Ingredients for Success

In documenting your expenses.  Catchy title though right?

Don’t roll your eyes, this is one of those often overlooked areas in business – especially since a large number of receipts are sent to us via email these days.  The fact that some of these expenses are possibly limited as a tax deduction also diminishes the urgency behind providing sufficient documentation.  But, it is still essential that you always document your spending in business, no matter how tedious.  And the biggest headache of all is meals and entertainment.

It begins with the basis: Who; What; Where; When; and why.

Who did you eat with?

If you have invested in a simple expense tracking app, then this should be one of those mandatory fields.  Provide the names of the people and their businesses.  If you have a CRM, identify the participants there and add new contact information in they don’t exist.

What did you talk about?

You don’t need to record the meeting but provide your employer (or you if you own the company) with enough information about the meeting to decide if it is something worth pursuing.  If you discussed a sale opportunity or potential prospects, again, update your CRM for this, especially if it is a new opportunity.  Don’t wait until your lunch guest decides to call you.

Where did you discuss business and where did you eat?

Sometimes the meal is the meeting and others the meeting happens before or after.  For instance, I often go to a referral sources office to meet with the entire staff, but my conversation is with, say, their sales manager.  I like to document that we met at their office and then walked to the restaurant and name the restaurant.

When did you have the meeting and lunch?

Day and time of both are important but really it is about tracking how much time you spend in meeting with the other participants.  It is also good to track when you have to explain your day to your boss (or wife as the case may be).  And, it is also helpful in understanding how you use your time: was it a 3 hour meeting about a sales opportunity that never arises?  Is it your 3rd such meeting this month?

Why did you meet and decide to eat?

The why is oftentimes the most important issue to document for your business.  Was it a business opportunity?  Did you meet to discuss their new business line and how you might be able to share its benefits with your referral network?  Was it an intentional lunch meeting or was it because your meeting ran over and you felt it was an appropriate goodwill gesture?  Be clear.  I do many lunches with my referral network simple to stay in contact – especially those who take a clear interest in what we do.  And sometimes, especially with potential customers who could generate substantial fees, if a meeting runs long I think it is appropriate to recognize the value of their time by saying thank you over a burger and fries.

And for those who love the biggest question of all?  How?

How did the meeting and lunch benefit your company?

I love talking with people.  But the reality is, it is often more effective and efficient to have a video chat than to drive to someone’s office and then go to lunch.  It is a cost/benefit analysis which simply begins with you recognizing that your time is extremely valuable.  So, be honest with yourself when you document your lunch meeting by asking how your company benefitted.  Is it a lunch with your top referral source or a lunch with a friend that couldn’t care less what your company does but likes talking about his kids?  I am not saying that having a deep personal relationship isn’t worth it, but be clear that the business benefit is probably not there.

Tax deductibility should not change your overall business approach.  If you make money through lunch meetings I recommend continuing them.  But be ready to analyze how these meetings, and expenses, are working for you and make smart strategic choices that satisfy your needs and also your company’s.  You will be happy by possibly saving money, but more importantly, your very valuable time.

 

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Understanding Why Financial Reporting Exists

I was asked to answer a question on financial accounting concepts on Quora.   I felt that it is an issue worthy of sharing on my blog as well as we don’t often discuss why we have expectations when we prepare and audit financial statements – other than to say GAAP requires it.

The most basic concept underlying financial reporting (and the accounting procedures used to accumulate the data) is investment decision-making.  Everything Mahesh spoke to, and what I am going to elaborate on, is premised on the need for some information for investment decisions.

FASB and IASB have concept statements.  I am most familiar with US GAAP which is put out by FASB.  But I believe both standards setters agree overall on the concept of information necessary for decision making.

Ask yourself, if you were ready to make a decision to invest in a company, what information would you like to know?  Conceptually, the argument goes, you would like to know the business’ financial position – its balance sheet; its operations – profit and loss statement; and its cash flows.  These collectively make up the general purpose financial statements.
Oftentimes, the information presented on the face of one of those statements does not tell the whole story.  Take inventory as an example.  Lets say the statement of financial position says only that inventory is $1.0 Million.  As an investor, your decision to invest might change if you knew that the inventory was all finished goods: Or perhaps it is all work-in-process.  Knowing additional details which can impact an investment decision might still be necessary, the standards require additional disclosure – footnotes – to help investors put those statements into context and provide details that otherwise do not exist.
These statements do not exist in a vacuum.  They are the accumulation and summarization of thousands and millions of transactions.  And to ensure the necessary information is presented timely, is a faithful representation of what actually happened, and is relevant, the standard setters created accounting principles.

And to ensure that investors receive accurate information based on these guiding concepts, it is important that reported information be verifiable (can be audited successful) and comparable to others in similar situations.  This is why there are industry-specific principles and there is a focus on establishing an effective audit trail.  Investors should be wary where there is first, not an independent examination of the statements and second, where the underlying accounting is totally dissimilar to everyone else in the industry.  Sadly, it happens all too often.

If you are a small business and your bank requires you to prepare GAAP financial statements, it is important to understand that this is what they are looking for: Investment Decision information.  It doesn’t matter if the financial statements are prepared by your bookkeeper or audited by an independent CPA.  Your business is responsible for sharing financial information that the bank can use to make an investment (loan) decision.  You have an obligation to ensure it is accurate, tells the whole story, can be compared to other businesses that are in the same industry as you, and ensure that whatever is recorded can be independently verified.

You, management, are responsible for the accumulation, summarization and reporting of the information.  Management decides when to recognize revenues; or to have it be reported as unearned because the job isn’t done; Management decides if a product was actually sold; or was actually shipped to another warehouse across the country.  There is an undeniable tension between management sharing accurate accounting information and investors receivable actionable investment information.  You see this played out frequently in the press when you see a stock slide because a company missed its revenue target.

Accounting principles exist to put the concept into context.  Accounting principles are not complex or difficult to employ, business is moving farther and farther away from simple transactions of shifting values from producer to consumer.  Complex transactions make for challenging financial statements as investors cannot see where value begins and ends.  So ask yourself, do you really want to invest in a company where you can’t tell who owns what and who is owed what?  If not, demand that GAAP be followed; otherwise:

Caveat Emptor baby.

 

 

How Small Business Can Apply GAAP Successfully

There are two big GAAP changes coming up that could have a major impact on small business if decision makers do not start thinking about the issues.  These are changes to lease accounting and the new revenue recognition standards.  The lease accounting is probably the more challenging of the two, as I will hopefully explain below.

New Lease Standards

The new lease standards will challenge every small business who needs access to capital and where the money people want GAAP financial statements.  So, if you are even thinking of going public or taking on substantial bank debt, you need to think about implementing the new lease standards.

The new lease standards now require you to record an asset and a liability as though you bought the asset on a contract.  You then amortize (depreciate) the new asset over the lease term.  This is substantially different from old GAAP which handled leases off balance sheet – meaning payments were treated as an expense in the period incurred.  The commitment for the lease was then reported in the disclosures.

Obviously, the kicker here is that you will now have additional debt on your books which did not exist before.  And like all debt, the current portion, that amount due in the next twelve months, is considered a current liability.  So businesses with tight current ratios (say 1.1:1.0) and an affirmative covenant to maintain a current ratio of 1.0:1.0 may find themselves out of compliance.  Noncompliance is a default condition.

So, if you are thinking about leasing equipment you may want to reconsider this approach IF GAAP statements are a business requirement.

Recognizing Revenue from Service Contracts

This is a major rewrite for GAAP but is probably will not have a huge impact on most small businesses.  Yes, conceptually the issue exists, but most small businesses do not have agreements with customers which extend for long periods of time.  But, where your business does have an ongoing customer relationship where money is changed hands intermittently and service is on-going, then you will want to start looking at this ASC.

The biggest change is realizing that billing a customer no longer drives revenue.  For QuickBooks users, this could cause problems.  As an example, lets say your business enters into a maintenance contract which runs for twelve months.  You agree that the client gets up to 20 hours of on-call service plus a 5 hour preventative maintenance visit monthly.  The on-call hours do not roll-over and you charge $100 per hour for any hours over 20.

Historically, you know that your clients use about 300 hours additional during the year and you anticipate that this new client will be the same.  The new ASC, ASC 606, would require you to anticipate this when you recognize revenues.

What is happening is that we are separating out the revenues from what customers are going to pay.  This separation is a good thing, even though it may not seem like it.  But anyone who has ever worked with contractors and percentage of completion will understand this concept.  Billings are the offset to the accounts receivable and costs and gross profit on contracts is the offset to revenues.  The separation will make almost all businesses with contractual relationships with customers record revenues similar to contractors.

This is because we are moving into a transfer of control (knowledge, ability, compute cycles, etc.) instead of transfers of products.  Stores will likely continue their accounting the way they used to; unless they have after-sale service offerings.  Then, this will become a little more complex but still somewhat like what you are already doing.  But you need to start analyzing your processes now to see what can remain the same and what you need to change – assuming GAAP is required.

If you have questions or would like to discuss how the new accounting standards might impact your business, make sure you talk with your CPA.  Or, if you would like some help understanding what is about to happen, feel free to contact me with your questions.  We are here to help.

Have a great day.

What to Look for in an Auditor

“Why should we engage C.O.R.E.?”, asked the condominium board president.  It is an interesting question which deserves an entertaining answer.  And, even though Kubae says I should never do it, I always answer that question with another question.

“What do you hope to get from your audit?”

If you are looking for an independent CPA firm who believes that it is important to hold management accountable, then you should engage C.O.R.E.  If you want to feel good that the financial information you are using for decision-making is accurate, you should engage C.O.R.E.  If you want to understand how to better protect your neighbor’s hard earned money, then you should engage C.O.R.E.

If you are interviewing audit firms for your association, you may want to think about asking the following questions of the prospective firms:

  • Have you ever had a disagreement with management?  If so, explain the disagreement and how it was handled
  • Who do you believe is responsible for the preparation of the financial statement?
  • What steps do you take to ensure that client money isn’t misappropriated by management?
  • How do you handle GAAP departures when management doesn’t record a transaction correctly?
  • What are the three biggest weaknesses you see in association accounting overall?
  • Who do you believe is your client?
  • Have you ever caught management doing something which showed a significant weakness in the internal control structure?
    • What did you say about it?
    • Did you help management resolve it?
    • Did you help the board understand the weakness and how to address it in the future?

Each of these questions will give you insight into how the auditor might respond to your particular needs when it comes to auditing your association’s financial statements.  It is important to remember that your role, as directors, is oversight, not operations.  You are there to make sure that the management team you hired is presenting accurate information that you can use in making decisions about your association.

You want to make sure your auditor takes their role as independent, objective auditors seriously.  They do not need to go out of their way to find fault with management, but the reality is, they have almost total control over how your money is being spent.  You should want your auditor to focus on their spending of your money to ensure it is done to support your association.

As a director, you want to feel confident that the financial information that management presents is accurate and follows some standard.  How your auditor handles a GAAP departure could be important as the more management does things “their own way” the harder it is for you and your neighbors to follow it.  Make sure your auditor challenges management’s accounting treatment so you get the best information possible.

You want to feel confident that your auditor is looking for risk of material errors.  Your auditor should have a strong idea of what could go wrong and plan the audit for those key risk areas.  Thinks like spending money over the approved budget; paying themselves above their contract without the board reviewing the additional charges; hiring businesses where there is a conflict of interest.  The auditor should be on the look-out for those activities.

Keep in mind that the auditor works for the board.  This means you will want to interview the auditor and approve the audit engagement letter.  The audit is focused on management’s work so you never want to allow management to select the auditor.  Keeping these questions and approach in mind will help you get the maximum value from your audit and auditing professional.

Have a great Monday.