Accounting for Stock-Based Compensation (#293)

In this podcast episode, we discuss the accounting for stock-based compensation. Key points made are noted below.

The Nature of Stock-Based Compensation

What we’re talking about is how to account for various types of stock grants made to employees, which might be in the form of an outright grant of stock, or as a stock option, which gives an employee the right to buy company shares at a later date, and at a specific price. In either case, the essential accounting is to recognize the cost of the related employee services as they’re received by the company, at their fair value.

The accounting is based on three concepts. The first is the grant date, which is the date when the award is approved, usually by the Board of Directors. There are some variations on this, but the grant date usually corresponds to the approval date. The second concept is the service period, which is usually the vesting period. So, if you’re granted 10,000 shares after three years of service have passed, then the vesting period is three years. And the final concept is the performance condition, which is the goal that has to be achieved in order to obtain the compensation.

Stock-Based Compensation Accounting Rules

The basic approach is to accrue the service expense related to the stock-based compensation over the service period, based on the probable outcome of the performance condition. For example, a board of directors grants stock options to the company president that have a fair value of $80,000. The options will vest in either four years or when the company achieves 20% market share in a new market. Since there’s no way to tell when 20% market share will be achieved – if ever – we throw out that performance condition and go with the four year vesting period instead, which is pretty certain. So, with a service period of four years, we accrue compensation expense of $20,000 per year for the next four years, so that $80,000 of compensation expense has been recorded by the time the president is fully vested in the stock options.

In that example, what if the president managed to achieve the 20% market share performance condition in just two years? In that case, the first $20,000 compensation accrual would have already taken place at the end of Year 1, so you would accrue the remaining $60,000 of compensation expense as soon as the market share goal was reached in Year 2.

What about a case when the performance condition is not completed? In that case, the company reverses any compensation expense that’s already been recognized. To go back to the earlier example, the company president resigns after three years. Because he didn’t complete the performance condition, he won’t receive the stock options. Up to that point, $60,000 of compensation expense had already been recognized, so that $60,000 expense is reversed as soon as the president resigns.

What happens to the accounting if the terms of the underlying grant arrangement are changed? Then you have to match the accounting to the new deal. For example, a board of directors issues stock options to the sales manager that have a fair value of $100,000, and which will vest over the next four years. Based on this information, the controller starts to accrue $25,000 of compensation expense in each of these years. But at the end of Year 2, the sales manager has done such a great job that the Board accelerates the vesting, so that it’s completed at the end of Year 2. Based on this revision, the controller accrues $75,000 of compensation expense in Year 2, which completes all recognition of the stock option fair value.

What happens if the fair value of the stock-based compensation declines over time? In short, it doesn’t matter. The fair value is set as of the grant date, even though the associated equity might not be issued until years later. However, when it’s not possible to estimate fair value at the grant date, then you can continue to remeasure the award at each successive reporting date until the award has been settled.

Now, what if those stock grants are being made to parties who are not employees? This usually happens when a small company is trying to conserve cash, and so pays its suppliers with shares instead. In this case, there are two rules to follow. The first is that you recognize the fair value of the equity instruments issued or the fair value of the consideration received, whichever can be more reliably measured.

The second rule is to recognize the asset or expense related to the goods or services being provided in the same period. For example, if the supplier being paid with shares is providing the company with production equipment, then the debit is to the fixed assets account. If the supplier is providing raw materials for the company’s production operations, then the debit is to the raw materials inventory account. It just depends on the nature of the transaction.

There are a couple of other rules relating to these stock grants to outsiders. If the company is issuing stock that’s fully vested and can’t be forfeited, then the entire fair value of the stock has to be recognized right away. In this case, if the supplier hasn’t delivered on its side of the deal yet, then the prepaid expenses asset account is debited. For example, an outside attorney demands $10,000 of stock in exchange for his services, to be paid in advance. In this case, the company hands over the shares and charges $10,000 to its prepaid expenses account. As the attorney provides services, this asset is gradually charged to legal expense.

 When granting stock to outside parties, the company recognizes the payment as of a measurement date. This is usually the date when the recipient’s performance is complete, though it can be earlier, depending on the situation. This is different from grants to employees, which are as of the grant date, rather than the performance date.

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Accounting for Stock-Based Compensation

How to Interact with the Auditors (#292)

In this podcast episode, we discuss how to interact with the external auditors. Key points made are noted below.

Problems Dealing with Auditors

A listener points out that he has trouble keeping tabs on their work, since they like to keep their workpapers “secret.” He also has trouble ensuring that his year-end books match the records of the auditors. Otherwise, the next year’s audit staffers begin by questioning his year-end numbers from the previous year.

There are a couple of issues here. One item you might have noticed from the listener’s comments is that he may have a control issue. This is actually pretty common when dealing with the year-end audit. Let’s face it, we are in charge of the books, and we don’t like it when someone else shows up, asking uncomfortable questions. The relationship can be pretty fraught. And to make matters worse, the controller or CFO has absolutely no control over the auditors, since they report to the board’s audit committee – not the management of the company. So, they can do pretty much whatever they want.

Recommendations for Dealing with Auditors

I have two very different recommendations. The first one is to unwind, kick back, and drink a margarita. Look, this inspection is going to happen every year, there’s nothing you can do about it, so relax and just try and get them finished up and out the door as soon as you can.

If you have a suspicion that they’re doing something wrong or reaching a wrong conclusion, then feel free to state your case as often and as vigorously as you want. That’s my second recommendation. And bring up your viewpoint with senior management, if you think it will make any difference. But in the end, if the auditors fundamentally disagree with you, then you’re stuck, and you have to make the changes that they require. So suck it up, make the changes, and drink another margarita.

Despite the way this is going, I actually do sympathize with the listener’s comment. Realistically, the controller or CFO knows way more about the company’s accounting than the auditor does. But – the auditor may have a better knowledge of the accounting standards, and may have more experience with how those standards apply to other companies in the same industry – so they could actually have a valuable perspective on the situation.

Now, the problem with matching up year-end records. This is incredibly common. The auditors leave the premises with a certain set of adjusting entries, and then they may dream up a few more back in the office, which they send over - hopefully. Ideally, this should mean that your trial balance should have been adjusted in exactly the same way as their trial balance, so both parties start off the next year with the same beginning balances. The funny thing is, that has not happened to me at least half the time. There’s always some kind of difference between the two, where an adjusting entry falls between the cracks.

The only way to fix this is through repetitive communications. This means sending your ending trial balance to the auditors at the end of the audit, to make sure that it matches their numbers. This is not so easy, because the audit team has already moved on to other engagements, and it can be hard to get anyone to deal with your request. Another approach is to send the ending trial balance to the audit manager a week or two before the start of the next annual audit, when there may be a bit more interest in reviewing the information.

This is not just a minor scheduling issue. It’s actually a reputational issue for the controller, since he or she may have to retroactively adjust the beginning balance for the next year with an adjusting entry from the prior year – which means that the financial records for last year are now a little different from what you’ve been telling management all year long.

So, to sum up the relationship, the controller or CFO probably resents having the auditors around, and throws a party when they leave, but because of this problem with getting the year-end numbers properly aligned, you have to keep talking to them even during the off-season. Sorry, but that’s just the way the relationship works. If it will help any, have another margarita.

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Budget Stress Testing (#291)

In this podcast episode, we discuss budget stress testing. Key points made are noted below.

The Effects of Not Stress Testing a Budget

It’s the one thing that most organizations don’t do. Instead, the management team fiddles with the numbers to arrive at just the right combination of projected sales and profits and cash flows. This usually results in a business that’s running pretty lean. They try to shave a few expenses here and there, maybe buying some lower-quality materials for their products, perhaps running the administrative staff a little too hard. Maybe they can run the sales staff with one fewer person, or put off some building maintenance for a year. We’ve all seen it, and usually the management team gets away with it. But not all the time. Sometimes, the result of this kind of behavior is a complete collapse.

The problem is that management is not stress-testing the budget. It’s simply shaving expenses down on the assumption that nothing bad will happen. And in your typical year, that might be a reasonable assumption. Over any stretch of 365 days, a low-probability event probably won’t occur. For example, if the risk of flooding in any given year is 10%, then something bad happens only once every 10 years, so why spend money to prepare for it at all? But every now and then bad things happen, and the losses can be catastrophic.

Taking a Longer View

A better approach is to view the budget over a much longer period of time. Let’s keep going with the flooding example – and especially because a lot of businesses are subject to flooding risk. You’re the CEO of a business that’s located in a flood plain. The business moved there three years ago, and you just found out about the flooding danger, as well as the probability, which is 10% per year. If you’re prudent, you’ll reserve some funding in every single annual budget to mitigate that flooding risk, because you know it’s going to happen – just maybe not in the next 365 days. This might mean an ongoing plan to move the most expensive machinery to an upper floor of the building, or installing pumps in the basement, or installing backup power generators. Or, of course, starting to move to a different location that’s not in a flood plain.

Yes, these are expensive steps. And yes, from a stress testing perspective, they need to be done. When viewed over any one-year budget period, these actions will drive down planned profits. But when viewed over a longer period, they increase profits, because over the long term, the business is avoiding a catastrophic loss.

Value Enhancement through Stress Testing

Let’s take this logic a bit further. When viewed from a longer-term perspective, stress testing is really focused on increasing value. That’s right, spending money now to avert losses at some indeterminate future date should increase the value of the business. Therefore, if you’re looking at some sort of risk that has an extremely low probability and will be very expensive to guard against, then maybe you don’t spend any money on it. Like guarding against a hail storm in an area that’s never experienced one. So, I’m not talking about spending money indiscriminately on all kinds of risks – just the ones where there’s a long-term payoff.

Where to Apply Stress Testing

Where else can stress testing work? At the department level, you’ll want to examine any situations where a key skill set is concentrated with just one person. That’s a definite risk, since that person could become disabled, or die, or leave the company. In this case, you need to evaluate the cost of bringing in a backup person or cross-training someone else who’s already there. There probably aren’t too many positions like this in a business. Maybe it’s a salesperson when sales are highly technical. Or maybe it’s a mechanical engineer in the research and development group. The CEO needs to know where these weak spots are, and guard against them with some targeted spending.

Let’s look at equipment. The most critical equipment is anything that has a long lead time, either for maintenance parts or to replace the machine entirely. This usually means highly specialized equipment. If you have anything like this, consider investing in a spare unit. If the existing equipment happens to be very high-end, this doesn’t mean that the backup also has to be high-end. It could be fairly basic, as long as it’s functional enough to keep the company going while the main unit is being repaired or replaced.

The same approach goes for suppliers. I talked about this a bit in Episode 287, which was Pandemics and Business Planning. Figure out where there’s most likely to be a failure in the flow of supplies, and work on either replacing that supplier or signing up a backup supplier. This can be difficult to figure out, because a supplier could be situated in a flood plain too – which is not entirely obvious. And nowadays, you have to consider the risk of borders being closed due to a pandemic, or maybe a trade war. These issues have a major impact on the budget, because the current suppliers are probably the lowest cost. So, if you need to switch suppliers, you’re probably going to be using more expensive suppliers – which impacts the cost of goods sold.

So in short, the senior management team, and especially the CEO, needs a really good understanding of where the risks are in a business, and prudently make investments to mitigate them. Yes, this will reduce profits over the short term, but it should do the reverse over the long term.

Stress Testing in a Changing Environment

Which brings up an interesting point. Some business leaders claim that their business models change so fast that there’s no point in even producing a budget that covers a full year – because they don’t know what they’ll be doing in a year. My comment is that these are usually startup companies that might end up pivoting three or four times before they figure out a viable business model. If so, they don’t really need to worry about budget stress testing. Also, since they’re startups, they probably don’t have any excess cash and so can’t afford any risk mitigation expenditures anyways.

But startups don’t stay that way forever. The business matures after a couple of years, and then there aren’t any more pivots. Instead, everything settles down, and the CEO is in a better position to analyze risks and guard against them.

Stress Testing as a Competitive Advantage

Another thought on stress testing is that doing so can give a company a major competitive advantage. The reason is that some – if not most – competitors are not doing this, so when they get hit by a major negative event, the companies that have done a better job of minimizing their risks will be in a great position to either scoop up more customers or buy those competitors for a really low price.

Stress Testing Assumptions

It can help to include stress testing assumptions in the budget documentation. To get back to the flooding example, this could be a statement that there’s a one in ten chance of flooding each year, and if the business floods up to one foot deep, that will cause a half-million dollars of damage. And if the business floods up to five feet deep, then the damage figure triples. To mitigate this risk, the budget includes five specifically identified expenditures.

This documentation helps to roll forward knowledge of the budget stress testing from one year to the next. And it’s especially helpful when someone new takes over as CEO, so they can understand why the company is spending more money in certain areas than might otherwise appear to be necessary.

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Accounting for Commercial Fishing Operations (#290)

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

Accounting for Fishing Permits and Quotas

A lot of this accounting, and really, the viability of a fishing operation, centers around the main purchases that are involved. Let’s start with fishing permits, which vary by state. They might limit the catch to a certain type of fish, and limit fishing activities to just the permit holder, or to the permit holder and a certain number of crew members. These permits are usually called limited entry fishing permits; they designate the area that can be fished, and when it can be fished. These permits usually don’t have an expiration date, and they can be transferred to another person. Which brings us to the first accounting issue, which is that many fishing operations buy their permits from someone else, which puts an intangible asset on their balance sheets. Which has to be amortized.

You might have noticed that those permits didn’t put a restriction on the amount of fish you can catch. That’s because quantity restrictions are covered by the individual fishing quota, which states a fisherman’s share of the total allowable catch. And, yes, quotas can be sold, which means that fishing operations may need to buy their quotas from someone else, which puts another intangible asset on their balance sheets. Along with the loans to pay for them.

The Fishing Operation Breakeven Point

Then we get to the fishing vessel. A small one that’s under 50 feet long will cost around $200,000, while a medium-sized one that’s up to 90 feet long will cost up to $500,000. A large one that’s up to 150 feet long will set the owners back as much as $5 million.

So as you can see, there’s a lot of fixed costs and debt associated with a commercial fishing operation. Which brings up the issue of the breakeven point. This is the sales level at which the operation can pay all of its fixed expenses. Except that for a fishing operation, what’s actually more important is the pounds of fish that have to be sold in order to break even, rather than the sales level in dollars. Which means that the breakeven calculation is total fixed expenses divided by the average contribution margin per pound of fish.

Unusual Fishing Accounts

And then we have some unusual accounts – ones that you really won’t find anywhere else. For example, there’s prepaid expenses, which is used to record any fees paid in advance for mooring or boatyard storage.

And there are some different fixed asset accounts. Obviously, there’s the fishing boat, but there are also accounts for vessel electronics, fish processing equipment, and fishing gear. The processing equipment can include things like holding tanks, separators, and my personal favorite, the automatic deheader. The fishing gear depends on the type of fish the operator has a permit for, such as crab pots, lobster traps, nets, and oyster dredges.

And then there are some unique expenses. Obviously, there’s fuel for the boat, groceries to feed the crew, bait expense, and ice expense. But in particular, there’s crew shares. The crew gets a share of the net profits from a voyage, and this can be a very large part of the total expense.

Commercial Fishing Payroll Issues

But beyond that, there’s an unusual payroll issue here. The crew might not be classified as employees, but rather as contractors. This happens when they’re only paid a share of the boat’s catch. Under this arrangement, the computation of their share of the catch includes deductions for their share of the bait, fuel and supplies. Or, if the arrangement is different on some voyages, they might be classified as employees instead. And, yes, that means they could be contractors on one voyage, employees on the next one, and contractors again on the voyage after that. It just depends on the arrangement each time.

The Capital Construction Fund

Another interesting item is the capital construction fund. This is a program that was established as part of the Merchant Marine Act of 1936. It allows a fisherman to establish a tax-deferred reserve fund to pay for the purchase of another boat, as long as it’s built in the United States. This represents quite a tax advantage, so many commercial fishing operations invest their excess cash in one of these funds, and so avoid paying income taxes. It also keeps them locked into the industry, since they avoid taxation only if they keep buying replacement fishing boats.

Permit and Quota Amortization

And then we have amortization of the amounts paid to acquire a permit and quota. These are intangible assets, so they have to be amortized over time, which reduces their carrying amount. Eventually, a fisherman might choose to go out of business, in which case the permit and quota are sold off. Since these assets have been amortized, their carrying values may be pretty low by the time they’re sold, which means that there’s probably going to be a gain on the sale – which is taxable.

A variation on this is that a permit or license can be condemned by the government, which happens when they want to reduce the total amount of fishing activity. When a condemnation occurs, the government pays out a condemnation award to the holder of the permit or quota – which results in the calculation of a gain or loss.

Fishing Accounts Receivable

The one area of accounting that’s easier for a fishing operation is accounts receivable. Most of them sell their catch to a single fish processing outfit, which means that there’s just one account receivable to deal with. Some alternatives are direct sales to auction houses and restaurants, but overall, the number of customers is quite limited.

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Economic Indicators (#289)

In this podcast episode, we discuss several key economic indicators that can show when there will be a tipping point in the economy. Key points made are noted below.

There are economic indicators that predict when you’re going into a recession, and when you’re coming out of one. Since we’re already in a huge one, I assume no one wants to hear about recession indicators. Instead, I’ll just focus on the ones that historically have predicted a rebound in the economic cycle.

We’re going to need this information, because the recovery from the coronavirus is not going to be V-shaped. It’ll be more like a gradual upward trend that’ll dribble on for several years, and that’s for a couple of reasons. I won’t try to predict when a vaccine will come out, but think for a minute about some capacity-related issues.

Despite the best efforts of Bill Gates, it’s going to take a while to produce 7 billion vaccine doses, especially since most of the existing capacity is already targeted at the production of other vaccines, such as measles and the annual flu. That production is seasonal, which leaves some production capacity, but the best current estimate is that existing capacity will only handle 600 million doses of the new vaccine per year.

Another consideration is that some vaccines require two doses, not one. For example, the shingles vaccine requires two doses. If that turns out to be the case for covid-19, then we’re looking at having to produce 14 billion doses. So in short, yes – there is a capacity constraint that will delay things.

The second issue that’ll delay the recovery is the manner in which the vaccine will be prioritized. The first batch will go to medical workers, of which there are about 17 million just in the United States. The problem is that most of them are already employed, so giving them the vaccine does not cause an upward spike in the economy.

The next batch of the vaccine will go to the at-risk population, which is everyone over 80 years old. Guess what, they’re all retired, so giving them the vaccine will also not help the economy recover. They won’t suddenly start making more money, because they’re all receiving retirement benefits. There are 16 million people in this group just in the United States.

The third batch of vaccine will go to the next most at-risk group, which is everyone from 60 to 80 years old. Unfortunately for the economy, a majority of them are retired, too. And there are 52 million people in that group just in the United States.

So in short, vaccinating these three groups – which we have to do – will chew up at least 85 million doses of vaccine just in the United States. You have to do all that before finally getting around to the main working age group, which is the one that most influences what happens to the economy. So, yes, this is going to take a while even after a workable vaccine is announced.

Weekly Rail Traffic Data

So, after all that, which economic indicators do I recommend? The trick is to find indicators that are way out in front of the purchasing process, so when there’s a spike in these indicators, it’s a clear sign that businesses are planning to ramp back up in a big way. With that in mind, my first recommendation is the weekly rail traffic data from the Association of American Railroads. This is great data, because trains are mostly transporting raw materials. They publish a chart every Wednesday that shows the total carloads transported in the preceding week, and shows the result in comparison to the last two years. Currently, the data looks bad – the numbers are far below last year. When this starts to go back up, it’s a really good sign of recovery.

Purchasing Managers Index

The next indicator is the purchasing managers index, which is released by the Institute of Supply Management once a month. Again, purchasing managers are on the front end of an economic recovery, so they’re in a good position to render an opinion. Unfortunately, it’s only an opinion. The Institute asks them if they think market conditions are expanding, contracting or staying about the same. The way the index is constructed, a score of 50 represents flat conditions. Right now, I’d be happy with that, since the current index is down at 41.5. The key here is to just look for an upward trend. It might be a while before it gets back to 50. So those too indicators are associated with purchasing.

Advanced Retail Trade Survey

For this specific crisis, a potentially really great indicator is food service and bar sales. It comes from the advanced retail trade survey that’s issued each month by the Census Bureau. The report contains all kinds of other information, but the reason the food service and bar sales piece is so important is that this is the exact area that we can’t indulge in right now, due to the virus – or at least, not without taking a lot of precautions. So when this number starts taking off, it probably means that people have been vaccinated and are feeling good enough about their prospects to go out and spend a little money.

Job Openings and Labor Turnover Report

And finally, there’s the Job Openings and Labor Turnover Report, which is issued by the Bureau of Labor Statistics once a month. It contains pretty much what the title says – job hires, separations, and openings, and it’s broken down into all kinds of subsets, like construction, government, and hospitality employment. To see what’s going on, all you have to do is watch the trend line on the report.

Out of these four indicators, I’ve bookmarked the weekly rail traffic data, and I check it every Wednesday. Unfortunately, everything else only comes out once a month, so the results aren’t exactly immediate. Still, these are good indicators for whether we’re clawing our way out of this mess.

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Environmental Accounting (#288)

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

The concept is in two parts. One is the reporting of greenhouse gas emissions, and the second part is the accounting for emissions-related fees paid by businesses.

Reporting of Greenhouse Gas Emissions

Now in the first case, there really isn’t any mandated greenhouse gas disclosure that goes into the financial statement footnotes. But, you’ll still see a lot of public companies putting out disclosures in their annual reports or in entirely separate reports. These disclosures talk about their greenhouse gas emissions and what they’re doing about it. So if these reporting requirements aren’t coming from the Financial Accounting Standards Board or the International Accounting Standards Board, then who’s doing it?

The answer is the Greenhouse Gas Protocol. It’s a nonprofit that’s come up with a really good reporting system. You can download it for free as a PDF by going to ghgprotocol.org and clicking on their Corporate Standard link. A big part of this reporting is based on what they call measurement boundaries. The most narrow definition of a company’s carbon emissions is called scope 1, which is direct emissions by the business. So if you’re running a diesel tractor on your farm, the emissions from that tractor fall within scope 1. Or, if you have your own fleet of delivery trucks, their emissions are also listed within scope 1. After that is scope 2, which is purchased indirect emissions – in other words, the emissions of the power plant relating to the electricity that you bought from it. According to the protocol, any business reporting its greenhouse gas emissions should do so for both scope 1 and scope 2.

In addition, the protocol also lists a scope 3, which is indirect emissions from third parties. For example, this can include the emissions related to airline travel by employees, or the carbon emissions from the cars of your employees when they commute to and from work. This is a lot more difficult to calculate, so the protocol leaves this as an optional reporting area.

Calculation of Greenhouse Gas Emissions

What about actually calculating your greenhouse gas emissions? The protocol lists a lot of ways to do that. The easiest approach for most firms is the indirect approach, where, for example, you track down the documented emissions of a similar building to the one your business is occupying, adjust for the square footage, and there you go – instant emissions information. But the protocol has more detailed tools on their website, in the form of downloadable spreadsheets that list more specific emissions data for all kinds of things, like different fuels and types of vehicles.

For example, you can use the company’s utility bills to figure out the amount of power purchased from your power company, figure out what type of energy source they’re using, like coal or natural gas, and then derive the emissions from a spreadsheet on the Protocol website. It’s not easy, and you’re bound to miss something on the first try, but this is a decent way to figure out your emissions number.

Bu this is not just a nice reporting system. You can actually use it to save money, too. Emissions come from the release of energy, and energy is expensive. So by cutting emissions, you’re also cutting energy usage, which in turn reduces your cost of energy, and increases profits.

Greenwashing

So, that was the upside of emissions reporting. There’s also a downside, which is called greenwashing. This is when management deliberately messes with the data to make the company look more green than it really is. For example, by outsourcing your manufacturing operations, the company is using less energy within the scope 1 category – which everyone reports. The operations were moved to a third party, which falls into category 3 – which almost no one reports. And yes, people actually do that.

Accounting for Emission-Related Fees

Now, there’s also an accounting aspect to environmental reporting. Some governments operate a cap and trade system. This is a system for controlling emissions. It sets an upper limit on the amount that can be emitted by a business – but – it allows for additional capacity to be purchased from some other business that hasn’t used its full allowance.

In a lot of cases, the initial allowance is granted to a business by the government for free, and each year, the government makes that allowance a little bit smaller, which puts pressure on the business to reduce its emissions. One way it might buy additional capacity is to get it from an operation that commits to planting a certain number of trees every year, which sequesters carbon.

The accounting that’s used for this arrangement in Europe is called the net liability approach. What they do is record the emissions allowance at its acquisition amount – which is usually nothing. Then they only record a liability when the actual emissions liability exceeds the amount of the allowances held by the company. If there is an emissions liability, then they record it as an intangible asset. Then they clear it off the books at the end of the year, when they report their actual emissions and the offsetting allowances to the government.

So for example, you’ve run the numbers for your scope 1 and scope 2 reporting, and you realize that you’re going to come up short by 1,000 tons of carbon emissions. So, you buy the emissions credits from wherever you can buy them for the least amount – maybe it’s a forest planting operation in Romania – and it costs you $10,000 for the credits. That’s recorded as an intangible asset, and it’s charged off at the end of the period. That’s a pretty easy accounting system, so of course I approve. When in doubt, keep it simple.

IFRIC 3 Reporting

Now, a much more complicated system was proposed by the International Accounting Standards Board back in 2005. It’s called IFRIC 3. Which sounds like a Viking war leader, but it’s actually the name of the committee, which is the International Financial Reporting Interpretations Committee. They suggested that those allowances granted by the government be measured at their fair value, which would result in the recognition of a gain. That’s because getting them for free from the government is definitely less than what the allowances would trade for on the open market. And, they wanted businesses to recognize a provision each month for a company’s emissions-related liability, which would be measured at the market value of the allowances needed to settle it.

I won’t get into a complicated example to show how all that works, since – luckily – the standard was never approved, and nobody does it this way. It’s a good example of presenting a theoretical approach that looks good on paper, but it’s difficult to implement – sort of like our new lease accounting standard.

Donation Suggestion

And here’s a recommendation for you. My wife and I pay the National Forest Foundation to plant 6,000 trees every year, which they do for a dollar a tree. That sequesters about 3,000 tons of carbon over the life of those trees. We’re going to keep doing that for as many years as we can, since global warming is the defining issue of our times – the coronavirus is bad, but that will go away when a vaccine is rolled out. That’s not the case for global warming, which is not going away. If you want to donate to the national forest foundation, their website is nationalforests.org.

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Pandemics and Business Planning (#287)

In this podcast episode, we discuss the impact of a pandemic on business planning. Key points made are noted below.

Planning for the Next Pandemic

Right now, we’re just trying to get through the covid-19 pandemic, but it might be time to consider what impact it will have long-term, on business planning. Obviously, no one planned for it. But, maybe it’s time to start planning for the next one. You might say that the last big one was the Spanish Flu, in 1918, and with such a big gap since then, why bother to plan for it? A key point is that the Spanish Flu was not the last pandemic. According to the Centers for Disease Control, there were declared pandemics in 1957, 1968, and 2009. That means the last one was just 11 years ago, and there have now been four of them in the past 63 years, or one every 16 years, on average. The 2020 pandemic just happens to be worse, because it’s much worse than the average flu, and its mode of transmission makes it easy to pass along.

So, based on recent history, there’s about a six percent chance that a pandemic can arise in any given year. From a risk management perspective, something that can kill your business and which might pop up every 16 years or so is worth some advance planning. That’s right up there with planning for the occasional flood if your business is located in a flood plain.

Breakeven Point Analysis

So, what can we do? First, when engaging in planning, elevate the focus on your breakeven point and how long you can stay in business before running out of cash. By keeping the sales breakeven point as low as humanly possible, your company can still stay in business even when sales drop by a lot. For example, restaurants are being closed because of the pandemic, but you can still order take-out in some places. If I were a restaurant owner, I’d have a plan in place to survive on those takeout sales, which might even include a low-cost marketing plan to tell customers that the business is still open. Or if you’re a gym owner, is there a backup plan to do video training sessions with clients, which everyone can do from home if the gym is shut down by the government?

Cash Analysis

And then there’s that second issue of having enough cash to stay in business. I know a lot of business owners maintain awfully small cash reserves, so they can shovel more money into growing their sales or investing in more assets. But, it might be time to think about being more prudent and scaling back on those growth plans in order to keep extra cash in reserve.

Debt Maturity Dates

Another point is to shoot for debt with longer maturity dates. Sure, you might only need a loan for the next year, but to have extra cash on hand as a reserve, and if the interest rate is low enough, you might want to consider applying for something a lot longer, like a five or ten year loan, or a bond offering – just to have the extra cash reserve in case a pandemic comes along.

Sale of Shares

And along the same lines, if you’re planning to sell shares anyways, then sell more shares. Build up the equity reserve in the business – again, just to keep that extra cash on hand. It also reduces your debt-equity ratio, which might be useful if you ever need to apply for a loan.

Rent Analysis

Another thought is rent. This pandemic is forcing a lot of us to work from home, so talk to your staff about how this is working out. It’s quite possible that this becomes the new normal, where way more employees stay home. Sure, there’s some added complexity in terms of everyone having a decent Internet connection, and computer equipment, and doing Skype calls, but is it really that hard? If this concept looks doable, then take a hard look at how much office space you really need for the company. When your office lease expires, you might want to move into something smaller instead. Which reduces the cost of rent, which reduces your breakeven point even more. I think this’ll be one of the most interesting items to come out of the pandemic. Expect to see a depressed commercial real estate market, maybe for several years.

A nice side benefit of using less office space is the reduced cost of utilities. You don’t have to pay as much for electricity or water, or trash removal, or heating and air conditioning, because less space is being used.

Business Travel Analysis

And an additional thought regarding the work-from-home culture is reduced business travel. Some in-person time is always needed, but it’s entirely possible that a good chunk of those business trips could have been handled through a video call instead. Which reduces the travel budget.

Virtual Conferencing

Another possibility. I totally expect a huge business to spring up for virtual conferences. Not sure how the technology will work, but it makes an awful lot of sense to shift over to this format. Especially when conferences are such a high-grade way to spread a virus to a lot of people within a short period of time.

Supply Chain Analysis

Another issue is supply chains. So far, the emphasis has been on driving costs down by sourcing components all over the world. Now, keeping costs down obviously allows a business to stay competitive, but those supply chains might be worth a rethink. Look at where your most critical components are coming from, and see if they can be sourced really close to home instead. This means balancing the higher cost of local sourcing against the reduced risk of being able to buy from a supplier who’s really close – and who’s more likely to stay open during a pandemic, without having to worry about borders being closed.

If you were to do this with all suppliers, the cost would probably jump too much to keep the company competitive, so instead, look at just those components that are most at risk during a pandemic.

Inventory Stockpiling

And along the same lines, it might make more sense to keep a reasonable stockpile on hand for the most essential components. For the past few decades, the focus has been on driving down inventory levels in order to reduce your investment in working capital. That’s fine, but a massive supply chain disruption like a pandemic can wipe out your production operations overnight.

Again, I’m not recommending a complete transition to massive piles of inventory. Just take a look at what’s really essential, and work on a plan to gradually build up the stocks of those items – at least enough to tide you over through a month or two of disruptions.

Compensation Analysis

Here’s another thought. Compensation structures. It might make sense to explore more extensive use of profit sharing with all employees. The point is to drive down base pay levels to keep a nice, low breakeven level for the company as a whole, but to also hand out some rich paychecks when there’re profits. That way, with low base pay, the company can afford to stay open longer in the event of a pandemic, rather than having to lay everyone off.

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Budgeting

Business Strategy

Accounting for Investments (#286)

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

Initial Accounting for an Investment

First of all, how do you initially account for any investment? When you buy a security, the initial cost of the investment is the purchase price, plus any brokerage fees, and service fees, and taxes paid. This becomes the initial carrying amount of the investment. On the back end, when you sell a security, the net proceeds are the selling price, minus any brokerage fees, service fees, and transfer taxes paid. The difference between these two figures is the gain or loss on the investment. If the accounting standards require that you adjust that initial carrying amount to the fair market value of a security, but you haven’t sold the security yet, then any gain or loss is considered to be unrealized. When you do eventually sell the security, then any associated gain or loss is said to be realized.

Classification of Trading Securities

A business may have debt securities that it acquired with the intent of selling them in the short term for a profit. These are classified as trading securities, and you have to adjust their carrying amount at the end of each reporting period to their fair values. If there’s a gain or loss on this adjustment, you record it in earnings.

Classification of Held-to-Maturity Investments

Next up, a business might have a debt security that it acquired with the intent of holding it all the way to maturity. It’s called a held-to-maturity investment, and there is no adjustment to fair value in each period. The reason is that it’s a debt instrument, like a bond, and you’re planning to hold it until maturity, when you get paid the face value of the instrument, so logically, there’s no need to worry about a gain or loss, because as of the maturity date, there won’t be one.

Classification of Available-for-Sale Investments

And finally, any other security that’s not classified as a trading security or a held-to-maturity investment is classified as available-for-sale. It’s not held strictly for short-term profits, but it’s also not expected to be held-to-maturity. If you have an unrealized gain or loss for this kind of security, it gets recorded in other comprehensive income, which is essentially a parking lot for gains and losses until the security is actually sold. When it is sold, the gain or loss is shifted out of other comprehensive income and into earnings.

Recordation of Equity Securities

Which brings us to the first change to the accounting standards for investments, which is that those three classifications now only apply to debt securities. Equity securities used to be classified as either trading investments or available-for-sale securities, but now they’re just treated as equity securities. You initially record these equity securities at their acquisition cost, and then adjust their carrying amount to their fair value. Any unrealized holding gains or losses are included in earnings. And here’s a new item: There’re lots of cases where you can’t determine the fair value for an equity security, such as shares in a privately-held company. When this is the case, you can now use what’s called the practical expedient of estimating fair value. This means estimating fair value at its cost minus any impairment, plus or minus any changes resulting from observable price changes in orderly transactions for a similar investment of the same issuer.

Now, let’s cut through that really long sentence to figure out how you actually value these shares. You start by initially recording whatever you paid for them. After that, you have to monitor the prices at which the issuer is selling similar securities or the prices at which these shares are being sold between third parties, and develop a guesstimate of a market value from there. I suppose that’s sort of guidance, but the real issue is that these types of shares are usually restricted, so they can’t be traded. And the issuer may only sell shares every five or ten years. So, realistically, the practical expedient sounds good, but there’s just not enough information out there to value shares that aren’t being traded on an exchange. In which case, you may end up just leaving them on the books at their initial acquisition cost.

Impairment Analysis

No matter what kind of investment you have, debt or equity, you still need to evaluate it for impairment, and take a write-down from its carrying amount down to its fair value if there is an impairment. There are a bunch of indicators of impairment. The issuer could have reported a significant deterioration in its earnings, or it just got hit with more restrictive regulations, or its industry could be going through a downturn, or it might have just reported that it can’t continue as a going concern. In short, you need to periodically investigate the financial circumstances of the issuer, to see if the related investment is still viable.

Accounting for Credit Losses

Which brings us to the other new accounting item relating to investments, which is credit losses. When a business has debt security investments that it’s classified as held-to-maturity, it may need to set up an allowance for credit losses. This is a reserve account that’s deducted from the carrying amount of those securities on the balance sheet. This means that you have to fund that reserve account by charging a credit loss expense in whatever amount is needed to top up the reserve account.

There’s no single mandated way to estimate the amount of this credit loss, though a probability of default method seems reasonable. Whatever you use for the analysis, just be consistent about using it, so that you can justify it to the auditors at the end of the year. And by the way, you don’t have to record a reserve at all, as long as your historical credit loss information, adjusted for current conditions and forecasts, shows a nonpayment risk of zero.

As long as you invest in high-grade debt securities where the default risk is minimal, you can probably get away without recording a reserve. But if your treasurer wants to invest in something riskier, then expect to do some analysis to arrive at a reserve amount. Consider talking to your auditors in advance of year-end about setting up this reserve. They may have some suggestions about how to calculate and document it.

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Accounting for Investments

The Nonprofit CFO (#285)

In this podcast episode, we discuss the concerns of the nonprofit CFO. Key points made are noted below.

Cash Flow Issues

The main issue with nonprofits is incoming cash flow. The business has no equity, since it’s a nonprofit, so it’s impossible to sell shares – though a larger nonprofit may be able to take out a loan – but don’t count on it. Instead, cash flow comes from revenues and donations. The CFO has to be totally on top of the entire cash flow situation, since most nonprofits don’t have a whole lot of cash reserves to fall back on.

Instead, if cash receipts decline, then the CFO needs to slash expenses right away, to maintain a positive bank balance. So, the first thing for the nonprofit CFO to watch over is a really detailed cash forecast. You’ve got to watch it constantly, which is not always the case for a for-profit business that’s flush with cash. Instead, assume that any hiccup in the cash flows will kill the business, so watch the forecast like a hawk.

Expense Monitoring

The second item to watch out for is the offsetting expenses. The expenses actually incurred have to match the budget, because there’s usually not enough excess cash on hand to cover a spike in expenses. And so, this means that the CFO has to monitor expenses much more than would be the case with a for-profit business, and investigate any expense overages in detail – especially to see if those overages are going to be recurring. If they are, then that’s an unplanned drain on cash, and that’ll require an immediate redo of the budget to at least keep cash flow neutral.

Revenue Management

The CFO doesn’t just sit behind the scenes and analyze numbers. Instead, you have to work on every possible revenue management idea, to squeeze the largest possible amount of cash out of customers and donors. This can include things like pop-up reminders on the nonprofit’s website to donate your old car to charity, or listing the nonprofit in your will. The range of possible fund raising opportunities here is endless. The CFO can benchmark what other nonprofits are doing, to see if any of their techniques can be used. Again, positive cash flow is king, so the CFO has to be constantly working on improving it.

Donation Management

And… the CFO needs to be even more active than that. Donation management is a big deal. You have to track who has promised donations, and in what amounts, and when the payments are supposed to be made. There can be some debate over who is supposed to contact donors if those payments are late, but it’s entirely possible that the CFO will have to get directly involved. It all depends on who the donors are accustomed to dealing with, since they may want the same point of contact for all donations.

And once donations are received, they may not be in cash. They might be stock certificates, or works of art, or old cars, or even real estate. When a donation is not in cash, the CFO needs to figure out what to do with it, which usually means converting it into cash as soon as possible. So, expect to spend some part of your time working with brokers to sell off assets.

And, of course, the CFO needs to continually work on donation plans for the future, since some donors will drop out every year as they die or move away, or maybe their economic circumstances decline. This means targeting existing donors for more money, and planning to locate new donors, and maybe even some occasional contacts with old donors to see if they might be brought back in.

Capital Improvements

And on top of all that, the CFO needs to plan for capital improvements. The organization might need a new building or equipment at some point, or maybe new vehicles. Whatever it might be, there’s probably no cash reserve to pay for these things, so the CFO will need to figure out a fund raising campaign for each one, usually by targeting specific donors or local businesses who’ve donated to the nonprofit in the past. This can be a major effort that takes up a large part of the CFO’s time.

Summary

A common theme running through these points is the ongoing need to look for cash. This is much worse than with a for-profit business, so if you’re not comfortable with it, stay away from the nonprofit industry. Also, making the incoming and outgoing cash flows balance is difficult, so cash forecasting is a much more significant chore than is usually the case.

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CFO Guidebook

Nonprofit Accounting

Economic Nexus (#284)

In this podcast episode, we discuss economic nexus as it related to sales taxes. Key points made are noted below.

Recent Sales Tax History

Until 2018, a company could sell into another state and not have to withhold any sales taxes, as long as it had no nexus in that state. This meant that it had no facilities or employees in the state, and didn’t use its own vehicles to deliver goods there. This became a major problem for the state governments, which were losing all kinds of sales tax revenue, because so many sales were being made over the Internet, and so goods were being shipped in from out-of-state.

And then came the South Dakota vs. Wayfair decision by the Supreme Court in 2018. In that case, South Dakota claimed that an Internet store, Wayfair, had to collect sales taxes from its customers in South Dakota and remit those taxes to the South Dakota government. The Supreme Court agreed with South Dakota, partially because that state had set up a sales tax collection scheme that was quite simple, so the Court stated that it didn’t impose a burden on interstate commerce.

Economic Nexus

The Wayfair case means that the concept of economic nexus is now a major issue for anyone selling to customers located in another state. It’s created when a business generates a certain amount of sales in a particular state. Some state governments measure this figure based on the overall dollar amount of transactions generated, while others combine the concept with the total number of individual sales transactions completed.

The state governments have mostly set up economic nexus rules, though a few are still hashing out the details. At the moment, it looks like the most common threshold for having to withhold sales taxes is having $100,000 of sales into a state or 200 separate sales transactions. So, for example, you have to start collecting sales taxes if you sell $100,000 or have 200 sales transactions into the state of Ohio. That word “or” is important. For most businesses, selling 200 transactions into a state is going to come way before $100,000, so that’s the operative threshold. However, one state – Connecticut - has set up the rule differently, so that it’s $100,000 and 200 sales transactions, which is a threshold that’s quite a bit harder to reach.

And a few states have set higher thresholds – which they could change at any time. For example, the dollar threshold for Alabama is currently $250,000, while it’s $500,000 in California, New York, Tennessee, and Texas.

Applicability of Economic Nexus

So who cares about these threshold limits? Smaller business do – like mine. At the moment, AccountingTools collects sales taxes for Colorado, which is our home state, and Ohio, where we exceed the minimum threshold for economic nexus. And we’re also keeping close watch over Florida, which is getting close to passing a sales tax that will probably require us to collect sales taxes there, too. In fact, it’s reached the point where we check all of the state sales tax laws once a year, just to see if anything has changed.

Paying Sales Taxes to Other States

So, let’s say that your company exceeds one of these thresholds. What then? Ohio is a good example. They have a centralized web site where you can remit sales taxes for all locations into which you sold products during the reporting period, so it’s pretty much a case of making one payment and you’re done.

Except for one thing, which is that Ohio currently has 98 different sales tax jurisdictions, so the sales tax where one customer is located may be entirely different from the sales tax for a different buyer in the next town over. This is kind of tough if your accounting software doesn’t charge the correct sales tax based on the customer’s exact location. If the software only has a single tax rate per state, then you can only charge the portion of the sales tax that applies to the entire state – which is currently 5 ¾ percent for Ohio – and then pay any additional sales tax out of your own pocket.

And in case you think the scenario I’ve stated for Ohio isn’t good – that’s actually one of the better-run sales tax systems in the country. For a really bad one, let’s take a look at Colorado. In that state, most of the larger cities collect their own sales taxes directly, rather than having the state government collect it for them. What this means for us is that we have to pay for an annual sales tax license with each one of these cities, and make separate sales tax filings to each one. Right now, we have sales tax licenses with 20 cities in Colorado, which cost anywhere from $10 to $50 per year. Our actual sales tax payments are so small that we pay three times more for sales tax licenses than we do in actual sales taxes.

It’s so bad in Colorado that I really do recommend that if you have a choice of places to put your business, put it somewhere besides Colorado, and configure your systems to deny sales to any customers located in the state. It’s really that bad. And to make matters worse, there are currently 328 different sales taxes in Colorado, which can vary even by which side of the street you’re on, which makes it almost impossible to calculate the correct tax.

And if you think that’s bad, Colorado isn’t even in the top 10 states for the number of different sales tax jurisdictions. At the top is Texas, with 1,594. Then there’s Missouri, with 1,393, and then Iowa, with 1,002. And in case you’re curious, only eight states have imposed a single state-wide sales tax. Every other state besides those eight is going to cause trouble.

The point being that some states are accepting the new economic nexus concept pretty well, while others are so screwed up that they’re going to drive small companies crazy. I think the logical outcome is that a lot of small businesses are going to ignore it, and make the state governments come after them for payments. If a small business tries to be in compliance with the new rules, then there’s a good chance that they’ll have to pay for a portion of the sales taxes out of their own pockets, which could wipe out part of their profits.

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Form 1099 Compliance (#283)

In this podcast episode, we discuss how to deal with the Form 1099. Key points made are noted below.

Background on the Form 1099

For those not involved in accounts payable, the Internal Revenue Service requires that the 1099 form – and there are a bunch of variations on it – be compiled following the end of each calendar year to show the grand total of different types of payments that businesses have made to third parties. A copy goes to the IRS, and the applicable state government, and to the third party that was paid.

Why is this important? After all, it’s just an informational return. The payables department isn’t submitting a payment along with the return. Well. The IRS uses it to uncover cases in which payments have been made to suppliers that it might not otherwise have been aware of. And it serves as a useful memory jog to the supplier, who now realizes that the IRS knows that they were paid something, and just might start making inquiries if those payment amounts aren’t included on its income tax return.

In particular, let’s talk about the listener’s question about how accurate these forms are supposed to be. The answer is – very accurate. If you’re not accurate, you’re screwing over the supplier, who has to explain to the IRS why the amount reported on the Form 1099 is incorrect in some way. This brings up a few best practices to implement.

Form 1099 Best Practices

First, a major component of a Form 1099 is getting the taxpayer identification number right. To do so, always require suppliers to provide a Form W-9 before you ever pay them any money. And if you don’t know, the Form W-9 requires the supplier to document its taxpayer identification number and the type of organizational structure. In fact, it’s called the Request for Taxpayer Identification Number and Certification.

Requiring a Form W-9 right away is essential, because at that point you have all sorts of bargaining power over the supplier. Which is – you don’t give me a W-9, I don’t give you a payment. This is important for another reason, which is that, if the supplier can’t provide a taxpayer identification number, then you have to withhold 24% of each payment and forward it to the government. If you don’t do that, then you’re liable for the withholding. So, it makes all kinds of sense to get a W-9 right away.

Another best practice is to review the payables records well in advance of year-end to see if any suppliers are being paid through several different vendor accounts. You might need to consolidate these accounts so that a single Form 1099 can be issued.

And speaking of starting early, a third best practice is to do a full review of the detail for all proposed 1099 forms a month before year-end. Examine each expenditure to make sure that belongs on the 1099, and that it’s going to be stated in the correct box on the form. Otherwise, you’re going to be in a rush to do this review in January, since the completed forms – in  most cases – have to go out by the end of January.

It makes sense to straighten out these problems up front, because if you send out a 1099 that’s wrong, the IRS will eventually send back what’s called a “B” notice, saying that you got something wrong – it’s usually the taxpayer identification number. Which means that you have to research the problem and then issue a corrected 1099 – all of which takes time. And along the same lines, it’s quite possible that suppliers will take issue with the numbers you stated on their 1099s – which means that you have to spend even more time dealing with irate suppliers, and doing even more research based on their complaints. So, in short, do as much work up front as possible, to avoid problems down the road.

Let’s try a fourth best practice. Set up a procedure with the mail room staff, where any 1099 mailings returned by the Postal Service as having incorrect addresses are sent straight back to accounting, to be fixed. When these forms show up, drop everything, figure out where the supplier went, and mail it out again. Otherwise, imagine the situation from the perspective of the supplier. The IRS comes after them for income that the IRS was warned about, but which the supplier never received from the company. Kind of like being blindsided.

Form 1099 Penalties

You may not think that you have time for this, and it’s just fine for me to talk about your responsibility to issue accurate filings. OK. Let’s talk about penalties instead. The IRS recently changed its penalty system for late or missing 1099 filings. If your company has sales of at least $5 million, and you submit 1099s a month late, then the IRS will only charge you $50 per missing return, with a maximum penalty – get this – of $556,000. And what if you never send one in? Then the penalty is $550 per return, with no limit on the maximum penalty. And there’re increasing penalties if the filing is later than one month.

What if your company is smaller than $5 million in revenues? Then the penalties per missing form are the same, but the penalty caps are smaller. So for example, if a smaller business only submits a 1099 a month late, then the maximum penalty is reduced to about $195,000. That’s a lot of money for a small business. And there’s no cap at all on the penalty if the 1099s are never turned in. So, yes, you want to do a good job with 1099 filings.

Elimination of the Form 1099-MISC

And one more topic. A listener requested that I talk specifically about the Form 1099-MISC. The trouble is, that’s not really the form anymore. The key part of this form, which is the nonemployee compensation box, is being moved to the Form 1099-NEC as of the calendar year 2020. Nonemployee compensation is by far the most commonly-reported item on the 1099, so just be aware that you’ll be dealing with a new form right after 2020 is over.

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Key Performance Indicators (#282)

In this podcast episode, we discuss key performance indicators, or KPIs. Key points made are noted below.

Definition of a Key Performance Indicator

The standard definition of a KPI is that it’s a measurement for monitoring progress toward achieving a key goal. It has to be a major contributor to the success or failure of the business, it has to be controllable, and it has to represent the actual performance of the company. So why do I bring up KPIs on an accounting podcast? Because the controller always gets stuck with reporting it. Which isn’t right, as you’re about to find out.

Why Accounting Should Not Report Key Performance Indicators

Management frequently thinks that KPIs are just another measurement, so they tell the controller to create a KPI category in the month-end reporting package, and report them there. There are a couple of problems with doing this. The first one, and it’s big, is that KPIs are never, ever financial. When the controller lists profits as a KPI, that’s just wrong. Profits are a result of how well – or not – the company has been handling its actual KPIs. Financial results are just the outcome. Therefore, revenue is not a KPI, and the return on investment is not a KPI and nothing else in the financial statements or derived from them is a KPI.

How Key Performance Indicators Should be Used

It might be helpful to show what actually is a KPI. Let’s say that you’re running an airline. If so, a reasonable KPI is the number of planes that arrive more than 15 minutes late. Customers tend to get pissed off when their flights persistently arrive late, so they’ll look elsewhere the next time around, which means that the airline loses money if its planes arrive late. Ideally, this metric should be reported to the airline president every day – who then badgers everyone in the organization about why those flights were late. Maybe it was due to the assigned gate being occupied by another plane, or a passenger arriving late on the front end of the flight and having to wait for him, or maybe there was a maintenance problem that should have been fixed the week before. Some of these issues are outside of the airline’s control, but a lot of them can be fixed.

So let’s compare on-time arrival to the definition of a KPI. First, it’s a measurement for monitoring progress toward achieving a key goal. Check. The goal is to never have a flight arrive late. Second, it has to be a major contributor to the success or failure of the business. Check. If planes are late all the time, customers will go elsewhere. And third, it has to represent the actual performance of the company. Check. The reason for late arrivals has to do with a swarm of operational issues within the company, all of which can be improved.

Let’s try a few KPIs in other industries. Like consulting. A good KPI is the number of job offers outstanding today that have been open at least a week. Why is this a KPI? Because the lifeblood of a consulting business is having high-quality staff, and if you can’t hire any, the business will fail.

Let’s try restaurants. A good KPI is the number of chefs who have resigned in the past day. This one should be obvious. When the chef leaves, junior staff have to fill in, so the quality of the food goes down. If you don’t get a replacement chef really fast, the restaurant goes out of business.

How about any supplier? A good KPI is the number of late deliveries today to key customers. You can’t afford to be late with these customers, because they’ll stop buying from the company, and then you’ll go out of business.

As you can see, none of these KPIs have anything to do with the numbers found in the financial statements, so the controller can’t do much about them.

Frequency of Reporting

Which brings up the second problem with having the controller report KPIs – which is that they need to be reported every day, not at the end of the month. A KPI should be so critical that you have to deal with it right away, or else the business is screwed. If you can afford to wait a month to look at it, either you have a poor attitude about how to run the business, or it’s not a KPI.

So can the controller realistically be expected to report on KPIs every day? No. Instead, it needs to come from whoever is in the best position to report on it. Getting back to the airline example, that’s probably the IT department, which aggregates information about airline arrival times. In the case of the consulting department, the number of open job offers obviously comes from the human resources department. What about the restaurant? That would also be human resources, though if the business is small enough, I think the owner’s going to find out about the departure of a chef pretty fast from any number of people.

And finally, if deliveries to customers are late, this either comes from the shipping department or the IT department, depending on how the company’s information system is organized. Notice that in none of these cases does KPI information originate in the accounting department. It’s pretty rare for any business to have a KPI that has anything to do with accounting.

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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.

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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