Nonprofit Accounting, Part 2 (#303)

In this podcast episode, we continue with the discussion of accounting issues that are unique to nonprofit entities.

Pass-Through Contributions

In this episode, I’ll go into some accounting issues that you just don’t see outside of a nonprofit. The first of these is pass-through contributions. This is when a nonprofit raises money on behalf of other nonprofits – and then it passes through all the funds it receives. For example, a nonprofit might have a separate foundation whose sole purpose is to raise money for the nonprofit. The accounting by this pass-through organization is to record an asset in the amount of the donation, and a liability to pass it through. The pass-through entity never records any revenue.

However, there’re two cases where the pass-through entity could record the donation as revenue, and then the funds transfer to the nonprofit as an expense. In the first case, the donor grants variance power to the pass-through entity, which gives it the unilateral power to direct where the funds go. This power allows the pass-through entity to override the wishes of the donor, so a lot of donors aren’t going to agree to it.

The other situation in which the pass-through can record a donation as revenue is when it’s financially interrelated with the nonprofit to which the funds are being sent. This is the case when one of the parties can influence the financial and operating decisions of the other. I only bring this up because pass-through entities are really common among nonprofits, so their accountants have a deep knowledge of all the associated reporting rules.

Accounting for Government Grants

And then we have government grants. When a nonprofit receives a grant, this is basically a contribution, since the money doesn’t have to be repaid. If a grant is paid in advance of a nonprofit actually doing anything, then the money is booked into a net assets with donor restrictions account. When funds are spent against these grants, an equal amount of money is released from the net assets account. This means that the amount spent matches the amount released.

An alternative approach is for the nonprofit to spend the money first and then apply for a drawdown of a matching amount from the grant.

Depending on the terms of a grant, a nonprofit might only be able to charge the direct costs of an activity against it. That means the cost of the materials and staff directly related to the program that a grant is funding. But in some cases, a nonprofit can also charge an additional amount against the grant, which is called the indirect rate. It’s basically an overhead charge. There are a couple of ways to derive the indirect rate, which are defined by the Office of Management and Budget. If you really want to get into that, then look up their Circular 122 for more information.

The indirect rate is a big deal, because it allows a nonprofit to get paid for some of its general expenses. This gets back to my earlier point in the preceding episode about the pressure that accountants are under to record as many expenses as possible as program expenses, because doing so can attract donors. When they can’t do this, then the indirect rate applied to grants provides nonprofits with a good way to pay for some of those non-program expenses. This is one of those rare areas where proper accounting can improve the financial health of a nonprofit.

Accounting for Donations

Let’s switch to another area. Donors contribute all kinds of assets to nonprofits. Let’s say somebody donates a delivery van to a nonprofit. How do you account for that? The van is recognized at its fair value as of the date of receipt. There’re three ways to derive the fair value. For the van, the most likely approach is to use market prices, since there’s a large market for used vehicles.

If it were some other type of asset for which there isn’t much of a resale market, then you might need to derive a fair value based on the discounted cash flows that can be generated by the asset – such as when a rental property is donated. Or, you could derive its current replacement cost, which is essentially the cost to buy or build a substitute asset.

A pretty common donation is stock. You should account for this at its fair value on the date of receipt, which means using the price at which the stock is trading on that date.

From the accountant’s perspective, it can make sense to create a policy for how to recognize the fair value of assets, so that there’s a standardized approach to doing it. This shouldn’t be too hard, since the typical nonprofit is going to receive roughly the same types of assets from donors on a recurring basis.

For example, a land preservation nonprofit is probably going to have a lot of land donated to it, so it needs to have a rock-solid process for valuing donated land. It probably doesn’t have to worry about valuing donated machine tools, because it isn’t going to receive any.

Accounting for Donated Works of Art

What about donated works of art? It’s still an asset, so it’s recorded at its fair value, and that’s the amount also recorded as revenue. Usually, an appraiser has to be brought in to determine the fair value.

Now, let’s say there’s some damage to a donated painting. In that case, you can capitalize the cost of major restoration work. The painting is not depreciated, since it’s supposed to have an indefinite life. More on that in a moment. But the cost of the restoration can be depreciated, where the useful life goes until the date of the next scheduled restoration. So if that’s going to happen 50 years from now, then that’s the period over which you depreciate the cost of the restoration.

I just mentioned that artwork is not depreciated. That’s not entirely true. There’s no depreciation when the intent is to preserve it forever, and the nonprofit has the ability to do so, such as by setting up a protected environment, maybe with controlled temperature and humidity levels. This places the accountant in the extremely odd position of deciding whether works of art need to be depreciated. I’ve never seen a business school offer a course in art preservation, so it’s safe to say that no accountants on the planet are qualified to do this. And yet, the judgment is supposed to be made. This probably calls for an annual meeting with those people on staff who actually know about it, to talk about whether any artwork is degrading. If so, some depreciation is in order. And document that meeting, because the auditors will want to look at it.

Things get a bit more complicated if a work of art is considered to be part of a collection. In that case, an alternative approach is to not record the artwork at all. If you do that, and then contribute the work of art to another nonprofit, then you can’t record an expense. But, if you had recorded the artwork as a fixed asset, then you can record the donation as an expense.

And for a quick aside on works of art, I grew up in the town of West Newbury, in northeastern Massachusetts. About 20 years ago, the pastor of All Saints Episcopal Church in West Newbury discovered a Renaissance painting sitting in its attic that was worth $1.1 million. The point being, get everything appraised.

Related Courses

Nonprofit Accounting

Nonprofit Accounting, Part 1 (#302)

In this podcast episode we discuss the characteristics of nonprofit entities and several unique accounting issues.

The Purpose of a Nonprofit

As the name implies, a nonprofit organization is not in the business of earning a profit. Instead, it has some other operating purpose, it has no ownership interests at all, and a good chunk of its income comes from contributions. There are all kinds of nonprofits out there, such as animal shelters, churches, art museums, and food banks. A few of the better-known ones are Doctors without Borders, the American Heart Association, and the Sierra Club.

Net Assets in a Nonprofit

The accounting for a nonprofit varies a fair amount from what we use in for-profit businesses. I already referred to one of them, which is that a nonprofit has no ownership interests. This means there’s no equity. There’s no account for its common stock, or additional paid-in capital, or retained earnings. Instead, a nonprofit has net assets – which, despite the name, takes the place of the equity section on its balance sheet.

Types of Donations

What goes into the net assets section is mostly contributions from donors. They’re split up into two pieces, one of which is net assets with donor restrictions, and the other is net assets without donor restrictions. As an example of donor restrictions, you donate a pile of money to your local zoo, but with the restriction that it all be spent on the hippopotamus enclosure, because you like hippos. Which is a mistake, by the way. They’re smelly and aggressive. Anyways, the zoo has to record your contribution in the account for net assets with donor restrictions. If you had instead just sent in your money, then it would have gone to the net assets without donor restrictions account.

And incidentally, this is a big problem for a lot of nonprofits. They need people to make unrestricted donations, so that they can use the money to pay for their general and administrative activities, but the biggest donors are the ones most likely to put restrictions on their contributions. Which means that a nonprofit can be in the odd position of having a lot of assets, but not enough cash to pay for basic operations.

The Statement of Activities

Now, let’s move over to a nonprofit’s income statement – which is called the statement of activities. The main issue here is that the presentation is not the usual revenues and expenses format.

Instead, they have to subdivide everything into programs, fundraising activities, and management and administration. Programs are the key part. They’re the expenditures made for the main purpose of the organization. For example, one of my main charities is the National Forest Foundation, and one of their biggest programs is tree planting. Or, if the nonprofit is a food bank, then the main program is providing meals to people. The other two categories are pretty self-explanatory. The fundraising section includes expenditures for things like writing grant proposals, sending out email solicitations, and doing fundraising events. All of which is unique to nonprofits. In a for-profit organization, the closest equivalent would be sales and marketing.

Which brings us to the final classification, which is the management and administration classification. This contains everything else, such as accounting and finance, human resources, and legal fees.

These classifications are important, because big donors will only contribute money when they see that most of the funds they pay in are going to programs. So they look at the proportion of expenditures going to programs. And if that number is too low – like less than 80% of total expenditures – then they just take their money elsewhere. This is a big problem for the accountant, because you’re under constant pressure to allocate expenditures toward programs and away from everything else in the statement of activities, to make the programs percentage look better.

The problem can be big enough to verge on reporting fraud, so your best bet is to set up a standard methodology for how every single expense is going to be allocated to the three classifications, and have the board approve it. Then, if the executive director lays on the pressure to shift more expenses over to programs, you have a solid defense to fall back on.

Nonprofit Reporting

Running the accounting for a nonprofit can be difficult. Depending on the types of reporting that donors want to see, you might be forced to prepare a special report to each one, showing how their funds were used. If the nonprofit is a small one, with rudimentary accounting systems, it may not even be possible to generate the information they want. One way to get around this is to review the reporting requirements for the big donor organizations, to see if you’re even capable to generating these reports. If not, don’t apply for the money. Otherwise, you might have to overhaul your accounting systems just to create the reports that a few donors are demanding.

Donation Restrictions

Another accounting issue is that donors might send in money with all kinds of odd restrictions – each of which has to be tracked. Imagine a zoo receiving money that’s restricted for use on a polar bear enclosure, when it doesn’t even have any polar bears. To get around this, set up just a couple of sub-accounts for specific types of restricted activities, and encourage donors to donate just into those activities. By doing so, the nonprofit isn’t being forced to engage in any peripheral activities; instead, the money is flowing into just a few areas that the board wants the nonprofit to focus on.

Nonprofit Bank Accounts

Another accounting issue is mixing up the money. It’s way too easy to lose track of where the money for the various programs has gone. A good way to keep track of the cash is to create a separate bank account for each program. When money is contributed to a program, the money goes to the associated bank account. Then the staff can plan expenditures based on the remaining bank balance.

Other Nonprofit Accounting Issues

An associated control is to keep a close watch on any negative account balances. This shouldn’t happen in a nonprofit, since you’re only supposed to spend the cash you have. Any negative balance means that you spent too much, and probably took cash from another program to pay for it.

And yet another accounting concern is making sure that you stay in compliance with all those donor restrictions. A good way to keep control of the situation is to maintain a summary list of all the large donations and associated restrictions, and update it a lot – probably once a month. This is a report for the executive director, since that’s the person donors will call if they find out that their money has been mis-spent.

Here’s another accounting issue. When a donor pledges money to a nonprofit, this results in a receivable that’s called pledges receivable. This only happens when the donor commits to a pledge without reservation. If a donor imposes a condition on a donation, then there’s no receivable. Instead, you have to wait for the condition to be fulfilled, and then record the receivable. A common example of this is when a donor pledges money, but only if you can raise an equivalent amount of cash from other donors.

When there’s any question about whether a condition can be fulfilled, just wait for the issue to resolve itself, one way or the other. It never makes sense to record a receivable – and the associated revenue – when there’s any doubt about whether the donation is actually going to be paid.

Related Courses

Nonprofit Accounting

The Solvency Budget (#301)

In this podcast episode, we discuss the use of a separate budget to act as a benchmark to track a company’s solvency. Key points made are noted below.

How to Spot a Solvency Problem

The topic of this episode comes from a listener, and it is – how to provide advance warning of a solvency problem. The listener is from Australia, and his request is based on the Corporations Act of 2001, which states that the directors of a corporation must pass a solvency resolution within two months of each review date for the business. That resolution has to state whether – and I’m quoting here – the directors believe there’re reasonable grounds to believe that the company will be able to pay its debts as and when they become due and payable.

And I couldn’t help noticing that this part of the Act also contains a reference to the Australian Criminal Code, so there must be some fairly severe penalties for getting this wrong.

So in essence, the request is to figure out a way for the accounting department, which deals with historical information, to come up with a system to detect solvency problems in the future. There’s an obvious disconnect right there, since the information needed is forward-looking, but there is one way to do this.

The Solvency Budget

Besides collecting and reporting on historical information, the accounting department is also in charge of the annual budget. As many of us know, the budgets that management comes up with can be a long way away from reality. Sometimes, we get to the end of the year and compare budget to actual, and they’re not even close.

But there is a way to adjust the budget concept so that it becomes a warning flag for solvency issues. To do this, the accounting department comes up with its own budget for the company – it can ignore whatever management created. Let’s call this the solvency budget. The only intent behind this budget is to present a reasonably solvent financial structure for the company. We can then compare actual results to the solvency budget to see how the business is doing. And better yet, we track this actual to budget comparison on a trend line, to see if the solvency situation is trending better or worse.

Solvency problems tend to be like a slow-moving train wreck, where you can see them coming a few months in advance as all of the financial ratios start trending worse and worse. And then the company goes bankrupt, just like all of the financial indicators showed a few months earlier. Which is why tracking these variances on a trend line is such a good idea.

So, how do we derive a solvency budget? One good starting point is any covenants attached to company loans. These covenants might require that the company maintain a two-to-one current ratio, or always have a million dollars in cash in the bank. These covenants are set by the lender, because the lender considers these thresholds to be the minimum acceptable level for a solvent borrower. So if that’s how the lender defines solvency, then that’s good enough for me.

Or, you can go back through the company’s historical records to see how its liquidity ratios looked during a good year. That means deriving its current ratio or quick ratio, and maybe its debt service coverage ratio, based on the financial structure the company had back then. These are good ratios to use, because they relate to the company’s own operations, not some theoretical values derived by an outside analyst about what constitutes solvency. In short, these are ratios that the business has proven that it can maintain during solvent times.

Next, build your own solvency financials, using those ratios. For the income statement, I would create your best estimate of what the company is actually going to do, which could be a lot lower than what management is guesstimating. And set up the balance sheet based on those solvency ratios. I would do this by month for just the next three months. The reason for going so short is that even the best accountant can’t project very far into the future, so don’t try. Just keep rolling forward the three-month forecast, always building into it your minimum acceptable levels for solvency ratios.

Rather than loading this budget into the accounting software, I would just keep it on an electronic spreadsheet. There are going to be so many changes to the forecast that it’s just easier to make spreadsheet adjustments. Most accounting software is a bit kludgy when you want to keep updating the budget.

How to Report Solvency Issues

So, you’ve developed a solvency budget – what are you going to do with it? I would set up a report for management, to go over with them in person once a month. In that report, the main focus is on how close the company is getting to those minimum solvency threshold values, and especially when there’s a negative trend. So if there’s a loan covenant that says the loan can be pulled if the current ratio drops below two-to-one, it would be a good idea to start warning management months in advance when the ratio drops from three-to-one, to 2.5-to-one, and so one. This emphasis on trends should provide management with enough time to take corrective action.

When Solvency Reporting Does Not Work

And now, for the downside. This solvency budget approach only works when a business is stuck in a long, slow decline. It doesn’t work at all for sudden liquidity problems, like having a big customer go bankrupt and stick you with a huge bad debt.

It’s also not all that useful when the business has a lot of ready financing available, which might be the case with a hot new startup that has lots of backers. In these cases, if the solvency ratios look bad, who cares? The investors just dump in more money. But for the bulk of businesses – those that have been around a while and don’t have wealthy backers – a solvency budget might be a good way to keep things on track.

Related Courses

Budgeting

Effective Sales Forecasting

Financial Forecasting and Modeling

What to do the Rest of the Time (#300)

Since this is the 300th episode, and the AccountingTools podcast has been around for 15 years, I thought it might be fun to step away from the usual accounting topics and talk about – what to do the rest of the time. It’s pretty much my philosophy on how to use leisure time.

Now, accounting does not have the best reputation for being exciting. I know, we all realize that there’s nothing more interesting in the world, but everyone else thinks that accounting is a boring profession. By comparison, there are smoke jumpers – those are the folks who parachute out of planes and into forest fires. Strangely enough, the only smoke jumper I ever knew was also a smoker – but that’s not relevant.

What is relevant is what to do with the rest of your time to make life a bit more exciting. I approach the issue by first deciding how much time to put into it. On the high end, there’s professional work, which generally takes up about 2,000 hours per year. On the low end is the beginner, who might spend 10 hours a year on something. Between those two extremes are intermediates, which I figure takes around 50 hours per year, and advanced, which takes upwards of 200 hours per year, and expert-level, which takes anywhere from 500 to 2,000 hours per year.

My point in describing these categories is that each successive level requires multiples more time than the level before it. To be intermediate requires five times more effort than a beginner, and to be advanced requires four times more effort than an intermediate, and so on. So to become really good at something requires an increasingly large block of your time.

I’ve sometimes dabbled in the range of being an expert. For example, I used to be on a men’s volleyball team that trained five nights a week, and had a coach. We gradually improved from a BB ranking, which is recreational, to a AA ranking, which is pretty competitive against college teams. We were good. And when I mean good, in our standard lineup, I had a guy from the Jamaican national team on my left, and a Junior Olympian on my right. That was pretty awesome.

A major advantage of operating at this level is that it’s an across-the-board confidence builder. When you’re really good at something, the confidence crosses over into your professional life, so you get better at that, too.

So, am I saying that being a really good setter on a AA-level volleyball team made me better at accounting? Yes, I am. Therefore, lesson number one, get really good at something else, and it improves your attitude towards everything.

But, there are some problems with operating at an expert level. One issue is that it hogs all of your time, so if you choose to be an expert at something, then that’s it – you can pursue just that one activity outside of work. There’s no room for anything else.

Another problem with training at an expert level is that it can be a love/hate relationship. It takes up so much time that at some point, you might begin to question why you’re doing it at all. For example, the other activity that I used to pursue at an expert level was mountaineering. It was absolutely consuming, and I was really good at it. I ended up climbing well over 500 peaks, and most of them were at least 13,000 feet high. But by the time I got to the last one, which was the Grand Teton in Wyoming, all I could think of was how many more hours before I’d be back at the trailhead and could drive home. So in short, operating at an expert level can be a dicey proposition.

I think a better approach is to deliberately keep the hours lower and go for an advanced level of expertise. That way, you don’t get burned out anywhere near as fast, and you’re still much better than an intermediate. And also, by only putting in around 200 hours per year on each activity, you can engage in two or three activities. It makes for a more well-rounded lifestyle. Which is lesson number two.

For me, that means being advanced at things like skiing, mountain biking, and rock climbing. Really quite good at them, but with nothing like the level of expertise of someone who’s gone all in on just one of them.

That’s my general philosophy on what to do with the rest of the time. I’d like to finish with a few comments about just how spicy life can get when you’re doing sports at this level. Now, you’re probably not going to get killed playing volleyball, but you sure can in skiing or mountaineering.

As a prime example, I was solo climbing a peak in California, and the route just below the summit involved going up a chimney, where one side was open to the air. Not especially hard, but it was about forty feet high. Just below the top of the chimney, I got stuck.

My backpack was jammed between a couple of rocks. I was wriggling around trying to get the pack loose, when it suddenly got incredibly loud. I had no idea what was going on. And then a fighter jet went by about 50 feet away. The pilot was banking away just as the plane went by, so all I saw was the undercarriage of this jet right next to me. And if you’ve ever been to an air show when one of the jets buzzed the crowd, you know just how loud they can be. Now picture it 50 feet away. I was so startled that I let go. And fell about an inch, because the pack was still stuck. I eventually got unstuck and kept going. But can you imagine if my pack had not been stuck when that jet went by? I really don’t know if I’d have fallen back down that chimney.

Here’s another example. If you go to Aspen, Colorado, one of the prime attractions is the Maroon Bells. It’s a famous couple of peaks that are photographed by everyone. If you were to look to the left of those peaks, across the valley, there’s another peak, called Thunder Pyramid. Which is an awesome name. It doesn’t get climbed anywhere near as much, because it’s not quite as high as the Maroon Bells. And it’s also harder. I decided to do a solo ascent, and got to the top pretty quickly. Since there was still some time left in the day, I decided to keep going and climb an unnamed 13,000-foot peak that was a little further along the ridge. The only obstacle was a 20-foot cliff face partway along the ridge. I climbed it – and just as I reached the top of the cliff, the whole thing broke loose below me and rolled away.

I don’t think there’s any skill level that tells you when something like that’s going to happen. I remember sitting there at the edge of the cliff, maybe breathing a little more rapidly than usual – and then skipping the rest of the climb, turning around, and going back down.

And for a final escapade, I was backcountry skiing in the mountains near Steamboat just last winter, and was going through the trees in pretty deep powder. I came up to a series of drops over snow-covered boulders, and it looked a bit marginal, so I decided to skirt around the edge. I was still looking at the boulders over my shoulder as I skied down, and turned forward just in time to see the broken-off tree branch that was about to go through my neck. That, without a doubt is, the closest I’ve ever come to getting killed. If I’d turned around a second later, it would have been messy. As it was, I dropped down and slid under the branch.

So why do I bring this up? Because when you get to the end of your career, what are you going to remember? That great set of financial statements that you issued as a controller? Or maybe that road show where you raised a few million dollars? Probably not. It’s the other stuff. I remember things like the view from the summit of Denali, and a lunar eclipse from a dive boat off the coast of the Philippines. Now that’s worth remembering.

The Audit Risk Model (#299)

In this podcast episode, we discuss how the audit risk model works. Key points are noted below.

The Nature of Audit Risk

Audit risk is the risk that an auditor expresses an incorrect opinion on financial statements that are materially misstated. Since auditors can get sued for this – and will lose the court case and have to pay up – they need a tool for reducing the risk.

They could reduce audit risk by brute force, which means examining every single one of the client’s transactions. But that would be incredibly expensive. So instead, they have the audit risk model. This model calculates the total amount of risk associated with an audit by breaking it down into three pieces. There’s control risk, which is the risk that material misstatements wouldn’t be detected or prevented by a client’s control systems. This is a big one, since auditors can rely on a good control system and cut way back on their audit procedures. But if the control system stinks, then the auditors need to compensate for it with more procedures.

And then there’s inherent risk, which is the risk that a client’s financial statements are susceptible to material misstatements in the absence of internal controls. This can be a problem in a complex business, and especially ones where there’s a lot of judgment involved in making decisions, because an inexperienced person is more likely to make a mistake. There’s also more inherent risk when a business deals with a lot of non-routine transactions, where there aren’t any procedures for them. Same problem – an inexperienced person could screw them up. In short, a business with inherent risk is just structured so that stuff can go wrong.

And finally, there’s detection risk. This is the risk that the audit procedures to be used aren’t capable of detecting a material misstatement. The auditor can control detection risk by adding on more procedures – or at least, relevant procedures. This one is the main variable. The auditor can dial up the procedures when the other two risks are looking bad, or dial down the procedures when the other risk levels look fairly low.

So – the audit risk model states that you multiply the assessed percentage of control risk by the assessed percentage of the inherent risk, and by the assessed percentage of detection risk, and that gives you the percentage audit risk.

In other words, if any of these subsidiary-level risks are on the high side, and especially if several of them are, then the auditor will be looking at a seriously high risk of expressing an incorrect audit opinion. Which can be career-ending. And drain their bank account if there’s a lawsuit.

Problems with the Audit Risk Model

The model seems simple enough, but there’s one basic problem with. How do you come up with those percentages? Who’s to say that control risk should be assessed at ten percent? Or twenty? Or thirty? Defining these risks is subjective, so it would be really hard to defend any specific number. It would be foolish to set inherent risk at, say, fourteen percent – how would you justify it?

And for that matter, since every input to the equation is subjective, how can anyone realistically expect to multiply them together and get a meaningful result? Essentially, we’re trying to apply mathematical concepts to opinions.

A Simplified Approach

And that’s why auditors prefer to assign either a high, medium, or low rating to each one of those risks. It’s sort of like a traffic light. Green is a low risk rating, red is bad, and amber is somewhere in between. When everything is green, the auditor is happy because the audit risk is green, too. When everything is red, it’s time for the auditor to walk away from the audit, because there’re no way to develop a cost-effective audit opinion.

So how do auditors come up with these high, medium, or low assessments? It’s still a judgment call. Inherent risk is red when the environment is complex and there aren’t a lot of procedures. In the reverse situation, it’s green. When the auditor does a preliminary test of controls and all the controls are working as planned, then it gets a green score. When the result is more like a war zone, it gets a red score. Those are the easy ones. The auditor needs to decide under what circumstances a medium rating will be handed out. There isn’t any clear guidance on this – it’s still a judgment call.

So, what about practically all of the audits, where the score is not all red or all green? As a general rule, if control risk and inherent risk are both high and detection risk is medium, then the auditor will not accept the engagement, because the cost of all the audit procedures needed will be too high. If the detection risk drops to green, then it’ll probably be cost-effective for the auditor to proceed, but she needs to watch the outcome of the audit procedures, to see if anything squirrely pops up – and there’s a good chance that it will.

On the other hand, if any combination of two risks are considered low, then the audit can proceed. That’s nice. The trouble is, that if you calculate the number of variations of three audit risks and three risk rankings, you have 27 possible combinations of outcomes, and in about half of them, it’s not clear if the auditor should walk away or take the engagement.

So, as you might expect, this is a fraught area for auditors. All the way through an audit, they’re constantly re-evaluating the audit risk, and altering their audit procedures to deal with what they find.

It might seem that this episode was entirely for the benefit of new auditors. Not entirely. Look at this from the perspective of the client. If you present the auditor with a crappy control system or an inherently complex operating environment, the only way the auditor is going to be able to provide a clean audit opinion is by piling on the audit procedures – which can get pretty expensive.

So, it makes sense to keep working on your control systems during the off season when the auditors aren’t around, to make them as robust as you can. And try to persuade management to streamline the business a bit, install more procedures, and pay for more employee training, so that the inherent risk goes down, too.

When you do that, the auditors have less heartburn and more importantly, they’ll have less work to do, so their audit fee will be less.

Related Courses

How to Conduct an Audit Engagement

The Audit Risk Model

How to Create a Sales Forecast (#298)

In this podcast episode, we discuss how to create a sales forecast. Key points are noted below.

The Need for Sales Forecast Detail

The easy approach that lots of companies use is to take last year’s sales, adjust it by a few percent – usually upwards – and call that the forecast for the next year. That’s not a good idea, because there’s a lot going on underneath that grand total sales figure from last year. You really need to get down into the details.

The Three Parts of a Sales Forecast

At a gross level, the sales forecast can be broken down into three parts. The first one is the basic sales forecast, which is those sales that predictably keep coming back. Sales may not always be from the same old customers, but you can usually rely on a basic sales level from the same old product and service sales, every month. So that’s your base layer. We’ll get back to that in a minute.

The second part is the promotional sales forecast. In this part, sales are directly tied to marketing activities. So if the marketing department runs a coupon promotion that reliably generates an extra $100,000 of sales, then those sales are part of the promotional sales forecast. For this part of the forecast, you need to work with the marketing department to figure out the timing of their promotions, and then put the historical results of those promotions into the forecast on the dates set by marketing.

The third part is new product sales. The forecasting here can be tough, since there’s no sales history to base it on. Usually, the marketing folks derive estimated sales from how similar products have sold in the past. That’s pretty much all you’ve got to work with. A concern here is whether a new product will cannibalize sales from some other existing products, in which case total sales will be less than you expected.

Drivers of the Basic Forecast

Those are the three parts of a sales forecast. Let’s get back to the basic forecast. Even though I’m calling it basic, there’s still a lot going on here. Let’s say that the sales manager is projecting a five percent increase in the basic forecast from last year, because that’s what the actual increase has been for the last couple of years. Is that a viable number? Once again, you have to get down into the weeds to figure it out.

First, let’s say that sales are being driven by a large sales force, and they’re organized into sales regions. Is it reasonable that the sales coming out of each sales region will keep going up? At some point, they won’t. Sales regions do not generate more sales forever. So, take a look at how sales are growing – or not – by salesperson, by region, to figure out when sales are cresting, and maybe when they’re starting to go down. This takes an in-depth analysis to figure out what sales are going to do.

Here’s another example. What if sales are based on contracts that have a specific end date? In this case, you need to identify the termination date of each one of these contracts, and then aggregate them all to figure out when the related sales will end. Then separately compile the sales department’s best estimates of which new contracts it thinks it will get, including the estimated contract start dates and the associated amounts, and layer these figures on top of the information for the existing contracts. In this case in particular, if you just roll forward last year’s sales numbers into next year, you’re probably in for a big surprise. Contract-based sales forecasting requires a lot of detailed analysis.

Now, let’s say that there is no sales force. Instead, you’re operating a bunch of retail stores. In this case, sales can be estimated based on the historical sales per square foot of store space. Of course, it’s not quite this easy. The sales per square foot figure tends to go up over time, so the sales associated with new stores are usually lower than the sales for existing stores. And there might be a declining trend of sales per square foot, too, which should be rolled forward into next year’s forecast. So if you want an accurate sales forecast for retail stores, be prepared to analyze sales at the level of the individual store.

Here’s another one – the Internet store. Again, there aren’t any salespeople, so you’re forecasting based on historical sales levels. In this case, you need to dig in the historical data a bit more. This involves seeing if there’s a long-run trend in the data, as well as any seasonality effect, so that sales are consistently changing during certain months of the year. And also look for the recency effect, which is recent changes in the data. This is not something you can just put on a plot in Excel and visualize. A better approach is to use the exponential smoothing function in Excel. What it does is assign exponentially decreasing weights to older data when it creates a forecast. In other words, more recent historical data are weighted more heavily in deriving a forecast.

This concept of data recency is an important one, especially when you’re trying to figure out when sales are cresting. Cresting is a big deal, because this is when product sales transition from a steep uphill climb to gradually flattening out. Management needs to get this right, so that it doesn’t keep investing in infrastructure to support sales that have stopped increasing.

A good way to watch for the cresting effect is to flag a decline in the rate of sales growth. As soon as this happens, start forecasting much more frequently, because the rate of growth could start dropping off really fast. Also, it can make sense to watch the sales coming from the company’s original core customers. When their purchases start to drop off, it’s a good bet that they’re the leading indicator for a general drop off in sales for customers who came in later. This means that the original markets show cresting sales first, as they become saturated. You can then extrapolate this information to other markets, to predict when sales will crest in each successive market.

Sales Forecast Constraints

Let’s switch over to constraints. When setting up a sales forecast, you can’t just dither around with sales figures. You also have to understand whether the business can even generate the sales from an operational perspective. For example, let’s say that a business sells a very technical product, which requires an extremely well-trained salesperson to make the sale. In this case, the bottleneck in the system is being able to find and train enough qualified salespeople. The market could be enormous, but if you don’t have the sales staff, then you can throw out any massive sales increases.

Or, what if the company is a manufacturer, and its bottleneck operation on the production floor is completely maxed out already? If so, not matter how strong demand may be, the sales forecast is really driven by how fast the capacity of that bottleneck operation can be increased.

Here’s another one. A new retail chain has a great new concept store, and customers love it. The problem is that the company only has the capability to sign leases, train up retail staff, and open new retail stores at the rate of one a month. In this case, the sales forecast is driven by the rate of store openings, not by customer demand.

To summarize, you can’t just sit in your cubicle and dream up a sales forecast by extrapolating out last year’s sales numbers. This requires a major amount of detailed analysis.

Related Courses

Budgeting

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Accounting for Art Galleries (#297)

In this podcast episode, we discuss unique accounting issues pertaining to art galleries. Key points made are noted below.

Background on Art Galleries

A little background on art galleries. Most of them make very little money, usually less than $200,000 of revenue per year. Half of that goes to the artists, so they don’t have much money left over to pay for the rent and utilities and employee pay. Which is why most of them only have a couple of people on staff. However, about 15% of the galleries generate more than $1 million of revenue per year. These galleries are in the sweet spot of the industry, because they’ve been able to attract the best artists, whose works sell for a lot more money.

Most artists enter into representation agreements with art galleries, where they commit to sending in a certain amount of artwork each year, in exchange for giving half the sales to the gallery, and getting their own show at the gallery once every couple of years. Depending on the artist, they can sell every single piece that’s displayed in these shows, and sometimes it’s even sold in advance. That’s because most artists have a following of collectors, who want access to their artwork before anyone else can buy it. So that’s what happens – the collectors buy the artwork in advance, and then its displayed at the show, with a little red dot in the corner, which signifies that it’s already been sold.

Art Gallery Revenues and Expenses

So let’s get into some of the art gallery expenses. The first issue is the rent. Gallery owners like to set up shop in high-rent districts, because the people who buy their products are generally wealthy, and they tend to hang out in high-rent areas. In addition, gallery owners rent space at art fairs, especially if they deal with high-end works of art. This is really expensive. There’s the booth fee, and shipping charges to transport the artwork to and from these locations. And there’s the travel and entertainment cost to send staff to the fairs, and put them up at hotels. In short, both types of rent can take up a massive chunk of operating expenses.

And there can be substantial marketing expenses. Some of this is the cost of food and drinks at gallery events, but in addition, the gallery may pay for the shipping costs when artists are shipping new works to them.

And if it can’t sell something, it has to pay to ship the artwork back to the artist, so that it can clear out room to make way for new artwork coming from other artists. So – yes, freight can be a significant cost.

The biggest expense of all is that each sale has to be associated with a specific work of art, so that a commission can be calculated and sent to the artist. In addition, the gallery pays for framing costs once a painting arrives at the gallery, and then deducts the cost of the framing from the proceeds of a painting sale, before calculating the commission split.

There’s a whole different set of accounting issues associated with the other side of the gallery business, which is the secondary market. In this case, the gallery owner buys art at estate sales and auctions, or from private collections, and then turns around and sells it to collectors. Now in the prior case, where the gallery is representing artists, the inventory is on consignment, where the artist still owns it. But with secondary market transactions, the gallery owner is buying the artwork and trying to sell it at a profit, so now the gallery has to record its purchase cost.

And then we have other forms of revenue to account for. A gallery might create some quite fancy catalogs of artist works – which are usually for a show, but which can also be sold. Collectors like to keep them on the shelf. Another source of revenue is brokering the repair of artwork. For example, a painting might get water damage, so the gallery charges the owner to handle the repair work, which usually means sending it back to the original painter.

Another revenue source is home delivery and hanging services. They bring artwork to your home and hang it for you, and might even arrange to have lighting installed for it. Which is not free.  And as another source, galleries sometimes rent out their space for private receptions, so there can be some rental revenue.

And finally, when a gallery represents an artist, it’s usually an exclusive arrangement within a certain territory, such as an entire state. If the artist’s works are then sold within this territory where the gallery wasn’t involved, then the gallery gets a cut of the sale. A fee of 20% of the sale price is pretty common. So in short, the revenue accounting has to deal with a lot of different sources of income.

Another accounting issue is sales taxes. Given the cost of artwork, a gallery may end up having to charge sales taxes in the hundreds or thousands of dollars on a single sale. Which means that it needs to have a sales tax license, track sales taxes, and remit them to whichever government is collecting it.

Another expense – and a large one – is insurance. A gallery contains a lot of expensive stuff, so of course the inventory insurance on the artwork is also very high. The insurance covers the in-transit period and while works are stored in the gallery, and transfers to and from art fairs, and while the works are being displayed at the fairs.

Not done yet. Many galleries also maintain off-site storage for excess inventory, which is climate controlled and heavily secured. Which means that it’s expensive.

And we can’t leave the expenses topic without covering professional services. There are a lot of them. An art gallery needs to hire art handlers, who take care of crating for deliveries, as well as customs forms for international shipments. And then there’s the attorney, who writes consignment agreements for artists, and the conservator, who may be needed to inspect and repair artwork – usually for items acquired on the secondary market. And then there’s the curator, who’s hired to set up an exhibit. To make the accounting a bit more difficult, curators might be paid a percentage commission on whatever is sold during the exhibition.

And finally, a gallery might even pay for scholar services. This is needed for authentication purposes, usually when the gallery owner suspects that something he’s about to buy on the secondary market is not the real thing. And, a scholar might be hired to write material for an exhibition or a catalog.

Profitability Reports

And after all these transactions are recorded, the accountant will probably be asked for two profitability reports. One is the profit per square foot of gallery space, because the rent is very expensive, and the owner needs to know if it’s paying off with increased sales.

The second profitability report is for art fairs. This is the same concept – was a fair profitable for the gallery? To do that, the accountant needs to track both the sales and the expenses for each fair that the gallery attends.

Entity Issues

Before I finish up, there is one more issue, which is the tendency of gallery owners to mix their personal assets in with those of the gallery. In particular, the owner might buy artwork from an artist and then keep it on display at the gallery, so it can be difficult to figure out which transactions are associated with the business and which ones are with the owner. This can be an interesting tangle to deal with when trying to create financial statements for the gallery.

Related Courses

Accounting for Art Galleries

Types of Business Entities (#296)

In this podcast episode, we discuss the various types of business entities. Key points made are noted below.

The Sole Proprietorship

Let’s start with the sole proprietorship. It’s not incorporated. In fact, it’s really just an extension of the person who owns it. This means that the owner is entitled to the entire net worth of the business, and is also personally liable for all of its debts. It has no legal existence without the owner.

A sole proprietorship is a pass-through entity, which means that its financial results go straight through to the personal tax return of the owner. It’s generally OK to use any losses from the business to offset any other income the owner might have earned, unless the IRS decides that the business is not being run to earn a profit. In this case, the business is considered a hobby, so the owner can only deduct hobby losses up to the amount of any hobby income.

You generally want to stay away from a sole proprietorship because of the unlimited personal liability issue, and because you can’t sell shares in the business to get more funding. And that’s because there aren’t any shares.

The Partnership Entity

Next up is the partnership entity. In this case, the partners share in the profits and losses, and are also personally liable for its liabilities. Once again, it’s a pass-through entity, so its profits and losses are reported on the partners’ tax returns. There’s usually a partnership agreement that states the ownership percentages and how profits and losses are split among the owners. As was the case with a sole proprietorship, using a partnership is not always the best idea, because of that personal liability issue. Another problem is that the partners are taxed on the income of the partnership, even when the income hasn’t yet been distributed to them – which can cause some cash flow issues for the partners when the taxes are due for payment.

However, you can keep adding partners, which makes it a better vehicle than a sole proprietorship for raising money.

You can get around the unlimited liability issue by setting up a limited partnership. Under this arrangement, limited partners are only liable up to the amount of their investment. The party who actually runs the limited partnership is called the general partner, and he, she or it still has unlimited liability – but at least that’s just one of the partners, not all of them. Unfortunately, this feature comes with a downside, which is that the limited partners have no control over the business.

The C Corporation

Next up is the C corporation. This is an entirely separate entity, so it’s taxed on its own income – it doesn’t flow through to the shareholders. Instead, the corporation files its own tax return and pays its own taxes. However, the shareholders are sill subject to something called double taxation, which occurs when the company pays them dividends. In this case, the company has already paid taxes on its own income, and then the shareholders have to pay taxes on any dividends received – so the same income is taxed twice.

Despite the double taxation issue, C corporations are great for raising money. They can sell shares to investors, and raise lots of cash. Also, if the shares are registered, shareholders can fairly easily sell their shares to other investors. And on top of that, the corporation acts as a liability shield, so the shareholders are not liable for the debts of the business. This is why most really large businesses are C corporations.

The S Corporation

A variation on the C corporation is the S corporation. It’s basically the same thing, expect that its profits and losses flow straight through to its shareholders. If you don’t have many shareholders, it can make sense to convert a C corporation into an S corporation, to avoid the double taxation issue. And it still provides shareholders with protection from the liabilities of the business, so it’s generally better than a C corporation. The main problem with an S corporation is that it has to transfer most of its excess cash to the shareholders, so that they can pay their tax bills. This can be a problem when the business also needs the cash.

The Limited Liability Corporation

And finally, we have the limited liability corporation. It gives its members protection from the liabilities of the business, and passes through its earnings to them – sort of like an S corporation.  An LLC is created by state statute, so its characteristics vary a bit, depending on the state. But generally, it’s treated like a partnership for tax reporting purposes. A key difference between an LLC and an S corporation is that an LLC has no cap on the number of members, while an S corporation is capped at 100.

How to Select a Business Entity

These entities are much more complex than the summary I’ve just given. There’re also issues with things like the self-employment tax, ownership basis, and the number of classes of shares you can offer, but I think I’ve touched upon the essential characteristics of each entity type.

So when would you use each one? It depends on your specific circumstances, but I’ll provide a few examples. Let’s say you have a small family-owned business, so there aren’t many shareholders. In this case, an S corporation would be a good choice, since it provides liability protection.

If you’re running a business that’s growing really fast, then a good choice is a C corporation – because you can sell shares to lots of investors, to raise money. And finally, if you’re investing in real estate, it can make sense to form a limited partnership, since that format gives the limited partners some protection from creditors.

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Divestitures (#295)

In this podcast episode, we discuss corporate divestitures. Key points made are as follows:

The Need for Divestitures

First of all, why engage in a divestiture?  Most companies are more concerned with acquisitions, not getting rid of existing business units. There are a lot of good reasons. First, you might need the cash, and some business units can sell for quite a bit of money. Second, a business unit might not be doing all that well, and it’s taking up too much management time. And third, the company strategy might be heading in a different direction, so you need to shed some business units that no longer align with the strategy. In particular, a conglomerate is always changing its portfolio of companies. It buys a few, and it sells a few.

Types of Divestitures

There are some variations on the divestiture concept. One is the spinoff, which is when you create a new corporate entity by separating a business unit from its parent. The result is a free-standing business that has not been bought by another firm. Instead, the shares might be distributed to the parent company’s shareholders, in which case the parent gets no cash from the deal – only the shareholders benefit. Or, the parent company can then turn around and sell the shares in the new entity to investors – in which case the parent directly benefits from the deal. There could also be a buyout, where the managers of the business unit buy the shares of the spun-off entity – sometimes with financing from the parent.

Problems with Divestitures

There can be lots of problems with divestitures. One is certainly the accounting system. Larger businesses have comprehensive, centralized systems that contain the accounting records for the entire business, so you need to figure out a way to split off the accounting transactions for the business unit into a separate accounting system. This can be really hard when the business unit being divested didn’t really exist as a separate entity within the parent company beforehand. For example, it might be parts of three different business units. In which case, how do you identify which transactions go with the divested business unit? The same problem comes up for finances, where cash flows might have been centralized at the corporate level, for hedging and cash management purposes. Now some of it has to be pulled out and moved over to the divested unit, which might require new bank accounts. This is a real problem when new legal entities are being set up for the divested business, because the bank accounts have to be tied to the new legal entity – which in some countries can take months.

Another problem is patents. The divested business might own patents that the parent company is using, or the other way around. If so, there needs to be an arrangement to keep using the patents, maybe in exchange for a royalty.

Yet another issue is staffing. The divested business might have to increase its staffing to take care of the administrative areas that used to be handled by the parent company. If so, you might have to transfer some employees from the parent company, or hire new ones and train them up. And on top of that, if you’re transferring people over from the parent company, their payroll and benefit information has to be transferred over too, along with their seniority information.

An uncomfortable outcome is that a divestiture might cost more than the parent company expects to earn from selling it. You need to consider a lot of costs. For example, just the cost of creating separate financial statements for the carved out entity could be in the tens or hundreds of thousands of dollars. And then there are banking fees to set up new accounts, legal fees for new entities and regulatory filings, consulting fees to set up new systems, and payments to relocate or terminate employees.

And then there’s this thing called dis-synergies, where operating costs increase. For example, the volume discounts that the divested business used to get by being part of the parent company go away, which means that its gross margin goes down, so it’s worth less money.

Another problem is stranded costs. These are costs associated with the divested entity that are left behind at the parent company. For example, the parent might have constructed a data center, for which half the capacity was intended for the business unit that’s now being divested. In this case, the parent can’t very well shift the data center over to the divested business, so it’s basically stuck with more data center capacity than it needs. It helps to make a first pass at what these costs might be before going too far down the road of divesting a business unit.

Shared Services Arrangements

And there may be cases in which you can’t just divest a business unit and walk away. It may take a long time for the new business to set up some functionality that the parent company had been taking care of for it. If so, you might need to set up a shared services arrangement, where the parent company keeps supplying a few services – like human resources or accounting – for a fee. These arrangements have a bad habit of getting extended, so the agreement should include a cutoff date, or at least an increased fee schedule, so the divested business has an incentive to get off the arrangement as soon as possible. Since the parent company is probably not in the business of providing shared services, it’s quite possible that it won’t do a good job, so the divested business might want to include performance criteria in the agreement, where it can withhold payment if service levels fall below a certain minimum threshold.

The Separation Management Office

If you’re in the business of doing a lot of divestitures, then it can make sense to set up a separation management office. This group provides analyses for each proposed divestiture, and standardizes some of the transactions. For example, it can provide an analysis for what it will cost to divest a specific business unit. It can also provide a canned legal agreement for shared service arrangements with divested businesses. Another possibility is to monitor each step in the divestiture process, and step in when something isn’t working right. In short, this is an in-house consulting group that smooths the way for each divestiture.

Accounting for Divestitures

Let’s tackle some accounting issues. The accounting staff of the parent needs to know exactly which assets and liabilities are going with the divested business, so that they can be shifted out of the parent company. This can be really difficult when you’re dealing with individual receivables and payables. The accountants might also need to apportion some of the parent company’s goodwill asset over to the new business. This might be a good time to see if some of that allocated goodwill is impaired, too.

Another problem is compensation. The accountants will need to shift some of the parent’s pension expense and liabilities over, as well as some of the deferred compensation expense.

Yet another problem is hedging. Hedging instruments should be assigned to the divested business if they’re linked to something within the entity, such as commodity trades or foreign exchange transactions. This can be hard, since the parent company might be setting up hedges based on aggregated transactions from all of its subsidiaries.

And finally, if the intent is to sell the divested business, then it’s quite possible that potential buyers will want to see audited financial statements, so the books have to be cleaned up enough to withstand an audit.

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Health Care Accounting (#294)

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

Overview of the Health Care Industry

Despite health care being one of the largest industries in the world, there isn’t that much accounting that’s specific to it. Other industries get a lot more attention in the accounting standards. To keep things focused, I’m going to only mention accounting issues that are specific to health care. But first, when I’m talking about health care, this includes a lot more than hospitals. It also includes health care clinics, rehabilitation centers, hospice care, laboratories, nursing homes, and individual practitioners. In the United States alone, we’re talking about roughly 17 million people in this industry.

The Nature of the Organization

The basis for a lot of the accounting for health care begins with the type of organization. The first type is an investor-owned business, and it’s supposed to earn a profit. The second type is the not-for-profit, which doesn’t have any ownership interests, and it gets by mostly from the fees it charges. It’s usually exempt from federal income taxes. If the business is organized as a nonprofit, then it’s accounted for under the nonprofit accounting rules, which I’ll get to in another episode. And a final version is a health care entity that’s run by the local government, in which case governmental accounting rules apply. I talked about governmental accounting back in episodes 274 through 277.

Health Care Billings

So, our first issue is billings to the insurance company. They can be really complex, which increases the risk of an incorrect invoice that won’t get paid. There are a couple of underlying problems. One is that the physician might not have documented a procedure correctly, so the wrong procedure is billed. Or, the person coding information into an invoice uses the wrong code to classify a billed item. For example, some insurers require that a classification code be included from a standard list, such as the World Health Organization’s ICD list, which is short for the International Statistical Classification of Diseases and Related Health Problems. This list contains more than 16,000 codes, so the billing clerk could easily screw up and include the wrong code. Whatever the reason might be, you either don’t get paid or get paid the wrong amount. So obviously, some cross-checking is needed before these invoices go out.

Health Care Payment Plans

Now, let’s flip that around. What kind of payment plans does the insurance company use to pay the health care providers? There are a bunch of variations, and each individual health care provider might end up being paid under more than one of these variations – or all of them. For example, they could use a fee for service, so a physician provides a specific service, and gets paid a specific amount for it. Or, payments could be per diem, which is a flat rate per day of care, no matter what level of service is provided. Or, payments could be episodic, where payments are based on the type of patient condition or the treatment being provided.

Then we have capitation payments, which are a fixed amount paid at the beginning of the month in exchange for a commitment to provide services during that month, even if the patient never shows up. And finally, we have risk-based pricing, where the provider agrees to provide certain services in exchange for a negotiated price, which is designed to control costs.

I won’t get into the logic behind each of these payment schemes, but consider the impact on the accounting department that’s receiving the payments. It needs to track payments under as many as five different systems, and probably needs to report internally on the profits derived from each one – which could get pretty time-consuming.

Health Care Receivable Valuation

And on top of that, consider the receivable valuation problems, because the health care provider is routinely not getting paid the full amount of what it bills. Instead, the insurance company might pay a lower rate, and then the residual might get billed to the patient, and who knows if that’s going to get paid. Or, the insurance company rejects the argument that a medical procedure was even necessary, and refuses to pay it at all. Or, the insurer could claim that a service was provided based on an improper referral, and – again – refuses to pay.

And it gets worse. The federal government could conduct an audit, and decides that a payment was improper. If so, the health care provider has to pay it back to the government.

Because these non-payment numbers can be quite large, the accountant has to take a best guess at a loss reserve, and then keep updating it over time.

Health Care Billings on Behalf of Others

But we’re not done yet with billings. A health care provider might be in an agency relationship, where it issues billings on behalf of physicians, collects the receivables, and then passes along the receipts to the physicians. This just adds another layer of work to the collections process.

In short, it would safe to say that billing and collections for a health care provider is somewhere between annoying and infuriating. Working in this area would probably not be considered fulfilling.

Prepaid Health Care Services

And then we have prepaid health care services. A provider of these services might be contractually required to provide services to patients for a period of months into the future, such as when it’s being paid capitation fees. If so, it has to accrue an estimated expense for the services that will be provided in those future periods. The estimate is usually based on historical experience.

Medical Malpractice Claims

Another liability is medical malpractice claims. This includes the cost to litigate claims, as well as the amount of any settlements. Some of that is covered by insurance, but some of it might be paid directly. The health care provider should accrue a liability when an incident arises that could trigger a claim, and then adjust the amount of the accrual based on the latest information about each claim. And, the accrual can include the cost of probable unreported incidents. In other words, if you’re pretty sure a lawsuit is coming, even if you haven’t yet been notified, then accrue an estimate of what it will cost.

Retirement Community Medical Services

So, let’s switch over to retirement communities that offer medical services. In some cases, they charge residents a single up-front fee in exchange for future services, usually until the person dies. In these cases, the business has to analyze its obligation to provide services once a year or so, and then recognize a liability for this amount. This one can get pretty complicated, because the analysis has to include actuarial assumptions, and estimates of future expenditures, and the facility’s historical experience. And on top of that, a separate analysis should be made for each type of contract that the company offers to its residents.

Of course, these retirement communities also provide ongoing monthly services for a fee, such as rent in order to live there, and meal service, and parking fees. These are billed monthly and collected without too much trouble, so this is a rare case where revenue is recognized right away, with maybe a small loss reserve that’s easy to calculate.

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Health Care Accounting

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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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.

Related Courses

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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Sales and Use Tax Accounting