New Controller Tasks (#318)

In this episode, we discuss what to do in your first week as a controller.

The Need for Cash Forecasting

What should new controllers do in their first week? The answer is simpler than you might think. Always focus on the ability of the business to survive. So, if there’s not enough cash to pay the bills, then all other activities are insignificant, because the company won’t be in business. Based on that one issue, your absolute first task is to create a short-term cash forecast. Just put one together on an electronic spreadsheet, nothing fancy. The goal is to know the expected cash balance at the end of each week for the next month.

Second in priority is understanding the receivables situation. To do that, review the accounts receivable aging report with the collections people, to understand which customers pay on time, and which ones don’t. In addition, review all non-trade receivables, like employee loans, and figure out which ones can be collected, and when. Adjust the cash forecast based on what you find out.

Third in priority is understanding payables. To do that, review the accounts payable aging report with the payables folks, to learn about the payment terms associated with each supplier, the relations with each one, and which supplier invoices are likely to arrive during the cash forecasting period. Adjust the cash forecast based on what you find out. You might be detecting a pattern here.

Next up, review the schedule of debt payments. These payments might be automatically taken out of the company’s bank account by the bank – if it happens to be the lender – so that means you’ll have a reliable estimate for cash outflows related to debt – which you can plug into the cash forecast.

And for our last cash item, make sure that the bank reconciliations are up to date. If they haven’t been done, you might find that the company’s recorded cash balance is wrong, because it doesn’t include any fees that the bank took out of the account. If you find issues, make sure the cash forecast is updated.

So, all of those items – either directly or indirectly – involved cash. By working through those steps, you’ll end up with a cash forecast that should be reasonably accurate. That will tell you if the company is in trouble, or if you can proceed to working on other matters.

Set Up a Measurement Tracking System

Assuming that cash is not an issue, the next step is to create a system of measurements, so that you can monitor the condition of the company. Initially, this is all about spotting any critical issues that the company may have. So, you might want to calculate a trend line for the past few months for things like days of receivables outstanding, days of inventory on hand, gross profit margin, and net profit margin. And in particular, be sure to measure anything that has to be reported to the bank as part of the company’s loan covenants – like the current ratio. You definitely don’t want to breach the loan covenants, so stay on top of whatever measurements the bank wants to see.

Initially, just stick with measurements that you can pull out of the financial statements. Any other metrics that have to be derived with new systems should be left for later.

Investigate the Accounting Department

You should be able to complete everything I’ve talked about within the first couple of days. Next, spend some time investigating the accounting department. First up – of course – is reviewing collections, since these people can have a major impact on cash flow. Take a look at how collections are assigned, how everyone is performing, and whether there’re any collection tools they could be using to improve results. The immediate focus is on making the collections function more efficient.

After that, review billings, because it also impacts cash flow. In particular, look at how quickly billings are issued after products are shipped, to see if there’re any delays. If so, figure out what can be done to accelerate the billings. That covers the immediate issues related to cash flow.

After that, take a look at payroll. The reason I prioritize it right after cash flow is reputational, because any screwups in payroll reflect badly on the accounting department. It can take time to learn about payroll problems. Early on, you’re just trying to get a feel for what’s happening, so a good way to find out is to schedule a few lunches with the other department managers, and ask them. This might give you a few ideas for immediate fixes.

One more area that definitely needs a look is accounts payable. The main target at this point is just getting a feel for the process flow and where problems have occurred in the past. You’ll want to see if there’re any control problems that need to be fixed, and see if there might be any obvious efficiency improvements to start working on.

These investigations are not supposed to be overly detailed. You’re trying to get a feel for what type of a mess you’re walking into, so you can identify the larger issues and figure out what needs to be worked on first. You should also have a better idea of the strengths and weaknesses of the accounting staff.

Review Reports

It can also make sense to review a few documents to learn more about what other people say about the accounting system. For example, find the auditor’s management letter from the last couple of audits. This letter goes to the company president, and it itemizes any actual or potential control problems noted by the auditors. For even more information, schedule a lunch with the audit manager to discuss any other issues that might not have been included in the management letter.

If the company is big enough, it might have internal auditors. If so, ask them for any reports they’ve issued on the accounting department within the past couple of years.

One other source of information is the financial statement disclosures. The company might have revealed accounting problems in those disclosures. Don’t spend too much time on this one; any references made will probably be watered down.

So that’s what I would do during my first week as a controller. The intent is to get a decent overview of the situation, so that you can make plans from there for improvements. If you uncover something major – like a cash flow problem – then that’s definitely going to concentrate your attention.

Related Courses

New Controller Guidebook

Accounting for Crypto Mining (#317)

This episode described the accounting to be used by a crypto mining operation.

The basic task for a crypto miner is to solve a complex mathematical problem, which gives the miner a financial reward, which is paid in cryptocurrency. The process is more complicated than that, but we’re here to cover the accounting, not the mining process.

Accounting for Crypto Mining Costs

There are two major accounting issues for crypto miners. The first is how to deal with the costs of the operation. If a crypto miner uses cloud mining, this means the miner is renting space on someone else’s computers, which are called rigs. The rental cost of the rig is charged to expense in the period incurred. In this situation, the miner doesn’t have to invest in any computers or software, so there’s really nothing to capitalize.

Or, you might buy the equipment and choose to run your own mining operation in-house. If so, the computers and software are capitalized and depreciated over their useful lives. There’s also going to be a massive monthly charge for electricity, which gets charged to expense in the period incurred. Do not capitalize the cost of the electricity.

Accounting for Crypto Mining Currency

The second major accounting issue is how to deal with the resulting crypto currency. When mining activity results in the creation of currency, you can recognize it at once as revenue – there’s no need to sell it to someone else first. The amount you recognize as revenue is the fair market value of the currency on the date when it’s created.

If you then sell the crypto currency and convert it to cash, then there’s no further accounting to worry about. However, some miners want to hold onto their cryptocurrency for an extended period of time, to see if it appreciates in value. If so, just remember that cryptocurrency is classified as an intangible asset, not currency.

That means you have to reduce the value of the asset if the market value of the currency later declines. And, because generally accepted accounting principles mandate that you can’t write up the value of an intangible asset to a higher amount, you cannot do the reverse. In short, the accounting for cryptocurrency is a one-way street – you can only write its value down, not up.

The only way to record a gain on the value of your crypto currency is to actually sell it for a higher price.

Application of Section 179 to Crypto Mining

Is it possible to use Section 179 of the tax code to take an immediate tax deduction on the fixed assets associated with the operation? Yes, you can, though there’s a cap of just over a million dollars on the deduction for 2021. Another limitation of Section 179 is that the amount deducted can’t exceed the firm’s annual total taxable income. Any excess deduction is carried forward and taken in a later year’s tax return.

Related Courses

Accounting for Cryptocurrency

The Paperless Accounting Office (#316)

In this podcast episode, we discuss the best practices associated with having a paperless accounting office.

Benefits of a Paperless Office

First of all, consider the benefits of a paperless office. These days, the big one is having the accounting staff work from home, since there’s no need to access paper in the office. Second, it means getting rid of that paper storage space, which reduces the rent. And third, several people can access the same transaction at the same time, since everything is digital – which is more efficient. In short, yes, you want a paperless office.

So, what constitutes a best practice? Really, it’s any activity that gets you a step closer to having a paperless office. So, I’ll answer the question by describing how to get – or at least, how to get closer to – a paperless office.

Paperless Office Enhancements

Let’s start with payroll. I already talked about this in episodes 126 through 129, but it’s worth summarizing here. You can completely obliterate all paper records in payroll, subject to two items that I’ll get to in a minute.

First, everyone records their hours through either a badge or biometric scanner, or they log in their hours through an online portal. If you do that, there’s no need for time cards. That information automatically loads into payroll processing software, and employees are paid by direct deposit or through payroll debit cards. There are no checks. You can get all three of these functions by outsourcing your payroll processing.

Now, I mentioned that there were two issues with paperless payroll. One is that the human resources department probably maintains all kinds of paperwork on employees, and the payroll staff needs to access it for things like benefit deductions and garnishments. The best bet here is to have the HR people load these documents into a database, so that the payroll staff can access them.

The other issue is that you don’t have to print out copies of anything for archival purposes, but only if the backup system for the accounting database is absolutely bombproof. This means having an off-site backup. I don’t care how robust your in-house backup system is, if its backups are only stored on-site, then you have a problem, because any damage to the building can destroy the backup. Fix it.

The next item is invoicing customers. Going paperless here depends on your customers. Some will accept an emailed electronic invoice that also provides for an electronic payment back to your company. Others have a portal that you can access and load your invoices directly into their system. Which is labor intensive, but at least there’s no paper. But some customers are not helpful. Many of them only accept a printed invoice, for which they have a rigid payment processing procedure. If that’s the way they operate, there’s not much you can do about it. Somebody has to print the invoice and mail it.

Printing customer invoices is maybe the single biggest problem getting in the way of a truly paperless accounting office.

Next up, cash receipts. This is actually pretty easy. Set up a bank lockbox and have customers send their check payments to the bank. The bank scans the checks and deposits them, so you never see the checks. If someone sends a check to your company address, then mail it straight through to the lockbox, so the accounting department never sees it. The cash receipts clerk accesses the bank’s website to see the checks that have just been deposited, and records cash receipts in the accounting system based on that information.

There’s also a possibility of using automatic cash application, which I covered in Episode 38. This approach really only applies if you’re processing thousands of cash receipts every day and have the money to buy some expensive software, so check out the episode if that sounds like your operation.

Next up is payables. If you operate a supplier portal, then have suppliers load their invoices directly into your accounting system. If not, you’ll need to scan all incoming invoices as they arrive and store these files in the accounting system. Whether you can do that depends on your accounting software.

If you can do the scanning, there’s a question about whether to keep the invoices. It depends on the quality of your backup system, which I already covered. If there’s any risk of losing the database, then keep the invoices.

As for expense reports, your accounting software might have a module that allows employees to enter their expenses directly into the system, or you could use one of the expense reporting services, like Concur, to process them for you. Either way, there’s no need for a paper copy of the expense report or any receipts.

So, what about paying suppliers and employees? You can avoid printing checks by using online banking, where the bank issues either an electronic payment or a check. Either way, no checks are produced on the company’s premises.

That covers the main transactions. In addition, there are adjustments to the general ledger, either to make corrections generally or as part of the month-end closing process. In either case, most accounting software packages allow for some amount of narrative text that can be entered along with each journal entry, to explain the reason for it. In some systems, you may be able to include a scanned document. It all depends on the software.

As for the financial statements, it’s usually possible to print them straight to a PDF file, so there’s no need to print them out. And, you can email the PDF files straight to the report recipients.

I’ve saved the hardest item for last, which is incorporating approvals into a paperless office. This means sending documents to people for their approval through a workflow management system. This usually applies to approving supplier invoices, but it could be literally anything, like approvals for complex invoices or maybe for journal entries. Unfortunately, only the most expensive accounting packages have workflow management, so this level of paperlessness is going to be beyond most companies.

In short, it’s possible to operate a completely paperless accounting office, but it depends on the willingness of suppliers and customers to work with you on the project, and it depends on the quality of your data backups. And the amount of money you’re willing to spend on your accounting system. Realistically, most accounting departments fall a bit short of the ideal paperless system.

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Accounting Information Systems

The Financial Reporting Manager (#315)

In this episode, we discuss the nature of the financial reporting manager position, and how it varies for public and private companies.

The Financial Reporting Manager in a Public Company

What the financial reporting manager does depends on whether the company is publicly-held or privately-held. Let’s start with a publicly-held company. This business has to submit an extremely detailed quarterly report to the Securities and Exchange Commission, which is called a Form 10-Q, as well as an even longer report after the end of the year, which is called a Form 10-K.

The information required for these forms is so massive that it’s nearly impossible to do the job without a financial reporting manager. This person has to make sure that the presented information conforms to what the company has put out in the past. And, assemble a lot of footnotes. We’re talking about dozens of pages of footnotes. Which have to match the information in the financial statements. So if there’s a change in the financials, you have to comb through the footnotes to make sure that the change is reflected there.

This is an incredibly nit-picky job, and it requires a lot of experience in doing these public filings. A fair number of financial reporting managers come out of the Big Four audit firms, since they pick up the experience there when they audit publicly-held clients.

It’s an odd job. When it comes time for the quarterly reports, you work long hours. And if senior management wants to issue the financials earlier than usual, then you’re really going to be working long hours. And on top of that, the auditors will review the filing documents in detail, and if they see mistakes, they will tell the audit committee about them, so you may be looking for a new job. In short, this is occasionally a high-pressure, insanely detail-oriented job.

A really small public company might hire a part-time contractor to be its financial reporting manager, who basically only works for the company once a quarter, to complete these filings. That’s not the case for a larger public firm, where this is a multi-person team.

The Financial Reporting Manager in a Private Company

Now, let’s talk about what the job looks like in a privately-held firm. It’s completely different. What I just described for a public firm was really financial accounting – all about making sure that what you report follows the accounting rules. In a private firm, the emphasis is on management accounting. In this case, the goal is to get targeted information into the hands of the people who really need it.

This can involve a lot of things. For example, if it helps decision-making to get financial information to employees really fast and with a lot of frequency, then the reporting manager might get involved in creating data collection systems that collect just the information needed, as well as information aggregation systems to massage that incoming data and spit out reports as needed.

Now, the reporting might only be needed for a short time. If so, the reporting manager just has to cobble together some fairly rudimentary data collection systems. But, if the reporting is needed over the longer term, then it’ll be necessary to work with the IT staff to design a more automated system. Which means that some systems development expertise might be in order.

Let’s take that automation concept a bit further. What if management wants to access a dashboard of information on their computers, or phones? In that case, the reporting manager will need to get involved in the selection of an off-the-shelf software package that can handle dashboards. It’s not something you want to develop from scratch.

And another point. The information needs of a company change all the time. This means that the reporting manager should make the rounds of the management team pretty regularly, to talk about how the reporting system is working for them now, and what they want to have changed.

Part of those discussions need to address which reporting is no longer needed. In a lot of cases, managers request a report, so the accounting department keeps running the report – maybe for years – and operates the data collection system associated with it. In reality, the people who requested it quite possibly got the most benefit from it after just a couple of reports, after which no one took any additional action – which means that the subsequent reports were a waste of money.

A good way of looking at this is that the reporting manager has a certain budget for collecting data and issuing reports. And that’s it. If someone wants a new report, that’s only going to happen if the budget for issuing some other report is transferred over to the new project. Which means that the reporting manager is in the middle of the process of deciding which reports are the most cost-effective, and which ones are not. And if they’re not cost effective, then they’re gone.

So, what you’ve really got in a private company reporting manager is someone who’s comfortable talking to senior management, who knows how data collection and reporting systems work, and who understands how to configure report presentations to make them as usable as possible. Someone who can do this job should be well compensated, because they spot issues and bring them to management’s attention – which results in fixes that can improve profits.

So, what size private company hires a reporting manager? Keep in mind, this position can help to generate a profit, so the question is whether there are enough opportunities in the business to support a reporting manager’s pay. And that’s more a function of opportunities for improvement than the amount of revenue generated by the business. Nonetheless, I would guess that $50 to $100 million in revenue would be a good threshold for hiring a reporting manager.

And yes, this management accounting role for a reporting manager can certainly be used in a publicly-held company, too. After all, it’s really useful. It’s just that the emphasis in a public company is far heavier on the financial reporting side of things.

The Payables Address (#314)

In this episode, we discuss how to make a standard email address for the payables department work properly.

Overview of the Payables Email Address

This is about having suppliers send all of their communications, and especially their invoices, to payables@ the name of your company. Such as payables@ibm.com. This is one of the basic best practices for the payables department, because it creates a direct avenue between your suppliers and accounting. Otherwise, suppliers might mail invoices to the various department managers, which means that invoices can get lost in some manager’s “in” box, and you don’t find out until a supplier calls up, wondering when you’re going to pay them.

Implementing a Payables Email Address

Though it’s an obvious best practice, it can be helpful to understand the ways in which it might not work, just so you can be prepared for it. The largest issue is with notifying suppliers. You’ll have to conduct a notification campaign for all existing suppliers, so that they’ll change the default email address in their system to the payables address. Some will make the change, and some of them won’t. For the latter group, you’ll need to keep badgering them for as long as it takes.

You’ll also need a notification process for all new suppliers, which means that you include instructions in the notification packet that goes out to these suppliers when they first do business with the company. The problem is for random new suppliers who aren’t selected through any formal procurement process. Instead, a department manager just places an order with them without telling the purchasing department, and the next thing you know, the new supplier is sending invoices to that manager – which will call for a pointed phone call once the payables department realizes what’s happened.

There can also be a problem with the managers who are used to receiving communications directly from suppliers – because now they won’t be. If anyone raises a fuss, I suggest kicking the matter upstairs to the controller, who has more power to force the managers to switch to the new method. This will chew up some time, but if you really want a consistently applied communications channel for invoices, then you have to do the work.

Another issue is who gets to monitor this email address. Because if one person is designated to do it and then goes on vacation, you may not log any invoices into the system until that person gets back. This calls for a procedure to make sure that the account gets accessed at least once a day. And, if the intent is to do more than just receive invoices through this account and also address supplier problems, then the access frequency probably needs to increase to something like once an hour.

Responding to suppliers quickly is not a minor issue – because if they think you’re not monitoring this email address, they’ll go right back to sending invoices to their favorite department manager. So be sure to stay on top of it.

And just to make really sure you’re learning about any problems with the email account, post a phone number on the accounting department’s website for complaints, and make sure you monitor it.

Direct Invoice Entry

Of course, if you have a more advanced accounting system, you can require suppliers to enter their invoices directly into your accounting system through a web page. Instead of having them send invoices to an email address. Direct entry is fairly time-consuming for them, especially for big, multi-line invoices, but on the other hand, the system should send them a notification that their invoices have been received and accepted, which pretty much eliminates the risk of their not being paid.

Related Courses

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Payables Management

The Negative Impact of Policies (#313)

In this podcast episode, we discuss why you should minimize the number of accounting policies.

The accounting department issues a lot of policies, which are designed to provide some structure to how things are done within a business. The problem is that policies only work within a certain range of activities. Outside of that range, it would be better if you had no policy at all. Or, policies are designed to deal with a specific issue, but they have a negative impact elsewhere.

Examples of Excessive Policy Usage

For example. You think it’s a good idea to shift responsibility for collections among your collections people every couple of years, so that your collections staff doesn’t get too attached to the customers their assigned to. So you write up a policy to switch customer assignments every two years. What does this do? It will fix the problem you’re focusing on, but it will also make the collections people less efficient, because they have to learn about a new set of customers every two years. Maybe a better approach would be to informally monitor collection rates and make incremental adjustments if a collections person seems to be giving a few customers an excessive amount of slack in making payments.

Here’s another one, which relates to cash receipts. It may not be obvious where to apply cash received from some customers, so it’s recorded in a pending account, until you can figure it out. Some of these funds might stay unidentified for a long time, so you create a policy to review everything in the account every day. The intention is good, which is to minimize the unidentified amount of cash. But is creating a policy for it actually a good idea? If your cash receipts people are forced to review the account every single day, this is taking time away from other activities, such as helping to close the books at the end of the month. In short, issuing the policy elevates the importance of a task that isn’t really all that important. It might make more sense to spread out the policy requirement, and maybe enforce a review once a month.

Let’s move over to the accounts payable area for another example. You’re concerned about the risk of making a duplicate payment, because the invoice you have is a copy, not the original. This situation comes up when the original invoice is lost in transit, so the supplier sends a copy. To minimize the risk of a duplicate payment, you institute a policy that the responsible department manager has to personally sign off on all invoice copies. Is this a good idea? What if the invoice is for some minor amount, like $100? Someone from the accounting department will have to walk this piddling invoice over to the department manager, who then has to break away from more important work to sign off on the invoice. For invoices of this size, a better approach might be to just accept the risk of a duplicate payment, and not bother the department managers. This means that the policy might be restructured to only require a personal approval if the amount exceeds, say, $5,000.

And let’s finish with one that annoys everybody outside of the accounting department. The policy to require substantiation in an expense report whenever you want reimbursement for something paid for with cash. This is really annoying for employees, because they have to remember to ask for a receipt all the time, and if they don’t get a receipt, then they don’t get reimbursed.

Does it really make sense to impose a policy for this? Maybe for larger cash expenditures, but requiring it for everything just pisses people off.

When to Create a Policy

So what can be done? First of all, think long and hard before you create a new policy, because it could do more harm than good. It could make more sense to avoid having a policy at all, if only to maintain some flexibility in how you handle processes. If you decide that it really is necessary to issue a policy, then think about all possible ramifications, and structure the policy to deal with those outlier events that will be harmed by the policy.

And in particular, decide whether you really want to impose a policy in reaction to something that happened just once. If you keep devising policies to counteract one-time events, what you’re really doing is creating a hidebound, crusty organization that doesn’t allow its people to do anything. Instead, everything is ruled by a policies and procedures manual.

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The Accounting Controls Guidebook

The Accounting Procedures Guidebook

Making Accounting Decisions (#312)

In this episode, we discuss the process steps for making the right decisions in the accounting department.

How to Resolve Operational Challenges

The topic of this episode comes from a listener, and it is, how should professionals go about researching to resolve operational challenges. Your responses always seem so frustratingly cogent and to the point.

Annoying, isn’t it? It might help to keep in mind that I’ve been writing about accounting topics for 30 years, which is more than 10 million words about accounting. Which means that somewhere in those Word files is the answer to pretty much everything. But in cases where someone has a question that I’ve not run across before, I use trail running and mountain biking to come up with lots of ideas.

I read through a listener’s question, and then hit the trails for a few hours, and let the ideas bounce around. If it’s a tough question, it might take a couple of weeks to find the nugget of information that really drills down to the core issue.

The longest time I ever took to formulate a podcast episode was three months, and that was for episode 300, which was what to do with the rest of your time. I’ve also gotten the most positive responses from that one episode, which suggests that taking more time results in better decisions.

Example of Decision-Making

So, that’s what I do. What can you do? Let’s work through this with an example. You’re a company controller, and a department manager comes to you with a request to set up a petty cash box in his area, so he can take care of minor cash requests.

You know that petty cash boxes are a pain, because the cash is easily stolen, so all kinds of controls have to be put in place. You read through my books, and decide to take my recommendation that petty cash is bad, and that you won’t allow the request. Okay, that was step one, which was a search for outside information. Are you done? No.

You’re just making a decision based on the general principle that petty cash is bad. Is it really? In your specific circumstances?

Well, the only way to find out is to do some research out in the wild. Which means talking to your in-house expert, which is the custodian for whichever petty cash boxes the company already has.

Let’s say his name is Fred. You go to Fred and tell him that you’re thinking about banning petty cash boxes in such-and-such a department. What does he think? Keep in mind, he is the expert and you’re not, so shut up and listen. This is where accounting managers usually screw up, because they think they know everything, and they don’t. Your staff knows how accounting processes actually work, so rely on them.

Fred points out five different cases where it really does make sense to have some cash on hand to pay for immediate items. Let’s use just one, which is that the president likes to order flowers, which are delivered for the birthday of every office worker. The charge is $50, which the delivery person collects in cash. You call up the florist and ask if the company can set up an account with them, and just pay the bill once a month. Problem solved.

If – and only if – you can find solutions like that for all petty cash issues, then you have an actual case for getting rid of petty cash. Then go back to the department manager who wanted a petty cash box, ask specifically why the box is needed, and do the same thing – run through your alternatives for how not to have a petty cash box. If you can’t do that, then by default that department manager should get his petty cash box – irrespective of what I or anybody else might say about why petty cash boxes are a bad idea.

Which brings me to an uncomfortable truth for any accountant to consider. What does an accountant do? Let me quote my own website. Accounting is a system of record keeping that records transactions and aggregates the resulting information into a set of financial reports. Is that what anyone else in the company would tell you is the definition of accounting? I don’t think so.

They will say, in lots of pungent variations, that accounting is the sand in the corporate gearbox. We are the ones who get in the way of the business of the organization. We are the ones who reimburse expense reports late. And so on. There’s a reason why the Dilbert cartoon series portrays accountants as trolls in a cave. Sure, Scott Adams was going to an extreme to be funny, but that’s generally the view of the accounting department by everyone else.

Which means that your final step is to adopt the solution that best helps the rest of the company. Even if it’s not the most efficient one for the accounting department.

So let’s get back to the original question, which was how to research to resolve operational challenges. Step one, find a solution being used elsewhere. Step two, consult your own staff – or whoever is the in-house expert – to see if it will work. Step three, see if your solution needs to be modified to fit the local circumstances. And step four, make sure that the outcome helps the rest of the business. Only by helping everyone else will we be viewed as humans, and not trolls.

Managing Controls

That covers the question, but I’m going to slide over and also address the subject of controls. Because these are the real sand in the gearbox. As a general rule, adding controls slows down company operations, because you’re introducing non-value-added activities.

Logically, then, to avoid being labeled as accounting trolls, it would make sense to schedule an annual review of your control systems, to see if anything can be removed or at least streamlined. The funny thing is, the outside auditors will usually slam you for removing controls, because their focus is on risk reduction, not being cost-effective.

Have you ever wondered why the auditors are always so determined to force you to add controls? To do that, you need to drill all the way down to the baseline motivations of an outside audit firm – which means looking at the criteria used to promote auditors to the partner position. You’re not promoted if you’re the best audit manager, or the one with the most exquisite knowledge of accounting standards.

Auditors are promoted to partner for one reason only, which is their ability to bring in new business. But, what kind of new business? The profitable kind. And what kind is that? It’s the largest and most stable clients with the lowest risk of producing incorrect financial statements. You see, the risk of producing incorrect financial statements directly impacts the profits of an audit firm, because the firm can be sued for putting its stamp of approval on financial statements that turn out to be wrong, which means there’ll be an insurance payout to the plaintiff, which means that the audit firm’s insurance premiums go up, which means that the profits paid out to the partners go down.

That was a long-winded way of saying that audit partners want to increase their personal income, and they do that by lowering their risk, which means forcing their clients to install every possible control.

This puts a company controller or CFO in the odd position of constantly having to push back against the auditors to not install an excessive number of controls, because they’re trying to keep the company efficient. In short, the goals of the auditors conflict with the goals of the company, which causes trouble for the accounting department, which is caught in between.

My advice is, support the operational efficiency of the business by only installing cost-effective controls, even if it means being in conflict with the auditors all the time.

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Effective Decision-Making

How to Check for Accounting Mistakes (#311)

In this podcast episode, we describe the three-step process for minimizing and finding mistakes in the accounting department.

Step 1: Idiot Proof Accounting Positions

Checking the work of your accounting staff is a three-step process. The first step – and pardon me for saying it this way – is to idiot proof their jobs. That means making every activity as regimented as possible. For example, a payables clerk might code a supplier invoice to the wrong account. You can fix that by going into the vendor master file and setting up a default code for that supplier. The accounting software will automatically populate the account code field with this default, so that the payables clerk doesn’t have to fill it in. Most of the time, there’s no need to override the default code.

Or as another example, create a standard list of journal entry forms for closing the books, maybe with instructions for exactly how to fill out each one. That way the accounting staff understands exactly what it needs to do, and how to do it.

And as a third example, a remittance advice that customers are supposed to send in with their payments has a bar code on it that states the invoice number. By scanning the bar code instead of manually entering the invoice number, a collections clerk will always enter the right invoice number into the system – every single time.

In all three cases, we’re just making it more difficult to screw up. And incidentally, when you find an error, the first thing you should do is consider this step, to see if there’s a more idiot-proof way to complete the underlying transaction.

I’m not saying that an accounting department is filled with idiots, because it’s not – they’re usually very well trained. The problem is that a larger business might record thousands of transactions every day, and there has to be a system in place for how to deal with all of them. Otherwise, a few stray errors are bound to creep in. And that’s why you need to treat it as an industrial process, where there’s a procedure for how to do everything.

Step 2: Train the Staff

The second step in checking the work of your accounting staff is training. The number one source of errors in the accounting department is the newest accountants – as well as any older accountants who are taking on new roles. There should be a more senior person attached to each of these people, who monitors what they’re doing. The more senior person’s job is to decide when the new person’s transaction error rate is good enough to release him or her into the wild – in a manner of speaking.

A good way to make sure that a new accountant is allowed to start handling work without an intense level of oversight is to associate any errors made by this person with the responsible senior person. When you know that your own job performance depends on the performance of a newbie, it’s quite a bit more likely that you’re going to monitor that person’s performance – and in detail. So, this step is designed to ensure that newbies are closely supervised until their error rates drop – a lot.

Step 3: Find Errors with Audits

Which – finally – brings us to the listener’s question, which was how to check the work of the accounting staff for mistakes. The first two steps that I just mentioned were to prepare the groundwork, to minimize the number of errors that might be made.

So – finding errors. Since there are thousands of transactions to sort through, and it’s massively not cost-effective to review each one, the only real solution is to audit them. That means bringing in the internal auditing department to review a selection of transactions, or doing it yourself. This does not mean that you’ll find every error out there, but as long as the sample size is large enough, there’s a good chance that you’ll find a decent sampling of the types of errors that are being made.

And yes, I would conduct the sample selections by accountant, in order to get a decent set of transactions for each person in the department. And I would definitely focus the attention of the auditors on the newest accounting staff – after all, they’re the ones most likely to make mistakes.

This does not mean that other, more senior staff are exempted from the audits. They’re not. Their work still needs to be reviewed somewhat, and if you find an error in their work, then change the procedure or give them remedial training.

And a final thought. Error checking never ends. Even the most experienced accounting department in the world will make mistakes. Someone might be having a bad day, or gets distracted. So you always have to look.

Related Courses

Lean Accounting Guidebook

New Controller Guidebook

Performance Targets for Accountants (#310)

In this podcast episode, we discuss the need for quantity and quality performance targets for accountants.

The Need for Quantity and Quality Targets

The main issue here is to set a mix of quantity and quality performance targets, and the reason is that it takes a really long time to fix mistakes. I’ve never seen any studies about how long it takes to fix a mistake in accounting, but it’s got to be at least ten times higher than just doing it right in the first place. That’s because you have to locate the bad transaction, and then research it, and then formulate a correction.

Because of this enormous time requirement, you can’t just set a performance target for someone to blow through a huge number of transactions and then earn a bonus. If you do that, they earn the bonus and then you spend a massive amount of time cleaning up their debris trail.

Performance Targets for Clerks

So what does a proper mix of quantity and quality targets look like? Let’s say that a person is an accounts payable clerk. You could set a quantity target of entering at least 100 line items from supplier invoices per hour. That part of the measurement is pretty easy, and you can track it right away through the accounting system. The quality target might be no more than one error per hour – but how do you spot it?

The error might be a charge to the wrong vendor, or to the wrong account, or as of the wrong date, or in the wrong amount. There is no automated system to find this. Instead, you’ll need to accumulate these errors as they eventually percolate out of the system, and trace them back to who made the entry.

Which brings up an important point. Quantity measurements can be compiled right away, but quality measurements take a long time, so you can’t have a performance system that rewards accountants in the short term – like at the end of each month. Over that kind of a time frame, you can’t tell if a person is making mistakes. Instead, the tracking period can’t be anything less than three months, and I think even that is on the short side.

Here’s another issue. In some jobs, the work is heavily clerical, such as for a payables clerk, a billing clerk, or a payroll clerk. What I’ve just described would work pretty well for them.

Performance Targets for Skilled Positions

But then you have skilled positions where there’s less volume associated with the work. This might be a general ledger clerk or an assistant controller who puts out the financial statements. In these situations, the output may be only one product per month, which is the financials, where the quantity measure is how fast the financials can be completed. In this case, the quality of the product is way more important than the quantity measure, because you really don’t want to screw up the financials.

So for financials, the performance target is much more subjective. After all, just how accurate are the financial statements? They might be off by a material amount, but no one realizes it for a long time. In this case, the duration of the performance target really needs to be the entire year, until after the annual audit is done. Only then can you tell if the work is correct.

And even then, the performance target isn’t exactly precise. You could set an average of three business days to produce financial statements – OK, that’s measured easily enough. But then the quality target might be that the reported profit or loss for the year is within 5% of the value derived by the auditors. That sounds quantitative, but it also gives the preparer all year in which to correct her mistakes in the monthly financial statements. That means the monthly financials could be off, but the errors are fixed by year-end, so the preparer still gets paid a bonus.

An alternative is to be really subjective and just state that the financials will be prepared with a sufficient degree of accuracy – but what does that mean? So, in short, for the really skilled positions, judging quality can be a problem. I’m not sure there is a good performance target for it. But make sure that quality is included as a target, and give it a high weighting because it’s very important in this position.

Performance Targets for Intermediate Positions

And then we have jobs that are in between the clerical positions and the high-end skilled positions. These positions deal with some volume, and require more skill than someone in a straight clerical job. Let’s use the collections clerk as an example. The usual performance target for this person is how much money they can collect from customers, which is a quantity measurement. Is that really all you want to use? I think a quality measurement still needs to be used here, which whether the collections person pissed off the customer. You can’t tell right away, but track complaints from customers, and also whether those customers ever place any orders with the company again.

That can be a good indicator of quality. And, once again, it takes a long time to measure quality. And the measurement can be subjective.

Summary

So, to summarize, there should be a quantity and quality component in the performance measurement system that’s applied to anyone in the accounting department. The weighting should be more on the quality side for the more advanced positions, even though it’s difficult to measure. And finally, you’re going to need to install some tracking systems to collect information about performance quality.

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Public Utility Accounting (#309)

In this podcast episode, we discuss several unique accounting issues for public utilities.

What is a Public Utility?

First of all, what is it? A public utility is a business that performs a public service, and it’s normally regulated. It usually provides electricity, natural gas, or telephone service. For this episode, we’ll be talking about electric utilities.

If an electric utility is part of a local city government, then it generates reports based on governmental accounting standards. It’s usually reported as an enterprise fund, which is a self-supported government fund that sells goods and services to the public for a fee. Or, when a utility is privately-owned, it generates financial reports based on generally accepted accounting principles.

How to Classify Public Utility Accounting Transactions

In a public utility, one of the most important decisions for the accountant is whether an expenditure should be classified as a capital expenditure or as an operation and maintenance expense. The cost of a capital expenditure is recovered through a utility’s rate structure over several years, while an operation and maintenance expense is recovered more quickly through its rate structure.

Public Utility Rate Structures

Which brings up the rate structure. A regulated utility is allowed a certain rate of return on its rate base. This return is designed to give a utility a fixed rate of return on its operating margin. The rate base is the original cost of a utility’s plant, minus its accumulated depreciation. So, given the importance of the rate structure, it makes a lot of sense to be absolutely certain about which expenditures are classified as assets and the amount of depreciation charged.

A utility’s rates are intended to reimburse it for all operating expenses incurred. Conversely, it’s non-operating expenses are not recovered through the rates it charges to customers. Non-operating expenses usually relate to investment losses, or losses on the sale of property.

The Uniform System of Accounts

Based on what I’ve just said, the key issue in this industry is exactly which account is used to record a transaction. It’s based on some strict guidelines laid down by the Federal Energy Regulatory Commission, that itemize a complete chart of accounts and really detailed instructions for which transactions go into each of these accounts. The chart of accounts is called the Uniform System of Accounts.

And believe it or not, this uniform system is part of federal law – it has nothing to do with any of the usual accounting regulations. To find it, go to section 7 of the Code of Federal Regulations, Subpart B. It’s enormous. If you were to print it out – which I do not recommend – it would be 273 pages long.

An unusual aspect of this account structure is that it’s based on the activity-based costing system, where costs are linked to specific activities. By using this approach, you can determine the entire cost to conduct an activity, such as electricity generation or meter reading. For example, the cost of the miles that a truck is driven is then charged to a construction project to build a power transmission line. And the cost of the person driving that truck is also charged to the construction project, based on the hours of his time spent driving the truck. It makes for a pretty long chart of accounts.

I’ll just touch on a few of these accounts, so you can get a feel for the level of detail. There’s a set of expense accounts for steam power generation, another set of accounts for nuclear power generation, and even more accounts for hydraulic power generation. And then we have nuclear fuel expense, operation supervision, maintenance of structures, meter reading expenses, regulatory commission expenses, and – my favorite – customer service expenses. Didn’t know they had customer service. They also have power transmission expenses, such as overhead line expenses, underground line expenses, and load dispatching.

Regulators need this boatload of information, so that they can set rates.

Public Utility Work Orders

And then we have work orders. Construction of power generation and distribution facilities constitutes most of a utility’s capital expenditures, and that flows through a work order. So, a utility needs to have a work order system that accumulates costs for each project. And that means being able to charge employee hours to specific work orders, as well as charging supplier invoices to work orders when they’re first logged into the accounting system.

A utility construction project might very well have interest capitalized into it. The amount of interest expense that can be capitalized is not based on GAAP rules, though. Instead, it’s based on a formula put out by the Federal Energy Regulatory Commission, which takes into account all of a utility’s costs of financing, including the cost of its long-term debt, and short-term debt, and common equity.

Retirement Units

And it gets more complicated. When work orders are completed and costs are assigned to specific capital assets, the costs collected under those work orders are assigned to specific assets, which are called retirement units. A retirement unit is an asset whose cost will deducted from a utility’s accounts when it’s retired. For example, each individual pole on which power lines are strung can be classified as a retirement unit.

As you might expect, when the accounting system has to track the cost of each retirement unit, as well as its description, location, and so on, the system is going to be pretty massive. These records are called continuing property records. A decent-sized utility is going to need several accountants just to maintain these records.

Asset Retirement Obligations

And then we have asset retirement obligations, or AROs. This is the expected cost to retire an asset, and a utility has to record this obligation up front, maybe years before an asset is actually retired. The classic example of this in the utility industry is a nuclear power plant, where the retirement cost is incredibly high. The accounting for AROs is complicated, because the liability has to be constantly revisited over time, to see if the liability amount has changed. If so, the accountant has to record layers of adjustments to the liability. And again, for a larger utility, you might have an accountant who just does this.

Bond Transactions

Another large item for a utility is bond transactions. Utilities need to buy a lot of assets, and they get the funding for it from bond issuances. So, the accounting staff has to account for the sale of bonds, and fun items like unamortized discounts or premiums on long-term debt – as well as paying off the bonds.

So in short, public utilities are a tough environment for the accountant. There’s massive amounts of work to do in recording transactions in exactly the right accounts, and tracking fixed assets, and in a swarm of other areas. On the other hand, given the amount of work, you’re never going to be laid off.

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Accounting for Non-Fungible Tokens (#308)

In this podcast episode, we discuss the accounting for non-fungible tokens.

What is a Non-Fungible Token?

First of all – what is it? An NFT is a cryptographic asset with a unique identification code. Right now, the concept is mostly applied to collectibles. You might have heard of the NBA Top Shot site, where the NFT format is being used to buy and sell digital video clips of scenes from NBA games. And then there’s the largest NFT sale so far, of Beeple’s Everydays – The First 5,000 Days, for a whopping $69 million dollars.

NFTs are traded all the time on sites like Nifty Gateway. This is definitely an expanding market, so it brings up the question of how to account for them.

Accounting for Non-Fungible Tokens

There are no accounting standards yet that are specifically targeted at NFTs, but it’s pretty obvious that they’d be classified as intangible assets. So, when you buy an NFT, just record it at its purchase price. According to GAAP, the recorded value of an intangible asset can’t be increased, so the purchase price is the hard cap on the recorded value of the asset.

At the moment, the market value of NFTs is only going up. But at some point, the excitement will wear off and we’ll start to see some declines in value in the marketplace. If you’re still holding an NFT at that point, then you may have to record an impairment charge to reduce the initial purchase cost down to the current market value of similar assets.

Which brings up the issue of how to value them. You could use a comparison based on the prices at which similar assets are currently trading. Another possibility is deriving a present value for the expected future stream of earnings associated with an NFT – if there’re any earnings at all. Valuation is a tough one to pin down right now. The market is so new that market prices are extremely volatile. Given these conditions, I’d expect that an impairment calculation would be based on the average trading price of a set of similar assets over perhaps the last couple of months – just to come up with some sort of reasonably stable market value.

Another issue is whether you should amortize an NFT. Probably not, since an NFT is assumed to have an indefinite lifespan, like a trademark. In this case, there’s no point in recording a monthly amortization charge, since the NFT is expected to retain its value for an extremely long period of time.

The accounting is a bit different if you’re the creator of an NFT. In this case, the amount for which it sells is immediately recorded as revenue, since there aren’t any delayed obligations associated with the sale. And the sale price is probably going to be about the same as the related profit, since there won’t be much in the way of expenses associated with the sale.

Tax Impact of Non-Fungible Tokens

As for the tax impact, the initial sale of an NFT will be ordinary income for the creator. If you’re a subsequent buyer or seller of an NFT, then any gain will either be a short-term or long-term capital gain, depending on how long you hold the asset.

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Accounting for Intangible Assets

Accounting for Cryptocurrencies (#307)

In this podcast episode, we discuss the accounting for cryptocurrencies. I’m going to base the following discussion on what the International Accounting Standards Board has put out so far, because that’s all there is. And keep in mind that what’s been released is a bit sketchy, and needs to be expanded upon.

Classification as an Intangible Asset

The short answer for the appropriate accounting is to treat cryptocurrencies as an intangible asset. The main reason is that they’re not an established currency that’s recognized by a government. Instead, they’re issued by the private sector and designed to go completely around the existing monetary system. In most cases, they’re not backed by any underlying assets.

Cryptocurrency Held in the Ordinary Course of Business

In some cases, you’ll be holding a cryptocurrency for sale in the ordinary course of business. If so, you should initially record it at its purchase price, and then record gains and losses on the asset at the end of each reporting period. It’s going to be an unrealized gain or loss if you’re still holding the cryptocurrency at the end of the period, which means that it’s recorded in other comprehensive income. And, it’s going to be a realized gain or loss once you sell it, which gets recorded in earnings. At the moment, a good way to determine the month-end fair market value of your holdings is to look it up its price on coinbase.com.

Cryptocurrency Held for an Extended Period

So, what if you’re intending to hold cryptocurrency for an extended period of time? Well, this is where the accounting rules cease to exist. But, since I’ve stated that cryptocurrency is classified as an intangible asset, the most basic way to do it is to record the initial cost and then reduce it by any impairment later on. The problem is that this cost approach doesn’t allow for any increases in the value of a cryptocurrency.

The Revaluation Model

 One possibility is the revaluation model, which only exists under IFRS, not GAAP. Under this model, you can revalue a cryptocurrency to its fair value in other comprehensive income, and losses directly in earnings. That approach is more fair, since you can use it to record upward swings in value.

Cryptocurrencies Issued by a Legitimate Government

 So, what about a cryptocurrency that has been issued by a legitimate government? At this point, it’s barely happened. There’re a lot of countries considering it, but very few have completed more than a provisional rollout. A good example is the SandDollar, which is issued by the central bank of the Bahamas. It’s a direct liability of the central bank, and it’s backed by the country’s foreign reserves.

 So, the SandDollar sounds like a currency, but at the moment it can only be used within the Bahamas. They’re still working on rolling out a feature so that you can use it to buy foreign exchange. And when it does, will it have a separate exchange rate from the Bahamian dollar? At the moment, the Bahamian dollar is pegged at a one-to-one ratio to the U.S. dollar, but would their central bank let the SandDollar float against the U.S. dollar? Who knows – these things are still being figured out.

 But – on the assumption that government-back cryptocurrencies will be rolled out, then the accounting for them would be the same as for any other currency transactions you might have.

 So, let’s use a mythical British cryptocurrency as an example. We’ll name it after the current prime minister, Boris Johnson, so it’s the British Boris.

 A company in America enters into a transaction to pay 50,000 Borises to a London-based manufacturer in exchange for a delivery of 10,000 titanium combs. After all, the real Boris could certainly use a comb.

 At the point of sale, the exchange rate is five Borises for every one U.S. dollar, so the buying company records the seller’s invoice as $10,000. Payment is due in one month. But on the payment date, the exchange rate has changed, so the buyer has to pay $11,000 in order to deliver the same 50,000 Borises to the seller. In this case, the extra $1,000 paid is recorded as a foreign currency loss.

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The Payables Clerk (#306)

In this podcast episode, we discuss the key characteristics of a successful payables clerk. The job description is pretty simple – the payables clerk pays the bills. But, as I noted in the last two episodes, you need a particular kind of person for each accounting position. The ideal collections person is an outgoing negotiator type, while the billing clerk is an introverted process manager who doesn’t make any mistakes. When hiring for the ideal payables clerk, you need to look for yet another type of person.

The Personality of a Successful Payables Clerk

There are two factors that drive the personality of a payables clerk. One is the fact that they’re constantly getting crapped on. Somebody wants them to issue a manual check on a rush basis, and somebody else wants them to drop everything and issue an electronic payment, while a third person wants them to issue a payment to a favorite supplier, even though the paperwork isn’t quite all there yet. It can be a bit like operating in the middle of a hurricane.

And this is not a minor issue, because of the second factor, which is that the payables clerk is the last line of defense against fraud. This is the last person who really has a chance to dig through the supporting paperwork and verify that a payment is supposed to be made – and if not, to refuse to issue the payment, and tell the controller that someone is trying to force through a payment that shouldn’t be made.

So, you can see the problem. On the one hand, a payables clerk is under constant pressure to get payments out the door, and yet also needs to slow down and make sure that the supporting paperwork is correct. This calls for a very particular kind of person. A good term would be obstinate. The best payables clerk has an absolute knowledge of how the payment process is supposed to work, and is absolutely not going to deviate from it.

If that attitude pisses off other managers who want to get payments done as fast as possible, then that’s just fine – you have the perfect payables clerk. Of course, it doesn’t hurt if that same person has a reasonably polished manner when dealing with other people, so that he or she doesn’t really piss people off. Instead, the best approach is for the clerk to clearly state what the payment process is, and what paperwork is required.

As long as the clerk states exactly the same rules every single time with everybody, then eventually no one will try for a special exemption for a payment. At this point, the payables clerk will have trained the entire company in the procedure for getting a payment out the door.

A consideration here is whether you can really expect someone in a low-level clerical position to stand up to a department manager – or someone in an even higher position – about when to make a payment. No, of course not. But the ideal payables clerk will wait for approval from the company controller, and not just accede to every demand the moment it’s made. That takes the pressure off the clerk, and forces the controller to make the payment decision.

Characteristics of a Bad Payables Clerk

Based on this description, you can see what a bad payables clerk looks like. This is someone who’ll bend over backwards to accommodate anyone who needs to get a payment completed right away, even in the absence of the proper paperwork. Because of the need to please, any possibility of detecting fraudulent payments vanishes, which will eventually result in losses.

How to Measure the Performance of a Payables Clerk

Now, how can you measure the performance of a payables clerk to see if you have a good one? No, it isn’t based on the number of outraged managers bugging you about why the clerk isn’t issuing payments as fast as they’d like – though personally, I kind of like that one. The most quantitative measure is whether they’re paying suppliers exactly on time. Not too early, and not too late. In particular, look for early payments. A consistent pattern of early payments indicates that a payables clerk is suffering from that need to please that I mentioned earlier, and immediately issues a payment when anyone important badgers them about it.

So in summary, when I’ve been talking about accounting positions over the past few episodes, the focus has been on the ideal personality for each position. And there really is a difference. You could have a truly great collections person fail as a billing clerk or a payables clerk, because the personality type needed is different. This means that you should take the time during the interviewing process to spot the right personality type for each job. If you spend enough time on this, the effectiveness of your accounting staff should go up.

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The Billing Clerk (#305)

In this podcast episode, we discuss the characteristics of an ideal billing clerk. The basic billing clerk job description is pretty straight-forward; this person prepares invoices, processes credit memos, and might issue month-end customer statements. But let’s dig a little deeper.

The Billing Clerk Personality Type

The main focus of this job is to issue invoices that are accurate and on time. What kind of person does this? Probably not the personality type that I talked about last time for a collections person, which is an outgoing negotiator type. For a billing clerk, you need someone who really enjoys getting into the details – probably an introvert. The essential ingredient for a billing clerk is someone who does not make mistakes. And there’s a good reason for that, because even a tiny mistake on an invoice could cause a customer to refuse to pay, in which case the company isn’t going to receive cash that it might have been counting on.

So, in a way, you need the ultimate bureaucrat. This is someone who always checks to make sure that the amount ordered is the amount that was actually shipped, and that the pricing stated on the invoice is the same one that the customer put in its purchase order.

Why a Billing Clerk Needs to be an Investigator

Now, in case you think the ultimate billing clerk is someone who used to work in a library and has a permanently pinched look when everything is not in perfect order – not so fast. The ideal person for this job is a little bit different. Whenever there’s an error somewhere in the paperwork, the best billing clerk goes on a hunt. This means heading over to the shipping department to talk with the manager about why a different quantity was shipped – or maybe something else was shipped as a replacement.

Or, it could mean a visit to the order entry folks, to see why a customer was given a special price that’s not in the standard price list. Or, maybe a visit to the marketing department, to see why a cooperative advertising allowance is being deducted from an invoice.

What the ideal billing clerk is not, is someone who sees an error and then just passively waits for the answer to arrive, without issuing an invoice at all. They’re not aggressive about it, so invoices could be delayed for days, or weeks.

What I’m getting at is that a good billing clerk is a good deal chattier than you might initially think is needed for the job. This implies that a somewhat more senior person, maybe someone who’s been with the company for a few years and knows everyone, would be the best operator for the job.

The Billing Clerk as Process Consultant

This gets us into the general vicinity of the right personality type, but we’re not there yet. The billing function is the place where two different sets of information come together. One is the customer order, which comes from the order entry department, and the other is shipping information, which comes from the shipping department. These two data sets don’t always match up, which means that errors will occasionally pop out.

A good billing clerk doesn’t just have a chat with the originating person in order to clarify matters, but also digs around to see if there’s a structural flaw in the system that allows the error to occur. Maybe there’s a missing control. Whatever it happens to be, the ideal billing clerk has such a good knowledge of the procedures that he or she can figure out how the error occurred, and how to fix it. This results in a recommendation to the controller, who works on altering the system to eliminate the error.

So as you can see, our conception of what constitutes a good billing clerk has advanced from – well, basically a monk, to someone who’s also comfortable hitting up other departments for information, and then to someone who’s also a bit of a process consultant.

Billing Clerk Training

As I noted earlier, a more experienced person is probably going to do better at this job, since it involves being fairly comfortable with prowling around the organization. But in addition, you can accelerate the process by imposing extra training up front. This would involve a detailed review of exactly how the billing process is supposed to work, and walking the person through the organization so that they can actually see it in operation.  It also means talking about when to flag an error, what’s probably causing it, and who to talk to in order to get it fixed. Essentially, you’re giving the clerk every tool needed to be a consultant.

It can take a bit of work to measure whether a billing clerk is a good one. You can certainly talk to the collections people to see if any customers are complaining about billing errors. Another approach is to track billing errors by type, to see if the clerk is fixing them over time, or just letting them ride – so that error rates don’t go down. You can also monitor how much the clerk is visiting other departments to clarify billing information. This means that you’ll need to assemble a picture from a number of sources, but it should give you a good idea of whether a billing clerk is a keeper – or not.

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The Collections Clerk (#304)

In this podcast episode, we discuss the characteristics of the ideal collections person.

Requirements for a Collections Clerk

Consider just how difficult this job is. The ideal collections person needs to be an extrovert, because it requires a lot of time on the phone. And on top of that, it needs someone who’s a bit edgy – who not only doesn’t mind badgering people all day, but kind of enjoys it.

Also, the ideal collections person needs to be an introvert, in order to shut up and listen to what customers are saying about why they can’t pay. And they need to be a negotiator, to finagle the best possible payment terms out of the customer.

That right there is hard enough. But then, the collections person has to be super organized, in order to make contact with customers as soon as payments are overdue. And then if a customer makes a payment promise, the collector needs to track whether the cash came in when it was supposed to, and contact the customer again – immediately – if it doesn’t. This is more of a characteristic of an introvert.

And yes, I know – there are software packages that can help with the organizational side of collecting, right down to scheduling phone calls by time zone and incorporating an autodialer. Nonetheless, an inherently organized person will always do better in this job.

Not done yet. You might have heard that shit flows downhill. Well, in a company shit flows downhill to the collections person. This is because any mistake in product development, or procurement, or manufacturing, or shipping all ends up getting dumped on the collections person – and the reason is that customers refuse to pay because they don’t like whatever the company sold them.

The most awesome collections people listen hard to what customers are telling them about why the company’s products suck, and then work right back through the company to make sure that everyone knows about it.

Ideally, the collections person writes down internal process problems, and then badgers the people who are responsible for those problems, so that they get fixed. This is not easy. It means at least dumping the problem on the controller, and maybe going into a meeting to tell a bunch of department managers that they’re screwing up.

This is hard. It means telling the unvarnished truth to much more senior people, and as diplomatically as possible. And if the controller is a wimp, then the collections person might have to do this without any departmental support.

How to Measure a Collections Clerk

It might seem fairly easy to figure out which collections people are good, because you could just look at their collection rates. But that’s not the case. Someone might beat on customers to get paid sooner, but screw up the relationships so badly that customers end up buying from someone else. Or, someone who’s busy trying to solve an underlying problem doesn’t spend as much time making collection calls, so the collection rate doesn’t look so good.

So, it takes a more detailed analysis. You’ll need to chat with customers, to get their opinion. And talk to the other departments, to see if the person has been working problem resolutions back up through the company. It takes a lot of work. But you’ve got to find out, because someone with all of the right skills is very nearly priceless.

How to Build Up the Collections Department

Now, how can you build the reputation of the collections staff within the accounting department? One way is to set up a mandatory rotation through the group for anyone who wants to be promoted. By doing that, the assistant controllers and the controller will all understand how hard this is.

Another way to build up collections is to pay the best ones more money. And I’m not talking about a five percent pay boost. I’m talking about a fifty percent or a 100 percent pay boost. That might not seem economical, but consider two points.

First, collection people are the nearest thing to sales people in the accounting department. They save revenue from being lost through bad debts.

And second, if they can save revenue, then they’re worth way more than any other accounting clerks. By paying them a lot more, you’ll keep the best collections people for a lot longer.

I’m only talking about paying the best collections people a lot more money. Start new collection folks off at a normal pay rate, set high expectations for them, and provide massive amounts of training. Most of them will still fail, because this is a difficult job. But a few will be spectacular, and those are the ones to bury in cash.

And another point about a high rate of pay is that you won’t have any trouble attracting applicants for the job. Turnover will be high, because you’ll have to sort through the people who just aren’t going to be productive. That’s OK. The whole point is to dig through those applicants to find the few who can really do this job.

I’ll finish by returning to the earlier point about training. This is the only position in the accounting department that deals with customers all the time. So why would you have an untrained person contact a customer, and potentially piss them off? And then stop buying from the company. Instead, this position needs a lot of training, so you feel safe unleashing them on a customer.

Related Courses

Credit and Collection Guidebook

Effective Collections

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.

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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.

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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.

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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