Accounting Training for the CFO (#373)

The Level of Accounting Training that a CFO Needs

What areas of accounting are most important to know to be an effective CFO? Lots of chief financial officers do not come up the promotion path from the accounting department. They could also be promoted in from the treasury side of the business. When this happens, you have lots of expertise in raising money or investing it, but really don’t have any idea what goes on in the accounting department. You may not have taken any accounting classes at all, so this whole area is something of a black box.

The main item to understand is that you don’t need an excessively detailed understanding of accounting to be a CFO – things like how journal entries work, or the details behind the month-end closing process. If you have a reasonably competent accounting team, then they will take care of all that. Instead of going deep, I suggest getting a book on accounting for managers. AccountingTools sells one of these books, and you can find other competing books on Amazon. These books provide you with a basic introduction to accounting concepts, and talk about the financial statements, how to interpret them, the types of accounting reports that are of most use, and how accounting impacts different parts of a business. You can read through one of these books in a couple of weeks in your spare time, and that gives you a high-level understanding of what’s going on.

Is that enough? No. Being a CFO means that you’re responsible for risk management, and there are a fair number of areas within accounting that can go wrong. And you will be the person who’s responsible for those failures. For example, if you become the CFO of a publicly held company, you have to personally certify that the financial statements being released every quarter are accurate. If the financials are not accurate, then you personally could be criminally liable.

The Need for Controls Training

Given that you might end up in jail, I think that controls are a pretty good place to gain a deeper knowledge. Now, does this means that you should go crawling all over the company, digging into every control that’s ever been installed? No. That would be a bad use of your time, especially since larger companies may have hundreds or even thousands of controls in place. What it does mean, though, is that you’ll need to offload this work to the internal audit department, or maybe an outside firm.

Let them dig through the company and report back about any shortcomings in the controls. But this isn’t just about delegating the work. You’ll need a fairly in-depth understanding of what controls do, and what makes for a strong or weak control environment. So, in this one area, I’d suggest taking a course on accounting controls, or buying a book about it.

The Need for Risk Training

In addition to controls, you’ll need to understand any accounting areas in which there’s a significant risk of failure. For example, if your company sells software packages that include an installation component and a training component, that means you have a complex revenue recognition environment. In this case, you’d better get a book or a course on revenue recognition. If that’s not the case, and instead your company only sells lawn supplies for cash, then I wouldn’t worry too much about revenue recognition.

Here's another one. What if you’re the CFO of a high-fashion business, where the clothes you sell can go out of style at any moment? Better read up on the accounting for inventory, then, or else you might be caught with an overvalued inventory. But if your company doesn’t even deal with inventory? Then you can skip the topic entirely.

Training Areas to Skip

There are also some areas in which your knowledge of accounting can be pretty low and stay that way, because they’re basic nuts and bolts accounting topics that are usually fairly well run. That includes billings, accounts payable, and maintaining the general ledger. As long as they have the appropriate controls, of course.

Industry-Specific Training

And then there are very specific accounting topics that you’ll need to know about only in certain industries. For example, if you’re the CFO of an oil & gas firm, you’ll want to know all about the capitalization of drilling expenditures. Or, if you’re the CFO of a shipping company, you’ll really need to understand the capitalization of dry docking expenses. And if you’re running a nonprofit, then you’ll need to understand the finer points of how to classify expenditures as program-related or as management and administration – and if you get wrong, you’ll get pounced on by donors. So, when you’re hired into one of these businesses, sit down with the CEO and the controller, and discuss whether any of these super-important accounting topics exist – and then dig into them in detail.

Training to Manage the Department

That covers understanding accounting from a risk management perspective, but not from a management perspective. If you are the CFO, then you’re responsible for the accounting department, which means having an understanding of how it runs. To do this, your best bet is to get a book on the controller position.

I have one called The New Controller Guidebook, and you can find other ones on the market. The main point is to understand when the accounting department is operating correctly, and when it isn’t.  This doesn’t require an in-depth knowledge of accounting, but you will need a set of metrics for the department. For example, you might want a report on the time taken to produce financial statements each month, or the number of early payment discounts that were lost, and certainly something that lists the total compensation expense of the department. You can benchmark that last number against industry standards to see if it’s reasonable. It’s important, because compensation is the biggest expense within the department.

Training for the Financial Statements

Outside of risk management and overall department management, the other area in which to get some training is your employer’s financial statements. As the CFO, you’re the person that investors and lenders are going to talk to about specific items in the statements.

Which means that you need to fully understand every single line item in the financial statements, as well as all of the footnotes. Look at this from the perspective of a CFO who’s running a public company. You might do quarterly earnings calls with investors, and they can badger you about absolutely anything that was included in your quarterly Form 10-Q report. So you’d better be prepared.

This means that you’ll need a detailed knowledge of the structure of financial statements and the ratios that outsiders are likely to apply to them. This isn’t difficult. I sell a book called The Interpretation of Financial Statements, as well as the Business Ratios Guidebook, and again, you can find alternatives on Amazon. Read these books in detail, and keep them on your bookshelf. You might have to refer to them a lot, especially during your first few months on the job.

In addition, you’ll need to sit down with the controller and go over the contents of every single line item in the financials, so that you really understand what goes into them. And, you’ll need to do this after every set of financial statements is released, because you’re the one who’s going to be asked about them.

So, what is the learning curve like for all of this? Steep, for the first few months. And if you change industries, then there’ll probably be a whole new set of accounting rules that you’ll need to learn. But realistically, once you get over the initial hump of book learning, it’s mostly about keeping up-to-date on changes within the accounting department, and on changes in the financial statements.

Related AccountingTools Courses

Accounting Controls Guidebook

Accounting for Managers

Business Ratios Guidebook

New Controller Guidebook

The Interpretation of Financial Statements

The CPA Firm Business Model (#372)

The topic of this episode comes from a listener, and it is, please talk about the billable hours model of CPA firms. Do you think that is what’s preventing people from becoming CPAs? Do you think billable hours are an employee surveillance tool? Having enough billable hours and staying within budgeted hours causes me enormous stress. End quote.

Well, that certainly covers the experience of a lot of new auditors! To respond to that, I’ll describe the business model of a large audit firm. Then you can see why new auditors are under so much pressure.

The CPA Firm Business Model

The sole focus of this business model is how much money an audit partner can make. And believe me, they make a lot of money. In order to make that money, they have to tweak how their organizations operate. This involves a couple of changes that put a lot of pressure on their employees. One of these changes is a billable hours goal. When I worked for Ernst & Young, the audit partners came back from one of their retreats and proclaimed that everyone had to work an average of ten billable hours per working day. I have no idea what that number is now, but the main point is that any auditor is going to be reminded – frequently – that they need to meet their billable hours goal. This can be really hard, unless you want to work late and on weekends.

The second point is that you can’t just record any old hours against a client account. You have to charge hours that are actually billable. There’s always a cap on how much of a fee clients are willing to accept without a lot of pushback, so the audit partners want their employees to charge roughly as many hours as were charged against an audit job in the preceding year. If they charge more than that, then the excess is maybe not revenue for the firm, and the partners don’t make as much money.

Therefore, and on top of meeting a billable hours goal, you also have to be efficient. This is really hard for a lot of new auditors who are fresh out of school. They know about accounting and auditing in theory, but they haven’t seen it in practice before. So the expectation to get up and running right away, and also meet a billable hours goal, can be quite a shock. This is why a massive number of new auditors quit in their first year. They find that they can’t be both efficient and billable all at once. It’s not impossible, but it’s designed to be really hard.

Which brings me to the third part of the business model. The focus in a large audit organization is up or out. There’s a very specific promotion path, where you have to be promoted into the next level every year or two, or else you’re counseled out. This occurs at all levels, including at the partner level.  And even if you’re a successful partner, you’ll still be forced to retire, once you reach the mandatory retirement age. And yes, they have to force out nonperforming partners in order to make room for new partners. If you have too many partners in the business, then the profits have to be split among too many people, and that does not maximize the profits that each partner receives.

For example, you might have worked hard for years, make it all the way to senior manager, and then get hit with a new goal, which is to bring in new business. If you can’t generate the revenue – and it’s not easy – then you’ll eventually be pushed aside, to make room for someone coming up behind you. And, what if you do make that revenue target? Then you get promoted to junior partner, rather than full partner. Why is there such a position? Because it puts one more layer between you and the pot of gold that’s paid out to the senior partners.

Exceptions to the Rule

There are a few exceptions. If someone is an amazing specialist in one or two areas, then they may be kept there. For example, my wife turned down a promotion to senior manager for five consecutive years. She kept turning it down, because her billing rate would go up by so much as a senior manager that she knew she wouldn’t be able to generate enough billable hours. She was a really good project manager, so they let her stay where she was. Eventually, though, she was forced to take the promotion, and only lasted another couple of years before her billable hours dropped enough that she just couldn’t stay there any longer. She wasn’t forced out, but she was extremely unhappy. And, there were quite a few nights when I’d have to tell the kids that mommy couldn’t read them a bedtime story, because she was still at work. A few times, she got home at one o’clock in the morning. So, she eventually resigned. And there you have a real-life example.

Nonetheless, the up or out process applies to nearly everyone, and the point is to make sure that there’s always a constant stream of fresh blood coming up through the organization. And somewhere in that new group will be a few people who take to auditing right away, and who are willing to put in the hours to be sufficiently billable, and who can eventually bring in new business, too. As for everyone else, you’re out of luck.

And that is the audit firm business model. You force people to be extremely billable, you weed out the ones who aren’t efficient, and you dump nonperformers to make room for new people.

Why People Still Work at CPA Firms

This sounds brutal, and it is. Why would anyone put up with this crap? The reason is pretty simple. Working for a major audit firm is a big item to have on your resume. If you last a couple of years, then that gives you a big advantage in getting a mid-level accounting job in the private sector. If you can make it to audit manager and stick around another year or two, then you can probably pick up a controller position at a client. Or, if you bail out as a senior manager, it’s not unreasonable to expect a CFO position to open up for you somewhere else. In short, everyone knows the system is rigged against them making it all the way to partner, but they all put up with it anyways.

Does the Business Model Reduce the Number of CPAs?

Now, let’s go back and address a couple of other items that the listener brought up. Does this system prevent people from becoming CPAs? Yes, of course it does. A lot of people quit in the first year – usually about twenty percent of the new hires – and most of them never want to come near the profession again. So in their case, the experience drives them away from the CPA certification. Even if they already passed the CPA exam, they simply have no interest in being a CPA anymore, and they’re not willing to stick around long enough to complete the experience requirement.

Are Billable Hours a Surveillance Tool?

Now, let’s address that other listener question, which is, do you think that billable hours is an employee surveillance tool? Not exactly. It helps to understand how you’re assigned to an audit job. There’s usually a scheduling person within the firm who assigns auditors to jobs. The audit managers talk to these schedulers all the time, to see who they can get on their jobs. If you understand auditing and you’re efficient, then word gets around pretty fast, and all the managers will want you to work for them. But if you’re not, then that information gets around just as fast, and you’ll find that you’re not being scheduled on jobs anywhere near as much. In essence, you’re the last kid on the playground who gets picked to be on a team. And that means that your billable hours will drop, and you won’t make your annual goal. And if you don’t make the goal, then you’re out.

The Differences Between US GAAP and UK GAAP (#371)

What are the differences between US GAAP and US GAAP?

FRC vs. FASB

The first difference is that UK GAAP come from the Financial Reporting Council, which is located in London, while US GAAP comes from the Financial Accounting Standards Board, which is based in Norwalk, Connecticut. And as an aside, I’m not sure how long the Financial Reporting Council is going to be around. Back in 2018, an independent review council recommended to the UK government that it be replaced, but nothing ever happened. Since then, there seems to have been quite a bit of dithering within the UK government over how to replace it.

At a high level, UK GAAP is essentially a variation on International Financial Reporting Standards that generally allows for fewer disclosures than are required under IFRS. A bigger business in the UK will typically use IFRS, while a smaller business or a subsidiary of a larger one would use UK GAAP.

Asset Revaluations

A significant difference between the two standards is in the area of asset revaluation on the balance sheet. This is generally not allowed under GAAP, especially for fixed assets. That is not the case under UK GAAP, which follows the IFRS practice of allowing you to revalue assets to their current market values. This does not mean that you have to revalue certain assets under UK GAAP, only that it’s an option. Since revaluations require more accounting work, I generally advise against it.

Interest Capitalization

A potentially large difference involves whether you can capitalize the cost of interest on construction projects. Under US GAAP, you would capitalize this cost. Under UK GAAP, you have the choice of doing that or charging it to expense. I kind of like the UK approach, since there’s less accounting work involved in just charged off interest expense as it’s incurred.

Intangible Asset Treatment

And then there’s a difference between the accounting treatment of intangible assets. Under US GAAP, you have to conduct at least an annual impairment test for any goodwill assets or other intangible assets that have indefinite lives. UK GAAP has the annual impairment test as well, but it also requires some sort of useful life for all intangible assets, without exception, which is usually capped at ten years. This means that impairment testing is less necessary, since the underlying asset is going to be written off over time anyways.

And speaking of impairment testing, there’s another difference. Under US GAAP, you conduct impairment testing using undiscounted cash flows, while UK GAAP mandates the use of discounted cash flows.

Inventory

Another difference is in the inventory area. Under US GAAP, you’re allowed to use last-in, first-out accounting to value your inventory, while it’s not allowed under UK GAAP. Instead, UK GAAP only allows the use of first-in, first-out accounting, or weighted-average accounting. I think the UK GAAP has it right on this, since there’s very little basis in reality for using the LIFO system. Instead, it’s really just an excuse to drive down your reported profits, on the assumption that your inventory cost is increasing over time.

Product Development Costs

And then we have product development costs. Under US GAAP, you nearly always have to charge all development costs to expense as incurred. That’s not the case under UK GAAP, where you can capital these costs, but only if you can prove the technical feasibility and commercial viability of the product, as well as management’s commitment to sell it. This difference can be fairly significant. That being said, you can also elect to just charge off these expenses under UK GAAP, no matter what.

Contingent Liabilities

There’s another difference in the area of contingent liabilities, though it’s really just a change in the wording. Under US GAAP, you recognize a contingent liability when there’s a probable outflow of resources to settle an obligation, and you can reasonably estimate the amount. Under UK GAAP, it’s essentially the same thing, but now it’s called a provision instead of a contingent liability.

Related AccountingTools Courses

GAAP Guidebook

A New Year's Resolution (#370)

I sometimes talk about something other than accounting, if I think it might be of interest. So, I’ve timed this episode to be just prior to new year’s day, in case you want to try out my suggestion, and roll it into your new year’s resolutions.

The main problem with new year’s resolutions is that they almost never work. You might resolve to walk a bit further during the next year, or go to the gym, or maybe try to stop eating sweets. Good luck with that last one. I ate a couple of chocolates yesterday.

But. I’ve found something that works for me, and has been working for years, so I thought I’d pass it along. I set a target activity for a really stout piece of cardio work that going to happen sometime in the next year – probably in the second half of the year, which forces me to work towards it for months. And this is something that’s actually pretty exciting, and which requires a bit of a monetary investment to do it, so that I’m really locked into the project.

In order to achieve that target, I have to set up a series of training goals that really need to be met in every single month leading up to the event, or else I may not be able to do it. As an example, in 2024, my cardio target was to hike the Grand Canyon rim-to-rim, and to do it in October, when the temperatures are lower. This is not an easy target. You go down 5,500 vertical feet from the South Rim, hike 24 miles across, and go back up 6,500 vertical feet to reach the North Rim. And to make it even more challenging, there’s a shuttle that leaves the North Rim at two in the afternoon to bring you back around to your starting point, so you’ve got to complete the whole thing by 2 p.m., or else you’re pretty much screwed.

That’s a challenge. To train for it, I did a half marathon trail run in each month of 2024 leading up to the hike. And to train for each half marathon, I did a ten-mile trail run about every third or fourth day, on an ongoing basis. Which adds up to a lot of training. And on top of that, I decided to lose five pounds, since I didn’t want to be carrying any extra weight through the Grand Canyon. Now, normally, I have a hard time taking off weight. But when you’ve got a goal like that coming up, it really focuses the attention. So, yes, I lost the weight.

And in case you’re curious, I started from the South Rim at 2:30 in the morning with a headlamp, and finished at the North Rim nine hours and 42 minutes later. And got there in time for the shuttle.

In case you think this was a one-time event for me, no, not really. Let’s roll it back one year. In 2023, the target was the Laugavegur Trail, which runs from north to south in the backcountry of Iceland. If you look up any listing of the most iconic hiking trails in the world, you will definitely find it. The Laugavegur is 34 miles long, and the elevation gain is 7,000 feet. The usual approach is to take a bus from Reykjavik, which is the capital of Iceland, and which drops you off at the northern trailhead at about noon. Most people then take four days to backpack the trail, and they stay at huts along the way. At the south end of the trail, there’s another bus that takes you back to Reykjavik, and it leaves at 2 p.m. Though in this case, there’s also a late bus that departs about four hours after that.

I set a target of starting at the northern trailhead at noon, and catching the bus from the south trailhead at 2 p.m. the next day. So, 26 hours in total. That meant going ultralight with just enough equipment to camp out for one night. And to make things more interesting, there are a bunch of stream crossings to get through, and there have been a few drownings. The risk of drowning is really pretty low, but the crossings will slow you down.

The final score on this one was 24 and a half hours, trailhead to trailhead, and I got to the south end in time to catch the bus back.

So to prepare for the Laugavegur goal in 2023, I had the same intermediate goals of doing a half marathon trail run in every month, with lots of ten-milers to prepare for the half marathons. In fact, the half marathon goal has worked out so well that I’ve now done one in each of the last 103 consecutive months. And that streak is still going.

One problem that has come up over the years is a certain amount of wear and tear. But I’ve found that, if you stay on top of these issues, you can keep going. For example, I had a partial Achilles tendon tear a few years back. Well, there’s an electrical stimulation treatment that can heal the tendon. I had to take a few weeks off and go to the doctor’s office every few days for treatments, but it healed up, and I kept running. The main takeaway from that one was to do a very specific set of lower-leg stretches every single day. So that’s what I do, and the problem has never come back.

Or, here’s another one. I run on some very rough trails, and I was starting to roll my ankles all the time – which is not good. Well, there are strengthening exercises for your ankles that involve using a large rubber band. After a couple of weeks, I stopped rolling my ankles, and it’s never happened since.

In short, over the long term, there’s always going to be an injury, and you might be tempted to stop at that point. Instead, I suggest going to see a doctor immediately, and figuring out the options. With the proper therapy, you might be able to keep going, and actually come out of it with a better training regimen.

And, in case you’re curious, yes, I have another goal in mind for 2025, and it’s to climb the highest peak in Spain. I’m training for it now.

One more item – and call this one a pro tip, in case you plan to hike the Grand Canyon rim-to-rim. If you’re using a GPS to track your mileage, it doesn’t work so well on the north side of the Grand Canyon. The reason is that the trail goes through a slot canyon there, where your GPS has a hard time picking up satellite signals. I found that my GPS was off by almost two miles by the time I got to the North Rim. So, be aware.

And a final thought. If you’re not especially athletic right now, don’t go setting a new year’s resolution to do something that might kill you. A mid-range goal is perfectly acceptable. So if you set a goal and wake up at night, wondering what on earth you were thinking, that’s probably a bit too much of a stretch goal.

All right, one more thought. If the goals I’ve covered in this episode seem like a lot, just keep in mind that there’s always someone out there who is absolutely superhuman. For example, people also hike the Grand Canyon rim-to-rim-to-rim. Which is 48 miles and at least 12,000 vertical feet. And if you think that sounds crazy, the trail running speed record for the rim-to-rim-to-rim is five hours and 55 minutes. Don’t try to keep up with these people. Just set goals that work for you.

Accounting for Crypto Assets (#369)

Accounting for Crypto Assets

Until recently, the rule under Generally Accepted Accounting Principles was that crypto assets were to be classified as intangible assets. This means that when you purchase a crypto currency, you record it at the purchase cost. After the acquisition date, you could not increase the recorded value of the asset, even if the market value went up. Instead, all you could do was record an impairment to the asset if its market value went down. So essentially, it was a one-way ratcheting mechanism that resulted in the lowest possible cost being recorded.

The original reason for this treatment as an intangible asset was that crypto currency was considered to have such a volatile price that it couldn’t be considered a form of cash. And on top of that, it wasn’t issued by a sovereign government. So it couldn’t possibly be considered a form of cash – or, could it?

The problem is that crypto currencies do have value, and – depending on the currency – that value may go up by quite a lot. This resulted in a disconnect, where a business might be recording a crypto asset value on its balance sheet that was far, far lower than its market value.

So, as you might expect, the Financial Accounting Standards Board got a lot of complaints – about 500 of them – about the official line on how to account for and disclose crypto assets. This resulted in a change in the accounting that was announced at the end of 2023. I haven’t brought it up until now, because it’s set to go into effect in about two weeks.

Accounting for Crypto Assets at Fair Value

The new accounting is to account for crypto assets at their fair value, with any changes being recognized right away in net income. What this does is match the reported value of your crypto asset holdings to their market value at the end of each reporting period. If the market value has declined from the previous reporting period, then you recognize a loss. Or, if the market value has increased, then you recognize a gain.

This is a definite improvement in the overall accounting, since now you can really see the current value of someone’s crypto assets. An additional change is that crypto assets have to be listed separately on the balance sheet from all other intangible assets. This makes sense, because the other intangibles are measured differently, with a cost basis that’s subject to impairment testing.

If anything, it looks as though crypto assets are being accounted for like investments in equity securities. That being the case, I have to wonder why crypto assets are still being reported adjacent to intangible assets, when they really ought to be stated further up in the balance sheet, as part of investments. And someday, maybe that will happen.

Crypto Asset Disclosures

Which brings us to the required disclosures. A good one is a required breakdown of your crypto asset holdings. You have to disclose the name, cost basis, fair value, and number of units for each significant crypto asset holding, plus the same information in aggregate for any crypto assets that are not individually significant. This is really useful. Let’s say you’re a lender and you want to evaluate the riskiness of someone’s crypto holdings – this disclosure provides the detail that you need.

There are also some less useful disclosures. For example, if you sold any of these assets, you have to disclose the difference between the cost basis and the sale price. Not sure I see the point.

There’s also an annual roll forward requirement, where you have to present a table that shows crypto asset beginning balances, and subsequent purchases, subsequent sales, and gains or losses. I’m not seeing a good use case for that one, either. Still, overall, this is a significant improvement in the accounting for crypto assets.

Related AccountingTools Courses

Accounting for Cryptocurrency

Accounting for Carbon Credits (#368)

What is a Carbon Credit?

We begin with, what is a carbon credit? It’s a permit that allows you to emit a certain amount of greenhouse gases, which usually means carbon dioxide. Each carbon credit gives you the right to emit one metric ton of carbon dioxide or its equivalent in some other greenhouse gases. And by the way, one metric ton equals about 2,200 pounds. Governments issue these credits when they’re trying to reduce emissions in order to reduce the effects of climate change.

Carbon credits are part of a cap-and-trade system, where the government sets a cap on the total amount of greenhouse gas emissions that it’s going to allow per year. The intent is usually to reduce the amount of this cap over time, which forces companies to reduce their emissions of greenhouse gases.

Under the cap, a company can either receive or purchase the carbon credits that it needs. For example, if the government issues a manufacturer a permit to issue one thousand tons of carbon dioxide and it doesn’t actually use all of this amount, then it can sell its excess credits. Conversely, if it emits more than a thousand tons, then it has to buy credits for the overage, or else pay the government a penalty.

Under this system, you could buy the credits from an official offset project, such as an operation that plants trees that soak up carbon dioxide. And as an aside, AccountingTools is a partner of the National Forest Foundation, and in the past twelve months, we paid to have a little under 10,000 trees planted. In case you’re curious, each tree planted ends up sequestering about a half of a ton of carbon dioxide over its lifetime, so our annual payments end up sequestering a little under 5,000 tons of carbon dioxide. And we’ve been doing this for a long time. AccountingTools doesn’t actually emit many greenhouse gases – that’s pretty negligible. We just think that it’s a good idea to do something like this.

Anyways, a company can buy these carbon offsets from a third party, or it can purchase carbon credits on an exchange, which is run by the government. When everyone wants to purchase carbon credits, that increases demand, so the price of a carbon credit goes up. Or, if everyone is reducing their emissions, then demand goes down, so the price of a carbon credit goes down.

So in short, the whole concept of carbon credits is designed to create a financial incentive for companies to reduce their emissions.

How to Account for Carbon Credits

The next question is, how do you account for it? That is a multi-step process. The first step is to identify the nature of the carbon credits. Did you buy them on an exchange because of a legal requirement do so, which is called a compliance credit, or did you buy them voluntarily to offset your emissions, which is called a voluntary credit. For example, if you were to buy credits from a provider that plants trees, that would be a voluntary credit.

The next step is to determine the accounting treatment. There’s some argument about whether they should be classified as inventory or as intangible assets. I would say that most use cases would favor recording carbon credits as some form of inventory. If the credits are then used to offset internally-generated greenhouse gases, you would charge them to expense from the inventory account. Or, if you sell the credits to someone else, then you could also charge them to expense from the inventory account.

I’m not really seeing the use case for recording the credits as intangible assets, unless you’re just holding them with no intent of use – which would mean that you’re holding them as an investment that’s expected to appreciate over time.

You can make up your own mind about which way to go with the classification.

There’s no question that the initial recordation of the credit should be at its purchase cost, and you can add in any transaction fees, though there shouldn’t be many. An interesting option if you’re using international financial reporting standards is to subsequently adjust the cost of the credits to their fair value. This option is most possible if the credits are being traded on an exchange, so you can just revalue the credits at the end of a reporting period based on the price at which the credits are trading at that time.

Of course, if you’ve been listening to this podcast for a while, then you’ll realize that I would never recommend adjusting anything to its fair value if you can possibly avoid it. After all, adjustments like that require work, and I don’t advocate spending extra time on accounting transactions if it can possibly be avoided.

So. The next accounting activity occurs when you use up the carbon credits. This is done when you’re officially offsetting carbon dioxide emissions that have just occurred. That involves a credit to eliminate the recorded intangible asset or inventory item, and a debit to an expense account.

Personally speaking, I would record that expense within the cost of goods sold, since it’s directly associated with the operations of your business.

Another possibility is that you sell the credits on an exchange. If so, that could result in a gain or a loss, depending on how supply and demand have impacted the market price of the credits. Realistically, most companies use up all or most of their credits, so the amount sold tends to be pretty small.

And here’s a final issue – impairment. If you’re holding carbon credits that are losing value over time – probably due to a decline in demand on the relevant exchange – then you may need to test them for impairment and write them down to their market value. This applies to credits that are being recorded as intangible assets. If you’re recording them in an inventory account, the same general concept applies, but now it’s called the lower of cost or net realizable value.

From a practical perspective, a business is likely to hold only just enough carbon credits for its own needs, and flush them out fairly quickly – which means that the probability of having an impairment is not all that high. Also, the theory behind setting up a cap-and-trade scheme is that the price of these credits should gradually go up over time, thereby creating an incentive for businesses to emit fewer greenhouse gases. Consequently, the odds of having to take a write-down are relatively low.

Who Accounts for Carbon Credits?

A final point here is whether this whole concept of carbon credits applies to you. In the United States, there’s a cap-and-trade system that covers the eleven states in the northeast, plus California and Washington. Several Canadian provinces also have it, and the Canadian government is setting up a nationwide system that covers its oil and gas sector. China has a system that covers its electricity production. And of course, the European Union has had such a system for a while now. In most cases, these cap-and-trade systems are only targeted at certain sectors, and usually only for larger businesses. If you’re not in one of the targeted areas, then it does not apply.

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Accounting for Trade Spend (#367)

What is Trade Spend?

Trade spend is the amount paid by a manufacturer to enhance consumer recognition of its products, as well as to make its products more visible within the retail space, with the overall goal of increasing customer purchases. For example, this might mean paying a retailer to stock its goods in a prime location on its shelves, which is known as paying a slotting fee.

Or, the manufacturer might offer a promotional discount on certain products, or maybe offer a rebate if you buy its product within a certain period of time. And, it might enter into a cooperative advertising campaign with some of its retailers, where the retailers pay for advertising and then deduct some or all of this expense from the next invoice they’re paying to the manufacturer.

Accounting for Trade Spend

So what is the accounting for trade spend? The general rule is that trade spend is assumed to be a reduction of the manufacturer’s reported revenue. For example, slotting fees, volume rebates, and discounts are all usually netted against gross revenue, which means that your net revenue figure could be quite a bit smaller than your reported gross revenue figure.

But there are some exceptions. Trade spend can instead be recorded as an expense if the manufacturer can show that it received an identifiable benefit from having made the expenditure. In order to prove that there’s been an identifiable benefit, you usually have to show that the expenditure could have involved a separate transaction with some other party than the retailer that bought the goods.

For example, you could make a case that cooperative advertising expenditures should be listed as a marketing expense, rather than a deduction from gross revenue, since you could have paid some other party than the retailer for the advertisements. Why does this matter? Because most companies want to keep their reported net revenue figure as high as possible, even though the end result is the same net profit figure at the bottom of the income statement.

Another example. You’re a food manufacturer, and you pay Trader Joe’s $10,000 to conduct demonstrations of your guacamole product in its stores. By incurring that expense, you’re increasing the sales of your product, which is an identifiable benefit. In this case, you could probably record the expenditure as a selling expense.

Here's another example. You have a cooperative advertising agreement with Home Depot, which is paying for advertising that features your aluminum ladders. And you pay Home Depot $5,000 to run these ads. If Home Depot were not running these ads, you could run them yourself to increase your ladder sales. In this case, you can record the expenditure as a marketing expense.

Now let’s try an unusual example. You’re a brand-new manufacturer of baby diapers, and you pay Costco a slotting fee of $50,000 to place your diapers in a really good position on its shelves. Since this is a slotting fee, it gets netted against your gross revenues. The problem is, because you’re a new manufacturer, your gross sales are only $40,000, so you end up with net negative sales of $10,000. You should charge this net negative sale amount to expense.

There’s also a fair value issue with recording trade spend. When you’ve paid out a certain amount of money on trade spend and you have a justifiable case for recording it as an expense, the amount recorded as expense cannot exceed the fair value of the benefit received. If the amount is more than fair value, then the excess amount paid should still be recorded as a reduction of gross revenue. For example, if you pay $8,000 to a retailer for a marketing benefit and only get $2,000 of fair value from it, then the remaining $6,000 is recorded as a reduction of gross revenue.

Now, let’s talk about when to accrue an expense for trade spend. That would be as soon as you think it’s probable that you’ll incur the expense. For example, if you’ve offered a retailer a ten percent sales rebate if it sells at least 20,000 units of your product, then you should accrue the sales rebate expense as soon as you think the retailer is actually going to sell 20,000 units.

How to Track Trade Spend

Another item is how to track trade spend. This can be difficult, because your sales and marketing people are probably the ones setting up these deals, and they might very well not be keeping very good track of what deals were offered to which customers. The end result is all kinds of discounts being taken by retailers when they pay their bills – none of which you were expecting.

Now, you can just live with this, but it makes for atrocious financial reporting. It’s essentially impossible to make any realistic estimates of what your net sales or net profits are going to be. A better approach is to force the sales and marketing department to only enter into deals that have already been approved and included in the annual budget. This means talking to the sales and marketing people all the time about which trade spend items have been recognized on the books, and which ones are still hanging out there. By doing that, you can impress upon them that it’s really important to only spend the amount on trade spend that they were allocated in the budget.

And a final item, which is measuring whether you earned a profit on trade spend. To do this, you should calculate the increase in sales during the promotional period, which is presumably caused by the trade spend. Then calculate the standard gross margin on this incremental increase in sales, and then subtract out the cost of the trade spend. The result is the profit or loss on trade spend.

Accounting for Non-Monetary Gifts (#366)

The topic of this episode comes from a listener, and it is, I am a church treasurer and receive donations of non-monetary gifts. How do I account for them, and how do I determine their fair value?

Accounting for Non-Monetary Gifts

I talked about some of this back in episode 303, but that was a more wide-ranging discussion about nonprofits in general. Let’s get very precise on this one. We’re not talking about a cash donation, which is what happens most of the time. Instead, this is everything else. The basic rule is that you recognize revenue at the fair value of the donated item.

You could go into a lot of research on this, dig around among a lot of sources, and decide on a fair market value that balances the condition of the asset against maybe three or four prices that you found on the Internet. Yes, you could do that. But let’s be realistic. A lot of people involved with the accounting for a nonprofit are volunteers, which means that they don’t have time for all that crap. They just want a number that they can record.

Accounting Policy for Non-Monetary Gifts

In this case, what you really need is a standard accounting policy that specifies your fair value source. You go in, you get the price you need, and you recognize the revenue. That’s it. For example, the policy says that if someone donates a car, then you go to the Kelley Blue Book website, plug in the make and model and mileage, and use the first price that you see.

Or, if someone has donated a Tiffany lamp, then the policy says that you should go into eBay, find it, and recognize revenue based on a quick search of whatever seems closest to what got donated.

And on top of that, what if someone donates an item that’s obviously not very expensive? Maybe it’s some second-hand clothes, or a toaster oven. Not a problem, just don’t recognize any revenue at all. To cover yourself, have an accounting policy that sets a threshold. If a donated item falls below your best guess at a value of, let’s call it $500, then there’s no record keeping at all.

Or, if you’re uncomfortable with not recognizing any revenue, then set a policy to recognize some piddly amount for small donations. For example, a bag of used clothes has a standard value of $10. Or any used appliance has a value of $25. And you’re done.

The point here is to keep it short and simple. Sure, you won’t necessarily get a fair value that’s absolutely precise, but does that really matter? If you’re the volunteer accountant for a nonprofit – probably like the listener who sent in this question – then don’t waste your time.

Now, that being said, you should absolutely document your sources, which means printing out a screen shot of whatever web page you got the pricing information from. Then stick it in a binder, sorted by month. Done.

Accounting for Real Estate Donations

My advice so far should cover the bulk of the scenarios that a nonprofit might run into. But there are some scenarios that are more difficult. One is definitely real estate donations. These are one-of-a-kind donations, because values change based on the applicable zoning, and exactly where the land is located, and whether there’s easy road access, and on and on.

In these cases, your best bet is to find a realtor with expertise in that area, and get an appraisal from that person. And ask for documentation. The realtor should be able to provide you with a listing of comparables in the area with similar features, and a reconciliation that gives you a fair value that you can document. And this information will probably be free, as long as you give that realtor the contract to sell the property.

Accounting for Stock Donations

Here's another donation that can be difficult – stock. Someone might gift you their shares in a corporation. If those shares are publicly traded, then value the shares at the price at which they were trading on the day when you received the shares. That part is easy enough, but what if the shares are in a privately-held company? There is no market, so there is no obvious share price. What can you do then?

One option is to ask the donors what valuation they used when they donated the shares. After all, they must have some sort of justifiable number that they’re going to use for a tax deduction. So, ask for a copy.

If that doesn’t work, and the shares appear to be worth a lot of money, then this is a rare case in which you really might want to hire an appraiser. After all, if your nonprofit is about to score a six- or seven-figure donation, you’d might as well get it right.

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Accounting for Patents (#365)

The Classification of a Patent

The main issue to keep in mind with a patent is that it’s an intangible asset. That’s because it doesn’t have any physical substance, and yet it still provides some amount of long-term value to the owner. And so, because it’s an intangible asset, there are specific accounting rules to follow.

Capitalization of Patent Costs

First one. You can capitalize the cost to acquire a patent. That should include the cost of the patent application, which is the filing fee, and the documentation, and any associated legal fees. A reasonable question, though, is whether you should bother to capitalize the cost, or just charge the whole thing to expense as incurred. If you’re preparing the patent application yourself, then the cost may not be that great, and the filing fee is fairly modest, too. In that case, you might want to just charge it off, and not mess with all the subsequent accounting for a fixed asset.

A good way to keep from capitalizing these smaller expenditures is to set your capitalization limit a little bit higher than your expected patent filing expenditures, in order to have an accounting policy that backs up your position.

On the other hand, if you’ve got lawyers involved and the patent application is a big one, with lots of documentation, then the cost is going to be a fair amount higher, and then you might want to capitalize the cost.

There’s another scenario, where you buy the patent from someone else. In this case, you could be paying some serious money for the patent, in which case you’ll almost certainly want to capitalize the cost.

And then, of course, there’s the issue of whether you can capitalize the cost of the research and development that resulted in the patent. That would be a large no. Sorry, but you have to charge that to expense. The reason for this treatment is that R&D is considered to be inherently risky, so you can’t prove that there’ll be any future benefit. Therefore, charge it to expense as incurred.

The Useful Life of a Patent

Assuming that you’ve capitalized something into a patent asset, you’ll have to amortize the expense over the useful life of the asset. How long is that? You shouldn’t amortize it for longer than the lifespan of the protection that the patent is giving you. And in cases where you think the actual patent protection is going to be even shorter, it never hurts to set the useful life to that shorter duration.

Just document your reasoning, so that the auditors can access it for the year-end audit. Auditors are not usually going to fight you over shortening the useful life, since that’s more conservative accounting.

The Amortization Method

Then we have the amortization method for a patent. That would be straight-line amortization. It almost never makes sense to use accelerated amortization, since it’s difficult to prove that the value being provided by the patent is declining at an accelerated rate over time.

Patent Asset Impairment

A possible issue that you might have to deal with is the impairment of the patent asset. If it no longer provides value, or at least a reduced level of value, then you should recognize an impairment charge that reduces or eliminates the carrying amount of the asset. What I’ve found with impairments is that it’s really hard to judge whether there’s been a particular amount of impairment. So instead, it’s an all or nothing proposition. Either there’s been no impairment at all, or the impairment is total, in which case you write off the entire remaining carrying amount of the asset.

Keep in mind that, if you’re capitalizing fairly small amounts of expenditures into a patent asset, then no one’s really going to give a hoot if the asset becomes impaired at a later date. In these cases, the amount of the impairment is so small that it’s not worth writing off the asset.

Patent Asset Derecognition

And finally, at the point when you’re no longer making use of a patented idea, you can derecognize the remaining carrying amount of the asset by crediting the balance in the patent asset account and debiting the related balance in the accumulated amortization account. If you do this before the asset has been completely amortized, then any remaining unamortized balance is recorded as a loss.

That last point brings up an interesting issue, which is that you should theoretically be writing off these assets as soon as you’re no longer making use of the patented idea. Does anyone actually know when a patent is no longer being used? If you wanted to really comply with the accounting standards on this, you could get with some of the management staff each year to go over which patents are no longer being used, and then write off the associated assets. That might result in a slight acceleration of your overall expense recognition, which might be of use if you’re trying to report lower profits.

Accounting for Farming Cooperatives (#364)

Farming Cooperatives

Farmers use cooperatives to get a better deal. They can engage in bulk purchasing through a co-op to buy supplies at a lower price, and they band together to sell their crops through one at the highest possible price. Which can make a lot of sense.

There are two types of cooperatives. There’s the supply and service cooperative, which buys goods and materials on behalf of their members at the lowest possible price. And there’s also the marketing cooperative, which act as sales outlets for their members.

So, there are two types of farmers that interact with a cooperative. One is called a patron, and this is any party with which it does business on a co-operative basis. The other type is a member; this is both an owner and a patron and gets to vote at the co-op’s meetings. And, yes, that means there are no equity investors.

Now, a cooperative distributes its earnings back to patrons based on their proportional patronage of the cooperative, though it will need to retain some of the profits to maintain its own operations. We’ll get back to this part in a minute.

Accounting for a Farming Cooperative

What is the accounting for a cooperative? That begins with valuing the inventory that it receives from patrons. The co-op can value it at its estimated market price or its net realizable value, which are going to be pretty much the same thing. In either case, its cost of goods sold is going to be pretty close to whatever it eventually sells the products for, which results in not much of a profit passthrough to patrons. This is actually okay, since the patrons are simply getting the bulk of their profits up front, when they transfer their inventory to the cooperative.

A cooperative is divided up into profit centers, where the supply and service side of the business develops its own profit figures, and the marketing side calculates its profits. This might mean that one side of the operation has a loss. How does the cooperative deal with this loss? There are a couple of options. One is to offset the profits and losses from the profit centers against each other. Another option is to charge the loss against the co-op’s unallocated capital. Or, it can recover the loss from the patrons of the profit center that lost money.

And yes, that means that patrons don’t just receive profit distributions. Sometimes, they have to pay in more money.

So, how does a marketing cooperative pay its patrons? Let’s say a farmer brings in a load of grain for the cooperative to sell. The co-op assigns a price to the patron that’s about the market price, and recognizes a liability for it. This is an amount payable to the patron. Payment is made to patrons based on whatever accounting policy the co-op has, so perhaps the actual payment occurs one or two weeks later. If the co-op ends up earning more revenue than it paid out to its patrons, then it eventually pays them a share of these earnings.

How the distribution of earnings to patrons occurs can vary a bit. A cooperative can elect to retain part of that distribution, and put it in the capital accounts of its patrons. Doing so leaves cash in the business, and is essentially a form of free financing. These retentions are eventually paid out, though it may take a few years to do so, which means that they’re classified as liabilities of the co-op.

Accounting by the Patrons of Farming Cooperatives

Now, let’s turn this around and look at the accounting from the perspective of the patron. Farmers tend to do most of their business with just one or two local cooperatives, so they can concentrate their accounting transactions with just a couple of entities – which makes it easier to manage the books.

Let’s say that a farmer delivers a load of wheat to a marketing cooperative, which means that the co-op is going to sell the wheat on behalf of the farmer. The co-op will probably assign a price to the farmer that’s close to the current market price. The farmer records this as an unbilled receivable, and eventually receives a payment that could differ somewhat from the initially assigned price. If so, the farmer records an adjustment to his original revenue figure, and closes out the sale.

Another variation on the concept is when the co-op issues an advance to the farmer. This is a payment in advance of the final settlement, so it’s treated by the farmer as a reduction of the unbilled receivable. It’s not recognized as a sale.

For example, a farmer delivers a load of wheat to the local cooperative, and the co-op assigns it a price of $10,000. The farmer records this as an unbilled receivable, and as revenue. A week later, the co-op sends him an advance of $6,000, which the farmer deducts from the $10,000 receivable, leaving $4,000 unpaid. A couple of weeks after that, the co-op sends him a final payment of $4,200 which includes an adjustment of $200. The farmer records an additional $200 of revenue, and deducts the remainder from the outstanding receivable.

What about a case in which the farmer delivers products to the cooperative, but where title doesn’t pass to the cooperative? In this case, the farmer continues to record the inventory on his books, since he still owns it. Only when the cooperative sells the inventory does the farmer record a sale.

And what about patronage payments? Essentially a pass-through of a cooperative’s earnings? The farmer can recognize these payments as soon as he’s notified by the cooperative, or when the amount of the payment can be reasonably estimated. In most cases, it’s just easier to wait for the formal notification.

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Accounting for Crops (#363)

Accounting for Perennial Crops

Let’s start with what are called perennial crops. A perennial is a growing plant that keeps going for several years. For example, the apple trees in an orchard would be considered perennial crops. For these crops, it’s going to be a few years before they can begin commercial production. During that development period, the costs incurred to purchase and maintain the plants are recorded in an asset account.

The costs that you might include in this account are the purchase price of the plants, the compensation expense for hired labor and the related payroll taxes, and farm supplies. So, for example, if you were starting up an apple orchard, you’d buy apple rootstock, and then spend money on fertilization, spraying, weeding, and pruning. All of that expense goes into your asset account for the crops.

Now, let’s say that the perennial crop is now ready for commercial production. From this point on, all costs incurred are charged straight to expense. So for example, if you have people doing weeding or spraying or pruning once production begins, then that labor cost is charged right to expense.

Once the perennial crops are in commercial production, you depreciate the costs that accumulated during the development period, where the depreciation runs through the estimated useful life of the crop. So for example, if you expect an apple orchard to be in production for the next twenty years, then that’s the period over which depreciation occurs. And some perennial crops can run a lot longer than that. You might depreciate the development cost for a vineyard over a fifty year period.

Accounting for Growing Crops

And then we have growing crops. These are crops that are usually planted as seeds, and then harvested within a period of months. Examples are corn, wheat, and tomatoes. In this case, you accumulate all of the costs of these crops until harvesting time, and then charge them to expense when the crops are sold. This includes the costs of soil preparation, even though that occurs before the seeds are planted. Now, keeping track of all this is a pain, and farmers have better things to do with their time than accounting.

So, there’s another way. You can also value these crops at their selling price, minus any costs of disposal. This is called the net realizable value option, and it’s only allowed if the crop is available for immediate delivery, the disposal cost is minor, and it’s easy to figure out the market price. This net realizable value of your crops is recorded as an inventory asset until you actually sell it.

Here's an example. A wheat farmer has just harvested one of his fields, and the market value of that wheat is $50,000. But he thinks the market value of wheat is going to increase, so he puts it in storage and records an entry of $50,000 to the revenue account and $50,000 to the inventory account. And yes, that’s right – you can record revenue without actually selling anything. A month goes by, and the market value of his wheat goes up by $10,000, to a total of $60,000. This results in another entry, this time to increase his revenue by another $10,000 and to increase his inventory by another $10,000. One more month goes by, and the market value drops by $4,000, to $56,000. Now the farmer has to record a revenue decline of $4,000 and a decline in his inventory valuation of $4,000. And then he sells the inventory, resulting in an increase in his cash balance of $56,000, while the offsetting inventory account balance drops to zero.

Accounting for Intermediate-Life Plants

There’s another classification called intermediate-life plants, which fall between growing crops and perennial crops. These plants have a growth and production cycle that lasts for more than one year, but less than the period required by trees and vines. Examples are artichokes and asparagus. In this case, you should accumulate the cost of development until the plants begin commercial production, and then depreciate the accumulated costs over the estimated useful life of the plantings – which may not be all that long.

Accounting for Land Development Costs

That covers the basic accounting for crops. Another relatively farmer-specific accounting issue is the cost to develop land, which is supposed to be capitalized. Farmers can spend a lot of time on this, doing things like clearing and leveling land. These are considered to be alterations to the grade and contour of the land, and as such, they’re considered to have an indefinite life. That means you cannot depreciate this cost.

However, there are some land developments that are considered to have a shorter life, such as ponds, wells, and ditches. The cost of these items can be depreciated over their useful lives.

Accounting for Crop Insurance

What about the accounting for crop insurance? This insurance protects against the loss of crops from natural disasters, such as hail or frost. In this case, you’re paying in advance for the coverage period. This payment is classified as a prepaid expense, so it starts off as an asset. In each successive month of the period covered by the insurance policy, you charge a portion of this asset to expense. By the time the coverage period is over, you should have written off the entire asset.

So, let’s say that you have a crop insurance claim. How do you account for that? It’s revenue. You wouldn’t record it in your normal crop sales account, but it’s still revenue. In this case, you’d record it in a crop insurance proceeds account.

Accounting for Government Subsidies

Here’s another item – government subsidies. The government may pay out subsidies, perhaps because commodity prices are unusually low, or maybe to reimburse a farmer for withholding land from production. In these cases, a subsidy is recorded as revenue. You can record it as soon as you can reasonably determine the amount of the payment and your right to receive it. I would record this in a separate revenue account, just to track it separately from your main crop revenue and any crop insurance payments.

Accounting for Crop Sales to a Co-operative

And we have one more topic, which sales of crops to a co-operative. The co-operative sells the crops on behalf of its members, who are also known as patrons. If the farmer delivers product to a co-operative, then he can record a sale at the point of delivery. However, he can only do this if title passes to the co-operative and a price is available based on current market prices.

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Accounting for Pig Farms (#362)

Overview of Pig Farms

A quick word on the flow of operations. The furthest upstream operation is the breeder farm, which produces the pig breeds. The pigs then go to a finisher farm, where the pigs are fed – a lot – and made ready for the slaughterhouse. And, of course, the slaughterhouse is the furthest downstream operation.

The Pig Farm Chart of Accounts

So, let’s get into the accounting. First, there are a couple of new items in the chart of accounts. First is an inventory account, which is Inventory – Feeder Livestock. This is the cost of the hogs that are being fattened in a feedlot, where the intention is to sell them on to a slaughterhouse. You might have a separate record for each pig, which contains the weight and value of each pig over time, so you can track the increase in value of each animal.

You also have feed inventory, which contains the cost of the feed on hand that you’re expecting to use to feed the pigs. This account is used at both the breeder farm and the finisher farm.

You could also have an account for non-current assets, which is for breeding livestock. This one contains the value of any breeding pigs, so these are not animals that you plan to sell to a slaughterhouse. This account would be used in a breeder farm.

In addition, you have two revenue accounts. One is for the sale of feeder livestock, which of course is from the sale of pigs. But in addition to that, you also have a revenue account for the change in value – up or down – that’s caused by the change in total value of the pigs that are being held for sale at the end of the reporting period.

There are also two significant expense line items, which are the feeder livestock account and the purchased feed account. The first one is for the cost of feeder pigs, which are charged to expense as soon as the pigs are sold.

The second one is the cost of the purchased feed that was consumed during the period. Most other expenses, with the exception of veterinarian fees for the animals, are pretty standard.

Pig Valuation

Now, the most interesting transaction in pig farming is valuing the pig inventory. Under generally accepted accounting principles, you can value market livestock – which is to say, pigs that you intend to sell – at their net realizable value. This is its estimated selling price, minus the cost of transport. There are a couple variations on when you can use net realizable value, which I’ll get to next.

If you raise a pig for sale, then you can use the actual cost of raising the pig as its recognized cost. However, that can be pretty hard, so another option is to record its net realizable value. This option is only available if it’s easy to find the market price, and the pigs are available for immediate delivery.

But what if you purchase a pig for sale? In that case, you value it at the lower of its original cost or its current market value. But, if for some reason you don’t have that information, you can use net realizable value instead. Most of the time, it’s going to be at the lower of cost or market. For example, a pig farm buys a pig for its feedlot operation, and plans to eventually sell it to a slaughterhouse. The original cost to purchase the pig was $500, and its current market value is $600. Since we’re using the lower of cost or market rule on this one, the farm accounts for the pig at its cost of $500.

And then, what if you’re raising pigs for your own use – in other words, for breeding purposes? In this case, you cannot use net realizable value. The only acceptable option is to value the animals at the lower of their actual cost to produce, or their current market value.

In short, if you use the net realizable value option, you could end up making a valuation adjustment that alters the revenue line item in the income statement. Even if you haven’t made any actual sales. Here’s an example.  A pig farm raises pigs on its feedlot, which it intends to sell. At the end of the reporting period, the accountant adds up the number of pigs, and figures that they’re worth $400,000 at the current market price. The beginning balance of this valuation was $380,000, so there’s been an increase of $20,000 in the value of the farm’s pigs. So, you would debit the value of its inventory account for $20,000, and credit its revenue account for the same amount.

Actually, you’d probably credit a different revenue account, something like “change in value of raised livestock.”

The Cost of Pigs Kept for Breeding

Which leaves us with one other topic, which is what to do about the cost of those pigs that you’re keeping for breeding purposes. These animals are valued at their full cost. And this can get annoying, because you’re supposed to accumulate all direct and indirect costs of raising these animals. That means things like breeding fees, and the cost of feed, and farm labor, and fuel, and supplies, and veterinarian services. You keep on capitalizing these costs until the pigs are fully grown. At that point, you depreciate these costs over the expected useful lives of the animals.

Once the pigs are fully grown, any additional costs of these animals are charged to expense in the period incurred. So, the ongoing cost to feed them gets charged to expense, along with veterinarian fees, and vaccinations, and so on.

When you eventually sell one of these animals, you compare the price received to the book value of the animal, and then recognize a gain or loss on the sale, just as you would for any other type of fixed asset. If a pig dies, then you’d use the same accounting as though you’d sold it at a price of zero; which usually means that you’ll have to write off the remaining net book value of the animal.

This is obviously a lot of work, from an accounting perspective. You could tag each animal and individually accumulate the costs for each one, but it’s easier to just do it for an entire herd of pigs, and then allocate the cost to each individual animal in the herd.

Standard Costing of Pigs

The listener came up with one other question, which is whether it’s acceptable to assign a standard cost to a pig. Yes, of course you can. You can use standard costing in lots of industries. The main concern is to set the standard cost as close to the actual cost as you possibly can, so that your costs are fairly realistic.

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Accounting for Restaurants (#361)

Restaurant Inventory Problems

The accounting for restaurants is driven by a few characteristics of the industry. One of these characteristics is inventory spoilage, while another one is liquor theft. Because of the possibility of losses in this area, the accounting for it has to be really tight – which is why restaurants use more accounts to track inventory than the typical business. This includes food inventory, liquor inventory, soft drink inventory, beer inventory, wine inventory, and merchandise inventory. The basic concept is that if you store the cost information in more buckets, it’s easier to monitor.

Restaurant Revenue Tracking

And revenue and expense accounts are divided up in the same way, so for example you’ve got liquor sales and the linked cost of liquor sales, so that you can track the margin on each one of these categories. If there’s an unusual drop in the gross margin for one of them, then there’re a number of possible causes that you can investigate.

So. On top of those basic food and drink classifications, restaurants also track revenues in some other areas, which include banquet room rentals, delivery charges, valet parking, and cover charges – it all depends on the type of restaurant. They have to scrape up revenue from every possible source, because they have a lot of expenses.

Unique Restaurant Expenses

Speaking of which, restaurants have a ton of unique expenses. For example, there’s restaurant fuel. There’s the cost of employee meals. There’s also music licensing fees, in case you’re piping in music. And, there’s the cost of the reservation system, such as Open Table – which charges for each reservation made. And on top of that, there are a bunch of basic operating expenses, such as flowers and decorations, laundry and linen, and even the cost of menus. When you see the full range of expenses, you’ll wonder how any restaurant ever earns a profit.

House Accounts

They also have some accounting processes where you might not think they do. For example, they may maintain house accounts for certain customers, which raises the issue of having to bill those customers, and collect from them, and sometimes having to write off unpaid amounts. All of which requires more accounting time.

Restaurant Inventory Count Problems

Now, getting back to inventory. There are some unique concerns. One is the difficulty of just counting the inventory. In most businesses, you just count the number of units on hand, and you’re done. Not in a restaurant. There are so many units of measure, it’s really easy to mark down the wrong one, which completely throws off your inventory numbers. For example, if you have filet mignon, that’s counted by the case. Or, if you have sour cream on hand, that’s counted by the gallon. Or how about bread rolls? They’re counted by the dozen. While a loaf of bread is simply counted by the loaf, even though it has the same ingredients as a bread roll. Go figure.

And then you have the counting problems associated with liquor. It’s obviously quite expensive, so you want to keep close track of it. There are a couple of ways to do this. One approach is to count by the fraction full, which is just a rough guesstimate, such as 20% full. Another option is to count the fill height with a ruler. More precise, but way slower. And, to be really accurate – and really slow – you can weigh each open bottle, and then subtract out the weight of the empty bottle.

Restaurant Compensation Issues

Compensation also presents some unique challenges, since restaurants also have to deal with tips. For example, a restaurant might use tip pooling, where all tips collected are combined and then distributed among the group. Allocating tips can be a real problem, especially when there are lots of employees working each shift, and especially when their start and stop times carry over across different shifts.

Restaurant Fraud

But the big area that I’m reserving the most space for is restaurant fraud. This is a big side effect of some of the other characteristics of restaurants, which are low pay and lots of employee turnover. When this is the case, it’s not that hard for some questionable people to be hired who are really interested in stealing from the business. And there are lots of ways to do that.

For example, there’s the fake walkout. An employee could keep a customer’s cash payment, and then claim that the customer walked out without paying. Or, a server could take full payment from a customer, and then record the sale with a senior discount, and keep the difference. And, of course, you could always void a sale and then pocket the customer’s payment. Here’s another variation – after the customer pays, record part of the meal as being complimentary, such as a free dessert for someone’s birthday. Or, how about selling a gift card without ever recording it? The employee just hands over the gift card and keeps the cash.

And all of that’s nothing compared to what goes on behind the bar. A bartender could pour an unusually large amount of alcohol into someone’s drink, maybe to get a bigger tip. Or, you could sell a drink and then claim that it was returned by the customer. And here’s one that’s really hard to spot. You add a lower-quality liquor brand to a drink, rather than the more-expensive one ordered by the customer, while charging the customer the full price, and then pocketing the difference. Or, how about the reverse, where you add some water to a drink in order to cover for some alcohol that you’ve already stolen? This works best for drinks that don’t change color when water is added, such as tequila, gin, and vodka.

Here's a clever one. Bring in your own bottle of liquor and then pocket the proceeds from it, rather than selling from bottles owned by the restaurant. A tough one to spot, especially when the bottle you’re bringing in matches the one already being sold to customers by the restaurant. Of course, there’s always the reverse approach, where you just steal alcohol from the bar and take it home with you – either for personal consumption, or to sell it on to someone else. And I haven’t even mentioned the obvious one, which is pocketing the cash paid by a customer and never ringing up the sale.

In short, a really imaginative thief can cause major trouble for a restaurant, especially when they’re working in the bar area. Of course, there are controls for this, but they add to the cost of running the restaurant. For example, there needs to be a point of sale system, so that there’s a sale transaction associated with each customer. Another control is to investigate all complimentary meals granted to customers, and especially monitor whether they’re more common with just one server. Or, see if coupon redemptions are unusually high with one server; this person might be using his own supply of coupons to charge against a guest check, and then pockets the difference. Another obvious control is to track customer walkouts by server. If one server is claiming an unusual number of walkouts, there’s an increased chance that he’s actually pocketing their payments. Here’s another one – compare the amount of tips collected by a server to their sales; if the tip percentage seems high, it’s possible that they’re providing free food or drinks to their customers.

And I haven’t even talked about the controls for cash, or payables, or inventory, or payroll. There are just so many ways for a restaurant to lose money. All of this makes the job of the accountant extremely hard, because you have to not only set up and monitor all of these controls, but you also have to examine the data to spot instances of theft – before it gets so bad that the restaurant is driven out of business.

Related Courses

Accounting for Restaurants and Bars

Accounting for Ships (#360)

This episode is about the accounting for ships, as in oil tankers and container ships. Not lobster boats.

Revenue Accounting for Ships

Let’s talk about revenue. Ship owners have come up with lots of revenue-generating contracts, but as a general rule, they’re designed to recognize revenue on a daily basis, not at the end of a voyage. For example, a ship might be rented out under what’s called a time charter, where it’s rented out for a specific period of time. Under this arrangement, the crew obeys the orders of a charterer, who directs where the ship goes and what types of cargos it will carry. The ship owner charges a fixed amount per day, and the charterer pays for pretty much everything else.

Or, you might have a voyage charter, where the ship owner is paid to get from Point A to Point B. In this case, revenue is recognized by using a reasonable estimate of the progress towards completion of the voyage. In this case, you can recognize revenue every day, based on the percentage of voyage completion.

In addition to that, the ship owner might receive something called a ballast bonus, which requires some explanation. In some cases, the ship owner has to move the ship to a port where there’s a cargo in need of a pickup. If the ship is empty during that transfer, the ship owner is moving the ship for free. But, if the cargo owner is desperate – which usually means that there aren’t any other available ships – then this party pays the ship owner a ballast bonus, which offsets the cost of the voyage to the loading port.

And in some cases, a ship owner might receive a subsidy from the government in order to operate on a route that would otherwise be unprofitable. This is pretty common when the government wants to run supplies into a dinky little island in the middle of nowhere that only has a tiny population.

There are lots of other revenue types, but that gives you a feel for it.

Expense Accounting for Ships

Next, let’s look at some of the more unique expenses that a ship owner might incur.

The main cost for a ship is fuel, which can get pretty interesting. A ship owner could enter into a long-term contract with a fuel provider, which locks in the cost of the fuel. Or, the owner could take his chances at the current spot rate, which can vary all over the place. If the choice is to go with the spot rate, then ship owners will keep track of where fuel is cheapest, and so might divert to a nearby port to take on lower-cost fuel.

And another point regarding fuel. It’s called bunker fuel, and it’s basically tar sludge, which is the leftovers from an oil refinery. They have to mix other fuels into it to make it work in a ship’s engines, but – on a cool day – you can actually walk on bunker fuel. And if you’re running that kind of gunk through the engines, it might not be a surprise that their engines stop – as was the case with the container ship that ran into the Baltimore bridge.

Anyways. There’s also the cost of a vessel management company, which lots of ship owners use to hire the crew. Which means that ship owners are not direct employers of the crew – which, by the way, usually come from low-cost countries with a strong seafaring tradition, such as India and the Philippines.

And then there’s the maintenance expense, which is the third-largest expense. It starts fairly low when a ship is brand new, and keeps increasing over the life of the vessel, which is usually about 25 years. At some point, it’s just not economical to keep blowing money on the maintenance for an old ship, so it’s sent to the breakers to be torn apart. Which brings up a depreciation issue, which is the salvage value of a ship. If you’re planning to resell it prior to the end of its useful life, then the salvage value can fluctuate a lot, based on the projected supply and demand for ships. Or, if you plan to keep it for the duration, then the salvage value is the market price of its steel.

The fourth largest expense is insurance. Besides the usual insurance for the hull and machinery, there’s also war risk insurance to cover damage caused by pirates. You also have kidnap and ransom insurance, to cover the cost of negotiating with kidnappers and paying them off. Yeah, and you thought this was a boring accounting podcast.

Let’s touch on a few other good ones. Depending on where a ship is scheduled to travel, you might need to pay for armed guards during any transits through pirate-infested waters. And, there may be the cost of crew training for how to repel boarders, and even insurance to cover the loss of profits if a ship is detained by pirates. Good stuff.

Not quite as exciting are broker fees. Brokers line up the cargos for a ship. The fee for this is about 2½ to three percent of the freight fees earned. There are also consolidator fees. A consolidator firm receives items purchased on behalf of the ship owners, such as food supplies, and then breaks them down by individual ship, and then uses a freight forwarder to send them to the ports at which the owner’s ships are scheduled to arrive. And there are agent fees. These are local agents who represent the ship owner, who take of whatever a ship needs while it’s in port.

There are many more expenses, but I’ll mention just a few. Dockage fees are charged when a ship is berthed alongside a pier, while wharfage fees are assessed if the ship owner uses a wharf to unload cargo. And then we have the port fee, which is the daily fee charged by the harbor operator. As you can see, there are many, many expenses associated with ships. That’s why ship owners have really large accounting departments.

Accounting for Dry Docking

A big item for ship owners is dry docking maintenance. This is a standard ship overhaul that takes place every three to five years, when it’s taken out of the water and thoroughly inspected and repaired. The proper accounting for this is to capitalize its cost and then depreciate it until the date of the next scheduled dry docking. So what you’re doing is spreading the cost of the dry docking over the benefit period.

A related issue is that any components of a vessel that are scheduled to be replaced at the next dry docking should be identified and tracked separately in the accounting records. They should be completely depreciated as of that dry docking date. And, since lots of equipment is replaced over the lifetime of a ship, you can expect that all of them will be separately tracked. This means you could potentially have several hundred asset records associated with a single ship.

Impairment Testing for Ships

One final accounting topic, which is impairment testing. This is the bit where you have to write down the value of an asset if its fair value is less than its carrying amount. This is a problem for ship owners, because fair value is based on the supply of and demand for ships. There are periods when there are far too many ships being constructed, so their value drops. And on top of that, the fair value of a ship declines even more if the ship owner hasn’t kept up on its maintenance. So as you might expect, impairment testing time can be somewhat fraught, with the auditors seeing the need for a massive write-down, while the ship owner claims that the current market conditions are short-term, and fair values will come up again soon. Or not.

Related Courses

Accounting for Ship Owners

CPAs Gone Bad (#359)

What happens when CPAs don’t follow the rules? Who have gone bad? I’ve summarized ten recent cases. They come from Google searches on CPAs who received felony convictions. And believe me, I didn’t have to try very hard – there are a lot of CPAs who’ve committed felonies.

CPAs Who Have Committed Felonies

First person. A CPA resident of Birmingham, Alabama pleaded guilty to securities fraud and was sentenced to 44 months in prison after admitting to illegally diverting investors’ funds under his management for his personal use. He diverted $870,000 from six investor accounts that somehow ended up in his own account.

Next person. A Charlotte, North Carolina CPA engaged in securities fraud. He fraudulently obtained more than $3.6 million from at least 19 investors by asking them to invest in debenture notes. He then promised that the funds would be used for high-interest consumer loans, from which they’d receive interest payments. And… he kept the money. He got a 20-year prison sentence, and a $5 million fine.

So then I figured, let’s try to find a CPA gone bad from a really small state, like Delaware. That took about one minute.

A CPA from Middletown, Delaware took $3 million from a client’s trust account, parked it in his personal account, and then spent it to buy a couple of tax preparation franchises. And on top of that, he got signature authority over the bank accounts of an elderly widow, and became her executor. After she died, he wrote checks from her account for his personal benefit. He also didn’t notify the public pension system that she had died, and continued to collect – and spend – those pension payments. For all of that activity, he pleaded guilty to two counts of wire fraud and one count of making false statements on tax returns, and is currently spending four years in jail.

Let’s keep going. A CPA and attorney from Scarsdale, New York stabbed his wife more than 20 times while she was in the shower, which killed her. Apparently, they were going to begin divorce proceedings in five days. He pleaded guilty to first-degree manslaughter and is spending 20 years in jail.

And the next one. An Atlanta audit manager shot and injured her boss, who was a managing director. She then kept going and murdered two other people at a property management office. She had filed a federal whistleblower lawsuit against her employer the previous summer, alleging retaliation, persecution, harassment, intimidation, threats, etc. No word on her sentencing.

And here’s another. A Parker, Colorado resident ran a tax preparation service that provided payroll processing services to clients. He transferred payroll taxes from client accounts and kept it, rather than forwarding it on to the IRS. And then he spent it on mortgage payments and home improvements. He got 12½ years in prison for wire fraud and assisting in the preparation of false tax returns. He also had to pay $9.7 million in restitution. And if I might interject on this one, how on earth do you not get caught doing this? Incredibly stupid.

We have more. A Torrance, California CPA was convicted of felony drug possession charges. She also pleaded no contest to a felony count of assault with a deadly weapon, and received a jail term of just under one year. And on top of that, she didn’t report any of this to the California board of accountancy, which suspended her license.

And here’s another. An Evansville, Illinois CPA mischaracterized client payments for accounting services as loans, and then didn’t report the income on his income tax returns. He was actually pretty devious. He had direct access to the clients’ accounting records, and actually altered the invoices he had sent them to look like loan requests. All of this added up to $435,000 of unreported personal income. And for all of that effort, he received two years in federal prison, and had to pay $208,000 in restitution.

And we keep going. A Hawaii CPA was convicted of aiding a racketeering kingpin, who in turn was indicted for a whole range of offenses, including murder for hire, drug trafficking and armed robbery. The CPA prepared false tax returns that covered up hidden income over at least an eight-year period. No word on penalties imposed for this one.

And for our tenth and final CPA gone bad, three Texas CPAs promoted a tax shelter scheme that allowed high-income clients to claim fraudulent tax deductions that reduced their income taxes. They directed the clients to transfer funds into shell companies, and then returned the money to the clients, untaxed, for their personal use. To conceal the circular flow of funds, the CPAs commissioned fictitious business valuation reports, created invoices for fake business expenses, and drafted sham contractual agreements. The scheme concealed $1 billion from the IRS. They are looking at what appears to be well over 20 years in prison. Each.

So, in short, and despite all the ethics courses that CPAs are required to take, it does not appear that we’re any better than the average person you’ll meet in the street. Maybe we need to keep taking those classes.

Differences in Ethics Courses (#358)

What are the differences in ethics course requirements among the state boards of accountancy? Most people are only certified with one state board of accountancy, so they have no idea that there might be a difference. But there is. Quite a lot, actually.

Why is There an Ethics Requirement?

But first, why is there an ethics requirement at all? After all, most states require you to pass an ethics test every time your license renews. There are a couple of reasons. First, the boards of accountancy have to deal - all the time - with CPAs who break the rules. Not all of the Boards publish this information, but if you look at some of their websites, there can be quite a list of offenders for all sorts of reasons – and some of them involve jail time. The Boards have to go through an investigation process for every one of them, which soaks up their time. So, in short, reminding people about the whole concept of ethics reduces the work of the Boards of Accountancy.

The second reason is that a public screw-up by a CPA gives the whole profession a bad name, which doesn’t help any of us. And the third reason is that a lot of CPAs aren’t too familiar with the regulations of the specific Board of Accountancy that certified them. For example, they might not remember the rules for how to name their CPA practice, or how to deal with client workpapers, or – and this is a really common one – the precise rules for how much continuing professional education they’re supposed to get, and which types of training they’re allowed to get.

The Continuum of Ethics Courses

With all that being said, what are the differences in ethics course requirements? Well, think of this as a continuum, where one state requires no ethics course at all – that’s South Dakota – while at the other extreme, New Jersey requires you to take it in person or through a webcast. If you’re from New Jersey, you have my sympathies, because there aren’t many webcast options available, so you have to keep taking the same ones, over and over again.

State-Level Ethics Training

But there’s a lot in between those two extremes. The majority of the Boards just say that you have to take four hours of ethics training, and that’s about it. However, a fair number of Boards are getting annoyed that their own CPAs don’t seem to have a very good idea about what their rules and regulations are, so they require one or two hours of training in their state-level regulations. I sympathize with these Boards, because they just want their people to read the blasted rules.

But there’s a problem, because some of the course authors out there don’t put a whole lot of state-level regulations into their courses. And there’s a reason why they do this, because it’s a massive pain for the authors to review the regulations for all of the Boards of Accountancy every year, and make sure that they have the latest regulations in their courses. So, these authors put in maybe a half-dozen pages of state-specific regulations, and then fill the rest of their courses with generic ethics topics. Which doesn’t really address the intent of the boards of accountancy. An example of this case is Colorado, which publishes a list of what it wants in a state-specific ethics course, but the Board doesn’t have the money to certify any course providers – so it doesn’t.

Which brings us to the next level of Board involvement. The only way that a board of accountancy can make sure that there’s enough state-level regulations in a course is to review it themselves. Which is a pain, and it’s expensive. There are a couple of ways for them to do this. For example, Florida charges a few hundred dollars review fee to approve a Florida ethics course. Most course providers don’t care, because there are a lot of CPAs in Florida. So, everyone writes a course for Florida. That’s not the case in Wyoming, which charges the same amount of money, but there aren’t many CPAs. The result is very few ethics courses for Wyoming CPAs, because it’s not cost-effective to write a course for that state. In my case, I pretty much hand over all of my profits to the Wyoming Board every two years to pay for the next review fee.

Texas Ethics Regulations

Here's another example. Texas always markets itself as being the most free-market state in the country, and yet it’s actually the least free-market when it comes to ethics courses. Somewhere along the line, somebody managed to insert into their regulations that, in order to write a Texas ethics course, you have to be a current Texas CPA, and have taken college-level ethics courses, and taught ethics courses in person. No other board has these requirements. So, this means that a lot of course authors can’t write an ethics course for Texas. As a result, Texas CPAs have very few choices for who they can use. As a personal example, I’ve written 53 ethics courses, and yet I’m not qualified to write one for Texas. Go figure.

Other State Ethics Issues

Here's another example – the State of Washington. Their goal is to have the best CPA certification in the country, so they’re constantly changing their rules, which have to be reflected in their state-specific ethics course. They do not charge a review fee, but they’re very, very picky about the ethics courses that get submitted to them. I get rejected at least once every year, when it’s time for a new course update. It’s annoying for the authors, but that’s what they want.

And then we have Louisiana. Their board wants to refresh the ethics courses for their CPAs, so they encourage course providers to write them a proposal for a new course every few years. If you’re accepted, then you’re one of the few approved course providers for the next three years. The problem is that if you’re rejected – which is quite common – then you’re out. The result is that a lot of course providers – including me – don’t bother to submit new course proposals to the Louisiana Board.

And then we have what I think is perhaps the best approach. The Board of Accountancy for Virginia decided to create its own video that covers the essential points of its regulations. It’s pretty stylish. They then approve pretty much anyone who includes that video in their course materials, subject to a few restrictions. It’s not a bad approach. The Virginia Board is guaranteed to have the right content presented to Virginia CPAs, while also pushing the testing work onto the outside education providers. The only downside for the Board is that it has to pay for a new video production every year, which must be fairly expensive – it’s a nice video. Still, I’d say that’s the most effective approach I’ve seen for getting the really essential ethics information into the hands of CPAs, year in and year out.

Wedding Gown Depreciation (#357)

Wedding Gown Depreciation

What is the accounting for rented wedding gowns – specifically, the depreciation? The case study is as follows:

“We depreciate gowns over three years, but this means depreciating some dresses that have not been rented out in a year, so we are overstating our expenses and understating profits. After the end of the gown life, we will have a dress that is still in the shop and still being hired, at which point we will be recognizing revenue without any cost of sales, which will overstate profits and understate expenses.”

The reason this is so interesting is that there aren’t really any other expenses. You buy the wedding gown and then rent it out, and presumably charge the customer for the dry cleaning afterwards, and maybe for any repairs to the gown. So, the cost of goods sold is pretty much the depreciation – which is very unusual. If you conduct a normal depreciation routine, you guesstimate what the useful life will be – and I can’t help pointing out that it’s gown life, not useful life – awesome new accounting terminology there – and then charge a standard amount to expense in each month. If a dress never rents out, then the charge is still there, and really messes up your profits.

The Matching Principle

This is a good example of the matching principle not working. Under that principle, you’re supposed to recognize all revenues and expenses associated with a sale transaction in the same reporting period. But in this case, there may very well be months when there’s no revenue, and yet that pesky depreciation charge keeps coming up.

Usage-Based Depreciation

So what can be done? A possibility is to only recognize depreciation when a wedding gown is rented. This means that you’d have to estimate the likely gown life, not in terms of years, but in terms of rentals. There must be some standard point at which a gown is too beat up to be rented any more, and you have to retire it. I have no idea what that number is, but let’s call it fifty rentals. And let’s say that the gown originally cost $3,000 to purchase. In this case, you’d have to charge $60 to depreciation every time you rented out the gown.

By taking this approach, you’d be doing a better job of matching the rental revenue with depreciation. But that does not mean that this is a perfect solution, for a couple of reasons.

Problems with Usage-Based Depreciation

First, this involves extra accounting. Instead of just making the same old depreciation entry every month, you’d have to track gown rentals, and then calculate the depreciation for each individual gown for each month – which could be pretty time-consuming.

The second issue is that this system doesn’t work too well if a gown is rarely rented out. You could go years with maybe just a couple of rentals. So, to guard against this, you’d have to do an impairment review of the fair value of the gowns, to see if any of their fair values have declined below their book values. If they have, you’d need to write them down to their fair values, which could involve a fairly hefty charge. Some of the gowns might have to be written off entirely.

A Justification for Usage-Based Depreciation

And yet, I’d still say that a usage-based depreciation scheme is the way to go, for one reason – and that is the Pareto principle, which in this case states that 80% of all gown rentals will probably come from 20% of the gowns. This means that a small number of gowns are probably getting worn out fast, while the rest probably have a long tail on the distribution – which is to say that some gowns are very, very rarely rented. And so, based on that principle, this really is a case where depreciation should probably be based on usage.

The Net Worth of a Big Four Partner (#356)

Before you embark on a lifelong path toward becoming a Big Four partner, you might want to consider whether it is going to be worth the effort. To be exact, what is the value of a partner’s investment assets?

This is one of those topics that – in a way – is impossible to figure out, because it’s going to vary for every single partner. You have to make a guess at how much the average Big 4 partner makes, how old they are when they make partner, how long they stay in the job, what their average annual rate of return is, their tax rate, and – a very important item – how much they save.

Partner Net Worth Assumptions

All of that being said, I made a bunch of guesses. And here are those guesses. I’m assuming that a Big 4 partner starts off making a half million dollars a year and stays that way for the first five years. Then the pay goes up to 750,000 for the next five years, followed by a million a year for the next five years, and so on. Once they get to one and a quarter million, I figure that they top out and stay at that level until retirement. And by the way, the precise figures aren’t published anywhere, so I had to go with the information listed on message boards.

Next, I assumed that the average person makes partner at age 35, and retires at 60. Which is a bit rough, since lots of partners quit before then, or are forced to retire early.

Next, I assumed that income taxes would cut those income figures by thirty-five percent. That covers both federal and state income taxes. This one is extremely rough, since we can safely assume that Big Four partners, of all people, have some good ideas about how to avoid or at least defer paying income taxes.

The next big guess is their savings rate. I’m assuming they’ll save thirty percent of their income during their first five years, which is when they have the least income, after which it goes to a forty percent savings rate for the next five years, and then a fifty percent savings rate from there on out. This is a tough one to estimate, because some partners are going to be prudent with their expenditures, and some are going to blow the money. I ran across one reference to a partner who has a gambling problem and four ex-wives, so that one’s a good guess to have a savings rate of zero. Overall, I may be too optimistic on this one.

And finally, I assumed an average rate of return on investment of five percent per year. Of course, you can dig around for better investments, but they’ll also have a higher risk level. I think this number is prudent, and maybe a bit low, but I think the stock market is fully valued, if not over-valued, so there’s not as much room for it to grow as used to be the case.

Partner Net Worth Outcomes

What did I find out? Let’s take a first-year partner who’s earning $500,000. At a 35% tax rate, you have $325,000 of take-home pay, and a 30% savings rate leaves you with savings of about $97,000. Now move forward five years, when you’re earning $750,000. Now your take-home pay is about $487,000 and a 40% savings rate leaves you with $195,000 in savings. Let’s keep moving forward another five years, and your take-home pay from $1 million of gross pay is $650,000. If you save half of that, your savings are $325,000. Let’s run it forward one more time by another five years, where your income of $1.25 million ends up being savings of about $406,000, assuming the usual tax rate and a 50% savings rate.

Given all of this information, how much should a Big Four partner have in the bank after five years? Not much, only $538,000. At this point, you’re earning at a fairly low level in comparison to what’s still coming in the future, and you can’t afford to save as much, because you’re not making that much. After all, at this point you’re presumably 40 years old, and are married with kids. And kids are expensive.

Let’s move forward five years. You’re now 45, and your net worth has increased to $1.7 million. Not bad, but not enough to retire on. So after ten years of grinding away as a partner, you have a modest nest egg, but your big net worth years are still to come. I know this because – I ran the numbers!

Five years later, at age fifty, your net worth has gone up to just over $4 million, while at age 55, it’s $7.4 million. And at age 60, your net worth is about $9.5 million. Which is a solid retirement fund.

Lessons Learned

So, what else can we extract from this information? First, it really, really pays to stick it out as a partner for as long as humanly possible, since your big income years are well out along the partner track. You don’t really earn enough early on to pile up a whole lot of money. In fact, your net worth should go up in your final five years as a partner by about as much as your net worth went up in your first 11 years as a partner.

Another massive issue is that you have to invest a lot of your money to get into this range of net worth. Plenty of partners decide that they want a vacation home, and a couple of fancy cars, and maybe put their kids through private school – and the next thing you know, the amount you’re saving is way down. And so is your net worth.

And a final point – divorce. The overall divorce rate for the U.S. population is about 50%. I haven’t found any reliable information about divorce rates for Big 4 partners, but it would be reasonable to say that the number is not lower than 50%. This is a tough lifestyle, and you’re working long hours, and that would put a strain on any marriage. So, if you do get a divorce, there goes half of your net worth. And if you get married again, and divorced again, then your net worth keeps getting cut in half.

In short, you might work like crazy for years and years, but if you’re not prudent in your spending – and your investments – and your marriage arrangements – you’re just not going to end up with that massive nest egg that you thought you’d have.

Partner Pensions

And one more item. Net worth is not the only source of wealth for Big 4 partners. They also get a really nice pension. There’s not a lot of detailed information about it, but Price Waterhouse stated in a report in Australia a few years ago that it pays its retired partners about $140,000 per year. So, you’re not just relying on your net worth for retirement income. There’s additional cash coming in.

Real Estate Accounting (#355)

Preacquisition Costs

First up is preacquisition costs. These are expenditures relating to a specific property, but before you actually acquire it. This includes things like appraisal fees, engineering fees, feasibility studies, and title searches. You can capitalize these costs only if they’re directly associated with a specific property, and it’s probable that you’re going to buy it. Otherwise, you have to charge it to expense as incurred.

Selling Costs

And then there are selling costs. If you have a reasonable expectation of recovering selling costs, such as by selling the real estate, then you can capitalize those costs. The types of selling costs that you can treat in this way include the costs of model units, model furnishings, and signage. Conversely, there are several types of selling costs that are charged straight to expense, and they include advertising, grand openings, and sales brochures.

Project Expenditures

Next up, we have real estate project expenditures. This is what you’re spending money on after acquiring a property, and it includes things like demolition, permitting fees, construction, construction administration, and even project cost accounting. These costs are capitalized when they’re directly associated with the project. Otherwise, charge them to expense as incurred.

In particular, if the developer incurs any real estate taxes or has to pay for property insurance during the construction phase, then it’s acceptable to capitalize those costs. But, once the property is ready for its intended use, then these items have to be charged to expense as incurred.

Capitalization of Interest

Another issue is the debt funding used to pay for the construction. You should capitalize the related interest expense during the entire property development period, but no longer than that. The amount of interest you should capitalize is that amount of interest that the developer would have avoided by not developing the property.

Accounting for Phases of Work

Now, a big issue for larger developments is to separate out the accounting for successive phases of the work. For example, the earliest phase might have been completed and sold long before the last phase is even started. To do this correctly, the capitalization of real estate should be stopped as soon as it’s been linked to a real estate owners’ association, or been put up for sale.

Cost Assignment

So, when capitalization happens, how do you assign costs? The best approach is the specific identification method, when a cost is directly linked to a specific property. If that’s not possible, then you use the relative value method. Under this approach, the cost of the land and any common costs are allocated to land parcels based on their relative fair values before construction.

Then the costs of construction are allocated to individual units based on their relative sales values. And if it’s not possible to do an allocation based on relative sales values, then allocate costs based on their relative square footage. In short, there’s always a reasonable way to allocate costs.

Donated Property Accounting

Next up, how do you account for real estate that’s been donated to the local government by the developer? For example, the developer might intend that a certain parcel should be treated as open space, which is to be managed by the government. In this case, the cost of the donated real estate is a common cost of the project, so you should allocate its cost to the various components of the project.

Incidental Operations Accounting

You might also have incidental operations for a project, where the intent is to rent some space to offset the cost of developing a property. To account for these operations, the first step is to net the rental revenues against any related costs. If there’s anything left, then subtract it from capitalized project costs.

Real Estate Amenities

And then we have real estate amenities. These are features that improve the attractiveness of a property, such as a swimming pool or a clubhouse. The accounting here is to allocate their cost among those land parcels that benefit from the amenities.

Project Abandonment

So, what about those cases in which a project is abandoned? For example, economic conditions might change, and it’s no longer profitable to continue with a project. If so, you should calculate the recoverable amount of the costs, which is usually from selling the property to someone else. Then subtract this amount from the capitalized cost total, and charge the difference to expense in the current period.

Time Share Accounting

And now for a special case, and everyone’s favorite – time shares. Under these arrangements, the developer sells the right to occupy a property for a certain period of time on a repeating basis.

In a normal real estate transaction, you would charge to expense the costs associated with a specific property. You can’t do that with a time share, because there could be dozens of interval sales associated with a single unit. So instead, the cost of sales is determined with the relative sales value method.

In essence, you divide the estimated total project cost by the estimated total project sales, and then multiply that cost percentage by the sales generated in the period. The outcome is the cost of sales that you can recognize within the period. Of course, since that calculation involves lots of estimates, the amount charged to expense in each period could very well be wrong – but at least it sounds rational. Unlike the whole concept of investing in a time share.

Which brings me to the next point, which is the very high proportion of notes payable that time share owners never pay, because they’ve realized that it’s a crappy investment. This means that there’s a high risk that the amount of profit recognized from time share sales is overstated by the amount of these bad debt losses. To minimize this overstatement, you have to recognize an estimate of uncollectibility, which reduces the revenue recognized.

Participating Mortgage Loans

And here’s another special case, which is participating mortgage loans. In these loans, the lender can participate in the results of operations of the real estate development being mortgaged. Or, the lender might take a chunk of any appreciation in the development’s market value.

The borrower accounts for this participation feature by recognizing its fair value as a liability, where the offset is to a debt discount account. If the borrower ends up paying the lender a share of its profits, then charge it to interest expense, with the offset being to the participation liability account. And, the borrower should adjust the participation liability to match the latest fair value of the participation feature. And finally, if the mortgage is extinguished prior to its due date, then recognize a debt extinguishment gain or loss, which is calculated as the difference between the recorded amount of the debt and the amount paid to settle the debt liability.

Related Courses

Real Estate Accounting

Real Estate Investing

Real Estate Tax Guide

The Decline of the CPA (#354)

The Decline of CPAs

According to the AICPA, almost three quarters of all CPAs met the retirement age in 2020. And on top of that, the number of CPA exam candidates has dropped from 50,000 taking the exam in 2010, to about 32,000 now. That’s what I call a problem.

So, why the drop off in CPAs, and why so few new ones? A big issue is that it takes five years of classwork to qualify for the CPA exam, as opposed to the usual four years for most other undergraduate degrees. Given the cost of a college education, that is a big consideration. Do students actually have the funds to pay for this? If not, they look at other career paths, because accounting just too expensive.

Another issue is that the yellow brick road in accounting goes straight through the Big Four audit firms. Everyone wants to go directly from undergrad into one of these four companies, because they’re considered prestigious. And they really are prestigious. If you can make it to audit manager at one of those four firms, you’ll have some very nice career prospects after that. But there’s just one problem, which is that a lot of people find auditing to be an annoying and uncomfortable profession, so the dropout rate is really high.

A common standard is that twenty percent of the first-year hires into a Big Four firm either quit or a forced out within their first year. And the attrition keeps going after that. So, combine the two issues. A college student is looking at investing in an extra year of college, and has a pretty good chance of being bounced out of the Big Four after that. Which makes the investment look pretty crappy.

Now, let’s back up and look at why you need five years of training to sit for the CPA exam. The basic problem is that the accounting standards are massive. You could probably become a halfway decent bookkeeper with one year of training that covers the bulk of the accounting issues that you’re ever likely to face.

But, if you need to learn about all of the generally accepted accounting principles and auditing standards, then you’re looking at source materials that are fifteen inches thick, and that’s on very thin paper – trust me, I just measured it. Which is an astounding amount of material.

The basic problem is that the folks who produce accounting standards keep churning out more and more material, without really thinking about whether there should be so many highly specific technical rules, or whether you could just set some general principles and give people a little room for interpretation. If you’re wondering what I’m talking about, just look at the international financial reporting standards, which focus on general principles, and which are only four and a half inches thick. And which you could easily learn in a four-year program, along with the auditing standards.

Dump GAAP in Favor of IFRS

So, one solution is to dump generally accepted accounting principles right now and switch over to the international standards instead. Will that happen? Probably not, since there are lots of people who make their livings from producing more GAAP standards all the time. This is not just the people at the AICPA. This is also the industry behind it, which is – to be honest – people like me, who create training classes. And the Big Four audit firms, which can charge high fees because the accounting standards are so detailed that no one can follow them. So in short – no, we’re probably stuck with GAAP.

Offer Four-Year Accounting Programs

What other solutions are there? One option is for the business schools to offer a four-year program that skips all auditing subjects, and just instructs in the basics that you need to be an accountant, and not an auditor. They could keep offering a five-year program that you’d have to take if you wanted to also learn about auditing, and then sit for the CPA exam. Will that happen? Maybe. Consider how business schools work.

The Big Four audit firms don’t recruit everywhere. They only recruit at the top schools, so they’ll be putting pressure on those schools to provide lots of graduates from a five-year program. So what about all the other schools, which don’t directly deal with the Big Four? They may have students who want to prep for the CPA exam, and so will demand the extra class hours, but they may also see a lot of pressure to provide a four-year program – so I think that’s a possibility with these lower-tier schools. If that happens, then there’ll be a stream of accountants entering the private sector, just not the CPA profession.

Does that relieve the problem with fewer people becoming CPAs? Of course not, it doesn’t do anything at all, because it’s just making things easier for everyone else. If anything, that will drain away more people who might have stuck it out for the full five years.

Reduce the Hours Required for the CPA Exam

So are there any other options? One is being explored by the Board of Accountancy of Minnesota, which is thinking about reducing the requirement for college classes down from the current 150 hours to 120 hours, which would make it possible for people to take the exam with just four years of college. I think that’s a great idea, because it puts the burden of training incoming accountants onto the Big Four.

But right there, you can see the problem. The Big Four make enormous profits, and part of that comes from putting the burden on students to pay for their own five years of college, rather than having to provide the training themselves. Don’t get me wrong, all four companies invest a lot of money in training already. But, since they’re under a lot of regulatory pressure to raise audit standards, the last thing they want is to support a reduction in the college training requirement.

And another concern is that the AICPA is going against Minnesota, and making noises about having the other state boards of accountancy not accept CPAs who were certified in that state. In other words, it’s pressuring Minnesota to get into line with the other states and support the requirement for the full 150 hours of college training.

My Prediction - More of the Same

So, having said all that, what do I think will actually happen? I think the five-year training standard will stay in place for a long time, which means that the number of CPAs in the United States will continue to decline. The Big Four will still do fine, because everyone wants to work there. The real problem will be outside of the Big Four, where the smaller audit firms will have to really jack up their pay and benefits to attract new auditors. Which will also make them less profitable, so I can see a fair amount of consolidation among the smaller audit firms.

And on top of that, the audit firms will have to keep shifting work onto unlicensed accountants, and also shifting work to low-cost outsourcing operations, probably in India. If that happens, then the risk of audit firms being sued for doing crappy audits will go up, since the staff quality has gone down. And that will drive more CPAs out of the auditing business, because they’ll be under more pressure to put in more hours.