising fund, which it then uses to advertise on behalf of the franchisees. Advertising funds are usually collected first and then paid out; this means that the funds collected are initially a liability of the franchisor. In the reverse situation, where the franchisor first pays for the advertising and then collects the money from franchisees, the franchisor might charge interest on the funds that it’s already expended.

Franchise Buy-Back

So, what if a franchisor buys a franchise back from a franchisee? The accounting for it depends on the intent of the franchisee. If the intent is to close it, the franchisor apportions the purchase price among the acquired assets and liabilities and writes off any residual amount. But if the intent is to keep running the business, the same approach applies, except that any residual amount is now allocated to the goodwill intangible asset, because now the transaction is treated as a business combination. Which leaves us with a third possibility, which is that the franchisor intends to turn around and sell the operation to a new franchisee. In this case, reacquired assets are classified as held for sale, which allows the franchisor to hold the assets without depreciating them; the assets are then included in the cost of the eventual sale to a new franchisee.

Franchisee Accounting

Now let’s look at things from the perspective of the franchisee. When a franchisee pays an initial franchise fee to the franchisor, the payment can be considered an intangible asset. The franchisee can recognize this payout as an asset; if so, it should amortize the amount over its estimated useful life, which is probably the term of the franchise agreement. The asset should be tested for impairment at least once a year, so if its carrying amount is greater than its fair value, the franchisee has to take a write down. The judgment of what constitutes fair value is based on things like changes in revenues or expenses, regulatory changes, litigation, or maybe the loss of key personnel.

And what if the franchisee decides to pay a renewal fee when the initial franchise period expires? In that case, the fee is again treated as an intangible asset and amortized over the life of the new agreement.

It’s possible that a franchisee may sell out to a replacement franchisee, which usually calls for the payment of a transfer fee to the franchisor. The outgoing franchisee can account for this fee as a cost of selling the business, so it’s deducted from the gross proceeds of the sale.

Related Courses

Franchise Accounting

How to Get Financing from a Bank (#264)

In this podcast episode, we discuss how to obtain financing from a bank. Key points made are noted below.

Overview of Lending

Banks prefer to lend to companies that don’t actually need the money, because they’re in such solid financial positions already. Banks mostly – but not entirely – base their lending decisions on two criteria. The first is the cash flows of the borrower. You need to have a history of generating enough cash flow to pay back the loan. This presents two problems. If you have a history of solid positive cash flow, then why would you bother to apply for a loan? And second, if you’re with a new company with no financial history at all, then there’s no way to prove that you have any cash flow. So just based on this first criterion, you can see that banks are going to limit their lending to well-established and fairly successful businesses, which means that their preferred lending arrangement is for something like a company with seasonal sales that only needs the cash to pay for its peak season receivables, or maybe to a larger company to pay for a new headquarters building. Banks are not interested in giving money to a startup company that only has a business plan.

The second criterion that a bank uses for its lending decisions is whether the company has enough assets to pay for the loan if its cash flows don’t materialize. Banks will legally attach these assets to the loan as part of the lending agreement, so that if you don’t pay on time, they can seize the assets and sell them in order to get back the remaining balance on the loan. If the company goes bankrupt because they seized the assets, that is not their concern. They just want their money back.

Collateral

And to be really safe, they’ll try to attach every single asset in the company, which is called the collateral on the loan. When they do that, and then you want to take out another loan – you can’t, because there aren’t any assets left for the next lender to use as collateral on the next loan.

There are three additional issues related to collateral.  One is that, whenever a bank wants to use all company assets as collateral, you have to get into a dogfight with them to narrow the number of assets to be used as collateral down to the absolute minimum. Otherwise, as I just pointed out, you have nothing left to use for any later loans. This can be next to impossible if the company is fairly new, because the bank will classify the company as being high risk, and so will want to scoop up every asset in sight.

The second issue is that the bank will be really interested in taking the company’s most liquid assets as collateral – so it will be most interested in your cash and receivable balances. If you can’t pay back a loan, the cash balance will probably be quite low, but the receivable asset may be very high. If so, customers will probably pay off their receivable balances within a month or so, and then the bank will have its money back.

Working Capital Loans and Lines of Credit

If the loan is structured as a working capital loan or line of credit, the total amount of the loan is capped at the amount of cash and receivables on hand, usually reduced by some sort of a discount factor on the receivables. For example, if you have $100,000 of receivables, and $10,000 of that amount is more than 90 days overdue, then you can only use $90,000 of the asset base that supports the loan. And on top of that, the bank will only allow a percentage of the remaining balance in its calculation of the maximum amount of the loan that can be outstanding. So out of that initial $100,000 of receivables, if the bank only accepts 70% of the allowable receivables, then the maximum loan balance would be $63,000. If the remaining loan balance is higher than the amount of collateral on hand, you have to pay back the difference right away – which can be difficult.

Borrowing Base Certificate

For this type of loan, the bank requires that you create what’s called a borrowing base certificate at the end of each month and send it to the bank. This certificate states all of the ending balances for the asset classes being used as collateral, reduced by any deductions mandated by the lending arrangement.

It also subtracts out the ending balance on the loan, so that the bottom line on the certificate states either the available amount of the loan that has not yet been used, or the excess amount of the loan that has to be paid back. You have to sign the certificate, which means that you can be legally on the hook for fraudulent reporting if you put incorrect information in the certificate.

When You Have Few Liquid Assets

What if your company has less liquid assets, like inventory or buildings? In that case, the bank may not be so interested in granting a loan, because it could take a long time to convert these assets into cash – and the bank may be forced to accept a lot less than book value for them. What this means that the company could have a massive amount of less liquid assets, and find that no banks want to deal with it.

Personal Guarantees

Which leaves us with the third collateral issue, which is that the bank may not be satisfied with just the assets held by the company – it may also want a personal guarantee by the owners, or whoever else is willing to guarantee the loan. So if the company goes under, and the company’s collateral is not sufficient, the bank will seize the owner’s assets too. And, depending on the lending arrangement, if the bank thinks it’s easier to get its cash back by going straight to the owner’s assets and ignoring the company’s assets, then that’s what it will do.

Lender Risk Aversion

In short, a bank is not really in the business of issuing loans. It’s really in the business of making a profit, so it’s highly risk averse. If there’s any hint of a problem in the financial history of a company, or if its asset base isn’t sufficient, then don’t expect to get a loan. In case you hadn’t noticed, I have a fairly negative attitude when it comes to banks. While working for a series of startup companies, I’ve always had trouble getting loans from them.

The only cases in which we managed to secure bank financing were when we had a rich investor who was willing to guarantee the full amount of a loan. In those cases, the bank pretty much took the attitude that it was making a personal loan to the investor, who happened to then be forwarding the cash to the company. Of course, the bank insisted on taking the company’s assets as collateral, too – even though the investor had more than enough cash to pay back the full amount of the loan.

Related Courses

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Treasurer’s Guidebook

Accounting Career Advice (#263)

In this podcast episode, we discuss a number of listener requests about accounting careers. Key points made are noted below.

Moving from Public Accounting to Private Accounting

The first comment comes from Weston, and it is, I don’t want to stay in public accounting my whole life, but would rather go elsewhere and track for a CFO position. Please talk about careers outside of public accounting that accountants who start there can branch out into, and the type of firm that I would learn the most for doing something like that?

I’m surprised no one has asked this question before, because almost everyone in public accounting ends up somewhere else – and the chief financial officer position is a great target, since I think it’s the most interesting job out there. A pretty common career transfer is from being an auditor to being a company controller. Once you’re a controller, the next promotion is to CFO, so that’s a great track to follow. The trick is to stay in auditing long enough to qualify for a controller position somewhere else. That usually means hanging in there long enough to make it to audit manager, and then staying in that position for a couple of years. If you just can’t stomach being an auditor long enough to make manager, then keep in mind that shifting out of a more junior auditor position will land you in a more junior corporate job, too – like assistant controller or general ledger accountant.

As for the question about the type of firm that you’d learn the most from – it’s more a matter of the size of the audit firm. A big audit firm has a larger alumni network and a bigger client list, which makes it easier to network your way into a good job somewhere else. So in short, bigger is generally better. That does not mean that you absolutely have to work for a Big Four audit firm. It’s also quite acceptable to work for a large local or regional firm.

The Differences Between Finance and Accounting

The next comment comes from Nathaniel, who says, I’m interested in a career in finance or accounting. Please discuss the differences. Also, please describe the characteristics of a good accountant. I’ve been describing accounting on this podcast for the last ten years, so I’ll assume you’ve figured out that part. Finance is a bit more of a gray area for accountants. It’s essentially about tracking cash, organizing cash, and - of course - getting more of it. So that means setting up bank account structures to collect cash, aggregating the cash in those accounts into investment accounts, and investing the cash. It also means conducting a lot of cash forecasts, and working with lenders and investors to pull in more cash when you need it. On the one hand, this is an incredibly valuable job, since a company can go under if no one is watching the cash. On the other hand, it’s completely intangible – there’s nothing you can see, so you might not get an overwhelming sense of satisfaction from working in finance. Of course, you could say the same thing about accounting.

Another issue with finance is that smaller firms don’t have these positions. Instead, this is handled within the accounting department. So, there just aren’t as many finance jobs as accounting jobs.

As for the characteristics of a good accountant, I’ll focus on just one thing, which is the ability to see both the big picture and be detail oriented – at the same time. Most people think that great accountants just dig into the details and make sure that every transaction is accounted for perfectly. The accounting standards are followed and the correct accounts are used. That is a baseline requirement for the job, but if that’s all you are, then you’re more of a really good clerk than an accountant.

That’s where the big picture part comes in. A really great accountant is also able to see which informational items really matter to a business, and which ones can be ignored. For example, the great accountant will zero in on variances that could be leading indicators of a major problem, like an uptick in the number of customer returns that could indicate a product flaw, and will investigate it in detail. Management needs to know about that kind of information. At the same time, that accountant will completely ignore a jump in office supplies expense, because in the greater scheme of things, it just doesn’t matter. Not many accountants have both of those attributes, especially the big picture view. It’s worth pursuing.

Career Paths for Tax People in CPA Firms

The next comment comes from Tyler, who asks, please talk about the career paths of people who work in tax at a large CPA firm. The range of options available to a tax person is not that broad. If you really like taxation – and yes, some people do – then your best bet is to stay at the CPA firm for as long as you can. By doing so, you get to deal with more clients, each having a different set of tax problems that you can get your kicks out of solving. If you get hired away by a large company to do their tax work, you may find that the work is more boring, because you’re now dealing with the tax issues of just a single client.

And your final option is to go into business for yourself. In this case, you’ll probably end up doing tax work for smaller clients or individuals, since the big CPA firms tend to scoop up the tax work for the largest companies. You may find that these smaller tax jobs aren’t all that interesting; on the other hand, there are plenty of smaller firms out there, so you could develop a large group of clients. But give it time. Creating your own tax practice can take years of networking before you’re maxed out.

Why it is So Difficult to Get a Financial Analyst Job

And our final comment comes from Jason. It’s a long comment, so I’ll summarize it to say, how come it’s so difficult to get a job as a financial analyst? There are a couple of issues here. The financial analyst job is a hybrid between accounting and finance, and only large companies even have the position. This causes a couple of problems. First, you may need degrees in both accounting and finance to be fully qualified to do the work – though if you have a choice, get the accounting degree first – it’s more relevant. And second, because the position is only offered at large companies, you have to be willing to work where those companies are located, which usually means larger cities.

One variation on the financial analyst position is that it’s also commonly used in funding companies, like investment banking and private equity firms. They use these positions to calculate future cash flows for their clients, which is then used as one basis for deciding whether to invest in them. The same analysis can be used to convince investors to put money into a startup company. So if you want to make a lot of money, have virtually no time off, and experience an incredibly stressed life while flying business class, then consider pursuing one of those positions. But keep in mind, investment bankers usually only hire from the top 25 business schools.

Purchase Order Clearing (#262)

In this podcast episode, we discuss purchase order clearing. Key points made are noted below.

Overview of Purchase Order Clearing

Purchase order clearing is based on a standard report that’s located in the purchasing module of your accounting software. It lists all purchase orders for which there’s either no associated receipt or no associated supplier invoice – or both. For each of these open purchase orders, the report states everything you need to track down what’s going on, such as the purchase order number, the number of units originally stated on the order, the number of units received, and the number of units billed to the company.

Examples of Purchase Order Clearing

For example, let’s say that the report indicates an original order quantity of 1,000 units, and that zero units were received or invoiced to the company, and that the purchase order was issued several months ago. A reasonable assumption is that the purchase order was not actually issued, or the supplier rejected or lost it. In this case, the likely follow-up action is to check with the purchasing department to see if they plan to formally cancel the purchase order, which will remove it from the report.

Now let’s change the facts, so that the report indicates that 950 units were received and invoiced to the company. This is pretty common. The supplier shipped a bit less than the full amount, and will either ship the remainder later, or the purchasing department should get around to formally cancelling the remaining amount. No issues for the accountant here.

The remaining two variations are more interesting. Let’s assume the same 950 units were received, but the report indicates that the supplier never issued an invoice – or at least, it was never logged into your accounting system. In this case there’s a problem, because the inventory has been logged into the system as an inventory asset, with an offsetting credit going to the purchases clearing account, which is a liability account. The amount in the clearing account will stay there until you can log in the supplier’s invoice, which hasn’t arrived. So, you need to contact the supplier, figure out what happened to the invoice, and get a copy of it. When you enter the supplier’s missing invoice into the payables module, it references the purchase order number, which notifies the system to move the credit in the purchases clearing account over to the payables account.

Purchase Order Clearing in Accounting

In short, the purchases clearing account is a short-term parking spot for received goods, which indicates that a supplier invoice should be on its way soon. As the accountant, you should be scanning through the purchases clearing report for any cases in which goods have been received, but no invoice, and tracking down the invoices. To save work, you can certainly wait until a week has passed since the receipt of goods, since some suppliers take a while to issue invoices. After that, assume that there’s a problem.

And then we have the other variation, where the clearing report shows that a supplier invoice was received, but the goods were not. In this case, either the supplier has somehow mistakenly issued the invoice but not the goods, or the goods were shipped somewhere else, or your receiving department didn’t log in the receipt. You can address all of these options by asking the supplier for a proof of delivery document, such as a FedEx or UPS signature from the recipient. If there’s no proof of delivery, then the supplier probably screwed up and never sent the goods. That is not likely.

It’s much more likely that the goods were delivered, in which case you have to find them and then persuade the receiving staff to log the receipt into the system. By doing that, the receipt is matched with the supplier invoice and the whole thing is flushed out of the purchases clearing account.

So why do we use the purchase order clearing process? First, it ensures that the book balance for inventory items is as accurate as possible. Second, it ensures that supplier invoices are always posted to the system, so that payments to suppliers go out on time. This tends to improve supplier relations, and also gives you more time to take advantage of early payment discounts. And finally, this clearing process improves the accuracy of both the ending inventory and accounts payable balances, which is useful for closing the books and producing accurate financial statements.

Frequency of Review

How frequently should you review the clearing report and the clearing account? It depends. If your company issues a lot of purchase orders and the process is a bit buggy, then you might have to do it every day. In the reverse situation, once or twice a month might be enough. In the latter case, I suggest doing a review a few days prior to the end of the month. That’s because it may take a few days to investigate what’s wrong and then correct the inventory and payables records in time for month-end. A good way to see if there’s something wrong is to plot the total dollar amount in the purchases clearing account on a trend line. If the balance in the account is perpetually going up, then you probably have a lot of issues clogging up the account.

Trend Line Analysis

But. There’re two cases in which an increasing trend line does not necessarily indicate a problem. One is when the company is growing rapidly. In that case, you can expect the clearing account to grow at about the same rate as the growth rate for sales – or, more accurately, the growth rate for purchases. And the second case where the trend line can be justifiably going up is when the purchasing department decides to use purchase orders to buy a larger proportion of the goods being purchased. In that case, the clearing account will probably increase in size.

Reconciliation Difficulty

One final note is that the clearing report is simply a status report. The information in the report should represent the detail in the clearing account. However, the report may not even have a grand total stated anywhere on it, so you can’t necessarily reconcile the report to the clearing account.

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