Accounting for Films (#249)

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

Film Production Costs

The main issue with films is what happens to the production cost. For example, a studio pays an author for the rights to a book or a screenplay, which it can then adapt into a movie. For example, Amazon recently paid $250 million to the Tolkien estate to bring a Lord of the Rings prequel to television.

The cost of the film rights is capitalized. And so is the cost to adapt the story into a screenplay. And then, the actual cost to produce the film is capitalized. That includes the cost of the actors, the construction crew that builds the sets, the camera crew, and so on.

So, what about a situation where a scene has to be reshot? For a recent example, you might remember the film All the Money in the World, which was about the kidnapping of J. Paul Getty III. Kevin Spacey played the role of J. Paul Getty, but because of sexual misconduct allegations, Christopher Plummer was brought in as a replacement just a month before the film was scheduled for release. The reshoot reportedly cost somewhere between $6 million and $10 million. That cost would have been capitalized.

So let’s say you’ve completed the production work, and you’ve accumulated all of these costs into an asset. Now what? Then the amortization begins, where you charge the asset to expense over a period of time. They use quite a unique method, called the individual film forecast computation method. The calculation of the amortization rate is to divide current period actual revenue by the estimated remaining ultimate revenue as of the beginning of the year.

Ultimate Revenue

So I’ll stop here and go over a few items. First, what is ultimate revenue? Sounds like a video game, but it’s actually the estimated total revenue expected to be generated from a film, from all sources – which includes things like exhibition fees, sales of spin-off products, and foreign licensing. The estimation period usually runs for 10 years from the film release date.

Second item – let’s assume that the ultimate revenue figure is a perfectly accurate estimate. If that’s the case, then the amortization charge essentially matches the revenue that’s been generated in the current period. So, if actual revenues in the period turn out to be 40% of the total amount expected, then you amortize 40% of the production cost of the film. This sounds great, since there’s good matching of revenues to expenses, and the profit percentage should be the same in every period.

There’s just one problem, which is my third point. What if the ultimate revenue figure is wrong? Which usually means that the movie bombed. For example, if you do a search on biggest movie failures, you’ll find that the movie John Carter may have lost as much as $213,000,000, and the loss on the Lone Ranger may have been as high as $200,000,000. Those two are just the largest – there are several dozen movies that have lost at least $100 million – each.

So, let’s say that a movie has gone in and out of the theaters, and a cheap licensing deal with Netflix is the only remaining option. In that case, the ultimate revenue figure is revised downward – a lot. Since most of the revenue has already been earned at this point, the next amortization calculation is pretty much going to require that the rest of the production cost be written off right away. This is essentially the same as an impairment calculation, but the method used to get there is a bit different.

Asset Impairment

Which doesn’t mean that a production company doesn’t have an asset impairment process. They do, though the criteria for judging whether a film asset may be impaired are a bit different. For example, indicators of impairment for a film include things like production delays, a change in the roll out plans to a smaller number of theaters, and not having enough funding to complete a film.

Of course, that’s just to decide whether an actual impairment test should be conducted. The actual impairment test involves making estimates of its discounted cash flows, which are based on some pretty unusual metrics. For example, cash flow projections can be based on the public perception of the underlying story – or, the historical results of the people involved with the film – or, the run time of the film. I assume that a shorter run time is better, but that’s a guess.

In the end, though, no matter how the loss is calculated, a production company has a fairly high risk of taking a bath on each film it produces, so impairment testing is a big deal in the film industry.

A different form of asset write-off occurs when work is begun on a film, but it’s never released. In this case, the production company has three years to either get the project ready for production, or write it off. A good example would be acquiring the film rights to a book, and then deciding that the movie is too difficult to produce. In that case, the studio can sit on the acquisition cost for three years, and then has to write it off. Or, it could sell the film rights to someone else, and use the proceeds to reduce the amount of its write-off.

The Television Series Asset

But that’s just films. What about a television series? The cost of multiple seasons of a television series are rolled up into one big asset, and then amortized by comparing actual revenue to the ultimate revenue figure for all of the produced seasons of the show.

And what if the producer doesn’t directly make any money from airing a particular television series, or film? For example, HBO doesn’t accept advertising, so it can’t tie revenues to specific shows, like Game of Thrones. In this case, they just have to make estimates of how much to amortize as a film or series is exhibited – which is weak, but what else can they do?

Here’s another issue. Let’s say a major actor negotiates compensation that’s a percentage of the gross revenues generated by a movie, which is what Robert Downey Jr. does in his Ironman and Avenger movies. This participation cost is accrued over time, starting with the release of the film, and is charged to expense at the same time as the related revenue is recognized. Again, this means that the film generates a fairly consistent profit percentage.

The Overall Deal

And here’s another accounting issue that’s quite unique to the film industry – the overall deal – which is an arrangement under which a studio pays compensation to a producer in exchange for the use of that person’s creative talents. Under this arrangement, anything developed by the producer stays within the studio. For example, Ryan Murphy just signed an overall deal with Netflix for somewhere between $250 and $300 million dollars over a five-year period.

The main point is how do they account for these payments? If part of the cost can be associated with a specific film project, then it’s accumulated into the capitalized cost of that film. When there’s no way to do that, the remaining cost is charged to expense.

Exploitation Costs

But we’re still not done. Then there’re exploitation costs. This sounds vaguely illegal, but it just means the cost to distribute and promote a film, like advertising and promotions. These items are charged to expense as incurred. Since they’re basically sales and marketing costs, that’s not unexpected.

The Accountant Movie

And a final point, the movie The Accountant was released in 2016. The production budget was $44 million, and its worldwide revenue was $155 million. Which just proves that being an accountant can be profitable. Though, to be fair, the movie was really about a hit man. Which is not what most of us do.

Related Courses

Entertainment Industry Accounting

Revenue Management (#248)

In this podcast episode, we discuss several revenue management concepts. Key points made are noted below.

Revenue Management Principles

Proper revenue management is based on a few underlying principles. One of them is that customers love a discount and hate to be charged a premium. For example, a hotel could quote you a price for a more expensive room, and then point out that, for a reduced price, you could get one of their standard rooms. This is exactly the same as the hotel starting off with a low-priced quote for a standard room and then pointing out that, for a premium, you can get one of their better rooms, maybe with an ocean view. The difference is that, in the first case, it looks like the hotel is looking out for your best interests by offering a discount, even though both deals are exactly the same. Studies have shown that when people are offered a discount, they’re more likely to upgrade, so the seller makes more money by presenting prices using the discount approach.

Let’s turn the situation around and do it from the perspective of an airline. Years ago, the airlines used to present their prices using bundling, which means that everything they did was contained within one price. Then they switched to unbundling, which means that most airlines now charge for everything individually, such as the flight, the baggage fee, seating upgrades, change fees, food, and so on. Obviously, they did this to make more money, but the effect was that everything involving an airline requires paying a premium over the base price. And as I just noted, customers hate to be charged a premium. And so, by and large, people hate airlines.

The funny thing is, the airlines did not unbundle their prices for people in business class, who pretty much still pay just one lump sum. That’s because the people in business class are the most profitable customers, so the airlines can’t afford to piss them off, like they do with everyone else.

Revenue from Incremental Customers

Which brings me to the second underlying principle of revenue management, which is that incremental pricing adjustments are usually made to bring in new customers who are not the core customers of a business. Which is to say, when a business runs some sort of a discount program, it doesn’t want its core customers to take advantage of the program. After all, this group is already paying full price.

Rate Fences

The trick is to offer deals that have rate fences built around them. A rate fence is some sort of rule or restriction that segregates customers based on their needs or willingness to pay. There’re all kinds of rate fences. For example, consider a rebate. Rebates are really pretty awesome from the perspective of the seller, because it looks like they’re available to everyone, and the seller can advertise the price of whatever is being sold, net of the rebate amount. But what actually happens is that full-price customers almost never go to the trouble of filling out the paperwork and mailing in the rebate. Instead, only those shoppers who are really sensitive to prices will go to the trouble – and this group may not have been attracted unless the rebate was offered. Therefore, a rebate is subtle kind of rate fence.

Another rate fence involves student pricing. You have to show a student ID in order to buy something at a seriously reduced price. The intent here is to sell to people who might buy the product again later on at full price, when they’re employed and maybe can pass the charge through to their employer. Because a student has to show an ID, people who normally pay full price can’t take advantage of the special discount.

And one more example of a rate fence is when a resort hotel offers discounted rates to locals. The prices never appear on the hotel’s website, and you have to show a driver’s license that identifies you as a local. This is useful for filling hotel rooms during the off season, and tourists have no way of knowing that the discount exists, and couldn’t take advantage of it even if they knew.

So let’s assume that some sort of rate fencing is in place. How do you maximize profits by offering special deals? This involves figuring out how many customers are willing to pay full price, and how that compares to the available capacity. The easiest example is an airline. Let’s say that a flight has 100 seats, and the historical sales for the flight will include 25 people who are willing to pay full price at $500 each. So that leaves 75 seats that can be sold at a lower price. The airline offers the remaining seats at $250, but there’re some catches. The payment is nonrefundable and it has to be made more than three months prior to the flight. These rate fences are designed to keep business travelers away from the lower-priced seats, since business people usually have to travel on short notice, and may have to change their reservations at the last minute. And on top of that, the airline might decide to only offer the discounted seats on a separate website that’s run by a discounter, so that business people will never see it.

The Booking Limit

This method of setting aside a certain number of seats at a discount price is called the booking limit. When enough passengers finish buying up that block of 75 seats, the booking limit has been reached, and at that point only the more expensive $500 seats will be available. But this introduces a problem from the revenue management side of things, which is what to do if more than 25 people want to buy the higher-priced seats. In this case, you want to maximize revenues, so the system invokes what’s called a nested booking limit, which allows higher-priced ticket sales to intrude on the block of lower-priced seats. So if 30 people buy the higher-priced seats, this automatically cuts the allocation for lower-priced seats down to 70 seats. It would be theoretically possible for 100 full-fare passengers to buy out an entire planeload of seats, which means that no discounted fares are offered at all.

Overbooking

Another revenue management tool is overbooking. Everyone hears about overbooking on airlines, but that’s not the only place where it happens. A hotel can overbook rooms, a restaurant can overbook seats, and even a retail store can offer something for sale without having enough units to back up the sales. These are all cases of overbooking. The main overbooking scenario that annoys everyone is the airlines, so let’s take a closer look there.

On average, a flight experiences a non-show rate of 10%. So on a flight with 100 seats, the airline can expect 10 seats to not be filled that it had expected to fill. That’s a pretty major opportunity to increase sales. The airline maintains a record of the no-show percentage for every flight for every day of the year, so it can estimate the amount by which it can overbook each flight. Of course, the actual no-show rate is going to vary from expectations on almost every flight, so the airline won’t get it exactly right. Which brings up the problem of denied boardings.

Strangely enough, customers sometimes like it when the airline pays them to get off a flight, so airline approval ratings can increase as the result of a voluntary denied boarding. When the denied boarding is involuntary, though, an airline can earn an enemy for life and get a lot of bad publicity. And by the way, involuntary denied boardings currently run at about 1 person for every 10,000 passengers.

So, revenue management in regard to airline overbookings is a pretty complex process of applying historical trends to the present and having a system for paying off anyone who’s kicked off a flight.

Overbooking can be a pleasant experience in a hotel, since it usually means that they bump you up into a more expensive room for free. In the rare cases when there’s absolutely no room, they get you a spot somewhere nearby, which isn’t anywhere near as big a problem as being kicked off a flight, since it only involves a short drive to another hotel.

Restaurants also overbook, but you may never notice it. If a time slot is unexpectedly filled up, you end up waiting a few minutes, and get inserted into the next time slot. Eventually, somebody does not show up for a later booking, which eliminates the wait.

And when a retailer overbooks, it can either issue a rain check to a customer, or it states up front that quantities are limited. In the first case, the customer has to wait a bit longer for the goods to be backordered, but the retailer still makes the sale. In the latter case, customers tend to queue up at the beginning of the sale period in order to make sure that they get one of the units that’s available at the discounted price.

This was only a brief view of revenue management, but you can see that there’re lots of ways to tweak the amount of revenue, and hopefully generate more profits.

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Revenue Management

Fraud Schemes: Payables (#247)

In this podcast episode, we discuss fraud schemes related to accounts payable. Key points made are noted below.

The Stolen Check Scam

A business can lose a lot of money if it doesn’t keep tight control over its payables, because there are several ways for employees to redirect cash through the payables system. One of the easiest scams is for an employee to steal unused company check stock and write a check to himself. Or, since a bank reconciliation will spot the employee’s name on the check, to write a check to a business that’s owned by the employee. If the name of the party being paid is generic enough, no one may question the payment. Still, these amounts tend to be on the smaller side, in order to avoid notice.

Another element needed to make a stolen check scam work is access to the signature stamp being used to sign checks, or the perpetrator may just have a good ability to counterfeit the signature of an authorized signer. This problem can be stopped fairly easily. You have to lock up the check stock in one location, and lock up the signature stamp in another location – otherwise, if someone can break into a single location, he’s hit the jackpot, because he can steal checks and sign them with a valid signature stamp. Of course, the controller can’t leave the keys to these locations sitting in her desk drawer – which is all too common. In short, you need to exercise some prudence.

The Concealed Check Scam

A slightly more clever approach to the same fraud is the concealed check scam. This involves creating a check through the payables system, with a reasonable amount of fake supporting documentation. Then insert the check into a stack of other checks that need to be signed, and give the stack to the authorized check signer. If the signer has a reputation for signing anything without question, it should be easy to get a valid signature on the check, which the clerk can then cash. Obviously, blocking this fraud requires the check signer to be diligent in reviewing supporting documentation for checks. But sometimes even the best check signer is in a hurry, and blasts through a pile of checks without looking too closely at what’s being signed.

And furthermore, if the perpetrator creates supporting documentation that’s convincing enough, the check signer may fall for it and sign the check anyways. Even worse, the check signer may get used to seeing the same supplier name appear in the stack of checks, and will continue to sign off on these checks – which means that the concealed check scam actually gets easier through repetition.

The Duplicate Payment Scam

There are some additional variations. One approach is to create two payments to a supplier “by mistake” for the same invoice, then issue one to the supplier to cover the actual supplier invoice, and cash the other check into an account that’s in the name of the supplier, but which is owned by the payables clerk. This approach is a bit limited, since there’s a good chance someone will spot a large number of duplicate payments after a while.

The Intercepted Check Scam

Another approach is to fake a supplier invoice from a real supplier and cut a check to pay for that invoice. The check signer will be taken in by the name of the supplier, and so is more likely to sign the check. The payables clerk then intercepts the signed check and deposits it into an account that’s in the name of the supplier, but which is owned by the payables clerk.

You can mitigate these types of fraud by not allowing the payables clerk access to signed checks. Instead, they’re mailed as soon as they’re signed. This is not a good solution in a small business, where there aren’t enough employees to properly segregate responsibilities.

These kinds of fraud are an even worse problem when the person engaging in the fraud is an authorized check signer, such as an in-charge bookkeeper or a controller. This person obviously has access to the check stock, and no one will question the checks being issued. The situation is especially bad if the person sets up fake suppliers, so that she can submit fake invoices, and then signs the checks to pay for her own invoices. This class of fraud can involve some major losses, so the basic rule is to keep check signing authority out of the accounting department.

Expense Report Fraud

And then we have expense report fraud. There are so many ways for an employee to file an expense report that contains false expenses. When the company reimburses the employee for an expense report, the employee is essentially stealing funds. So here are some ways to pad an expense report.

You can make multiple copies of a receipt, and submit these extra receipts in successive expense reports, so that one expenditure is reimbursed multiple times. A variation is to submit several different types of support for the same expense in successive expense reports. For example, you could submit the itemized detail for a hotel room on one expense report and the credit card receipt for the room on the next report. Another approach is to charge an item to the company credit card and then claim reimbursement for it on your own expense report, using the purchase receipt.

And there are plenty of other ways to mess with an expense report. For example, you could characterize a personal expenditure as company business, and run it through the expense report. Or, adjust the amount on a receipt to make it larger, and then submit a photocopy instead of the original that’s deliberately fuzzy, so no one can detect the change. Or to be really artistic, create entirely fake documentation, with an official-looking form and a fake company logo. This last approach is not worth the effort unless you’re going for a really large reimbursement.

But, we’re not done yet. You could enroll in a class at a local college and submit the receipt for reimbursement – and then cancel the class and get a refund. Or, if you’re on an extended business trip, submit grocery store receipts for your grocery purchases – and then collect grocery receipts from other shoppers, and submit those receipts, too. By the way, I saw an audit manager do that one. For an easy reimbursement upgrade, try overstating the number of miles actually traveled on company business, and get reimbursed for the larger amount. Or, if you’re taking a cab ride, ask for a blank receipt from the cab driver, and fill it in with whatever number you want.

I’m not trying to turn this episode into a how-to guide for how to steal from your company – but you can see how easy it can be, especially with expense reports. Now let’s turn it around and look at the situation from the perspective of the company. How do you keep employees from padding their expense reports? It might seem like the only option is to view every expense report with deep suspicion, and spend an hour or so digging through each one – but that’s not very practical. A better option is to conduct an occasional in-depth review of an expense report. If you find something dubious, then that employee’s prior expense reports are all examined in detail. In addition, that person is flagged in the system as a problem employee, so that all future expense reports are subjected to a detailed audit. Of course, at some point you fire these people.

Another possibility is to make employees use a company credit card or a corporate travel agency, so that the company directly pays for all travel expenses. This eliminates most reimbursements, though it’s still possible for someone to run personal expenditures through the company card.

Related Courses

How to Audit for Fraud

Optimal Accounting for Payables

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Switching from Private to Public Accounting (#246)

In this podcast episode, we discuss the issues with switching from private to public accounting. Key points made are noted below.

Employee Sourcing for Audit Firms

The main source of employees for audit firms is people coming straight out of college. They’ve just gotten their accounting degrees and are more or less ready to sit for the CPA exam, so they’re a good source for filling the lowest-level audit positions. The second most important source of audit staff is poaching the auditors of other audit firms. These people are expensive, since it usually takes a significant pay raise to lure them away. But it’s worth it, because they already have experience, usually coming in as senior staff or managers.

Notice the difference in the slots being filled. People coming straight out of college go into the lowest positions, and people hired away from competitors move into higher slots. That’s pretty obvious, but hang on a minute.

This brings us to the third source of audit staff, which is trained accountants coming from the private sector. These people have accounting degrees, but they probably earned those degrees a few years ago, and so may be weak in some areas that they haven’t used since college. And on top of that, their practical knowledge of auditing is probably limited to taking requests from the auditors who show up for their annual audits. And that’s pretty thin experience.

Problems for Auditors from the Private Sector

This leaves people from the private sector residing in sort of a no-man’s land between the other two groups. They’re more experienced than new college graduates, but not in auditing, which is what really matters. So they won’t be hired into senior staff or manager slots. Instead, they’ll be hired into junior audit staff positions, because that’s the kind of work they’re capable of performing.

My first point in regards to a course of action is to get used to the idea that you may very well be taking a pay cut to switch from the private sector to the public sector, so decide up front whether it’s worthwhile to earn less money.

My second point is that some major brushing up will be needed to get ready to sit for the CPA exam. Don’t forget, this is all fresh knowledge for someone coming straight out of college, but that’s not the case for someone who’s already been working for a few years. This is not a minor point. Audit firms are famous for getting rid of their lowest-performing staff at least once a year, so if you don’t perform as well as the new college grads on the CPA exam, you may be kicked out of the firm. So my third point is to decide whether you can take the financial risk of quite possibly not making it in the audit industry. And don’t think it won’t happen to you. 80% of all recruits do not last.

Advantages for Auditors from the Private Sector

But – it’s not all doom and gloom. Someone coming in from the private sector has more real-world experience than a new college graduate, and so might become a better auditor over the long term. And on top of that, the private sector accountant is older and so is presumably more mature, and so is better able to deal with clients and other auditors. These aren’t minor advantages, but the real risk – again – is not making the initial cut as an auditor. And so my fourth point is to grind it out as hard as you can up front to learn how auditing works, because from then on, you might be in an advantageous position.

Another point in regard to being a bit older and more experienced is that you might be promoted more quickly, maybe shaving a year off the normal progression to partner. But don’t get too excited, since very few people ever make it to partner.

The more likely outcome, even for someone who succeeds as an auditor, is that you’ll make it up to the manager level and then get hired right back out of the firm by a client. But that’s OK, because the position you’ll be hired back into is probably going to be a controller or CFO, which presumably means a pretty hefty increase in pay over whatever you were making when you switched to auditing.

The Age Disparity

Another thought is to consider what it will feel like to start out in an audit firm where you’re the oldest person among the audit staff. This can be tough, so there’s sort of an informal cap on how old people tend to be who get hired in as new auditors. Very few people do it once they’re more than 30 years old. The age disparity is just too great.

An Additional Employee Source for Audit Firms

And a final comment is that there’s actually a fourth source of audit staff for an audit firm, which is people they’ve already hired, but into other parts of the business. So you may see a trickle of transfers from the tax and consulting sides of the business, and sometimes from the administrative staff. No matter where they come from within the firm, they already know the work schedule and they know the culture, so they usually have a higher success rate than people coming in from the outside. And from the perspective of the audit partners, these people are already a known quantity, which is always a plus.

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How to Conduct a Compilation Engagement

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Fraud Schemes: Inventory (#245)

In this podcast episode, we discuss fraud schemes relating to inventory. Key points made are noted below.

Theft of Inventory at Receiving

The intent behind inventory fraud is to steal the goods and then sell them, though a person might want to keep stolen inventory for his personal use. One approach to stealing inventory is right at the receiving dock. It usually doesn’t make much sense for a receiving person to steal a box right there at the dock, walk it out to the parking lot, and dump it in the trunk of his car. That’s not entirely subtle.  A more discrete way to do it is to come to an agreement with the delivery person who’s bringing goods to the receiving dock. Have that person park somewhere out of the way and extract the goods in private, and then deliver the rest of the goods in the normal manner. The receiving person signs off on the full amount stated on the packing slip, so the company pays for the full amount. The delivery driver and the receiving clerk then split the proceeds from the sale of the inventory.

This scheme falls apart when the warehouse staff keeps finding shortages in the received goods that they’re putting away in the warehouse. To find out what’s going on, they can trace missing inventory back to the person who signed for the goods. However, if the receiving clerk is clever, he’ll forge the signatures of other people in the department on the receiving documents, which muddies the water.

Quality Assurance Collusion

Another possibility is when a warehouse clerk colludes with someone in the quality assurance department. The quality assurance guy can designate inventory as not meeting quality standards, so it has to be scrapped – even though it’s actually good product. The warehouse person then intercepts the inventory and records it as having been scrapped. This approach can result in some pretty significant losses. It’s especially possible when there really are quality problems, so some stolen goods can be slipped in with all of the other quality issues being reported.

Finding this kind of theft calls from some trend analysis. See if there’s been a spike in the amount of scrapped inventory lately. And as usual, see if most of the scrap designations can be traced back to one person.

Accounting Department Collusion

Another form of collusion is for someone in the accounting department to create credit memos for supposedly returned goods from customers. The accomplice in the warehouse then writes off the supposedly returned goods as being damaged, and steals them. This approach will cause a spike in the amount of returned goods, which would hopefully trigger an investigation by the product design staff, to see what’s wrong with the product. Another indicator is that the credit memos will appear in the customer receivable records, which might prompt some questions from the customers.

Order Entry Clerk Collusion

Another collusion scheme is for an order entry clerk to enter a fake sales order into the system that triggers a shipment to an address where the inventory can be redirected. If a billing clerk is in on the scam, no invoice is ever logged into the accounting system, so there’s no record of a sale. Of course, the shipment is still listed in the system, so a reconciliation of shipments to billings would spot the missing invoice. So all of these are collusion schemes.

Theft from the Warehouse

It’s also possible to simply steal inventory items right off the shelf in the warehouse. A warehouse person can cover his tracks by writing off these items as being damaged and thrown out, or just inventory counting errors. This is really easy, and it’s tough to spot, especially if the warehouse staff is careful, and only steals a few items at a time. This doesn’t mean that detection is impossible. You could track who is entering write-down transactions in the inventory database, though – again – a warehouse person could log in as several different people to record the transactions. Another option is to put video recording equipment in the warehouse, though that can get somewhat expensive.

And along the same lines, even more opportunities are available if the company has overflow inventory that’s stored in trailers near the warehouse. In this case, an employee can break the lock and make off with the inventory, without bothering to hide the theft with some paperwork shuffling. Since the inventory was taken from a location outside the building, the theft could be blamed on an outsider.

Scrap Payment Theft

But that’s not all. Some inventory really is scrapped, and it’s thrown into a bin, which is picked up periodically by a scrap dealer. The dealer may pay cash on the spot, in which case anyone – but probably someone in authority – intercepts the cash, so it never appears in the accounting records. This is really easy to do, since scrap is maybe the least controlled asset in a company.

You can get rid of this problem by having the scrap dealer only pay with a check, which it sends to a bank lockbox. Doing so keeps the cash off the premises. Another option is to set up a pickup schedule for the scrap dealer, so you know when to expect a payment. And yet another option is to track the amount of these payments on a trend line, to see if the total amount is declining, or there are gaps in the payments.

Indicators of Inventory Fraud

So, what are some of the signs that inventory fraud is occurring? One item is that inventory count variances are always unfavorable – which means that you’re always writing off inventory as the result of a count. With normal inventory counts, there’s more likely to be a mix – a few items are written up, and a few are written down.

Another sign is that inventory-related documents keep disappearing. There may be missing packing slips, or shipping receipts, or physical count sheets. If so, employees are stealing the documents to hide their thefts.

Yet another sign is that the signatures or initials on inventory-related documents are completely illegible. Now, some people just write that way, especially when they’re in a hurry. But when lots of documents have illegible scrawls on them, it’s possible that one person is fudging the signatures of multiple people.

And here’s another one. Employees in the warehouse are always bringing baggage into the building. Sure, it could be their lunch, but what if there’s enough room in there to jam in some inventory?

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Fraud Examination

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The Numismatic Industry (#244)

In this podcast episode, we discuss accounting in the numismatic (coin collecting) industry. Key points made are noted below.

Inventory Tracking

A lot of a reseller’s business is conducted at auctions and trade shows. This means that their coin inventory can be scattered around, waiting for auctions to be conducted. And on top of that, they sometimes send coins to customers who might be interested in buying them. So their first issue is keeping track of the inventory, which could potentially be in dozens of locations. To do that, each coin is assigned a unique identifier code, which is what they use to track inventory in their database. And of course, they use the specific identification method, where costs incurred are assigned to specific coins.

Sales Taxes

A second issue is sales taxes. Coins aren’t necessarily sold from a single, fixed location. In fact, there may be no physical store front at all. Instead, a sale could occur at any number of locations, such as at an auction or at a customer’s location. So there may or may not be a need to charge a sales tax, depending on the local laws regarding whether nexus exists, and whether the sales tax applies to coins. This can get complicated.

Pooling of Cash to Buy Coins

A third issue is that some of these coins are very expensive. So expensive that a single reseller may not to bear the risk of purchasing a coin. To get around this, a couple of resellers will pool their resources to buy a coin. When this happens, one company pays the entire purchase price and is then reimbursed by their partner in the deal for part of the purchase price. The coin is shipped to the primary reseller.

Restoration and Evaluation Services

The primary reseller then pays for any restoration and evaluation services associated with the coin, and eventually sells the coin to a customer. At this point, the accountant for the primary reseller has to total up the original purchase price that it paid to the seller, subtract out the amount received from the partner, and add in all the other fees incurred, to arrive at the total net cost of the coin. Then the accountant subtracts all these costs from the revenue earned from selling the coin to figure out the profit, and then splits the profit with the partner.

Supplier Invoices

This is pretty complicated. It seems to be designed to make life difficult for the accountant, especially when you figure that some of these coins won’t be sold for a long time, so the supplier invoices may pile up for months, and could get mixed in with the charges related to other coins. And on top of that, it’s not unlikely for some supplier invoices related to evaluation services to arrive after the reseller has already sold a coin to a customer. This means the accountant has to use a checklist to make sure that all supplier invoices have been received before calculating the profit split with a partner. Or, if that’s not possible, he may just have to wait a while for the bills to arrive, which runs the risk of annoying the partner.

Billing Issues

A final issue is that the billing systems in the industry aren’t exactly world class. Instead, a sale at a trade show is usually documented on a hand written invoice. So you have to remember to log the invoice back into your system, in the correct amount, for the correct identifier code, in order to have an accurate record to match against all the associated costs.

Additional Issues

There are a few high level issues associated with the industry, too. One is that transactions are pretty much on a cash basis. Accrual basis accounting doesn’t really seem to have taken hold. Another concern is whether to write down the value of a coin if the market price declines. I would imagine that very few resellers even consider that option. After all, each coin is unique and the market is rather thin, so how could you even prove a write-down in the value of a coin?

The Hotel Industry (#243)

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

Cost Tracking and Capacity Usage

What is so special about hotels that they present a challenge for the accountant? The main issue is not any special accounting standards – there aren’t any. Instead, it’s all about tracking costs and capacity usage. For example, a lot of hotels are located in tourist areas where there’s a lot of seasonal variation from month to month. The accountant needs to separate out the fixed and variable costs of the hotel, and report on the fixed cost base for every month of the year. By doing that, management can figure out if it might make more sense to shut down the hotel during the off season.

Or, knowing the breakeven point of the facility, they can decide just how low they’re willing to drop prices during the off-season in order to pull in enough cash to offset their monthly operating costs. This is not a minor issue, since a hotel can easily go out of business if there isn’t someone available who can monitor the flow of revenues and expenses from month to month.

Discounts Granted

The accountant is also probably going to report on the discounts being given from the standard price for a hotel room. This standard price is called the rack rate, and it’s the price quoted to customers who request a same-day reservation without having made a prior reservation. This rate is usually discounted for people who reserve in advance, or who are preferred customers, or who buy rooms through a discounter. There can be a lot of discounting, since there’s not much variable cost associated with someone renting a room for a night. The price is nearly all profit, so there’s a temptation for the hotel manager to offer some pretty deep discounts in order to fill up the hotel. The accountant needs to keep track of the balance between offering discounts to attract customers, and being able to pay for all the fixed costs each month. So the accountant can maintain a model that shows how extra discounts increase the room utilization rate, but don’t generate as much revenue per room. This model should show a sweet spot where the prices are set at a level that maximizes profits, which probably also results in some rooms not being booked.

Ratio Analysis

The accountant can keep track of a few ratios that will give management a good idea of the hotel’s performance. For example, there’s the paid occupancy percentage, which  states the portion of rooms sold in comparison to the number of rooms available for sale. Another measure is the average room rate, which is the total room revenue for the day, divided by the number of rooms sold. Or, the accountant could keep track of the complimentary occupancy percentage, which tracks the number of rooms occupied for free, divided by the number of rooms available for sale. I never seem to get those rooms.

Labor Cost Tracking

Another issue for the accountant is to track labor costs being incurred during the day. Hotels tend to need a lot of labor during very specific times, usually during check-in and check-out, and for room cleaning in the morning. The rest of the time, management needs to know when it can let employees go for the day, so that the hotel doesn’t rack up unnecessary labor expenses during low-activity periods.

Profit Center Tracking

And yet another issue is that the accountant needs to track the performance of every profit center within the hotel. It’s not a single, monolithic entity that earns a profit. Instead, there’re profit centers for the vending machines, and in-room movies, and the hotel restaurant – if there is one – and for any stores located within the facility.

Unusual Financial Statement Line Items

In terms of what’s different in the financial statements, a hotel can have separate line items on its income statement for sales related to rooms, and food, and vending, at least. The expenses can look a bit different, too, and may include line items for things like cable television fees, cleaning supplies, grounds and landscaping, laundry, linen, and uniforms. And, of course, consumables – that’s those little bottles of shampoo and conditioner in the bathroom.

Payroll Accounting

And then we have the accounting for payroll. In the hotel industry, nearly everyone is paid wages, not a salary. Wage tracking takes much more time than paying a salary, so payroll is a disproportionately large part of the work in the accounting department.

Fixed Asset Tracking

Fixed asset tracking can also be much larger than usual, for obvious reasons. It’s not just the construction cost of the hotel facility. There’re also fixed assets in the restaurant area, and the massive amount of furniture and fixtures in all the rooms and common areas. And on top of that, there are land improvements that need to be tracked. And, as the hotel ages, a lot of these assets are retired and replaced with new ones, which also have to be tracked as fixed assets. And on top of everything else, constructing a hotel takes months or years, and during that time the cost of the interest associated with the funding for the hotel can be capitalized.

Maintenance Tracking

A hotel is going to need maintenance – all the time. The facility is being heavily used, so equipment and fixtures will wear out. The accountant needs to keep track of the incoming maintenance requests, classify them in terms of what’s critical, and then recommend to management which issues can be fixed right now. In some cases, the cash flows of the hotel just won’t allow for immediate maintenance, so some issues have to be delayed. And this is not just a cash flow issue. In a high-end hotel, the facilities are supposed to look great all the time, so delaying maintenance can lead to reduced bookings, which reduces cash flows, which makes it even more difficult to keep up on the maintenance.

Fraud Issues

There can be a few fraud situations that are unique to hotels, and they’re most likely to occur when someone pays cash for a room. For example, the clerk at the front desk could charge a customer the room rate for a better room, check him into a lower-priced room, and then pocket the difference. Or, the clerk could pocket the cash from a customer payment and then charge the person’s room to a corporate account – which works pretty well when there’s a lot of volume running through the corporate account, so that no one will notice an extra charge or two.

Summary

So in short, the main issue with hotel accounting is that you’re optimizing the use of a massive asset. The accountant needs to assist in tracking costs, prices, and utilization levels, which can vary a lot by time of year. The job is like a giant balancing act, trying to work with lots of variables to keep the hotel profitable.

Related Courses

Hospitality Accounting

Crowdfunding (#242)

In this podcast episode, we discuss new ways to sell shares through crowdfunding. Key points made are noted below.

Crowdfunding Regulations

First, the bad news. Regulations. The Securities and Exchange Commission issued Regulation Crowdfunding in 2016, which places a few restrictions on the process. A business can only raise a million dollars a year, which includes all other fund raising within the same period. This amount is inflation adjusted, so the fund raising figure for 2017 is $1,070,000, and that number will presumably keep going up. Nonetheless, that is not a lot of money, so crowdfunding is probably going to be restricted to small startup companies. Any organizations larger than that will need more money.

Funding Levels

The second bad item is that individual investors can only invest a relatively small amount of money. I won’t get into all the restrictions, but it’s basically ten percent of their annual income or net worth, which is reduced to five percent if the person’s income or net worth is less than $107,000. And again, this figure is inflation adjusted. This rule was put in place so that investors wouldn’t lose too much money if the investee goes bankrupt. From the company’s perspective, it means that they’re going to need a lot of investors to meet the maximum annual investment cap – probably around 200 of them.

Reporting Requirements

And then there’s the third bad item, which is reporting. Any business that wants to sell stock through crowdfunding has to file a Form C with the Securities and Exchange Commission, which is estimated to take 50 hours to complete.  In addition, the firm has to provide its tax returns if it’s raising a small amount of money, and reviewed financial statements if it’s raising a mid-range amount, and audited financials for amounts near the top of the allowed range.

Auditing Requirements

Audits are expensive and time-consuming, but if you want to raise at least $535,000 per year on an ongoing basis, then the audit must be completed – in advance. There’s also some reporting to be done while the fund raising is being conducted, as well as the annual Form C-AR, which has to be filed in each of the next three years, depending on the circumstances. Figure on spending a total of 200 hours on the Form C and then the three Form C-ARs.

Stock Registration

And for a final bad item, the shares that are sold will still have to be registered with the SEC if the company’s assets ever exceed $25 million. I talked about registering shares back in episode 93. The brief version of that episode is that stock registration is expensive, time consuming, and frustrating.

Investor Issues

So far, I’ve only mentioned the bad side of crowdfunding from the perspective of the company. There’s also a bad side for the investor, which is that the level of disclosure made by a company is relatively light, compared to a full initial public offering. Also, the investors who invest through a crowdfunding deal are less likely to be sophisticated investors. Put those two issues together, and you get people investing in stock offerings that may not be overly likely to pay off.

Crowdfunding Benefits

So, how do I balance all of this grim news with the benefits of crowdfunding? The main benefit is that a small startup company may have very few possible sources of funding, or at least, that aren’t rapacious – so crowdfunding gives them another option. In addition, if a business plan is really risky, a crowdfunding campaign might still raise money, whereas a more traditional investor wouldn’t consider investing. And finally – and not a small item – a business no longer has to be physically located near one of the main fundraising centers, like Silicon Valley or New York. Instead, since the fundraising is conducted on-line, the company could be located pretty much anywhere.

Crowdfunding Summary

So in summary, I haven’t really painted a favorable picture. Selling shares through crowdfunding could be useful for some smaller companies, but not all that many.

Regulation D

But don’t give up hope, there is an alternative, which is Rule 506-c of the SEC’s Regulation D. The quick summary is that Rule 506-c is pretty awesome, because you can raise an unlimited amount of money.

The downside is that stock sales can only be to accredited investors, and the company has to confirm that they’re actually accredited investors. An accredited investor is someone who has a net worth of at least $1 million dollars or annual income of at least $200,000 individually or $300,000 of joint income with a spouse. That’s the short definition – there are some other options.

This accreditation rule means that the pool of possible investors is reduced – a lot. People who qualify as being accredited constitute only about 3% of the population. On the other hand, there’s no cap on the amount you can raise from each one, so this restriction may not be much of an issue.

The way to use Rule 506-c is to go to a fundraising portal, which is a registered website that handles crowdfunding stock sales. The portal may have already investigated a pool of investors to see if they’re accredited, so that takes care of the legal requirement for reviewing investors. The fundraising portal posts the sale opportunity on its website, and investors can review the materials to see if they’re interested. Examples of these websites are crowdfunder.com, fundable.com, and microventures.com. And there’re many others.

The only real downside of this rule applies to investors, which is that the shares issued are not registered with the SEC – and that means the shares can’t be resold to someone else. So if you buy shares under Rule 506-c, you might have a hard time liquidating the investment later on. This usually means that you either hope that the company will be sold, or you pressure the company to register the shares with the SEC – which, as I already noted, is not easy. And even if the shares are registered, there may not be much of a market for them, so it could still be difficult to sell the shares.

So in summary, Regulation Crowdfunding is only good for small amounts of money and requires a fair amount of reporting. Rule 506-c is better all around, because you can raise much more money.

Related Courses

Crowdfunding

The Consulting Division of an Audit Firm (#241)

In this podcast episode, we discuss what it is like to work for the consulting division of an audit firm. Key points made are noted below.

Selling Requirements

There are many differences between the management consulting group and everyone else in an audit firm. One of the key differences is the need for way more sales activity. In auditing and tax, you may pick up a new client and then stick with it for years, so it’s recurring business. On the consulting side, projects tend to be discrete – which means that they happen once and then they’re done.

So, consultants are expected to dig a lot harder to find new business. Otherwise, the department runs out of projects and people get laid off – so there’s quite an incentive. Where possible, the senior managers and partners will try to work their relationships to get a sole source deal for a consulting project. That way, they don’t have to bid against any competitors, so their prices are higher. But a lot of the time, the consulting staff has to respond to a request for proposals document that’s issued by a prospective client.

Which means that a large difference between working in consulting, versus or audit or tax, is that you’ll become very good at writing these RFP responses. You could be involved in several dozen of them each year. Some firms have a group of specialists who only respond to RFPs – they don’t do any other work.

Project Size

Another key difference is the size of the projects. On the consulting side, there’s a lot of overhead cost involved in responding to RFPs, and of course you may win only a fraction of these bidding contests – which means that the size of the projects being considered needs to be large. It’s just not cost-effective to even bid on a small project. Instead, you want to park a bunch of staff on a consulting project for a long time – preferably a year or more.

For example, when I used to work at Ernst & Young, the most famous consulting project was a massive redo of the computer systems for Farmers Insurance. The project ran for way over a decade – so long that at least one person spent his entire career on just that one project. Those projects make a lot of money.

Which brings up the issue of what kinds of projects can last a really long time. Historically, these have been related to information systems. A consulting group loves these projects, because it takes forever to define the project specifications, write the software, test it, and roll it out. Yes, this means that a lot of hard core IT types work in the consulting division. But not everyone. They hire lots of accountants, because they need people to work on system specifications relating to accounting, as well as people to help roll out the software, which means writing training materials and training people on how to use the software.

Special Projects

Accountants are also needed for any number of special projects. For example, I was involved in examining the cost accounting systems for a slaughterhouse – which also wiped out any interest in eating sausages for about ten years. I also worked on the accounting procedures for a national health club chain, any number of software selection projects, and even did a best practices review of the administration of a college. So the work is quite varied. But in general, the work tends to focus on large systems projects.

Types of Personnel Needed

What kinds of people are they looking for? If the consulting group has landed an IT project, then they’ll need to staff it up with a lot of software developers. To do that, they could possibly recruit from colleges. But most of the time, they want more experience, so they won’t appear on college campuses. Instead, they’d rather hire you maybe five years into your career.

This delay in hiring isn’t just about getting more seasoned recruits. There are two other factors. One is that clients will hire a consulting firm based on the quality of the resumes they include in their RFP responses. And someone fresh out of college doesn’t yet have much of a resume. Instead, they need someone who’s piled up some accomplishments that makes them look impressive on paper. This is not a small matter. In some of these bidding competitions, there isn’t really much of a difference between the competing consulting firms, other than the quality of their staffs.

This has an odd side effect, which is that some consulting departments are very heavy on managers and very light on junior staff. And that’s because clients are willing to pay for managers – they want their projects to succeed, so they hire the very best. Some clients don’t even want to see junior staff on their projects.

Promotion Track

As you might expect, this means the promotion track in consulting is quite different from auditing and tax, where you start at the bottom and work your way up. In consulting, you’re more likely to come in as senior staff or a manager, and then start working your way up.

Travel Requirements

I had mentioned that there were two factors involved in delaying the hiring of consulting staff. The first issue was waiting for people to gain experience. The second issue is to not wait too long, because then people start settling down, buying houses, and having kids. And that means they aren’t willing to travel. And consulting is all about travel. You go where the work is, and the work could be absolutely anywhere. For example, I was based out of Denver, but almost never worked there. Instead, I was in places like Seattle, Houston, Kansas City, and San Antonio. And some much smaller places, like Denison, Iowa.

And then there’s the weekend commute. You typically head for the airport mid-afternoon on Friday, so you’ll get home later in the evening on Friday. And in many cases, you’re expected to be back at work Monday morning, so you have to fly back on Sunday afternoon. Which means that you only get Saturday completely off. And in other cases, there’s not enough of a travel budget to go home every weekend, so you’re expected to stay on-site, sometimes for months.

Now the travel may sound hard, but it’s actually kind of fun – for a certain age group. I would say the prime age range for consulting is from 25 to 35. During that time, living in different parts of the country feels more like an adventure than a burden. After that age range, not so much. I did consulting for five years, and enjoyed it most of the time.

Partner Requirements

The criteria for partner are different from what it takes to be an audit or tax partner. In consulting, the ability to sell completely overwhelms every other skill. And in addition, partners never really stop working – they’re always on call. A friend of ours is a consulting partner, and almost every time we take her up into the mountains for a ski trip, she’s in the back seat checking e-mails and doing conference calls. Because of the heavy workload and travel, a lot of partners retire well before the mandatory retirement age.

Careers that Combine Accounting and IT (#240)

In this podcast episode, we discuss careers that combine accounting and information technology. Key points made are noted below.

Applicable Personnel

This is a good topic for two groups of people. One is for people still in college, who might be considering a double major in accounting and computer science. The other group is people who are already accountants, and who have gotten involved in IT work within their companies, probably doing system implementations.

Project Types

If you try to be an IT specialist within the accounting department, the controller is most likely to need you when a new system is being rolled out. This is especially the case in a smaller company where there’s not much of an IT department, if any. But once the system is rolled out, you’ll be expected to go back to being an accountant, which doesn’t leave much time to hone your IT skills.

In a larger organization, there may be an ongoing series of IT projects within the department, so you’ll never be short of work. But, in a larger company, there may be several department locations, so you’ll be expected to travel to each one to handle the implementation. So in this case, there’s certainly a job there for you, but also lots of travel, which can be burdensome. And because you’re traveling, it’s pretty difficult to stay focused on getting promoted within the accounting department – so the chances are good that you’ll be stuck in the same position.

The Best Jobs

The best place for someone with both accounting and IT expertise is in a consulting company, probably as an implementation specialist. The usual position for this type of person is as a specialist in one of the really large integrated software systems, like Oracle or SAP. As an implementation specialist, you’re expected to know exactly how the system works, which flags to set in the system, how to test it, how to trainer users, and so on.

These installations are enormous – figure on each one taking a minimum of a year to complete, and probably a lot more than that. During that time, expect to be working on-site with the client. And that can put you anywhere on the planet, and not necessarily in the nicest locations. Not all corporate headquarters are in Paris. Though, about 200 major companies are located in Paris – so you never know.

The Small Company Option

So, let’s pick apart the alternatives. If you’re working for a small company, any IT skills you have are more likely to be considered a nice side benefit for your employer, but not absolutely essential. There’s also a risk that your career will be sidetracked into the specialist who maintains the accounting system. On the other hand, your job might be somewhat more protected if there’s no one else to take care of the systems. In regard to pay, the compensation could be somewhat higher, but there’s less of a track to a senior position, so your pay would probably be capped at some point.

The Larger Company Option

Now let’s switch to a larger company. In this case, you’re more likely to be a representative of the accounting department who doesn’t really do much accounting. Instead, you’re working with the IT department all the time, installing systems all over the company. The job pays well. But the odd thing is that there’s no real track to the top in either the IT department or the accounting department. Instead, you’re most valuable to the company as a specialist, so they’ll keep you there as long as possible.

This does not necessarily mean it’s a dead end job, where the implication is that the pay level is low. It’s not. The pay level is high. But you might feel constrained after a while, because you may be circling around through the same company locations over and over again for years, making return visits to install different systems.

The Consulting Option

The other alternative, as I mentioned earlier, is working for a consulting company. Yes, you will travel as a consultant. And yes, the pay is good. But those two points are the same if you’re working for a large company. The main difference is that there’s actually a career track in a consulting firm. In this role, you can work through the staff consultant and manager positions, all the way up to partner. And there’s one big difference between a consulting firm and an audit firm. In consulting, the career track is not up or out, as it is in auditing. Instead, if you’re a valuable person, they will find a spot for you. You might be parked in a manager role, or maybe go all the way up to the principal position, which is a variation on being a partner. And that’s not so bad.

But there are other issues with consulting firms. You’ll be expected to maintain a high level of chargeability, and course there’s the travel.

The Independent Consultant Option

This leaves the accounting / IT person with one other option, which is being an independent consultant. If you have really great skills at installing a particular piece of software, you can work for yourself and accept the jobs you want, usually as a subcontractor of a consulting firm. That means avoiding some of the worst client locations if you don’t want to go there, or at least being able to work from home a bit more. And you can take time off without having to worry about your chargeable hours. On the other hand, you’re probably being paid by the hour, so if you aren’t working, you aren’t getting paid. And there aren’t any benefits, since you’re the employer.

Summary

So there’s the mix of opportunities available to someone with an IT and accounting background. I have several comments. First, if you have this skill set, it doesn’t make a lot of sense to work for a smaller firm. Either you won’t get to use your IT skills very much, or you won’t be fully compensated for them, or you’ll be stuck in a niche.

Second, if you gain the IT skills while working for a larger firm, and you’re young enough to tolerate a lot of travel, consider applying to a consulting firm for a job. By doing so, you can make use of both sides of your training, gain lots of experience, and be on a promotion track. Which, by the way, is what I did. I had installed several systems at a company while working as its cost accountant, and then applied to the consulting division of Ernst & Young – where I became a consulting manager.

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Fraud Schemes: Cash (#239)

In this podcast episode, we discuss fraud schemes related to the theft of cash. Key points made are noted below.

Cash fraud is popular, because cash is usually untraceable – so if you can stuff it into your pocket and get off the premises with it, you’ve probably gotten away with a minor crime. I say a minor crime, because most organizations don’t keep a whole lot of cash on the premises, just enough to meet their immediate needs - so the theft of cash is fairly small.

Skimming

Let’s go through a few fraud schemes. One of the most effective ways to steal cash is to remove a portion of any incoming cash before it gets recorded in the company’s records, which is called skimming. There’re some really obvious ways to do this, like pocketing the cash from the sales of a hot dog stand, where there isn’t any record keeping. And some techniques are way more sophisticated. I remember one time back in the 1980s, when Deloitte was hired to investigate the theft of cash from one of the bars on the Queen Elizabeth 2 cruise ship. The task was to have Deloitte people sit at the bar all day and watch the bartenders.  They couldn’t figure it out, until someone mentioned the number of cash registers at the bar – which was one register more than there were supposed to be. The scam was that the bartenders added their own cash register, rang up a portion of the sales on that register, and then took the cash from the register. That’s quite innovative.

It’s even possible for the owners of a business to engage in skimming. When they steal money from their own business, the company earns less money, so it pays a reduced amount of income taxes. And the owners don’t report the stolen amounts on their personal income tax forms. So, in a twisted sort of way, stealing from your own company makes sense. The problem for an owner is that the owner sets the tone for the business, so if other employees see the skimming going on, they’ll probably do it too.

So how can you cut back on skimming? One approach is to require credit card payments in order to keep cash off the premises, but that doesn’t work too well in some types of businesses where cash payments are the norm. Another possibility is to install security cameras. Even if no one is watching the cameras, just having them present makes employees wonder if someone is documenting what they’re doing.

A good way to detect skimming after the fact is to monitor the gross margin percentage over time. The margin should go down when there’s skimming, because sales drop while the cost of goods sold remains the same.

But no matter what you do, the main problem is that skimming usually involves fairly small amounts of cash, so you might spend more money monitoring employees than you save by having no skimming. This is a tough call. In some organizations, they realize there’s some skimming going on, but they choose not to waste time tracking it down.

Discounted Sales

So let’s move along to a different type of cash fraud, which is discounted sales. In this situation, a customer buys something, and the sales clerk records it normally, so the system records a sale and outgoing inventory. Up to this point, everything is normal. However, then the sales clerk records a promotional discount in the system, takes the amount of the discount out of the cash register, and pockets the cash. The customer never knows, because he’s probably already walked away. This approach is clever, and the sales clerk can get away with it if he only records a few of these discounts each week. Otherwise, the controller will notice a lot of discounts being charged through the system, and will investigate.

It’s possible to stop this type of fraud by requiring supervisory approval before a discount can be recorded in the cash register, though that means calling over the supervisor – which might not be efficient. And of course, you can also install security cameras over the sales clerks.

Fake Refunds

A variation on discounted sales fraud is the fake refund. In this case, the employee creates a credit memo for a refund back to a customer, and then intercepts the check payment before it goes out, signs it over to himself, and deposits the check in his own bank account. There are some variations on this. One approach is to record a product return in the accounting system from a customer, which triggers an automatic refund payment in the system. Or, the employee could authorize a volume discount for a customer.

Fake refunds are always triggered by someone in the accounting department who also has access to outgoing checks. Otherwise, some of the refund payments will get out to actual customers, and they might contact the company about why they’re receiving a payment that they weren’t expecting. Therefore, a good way to keep it from happening is to maintain tight control over outbound check payments.

A good way to detect fake refunds is to look for actual inventory counts that are lower than their book balances. The difference is caused by fake returned goods being logged into the system.

Altered Receipts

And finally, cash can be stolen by altering receipts. This is most common in small firms, where a bookkeeper has control over the entire accounting process. They can intercept cash payments and alter receipts to cover the theft. As long as the bookkeeper keeps the amount of theft fairly small, any minor discrepancies between the amount of cash on hand and the amount stated in the books will probably be written off to expense with no investigation.

To keep this from happening, different people have to be responsible for the receipt of cash, recording cash, and depositing it at the bank. When you can do this, the person recording receipts has no incentive to alter records, while the person handling cash has no control over the recordation process.

Parting Thoughts

I’ll finish with a few thoughts about cash fraud. First, it can be really difficult to spot, especially when the person stealing cash keeps it down to small amounts and doesn’t steal very frequently. In those cases, the grand total stolen over time will probably be pretty small, and the person engaged in the theft is both smart and careful. So, you may never figure out what’s going on. And, if you install some expensive systems to spot the fraud, this type of person is too smart to keep stealing, and will just stop. So the perpetrator is still there, but you can’t prove anything.

Which does not mean that your basic choice is to either let these people keep on stealing or spend a lot of money to catch them. Another possibility is to keep all avenues of communication open – with employees and customers, and anyone else who might have cash dealings with the firm. These people may notice that something isn’t quite right, and you want to be on good enough relations with them that they’ll come to you about it.

And also, vary your routine a bit. For example, occasionally reconcile an account that you usually ignore. Or come back to the office after you’ve left for the day. Or come in early. Or switch jobs with someone else for a few days. By being unpredictable, you might find evidence of cash fraud. It’s not easy, but you might get lucky.

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The Audit Partner (#238)

In this podcast episode, we discuss the skills and attributes needed to be a successful partner in public accounting. Key points made are noted below.

Skills Required for Auditors

The best way to cover the topic is to describe the skill set you need at each level of the promotion path in an audit firm. We start with the base-level, newly hired auditor. At this point, you’re expected to take what you learned in school and actually use it. That’s not as easy as it sounds, and this is why about 20% of the incoming class of new auditors will leave the firm within one year, and another 20% the next year.

The auditing tasks you’re assigned in your first year are not especially hard, and you’re supervised fairly closely, so you won’t screw up too much. The audit seniors and managers are watching to see if you understand what you’re doing, and if you’re smart enough to ask for help when you don’t understand something. However, asking for help too much indicates that your knowledge of accounting and auditing isn’t good enough. At the end of the year, the audit managers get together with the partners and decide who has flunked. If you’re not good enough, you’re counseled out.

Therefore, someone who wants to make it all the way to partner needs to have a solid understanding of the fundamentals of how to audit. The same goes for the second year.

Skills Required for Senior Auditors

In the third year, and this varies a bit based on the firm, you’re promoted to audit senior. This means you get to deal with more complex topics, like valuing inventory. For a stretch of two or three years, they’ll throw the more complicated topics at you, and you’d better show a solid understanding of the material – or, you’ll be counseled out of the firm.

As you can tell, as you go through this half a decade of being a non-management staff person, you’re being evaluated all the time. There are a couple of reasons for this. First, they need to make room for the next incoming class of new auditors, so they have to continually cut older people who just don’t have the skill level.

And the second reason is that the next promotion is to manager, where you’ll be running audits yourself. And they really can’t afford to have anyone in the manager position who might screw up an audit.

Skills Required for Managers

And then you’re promoted to manager. By now, you’ve survived a lot of job cuts, and maybe 10% of your original group is still working for the audit firm. At this point, it’s been established that you know the audit skills. And, getting back to the original question, this means that an audit partner has to have a seriously excellent knowledge of accounting and auditing.

But as a manager, the focus changes. Now, you need to live up to the title. Can you manage an audit? There are a lot of steps in an audit, and you have to keep track of everything. On top of that, you’re being asked to oversee the audit staffers who’re working on your audit. And by the way, this brings up a third reason why audit staff gets counseled out. The audit managers just don’t have time to hold the hand of anyone who isn’t getting it, because these audits have time budgets, and the managers are expected to meet those budgets.

And in addition, managers are faced with one audit after another, in succession, all year long. That means they also have to know how to wrap up the loose ends on the last audit while already working on the next audit. This brings up another issue, which is that managers start working some fairly serious overtime. You can get away with less overtime as a staff person, but that’s not possible as a manager.

So at this stage, managers start to take themselves out of the firm. They get burned out, and audit clients start to give them job offers. Between the punishment of the work and some pretty nice compensation deals, it should be no surprise that a lot of managers leave the firm.

Assuming they stick around, managers stay in that position for about three years. By the end of that time, you can expect that at least half of them are gone. Maybe more. So let’s get back to the question – an audit partner should have managed so many audits that he’s completely comfortable with how the work is done, and he’s willing to work the extra hours.

Skills Required for Senior Managers

And that brings us to the final group, which is senior managers. These people continue to manage audits, but now they’re also expected to bring in new business. That means spending time, both during the day and after hours, networking throughout the local business community. And this is where extroverts start to shine. Up to this point, someone who’s a terrific accounting technician can become quite a competent manager, and could be promoted to senior manager. But that’s where a lot of people run into a hefty barrier, because they’re so uncomfortable with trying to sell audit business. They just don’t get it.

Skills Required for Partners

So, let’s say that the typical interval for being a senior manager is three years. During that time, it’s going to be pretty obvious which ones are really partner material and which ones can only sell an audit if the prospective client comes into their office and begs them to take the work. Therefore, getting back to the question, audit partners can to pull in new business on a pretty regular basis. They’ve figured out which of their contacts generate the most business for them. They only sit on those nonprofit boards of directors that give them the best return on their time, in terms of sales leads. They can make sales calls and close business. And this skill is on top of having excellent knowledge of the fundamentals of accounting and auditing, and being great managers. As you might expect, audit partners work massive hours. There’s just no way to get the in-house work done, as well as all the networking, within a normal working day. Instead, figure on working somewhere close to a 60-hour week, and longer during busy season.

But, there’s one more step, which is going from junior partner to senior partner. As a new partner, you’re given some of the crappiest audits and administrative work, because the senior partners don’t want to do it. So, even though your compensation probably doubled with the promotion to partner, your stress level went up, too.

So those are the skills and attributes of a successful audit partner. The success rate for making it all the way to partner is around 2%. And even at that point, the stress forces some people to retire before the usual retirement age. So I suppose a final attribute of a successful partner is being able to deal with a never-ending pile of stress.

Related Courses

How to Conduct a Compilation Engagement

How to Conduct a Review Engagement

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Artificial Intelligence (#237)

The topic of this podcast episode is the impact of artificial intelligence on accounting. Key points made are noted below.

The Nature of Artificial Intelligence

Artificial intelligence is the simulation of human intelligence processes by machines, which includes learning, reasoning, and self-correction. AI is usually applied to expert systems, speech recognition, and machine vision.

Artificial Intelligence in Collections

So where can this fit into an accounting system? I’d be a bit concerned about having an AI actually keep the books, since you’d somehow have to monitor the journal entries it was making. It could come up with some pretty strange financial statements. However, it could work well in the collections area. First, consider the state of the technology in the collections function right now. At best, you have a database that tracks which receivables are overdue, who to call and when to call them, and which keeps track of the results of each collection call. In essence, it’s a database that supports the work of the collections staff. It also provides a certain amount of automation, like automatically dialing customers.

How could an AI improve on the situation? Consider what it would be like if an AI takes the place of the entire collections staff. You’d have to interface the AI with the collections database, and add a realistic voice synthesizer. Then have the AI call customers directly. Let’s go through how this would work.

The Mechanics of Customer Contacts

As an example, the AI automatically calls a customer. The customer claims not to have received whatever you shipped to him, so he’s not paying. The AI pulls up the delivery information from the third party shipping firm and sends the information to the customer instantly, while it’s still on the phone. This means the customer could be barraged with all possible forms of transmission. The information could be attached to an e-mail, or a text message, or even sent by an old-fashioned fax. Or all three at once.

Then the AI interprets whatever the person is saying, obtains some kind of a commitment from the customer, and transcribes the entire conversation into the collections database. And the AI could be having similar conversations with multiple customers at the same time.

This is the ideal situation. Now, what if the AI can’t understand the customer or the customer is being unusually stubborn. In this case, the call kicks out to a real collections person, who handles the call from there. But these instances should be relatively rare, especially as time goes on. The reason is that the AI is always learning, so it builds a bigger database of experiences over time. Eventually, it should have dealt with even very low-probability situations, and will know what to do.

Third Party Service Provider

Now, consider what it would be like if the AI was maintained directly by a third-party software provider, so the system is not maintained by the company. In this case, the supplier may be running the same AI for thousands of phone calls every day for all of its customers. This means the system keeps getting better, and at a fast pace. The AI could end up learning from millions of phone calls, so it recognizes all kinds of accents and knows how to deal with every possible situation.

So, why would it make sense for a software company to develop a collections AI? Consider the business case. The software company could make a sales pitch that it will take over the collections function from its customers. Entirely. In exchange for an annual contract, clients could eliminate their entire collection departments, which could be a huge savings.

Let’s say that the supplier sets its prices at half what the in-house collections function was costing its clients. Would it be profitable for the supplier? Well, what’s the supplier’s cost? It’s almost all fixed cost, with a variable cost component for a backup collections staff that takes over when the AI can’t handle a call.

Cost Structure for Artificial Intelligence

The fixed cost is a mainframe for the AI, a backup power system, and the costs for a few thousand phone lines, plus developers to monitor the whole thing.  This costing structure means that the breakeven sales level is fairly high, but it’s nearly all profit for the supplier after that breakeven point is reached. So not only would this business be profitable, but it could create a billion dollar business, because it would make sense for a lot of customers.

Advantages of Artificial Intelligence

The reason I’m focusing on collections as a target for AI is that it doesn’t directly impact the accounting system. Instead, it just mimics a person in dealing with customers. And using an AI for collections is appealing for companies, because they can not only save a lot of money, but also the AI may be better than humans at collecting on overdue invoices. That means an AI could potentially accelerate the cash flows of a business.

Artificial Intelligence in Credit Analysis

Could AI be used anywhere else? I think so. Assigning credit to customers would be a good place for an AI. The system could access online credit reports, review the information, and issue a credit limit within a few seconds. That has two benefits. First, an AI always follows the credit granting rules, so it always issues the same amount of credit under the same circumstances. Which is to say that it can’t be persuaded by the sales manager to grant a larger credit line. The system would also learn from the ongoing bad debt history of the company, so its credit granting capabilities should improve over time.

There’s a good market for someone to create a credit-granting AI, since it could potentially be sold into hundreds of thousands of medium to large-size companies.

Artificial Intelligence in Auditing

Credit and collections are the best two opportunities. In addition, there might be a use for it in auditing, but only if there’s a way to input a lot of client financial information into the system. For example, what if a really large audit firm, like Ernst & Young, fed the financials for all of its clients into a central AI, which could then churn through the data and flag possible fraud situations? The AI could learn over time from the masses of financial statements, and probably develop a terrific skill level in fraud detection.

In this case, I don’t see AI saving money for audit firms through cost reductions. It can’t really replace auditors, since a large part of the job is having face time with customers. Instead, by pushing the fraud analysis angle, an audit firm could reduce its risk of being hit with shareholder lawsuits if it misses a client fraud situation.

Related Courses

Accounting Information Systems

Lean Accounting Guidebook

Accounting Automation (#236)

The topic of this episode is accounting automation - what traditional accounting processes are currently being automated, what might be coming in the future, and how to prepare accountants for this future state. Key points made are noted below.

The Underlying Accounting Process

The underlying structure of how accounting is conducted hasn’t changed at all in a long time. There’s a basic process flow that’s followed every time, everywhere. So when we talk about automation, what we’re really doing is using a technology tool to accelerate a small piece of the entire process – but the process itself doesn’t change.

Payroll Automation

For example, let’s look at payroll. This is the area that’s been automated the most. The basic underlying process flow for timekeeping is that someone writes their hours worked on a time card, which is submitted to accounting, which converts the time card information into a total number of regular and overtime work hours, which are then multiplied by pay rates to arrive at a gross pay figure.

Now let’s look at the technology that’s been added to this one small area. We now have timesheet apps on smartphones, and on websites, that can route this information into the payroll database without any need for data entry. We also have computerized time clocks that do the same thing, as well as biometric time clocks. So, the underlying process is still there, but tools are now available that strip out the related work.

Inventory Automation

And there’re so many more tools that have been added over the years. We bar code inventory in order to scan it into the system. We have remote deposit capture to scan incoming checks into our bank accounts. The payroll and payables departments use electronic payments. Suppliers send electronic invoices. And the accounting system can automate the three-way matching process for us.

Now, speaking of three-way matching. That’s the bit where someone in the payables department compares a supplier invoice to the authorizing purchase order and receiving documentation to see if the supplier can be paid. It’s a control point. This is one of those rare cases where the underlying process can be altered to make the payables process more efficient.  One way is to have the receiving staff approve received goods for payment at the receiving dock by checking off the received items against a list of open purchase orders in the warehouse’s computer system. Better yet, suppliers can deliver goods straight to the production line, and they’re paid based on the number of finished goods that came out of the production line. But this is a rare exception. And in both cases, those ideas were formulated about a quarter of a century ago. Which is to say that accounting process improvements are very, very rare.

Highest Levels of Accounting Automation

Now, in regard to which accounting processes are being automated. The most obvious one is payroll. There have been some advances in billings, payables, and cash collections. It’s possible for the accounting system to compile less-complex invoices for customers without any manual intervention. The same goes for payables, where suppliers can enter their own invoices through a portal, and the accounting system schedules the payments from there. And in cash collections, there’re fairly accurate systems that can automatically apply cash to unpaid customer invoices.

Problems with Accounting Automation

But that still leaves a lot of areas that involve mostly manual labor, such as liabilities, fixed assets, equity, collections, taxes, and inventory – especially inventory. These are all areas of opportunity if someone can figure out some new automation. But I don’t think it’s coming any time soon. And I have two reasons for thinking that way.

One is that a jump in innovation tends to coincide with a major new technology platform. So, we had a slew of new innovations when smartphones appeared, like having phone-based timekeeping and credit card processing and billings. That platform appears to be pretty much maxed out, so I’d be surprised if we see any more innovations from that platform.

My other reason is that, looking back on when innovations were first introduced, the rate of advancement is actually pretty slow. The first bar code scanner was produced in 1974. The first computerized time clock? 1988. Remote deposit capture? 2003. So in short, even though it seems like there are lots of automation tools, they’ve crept up on us over a fairly long period of time. Which means that it may be a long time before anything else appears.

Prospects for Future Automation

As for the question of what is coming in the future – it’s really difficult to say. After all, who could have predicted bar codes? It’s an inherently odd concept that happens to work really well. So no, I cannot tell. I can say that the areas most in need of innovation are where there’s a high level of transaction volume and a lot of labor, which points toward collections and inventory. If someone comes up with a great innovation in one of these areas, the potential cost savings would be so large that the adoption rate should be fast. And given the potential for rapid adoption, this is where inventors are most likely to be concentrating their attention.

The really good question is how to prepare for the future. Clearly, we can’t tell which innovations will appear, or when. But we can assume that whatever appears will need to be properly inserted into the existing processes. So. What I suggest is to pay attention in your accounting information systems class. That means having a complete understanding of exactly how and why accounting systems work, and why we have controls at certain points. Then, get involved in all systems integration projects in the company, to gain experience in how the projects are set up and managed. For example, if the company wants to install bar coded tracking of inventory, learn about the types of bar codes, where the labels are placed on products for readability, where to position scanners, what to do when the systems fail, what kind of training to schedule for users, how controls are altered, how to write the procedures for the revised system. How to test the system. There’s a lot to understand. If you keep volunteering for these projects, you’ll not only be indispensable, but you’ll also be much more marketable than the average accountant. And if any nifty new technology comes along, you’ll be in a great position to install it.

One final thought. New technology might be rare, but there are all kinds of other events in the life of a business that will call for changes to the accounting system. For example, management might decide to add a warehouse, in which case you’ll need to add accounting systems over there. Or there may be an acquisition, in which the systems of the acquiree need to be integrated with those of your company. Or the company decides to outsource its manufacturing, in which case there’ll be systems changes to link up with the new supplier. These types of changes are vastly more likely than entirely new forms of technology, so this is the area for which you need to prepare yourself.

Related Courses

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Job Hopping (#235)

In this podcast episode, we discuss the pluses and minuses of job hopping. Key points made are noted below.

Definition of Job Hopping

Job hopping means switching employers of your own volition within one or two years of being hired. Which is to say, you weren’t forced to leave because of a layoff or something similar.

Benefits of Job Hopping

Let’s look at this from several perspectives. One view is that you go into a company already assuming that you’re going to vacuum up a specific type of experience, and then job hop into something else that offers a different type of experience. This could make sense, for example, if your ultimate target is to be a chief financial officer, and you want to do a stint in cash management, just to pick up the basics, and then spend some time in risk management, and maybe another job in currency trading. Theoretically, this approach could accelerate the time it takes to be hired into a targeted job.

Under this line of reasoning, it’s not about getting a pay raise just for the sake of the extra money. Instead, it’s about achieving a specific position, so you’re trying to advance your career as quickly as possible. I don’t really have a problem with this, since the focus is on career building. However, if you hop through all of those intervening jobs too fast, it would be reasonable to expect that no one is going to give you a favorable job recommendation, because you didn’t stick around long enough to make a favorable impression.

The Pay Raise Conundrum

Another perspective on job hopping is that you’re pursuing the same job at different organizations in search of progressively higher rates of pay. Employers really don’t like this, because it’s a mercenary approach to your career. Shifting jobs for a bit more money can alienate your employer. It can make more sense to stick around in one position for an extra year or two, just to build up some goodwill with whoever might be writing your next recommendation letter.

The decision to switch jobs can be more difficult when the amount of the pay being offered by the next employer is a lot more than what you’re making now. Depending on your financial circumstances, the offer may be too good to resist, even if you know you’re going to tick off your current boss.

When to Leave Right Away

Another situation involving job hopping is when you’re not enjoying yourself in the current job. The required skill level may be too high or too low, or perhaps you don’t get along with a co-worker, or the commute is too long, or the job environment isn’t healthy – from any number of perspectives. In this case, why prolong the agony? Being unhappy at work can trigger all kinds of health problems, so my advice here is to leave as soon as possible, as long as the replacement job is a clear improvement. Otherwise, you’ll end up hopping from one job to the next in quick succession, and being dissatisfied in each one.

There may be another reason for the job hopping, which is that accounting is not a good fit for you. Maybe you don’t like the attention to detail, or the need to minimize mistakes, or maybe you’re not good with numbers. That last one would be tough. Whatever the reasons may be, you’re not going to do well in any accounting position, so stop job hopping within the accounting field and try something different.

As an example, I once ran into someone who had been admitted into one of the best dentistry schools in the world. He spent part of his first day poking around inside someone’s mouth, decided that he did not want to do that anymore, quit school and joined an amusement park. And no, I’m not kidding. That does not mean you should join an amusement park.

Downsides of Job Hopping

Now let’s look at some downsides to job hopping. One I’ve already noted is that you’ll have a hard time getting any decent references from past employers. If anything, you may have pissed them off. Another problem is that prospective employers are really concerned when they see a series of short-term jobs on your resume. In fact, the first thing I did when reviewing resumes for a job opening was to look for job hoppers, and immediately ignore those resumes. It takes too long to train someone into a position, just to have them leave a few months later, so that was a huge black mark. That does not mean that you can’t have one or two short-term positions on your resume. As far as I’m concerned, everyone gets a free pass on a few jobs in a career, because shit happens - a job doesn’t work out, and you need to move on. Even so, think carefully before switching jobs, because you may find that the new job environment is not as good as what you just left, which could trigger yet another job hop, and so on.

Summary

I’m not entirely against an occasional job hop, as long as you have a good reason for doing so. However, I’m also not a fan of people who persistently do it. If you’re in a job that’s pretty good, with reasonable prospects for advancement, and decent co-workers, it might be worthwhile to stick around for a few years. Chances are, you won’t be able to match that experience somewhere else.

And a final thought is to be wary of that new job prospect that a recruiter is telling you about. If someone occupied that position before and it’s now vacant, I’d be concerned about why your predecessor left. It’s entirely possible that the job you’re heading for has some real problems with it, and you’ll be blindsided by those issues when you show up. Which will trigger further job hopping.

How to Find the Right Metrics (#234)

In this podcast episode, we discuss how to find the right metrics for your business. Key points made are noted below.

The Need to Change Your Metrics

Metrics tend to be quite stale. There’s usually a traditional list of items, such as the ending cash balance, the amount of available debt left on the line of credit, or maybe a trend line of sales or profits. And then there are usually a few measurements that crept in because there were problems in the past, so the president wanted to start keeping an eye on them. For example, there might be a measurement for the number of customer returns, or maybe a measurement for the number of customer orders that won’t be delivered on time.

This existing set of measurements is not all that useful, for a couple of reasons. First, they tend to be focused mostly on financial measurements, which are too highly aggregated to be of much use. Just because sales have dropped by 4% doesn’t mean that anyone is going to take action. It’s usually not an overly large change, so it’s ignored.

A second problem is that they focus on the problems that the company used to have. Getting back to my earlier example, the number of customer returns is being reported, because it used to be the problem. It may not be a problem anymore.

A third problem is that the existing measurements are old, steady, and reliable. When managers focus only on these measurements, there’s a built-in assumption that there aren’t any other problems that need to be measured, so they never go looking for them.

The Controller’s Responsibility

And that last point is the real issue. When adding measurements to the financial statements, the controller has two responsibilities – one is to report them properly, which is what 99% of all controllers focus on. The other responsibility – which nearly everyone ignores – is whether the right measurements are being reported. Usually, the controller keeps shoveling the same measurements into the financial reporting package, maybe for years, without considering even once whether there might be some other issues out there that are flying under the radar.

Why don’t more controllers make an effort to find the right measurements? Or, for that matter, how come nobody seems to do it? The problem is that just about everyone is in a nice comfort zone. For example, the controller has to deal with the month-end close, the sales manager has to prep for a meeting with her sales staff, and the production manager needs to monitor the release of new jobs to the production floor. These are all administrative issues, and managers are usually quite competent at dealing with these kinds of things. None of these items need to be measured, unless the objective is to show how successful you already are.

How to Identify the Right Metrics

The real issue lies elsewhere. It involves digging around the company, and maybe outside of it, to figure out where the next problems are coming from. The controller is not going to hear about these issues at the next executive committee meeting, since the other managers probably have no idea that there’s an issue. Instead, you usually have to dig around in the roots of the organization, way below the other managers, to learn about the real problems. For example, Steve Jobs at Apple used to handle customer service calls every now and then, just to see what actual customers were saying.

Or, if you don’t want to go quite that far, how about digging through the customer service database – if there is one – to get a more aggregated view of customer problems. Or, talk to the people in the returns department to figure out which products are being returned, and why. Or, if the company submits bids to customers and loses a bid, how about calling the customer to find out what the winner had that you didn’t have? Or, how about talking to the purchasing staff to see if there’re any issues with receiving raw materials on time from certain suppliers? Or, how about talking to the people at the receiving dock to see if any suppliers screw up their deliveries? Maybe deliveries show up late, or they send incomplete orders, or they send the wrong parts. And here’s another one. What about tagging along on a field service call to repair a product in a customer’s home?

You could find out about whether the customer has to wait a long time for the service tech to show up, and what it is about the product that keeps breaking. And you have a great opportunity to chat up the customer and see if there’re any other problems.

Now, it could seem like this is going way beyond the normal job description of a controller. You’re snooping around in the areas of responsibility of the other department managers, which can create conflict. But consider that the controller has sort of a free pass to talk to anyone in the company. This is because you’re seen as being responsible for the financial health of the entire business, so you have not only a right, but an obligation to talk to everyone.

Another concern is that you may not like what you hear. This can be a bit of a problem, because, as I said earlier, most managers are administrators who are good at dealing with the current situation. They don’t go looking for trouble. And controllers are just like other managers. They don’t like to do this. And they really don’t like being the person who brings up these uncomfortable issues with the rest of the management team. Nonetheless, this is part of the job.

And a good way of looking at the situation is that going out and actively looking for trouble is exactly what sets apart the great controller from the average controller. It shows that this is the one manager who’s taking an active role in improving the business.

The Need to Dump Old Metrics

And a final thought is that the controller is also responsible for getting rid of any metrics that are no longer needed. It can be fun to do this and see how long it takes before anyone notices. Which could be another metric.

Related Courses

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The Casino and Gaming Industry (#233)

In this podcast episode, we discuss accounting issues in the casino and gaming industry. Key points made are noted below.

Casinos as Financial Institutions

Casinos are classified as financial institutions in the United States, because they accept cash, they exchange currency, they issue checks, they handle wire transfers, and a lot of similar activities. That means they have to fill out a currency transaction report whenever a cash transaction exceeds $10,000 in a single business day. That report is filed with the Financial Crimes Enforcement Network. These cash transactions can be for things like buying chips, making bets in cash, or depositing money.

Structuring

Customers with a lot of illicit cash don’t want to be reported, so they do things like structuring. Structuring occurs when a customer breaks up a large monetary transaction into a bunch of small ones, such as making 20 small deposits with a casino in one day, rather than one large deposit that could trigger a currency transaction report. Or, he could use gaming day overlap, where he splits his cash transactions over a couple of days, so that a total transaction of $10,000 is split up over different reporting periods, which doesn’t trigger a report. Another possibility is to hand out cash to your associates, so that the casino’s tracking system doesn’t figure out that a lot of money really came from a single source.

Suspicious Activity Reports

And on top of that, a casino has to file a Suspicious Activity Report whenever a customer seems to be avoiding the requirements of the Bank Secrecy Act, which usually means money laundering. For example, someone brings in stolen cash and swaps the cash for chips. He then plays very little, in order to avoid any gaming losses, and then cashes in the chips in exchange for different bills. In essence, he just laundered the money.

Casino Controls

Casino and gaming operations have an incredible number of controls, and that’s because each one was put in place because someone figured out a new way to steal from them. Let’s go through some of the better ones. We’ll start with controls for dealers.

Dealers have to wear aprons, or pants without pockets, so that they can’t put chips into their pockets. A lot of casinos don’t allow dealers to wear watches, especially large watches, because you can slide a chip behind the watch. Another control applies to when a dealer leaves a gaming table or moves chips to and from the storage area, which is called the chip rack. Whenever this happens, the dealer has to turn his hands upward with his fingers fully extended, which is called clearing hands. The intent is to keep a dealer from palming any chips and walking away with them.

How about controls over chips? First of all, casinos only buy chips from reputable suppliers that maintain tight control over their inventories. Otherwise, chips could be stolen at the supplier and presented at the casino for payment. Once chips arrive at the receiving dock, the security team takes over and matches them against the shipping documents to make sure than none have been stolen in transit. And then they’re stored in the vault. And finally, when chips are worn out, a specialist chip destruction firm is called in, which grinds up the chips while being watched by security. This might all seem like overkill, but keep in mind that chips are directly convertible into cash, so the controls over the chips need to be as comprehensive as the controls over cash.

What about the controls over the counting of cash and chips? This takes place in a count room, which is monitored by security guards and video cameras. The count table is made of clear Plexiglas, so that any currency falling under the table can still be seen. Anyone on a count team has his identification examined before he can enter the room. Everyone on the count team has to wear a jumpsuit without pockets, so they can’t slip any money into their pockets. The team divides up tasks, so that one person empties the incoming boxes of currency, while a second person sorts and counts the contents, and a third person recounts the currency and fills out a summary form. There’s also a man trap leading into the count room, which is a segregated room that requires key access to enter and exit. It’s used to lock someone in place as they try to pass into or out of the count room.

And then we have key controls. Currency and chips are stored in drop boxes. One key is used to release a drop box from it designated location, such as inside a slot machine, while a second key is needed to open the drop box. So you always need two keys. Keys are only issued to someone on the approved key access list, and you’re only approved for one key – not both. That means it always takes two people to remove money from a location and then open the box. There’re lots more variations on key control, but you get the general idea.

I’ve just described maybe one or two percent of the controls used in a casino. There’re also controls over specific games, such as Keno and bingo, and the race and sports book area. And so on, and so on. My point in mentioning controls is that this is the ultimate industry for cash controls. It can be really instructive to see just how detailed and multi-layered these controls can be.

Table Game Operations

I’m going to touch upon a few more aspects of the accounting for casinos and gaming. One issue is, how do you keep track of table game operations? A rack of chips is maintained at each table, so that players can be paid on winning wagers. This rack constitutes the table inventory. Over time, the dealer pays out winning bets from this rack and replenishes it with losing bets. Because the house has a small percentage advantage on the games played, the number of chips in the rack should increase over time.

If chips are bought with cash at the table, then the dealer issues chips from the rack and then drops the cash into the table’s drop box – which I already talked about, where a security team occasionally shows up and takes the drop box to the count room.

So, what about if the dealer has to make a large payout? Then the rack has to be replenished, which is called a fill. There’re a bunch of steps here, but basically a security officer shows up with the extra chips, which the dealer counts and signs for.

Whenever a table closes or there’s a shift change, the dealer reconciles the ending table inventory, just like a teller would do at a bank. When the beginning and ending chip inventories are taken into account, along with all of the transactions in between, the difference is the gross gaming revenue for the table.

Slot Machines

Let’s switch over to slot machines. A traditional slot machine accepts coins, which first fall into a hopper, which holds a certain amount of coins that are used to pay out jackpots. Once the hopper is filled by customers, the overflow goes into a storage box at the bottom of the machine, which is then emptied and sent to the count room.

When a customer wins a jackpot, the machine accesses the hopper to pay the required amount. If the hopper is emptied before the full amount of the jackpot has been paid, the machine sends an alert to the local change person, who handles the payment of the additional amount. This type of slot machine is starting to go away.

The replacement version is the ticket in, ticket out system. When a customer wants to cash out of this kind of slot machine, he presses the Cash Out button and the machine prints a ticket, which contains a bar coded dollar amount. This ticket can then be used to drop money into a different slot machine, or to cash out. This newer slot machine requires much less staff time for servicing.

Deferred Revenue

So far, I’ve been talking about reporting and operational issues. Are there any actual accounting issues related to casinos and gaming? Oh yes. First, we have deferred revenue. Bets may be placed in the race and sports book area on events that haven’t yet taken place. When this happens, the bets are recorded as a deferred revenue liability.

Discounts on Losses

Next, we have discounts on losses. A casino may offer discounts on losses incurred by their top-level players, so that the customer only has to pay a discounted amount of his losses. These discounts reduce the amount of revenue recognized. In case you’re wondering why a casino would do that, the point is to set the discount low enough so that the casino still earns a profit, while still attracting the business of high rollers.

Jackpot Insurance

And then we have jackpot insurance. A casino could buy insurance to protect it from really large payouts. When a casino has a claim under a jackpot insurance policy, the recovery is reported as net gaming revenue. The premiums paid are a reduction of net gaming revenue.

Unpaid Winners

There may also be unpaid winners, where someone wins a game, but they don’t come forward to collect their winnings. If so, the casino still has to record a liability.

Accounting for Chips

And you can even capitalize chips and treat them as fixed assets – though the usual chip acquisition cost isn’t really all that high, so the cost is usually just charged to expense.

Missing Chips

And finally, we have missing chips. These chips could be redeemed at any time by customers, so the casino has to maintain a liability on its books for unredeemed chips. Some of these chips will be lost, or maybe customers want to keep them as souvenirs. So, the accounting staff makes an estimate of how many chips may never be redeemed, and reduces the liability based on that estimate.

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Accounting for Casinos and Gaming

Accounting Ethics (#232)

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

The Ethical Quandary of the Controller

I’ve mentioned ethical issues off and on in the previous episodes, but let’s get into this in more detail. And let’s start with an example. Let’s say that you’re the company controller, and you’re fairly new to the job. It’s the last day of the year, and the entire management team is going to receive a hefty bonus if the company can ship out a lot of deliveries on the last day of the year. It’s now mid-afternoon of that last day, and the president calls a meeting of the management team – he says that the company will make its numbers, but only if the shipping department keeps shipping orders like crazy until 3 a.m. the next day.

At this point, the president looks at you and says, “That’s OK with you, right?” This puts you, as the controller, in a terrible position. Keeping the books open late is fraud, because you’re taking sales from the next year and stuffing them into the previous year. But on the other hand, let’s look at all of the pressure you’re under. The president has just asked for your opinion in front of the entire management team. The whole team will lose their bonus if you tell the president that sales will be cut off at midnight – which is what’s supposed to happen. And you’re new, so you don’t exactly have any power within the group to support your own position. Chances are, because of all that pressure, you’ll let the late deliveries be recorded in the wrong period, and you just committed fraud. What is everyone else’s reaction? The president personally thanks you, the rest of the management team invites you out for a beer, and you get a bonus. This is the problem with ethics when you’re an accountant, because there’s usually a choice between taking an unpopular position that opposes everyone else, or going along with the crowd. And that’s hard.

Before we get into what you should do about it, let’s keep going with that scenario. In the next month, sales are low again, because you incorrectly recorded some of its sales in the previous year. So the management team fully expects that you’ll leave the books open again, because that’s what you did the last time. And once your initial decision is made to commit fraud, you’ll always be tagged with having a reputation as an easy controller, someone who’s always willing to bend the rules, just to help out the rest of the company. If you extrapolate this scenario all the way out, it could easily lead to a controller - who came into the profession with good intentions – ending up committing a massive fraud and going to jail for it.

A key point to take away from that scenario is that it’s not just bad people who engage in fraud. It’s also people who are perfectly fine, but who get twisted by the circumstances they find themselves in. In fact, I’d say that only a tiny percentage of all people in the accounting profession have such a rigid sense of ethics that they always make the right ethical choice.

The Source of Ethical Problems

So, what can be done? Let’s go back to that example. Whose fault was it, really, that the controller made a bad ethical decision? It was clearly the president. The president imposed pressure on the controller to make a bad call. This situation is really common, because the people who run companies don’t necessarily have a strong moral compass. If anything, too many of them focus so much on performance that they completely ignore how to run the company in an ethical manner.

This is a real problem for new controllers in particular. Consider the situation. You’ve just landed your first job as a controller. Why? Why did the president hire you? Quite possibly because he knows you need the job, and you’re so junior that he’ll be able to force you into making all kinds of bad decisions. This is more common than you might think, because a bad boss runs through a lot of controllers. He’s constantly cycling through them, because they quit as soon as they can.

So the first thing to do when you get into a job at a new company is to take a really hard look at who you’re going to be working for. This means talking to fellow employees and maybe calling up the person who had your job before you. If you find out that your boss has caused problems in the past, then he’s going to do it to you, too. If so, start looking for a new job right away. Yes, I know – you may have been unemployed for months before getting hired, and it’s not economically possible to quit. I understand, but you need to start the next job search anyways, even if you haven’t quit yet. By doing so, you may be able to slide into a new job somewhere else before you’ve been damaged too much.

Boss Reformation

It might be tempting to think that you can reform your boss. By acting like a virtuous saint, your boss will see the light and start donating to orphanages. Right. Someone who is ethically challenged is probably going to stay that way for life. So I’d still say that the best solution is to go somewhere else.

The Accounting Code of Conduct

But if you really want to try to make other people behave better, I have some suggestions for changes that are within your control. One option is to create a code of conduct for the accounting department. And bring it up at regular intervals, so that the staff knows you’re serious. Also, make sure that every supervisor within the accounting department acts like a role model. That means you impose the highest possible standards on them, and reinforce your expectations with them all the time.

Scenario Discussions

Another possibility is to never put your staff in the position of having to make a sudden, knee jerk reaction to an ethically challenging situation. Getting back to my earlier example, what if there was a formal discussion within the accounting department at regular intervals about how to react when someone asks you to keep the books open into the next month? You can walk the staff through a bunch of these scenarios and talk about what the correct response should be. By doing that, no one is thrust into a bad position where they’re making an intuitive judgment call. Instead, they just know what to do.

That obviously helps a great deal with the accounting department, but what about with the rest of the company? The rest of the company is not under your control, so the best you can do is set an example. In this case, it means telling the other managers about what you’re doing. This sends a pretty clear signal that you take ethical positions seriously. And when they know that, they’re going to be much less likely to even present you with those ethically challenging situations. So, in effect, you set up the accounting department as the temple of right thinking. Within that department, everyone has discussed what might happen, and they know how to respond.

The Impact of Good Working Conditions

What else can you do within the accounting department to avoid ethical issues? One approach is to provide them with good working conditions, like flexible hours, not much overtime, and a fair wage. When this is the case, they’re less likely to get back at you by stealing assets or engaging in some other shenanigans that aren’t good for the company.

Set Reasonable Goals

Another possibility is to set reasonable goals for people. Don’t set goals so ridiculously hard that the only way to attain them is by committing fraud. Instead, set modest goals that they should be able to achieve.

Emphasize Communications

Another item is to work on the highest possible level of communication within the department. It could be a staff lunch every week, or cycling through lunches with the entire staff on a regular basis, or maybe just wandering around a lot, so that everyone has a chance to talk to you. That way, if there’s a problem, you’ll hear about it sooner, rather than later.

The Benefits of Fairness

And a final item is fairness. An employee is more likely to engage in unethical behavior if he feels that he’s being dealt with unfairly. For example, there’re two candidates for the assistant controller position, but only one position. So someone is going to lose out. And the loser may be more inclined to do something self-serving to get back at the company. When you have one of these situations, be very clear about the criteria you’re using to make a decision, and explain your reasoning. Someone is still going to lose out, but it’s possible that with the extra communication, they just might understand your position.

Parting Thoughts

All of this may sound quite grim, and you may think that I have a skeptical view of company presidents. Yes it is a grim discussion, because you’ll run across more ethical issues than you would think possible over the course of your career. And yes, I do have a somewhat skeptical view of company presidents, because quite a few of the ones I’ve worked with just don’t think about the ethical ramifications of what they’re doing to their employees.

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Ethical Responsibilities

Unethical Behavior

Dealing with a Subpoena (#231)

In this podcast episode, we discuss how a CPA should respond to a subpoena. Key points made are noted below.

Definition of a Subpoena

A subpoena is a formal document that orders someone to give testimony, and it’s usually issued by a court. Though, to be accurate, it’s usually issued by an investigating attorney without the knowledge of the court.

There’re a few kinds of subpoenas. The first kind is a witness subpoena. As the name implies, the recipient has to appear in court on a certain date and testify as a witness, usually in a trial. A variation on this is a deposition subpoena, where the recipient has to provide copies of business records and possibly appear at a deposition to answer questions asked by one of the parties in a lawsuit. This variation is part of the discovery process before a trial.

And the one that’s most likely to matter to the CPA is a subpoena for the production of evidence. This version requires the recipient to produce any records under his control at a specific time and place. In this last case, the CPA may be able to just mail in the records, or perhaps even use e-mail for the delivery. Which is to say, there may be no need to appear in person at all.

If you don’t comply with the requirements of the subpoena, then you can be charged with contempt of court, which can lead to fines or jail time. So in short, there is a legal requirement to comply.

Why the CPA Receives a Subpoena

So why would a CPA receive a subpoena? Probably because you have control over some client records that an attorney wants to look at. For example, there may be an investigation of fraud at a client company. Whatever the reason for the subpoena, this presents a problem for the CPA, because the AICPA Code of Professional Conduct states that a CPA should obtain the consent of a client before disclosing any confidential client information. However, the code of conduct also provides for a few exceptions to the rule, one of which is that it’s acceptable to disclose confidential client information if there’s a validly issued subpoena enforceable by court order.

Steps to Take

So, you’ve received a subpoena. Now what? The first step is to contact your attorney. The attorney will want to review the subpoena to see what kind of legal proceeding is involved, such as whether it’s a civil case, a criminal case, a tax case, and so on. There’s a different set of rules governing each of these types of legal proceeding. The attorney will also want to review both the situation and the document, to see if the subpoena was served properly and that it’s valid. Depending on the rules, a subpoena might have to be served to the CPA in person, or it might be acceptable to mail it. As another example, a subpoena issued by a state court is only valid in the state where it was issued.

The attorney will then want to talk about exactly what’s supposed to be produced. The attorney can advise on which documents need to be produced and which to hold back for other reasons.

According to the AICPA’s interpretation of its code of professional conduct, you do not have to notify the client that its records have been subpoenaed. Though you still can contact the client, except in cases where the subpoena is supposed to be kept confidential – which can happen with a grand jury. It might be useful to contact the client, in case your agreement with the client allows you to bill it for the cost of preparing any documents for a subpoena request.

The AICPA’s interpretation also advises that you might want to consult with your state board of accountancy, perhaps so that they can provide some additional knowledge about how the state-specific ethics rules might relate to the subpoena.

Objecting to a Subpoena

The client or your attorney can request that you object to either the scope of the request or the nature of the documents to be provided. This can be a valid concern when the subpoena covers confidential information, such as trade secrets or market development plans.

But before making an objection, it can make sense to have your attorney contact the attorney that issued the subpoena, to get a better understanding of what’s going on. The person who issued the subpoena may not realize just how much effort is needed to comply with it, and so could allow you to respond with a reduced amount of paperwork. This means negotiating for a narrow scope on the subpoena.

If you do decide to object to a subpoena, document everything in a letter and send it to the issuing attorney by registered mail, so there’s a record that the attorney received it. Depending on the situation, making an objection can mean that you no longer have to comply with the subpoena, unless the issuing attorney obtains a court order that enforces it. Consult with your attorney about this, since the rules depend on the situation.

A variation on issuing an objection letter is to file a motion with the court, asking that those parts of the subpoena relating to your objections be cancelled. This approach might work better when the issuing attorney is being a pain.

The Issuance of Documents

When it comes time to send documents to the issuing attorney, be sure to only send copies of the documents, since the originals might otherwise get lost or damaged. Also, make a complete record of exactly what was sent, which can guard against complaints that you didn’t send everything that was requested.

Accountant-Client Privilege

That’s the essential process flow, but we’re not done yet. In addition, quite a few state governments recognize an accountant-client privilege. This privilege means that the information communicated to the CPA by a client in regard to an accounting engagement is confidential. This information belongs to the client, not the CPA, so consult with your attorney to see if any documents are protected by this privilege.

There’s something similar to the accountant-client privilege in the tax area, which is the federally authorized tax practitioner privilege. This one only applies to tax advice between a client and its federally authorized tax practitioner. It probably doesn’t apply to most of the work papers involved in preparing a tax return.

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Sales and Use Tax Audits (#230)

In this podcast episode, we discuss sales and use tax audits. Key points made are noted below.

The state government may send a team of auditors to a business, to see if it’s been remitting the correct amount of sales and use taxes. If it hasn’t, the business not only has to pay the missing amount of taxes, but also interest on the unpaid amount and penalties.

Your Chances of Being Audited

Who is most likely to be audited? Look at it from the perspective of the government. Audit teams are expensive, so they need to be targeted at businesses that are most likely to end up paying more in fees and penalties than the cost of the teams. This means larger firms are more likely to be targeted. In addition, if an audit team finds a significant problem, the business will probably be put on a watch list, and so is more likely to be targeted again in the future. This does not mean that a small business will never be audited, but it is less likely.

Another possibility is that a company will be audited as the result of an audit of someone else. For example, a supplier is audited, and the auditors note that the company wasn’t charged sales tax on a large invoice. They then target the company to see if it paid use tax on that invoice. Use tax compliance tends to be much worse than sales tax compliance, so this kind of investigation can be easy money for an audit team.

How Auditors Find Errors

How does an audit team find sales and use tax errors? They send a notification to the targeted company, stating which time periods they want to look at. When they arrive, they select a sample of the customer billings and supplier invoices from these periods, and see if there were any cases on these invoices where sales or use tax was not paid. When no tax was paid, the auditors see if there was a valid sales tax exemption certificate that was the basis for the nonpayment. The auditors also check to see if all sales and use taxes were remitted to the government, both in full and by the required payment dates.

The auditors may go even further, and investigate whether any sales made to dispose of old assets had sales taxes charged on them. After this work, the auditors compile a list of all exceptions found, and forwards them to the company controller for review. At this point, keep in mind that the business is assumed to be guilty unless it can prove otherwise, so the controller has to make a valid case for why sales or use tax was not paid.

The Error Rate Extrapolation

If the controller cannot make a persuasive case to the auditors, then the exceptions are included in an error rate extrapolation. What this means is that the auditors extrapolate the error rate percentage they found in their sample to the full population of customer billings and supplier invoices.

For example, if the auditors find that $100 of sales tax was not collected in a sample that comprises ½% of a company’s total sales volume, it will extrapolate this finding to the rest of the company’s sales – which in this case results in a total charge for uncollected sales taxes of $20,000. And then, the auditors add a late payment interest charge onto the extrapolated amount, plus penalties. The result can be a startlingly large amount that has to be paid.

Pursuing Customers for Sales Taxes

It is technically possible that a business could go after its own customers for sales taxes that it never charged them, but this is not likely, either because it damages customer relations or because the sales occurred so far back in time that collecting the amounts due is impossible. So instead, the company has to pay the entire amount.

Damage Mitigation

How can we minimize the damage caused by one of these audits? First, conduct a periodic review of the Department of Revenue’s listing of what is and is not exempt from sales tax. This is most applicable when the company currently is able to not charge sales tax, since that exemption could go away. Second, if customers have submitted sales tax exemption certificates, make sure that they’re up-to-date and completely filled out. If not, the certificates are not valid and sales tax must be charged. Third, make sure that there’s a solid process in place for calculating and paying use tax. This is an area that’s usually quite weak. And finally, conduct your own internal audit to see if any exceptions crop up. If they do, figure out how the process broke down, and fix it.

How to Treat Auditors

An additional issue is how to treat auditors when they show up on the premises. As an overall guideline, these people are professionals, so treat them with respect and give them a decent amount of office space to work in. That being said, there are a few guidelines for minimizing the damage they can cause. First, have them work in an area away from the rest of the employees, so that they don’t overhear conversations that might cause them to expand their audit. Second, have just one point of contact between the auditors and the rest of the company, and have this person carefully review everything submitted to the auditors. Doing so keeps the auditors from ever receiving inaccurate or misleading documents. And third, minimize communications between the auditors and the rest of the company. It is not helpful for the auditors to walk around, quizzing everyone about what they do and trying to dig for more information. So, talk to the accounting staff before the auditors show up, and tell them to only respond to direct questions and to not volunteer information. And finally, don’t volunteer to give them a tour of the company. If they get a tour and then see some large and expensive equipment on the premises, they may want to investigate whether sales or use tax was paid on it.

Parting Thoughts

In general, the key to surviving a sales and use tax audit is to have solid systems in place already, so the auditors won’t find much of anything to include in their error rate extrapolation. This means that charging sales tax to customers should be your default method of operation. Any sales tax exemption certificates from customers should be well-organized and reviewed on a regular basis. There should be a solid use tax calculation system in place. And finally, make sure that sales and use taxes are paid on time, every time.

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Sales and Use Tax Accounting