Suggested Readings (#268)

In this podcast episode, we discuss a variety of readings that are definitely outside of the accounting area. Key points made are noted below.

Please keep in mind that there is absolutely nothing about accounting in this episode. Instead, my focus is on just giving you a broad knowledge of what’s going on in the world today. In the earlier episode, one of my recommendations was to read Business Week. That is no longer the case. Though I liked the magazine, they had a horrible time delivering it, where I was getting it maybe one week in three.

The Economist

So, in looking for a replacement, I decided to try the Economist, which has turned into my main reading source. I read probably three-quarters of it every week. It’s absolutely loaded with news about business and politics from all over the world, and it references research papers all the time, so you’re also getting the latest thinking on scientific research. They also run a special in the middle of the magazine that hits a broad range of topics in more detail.

Which is, that I score the Economist a 9 on a scale of 1 to 10. This is being picky, but I have two small issues with it. One is that, while they do produce some really amazing charts that must have taken a lot of time to compile, every now and then there’s a real head scratcher. I’m probably just stupid, but sometimes I have no idea what they’re talking about. Maybe the chart description needs to improve, or maybe they should just run their charts past the janitor before putting them in the magazine – just to see if a normal person understands them.

My second point is that their book review section at the back seems like a lot of wasted space. Either you’re a news magazine or you’re not, and sticking a half-dozen pages of book reviews at the end doesn’t seem like it’s worth the paper. More on that topic in a moment.

Foreign Affairs Magazine

My second recommendation is Foreign Affairs magazine, which is put out by the Council on Foreign Relations. This magazine comes out every other month, and I get it downloaded automatically to my Kindle. Foreign Affairs does exactly what the name implies. They ask experts to talk about various foreign affairs issues. Sometimes the topics are all over the place, and sometimes they focus on one theme, like the rise of China. The articles are very well-informed, and they come from major academics or senior people in the government.

If there’s a problem with Foreign Affairs, it’s that you can get so depressed from reading it. The commentary is generally from the perspective of what the United States could do better with its foreign policy decisions, and there’s a lot that can be done better. Nonetheless, if you want some really good, well-considered opinions about what’s going on in the world and how to make it better, Foreign Affairs magazine is a good place to start.

However – Foreign Affairs is not just about the essays. It also contains a massive listing of book reviews at the back of each edition. Unlike the Economist, the Foreign Affairs editors are taking the position that the magazine itself can’t possibly cover all the topics that are out there, so here are all these extra books you might want to read.

Specific Book Recommendations

Sometimes, it seems like I’m just trying to survive the essays in order to get to the book reviews –because this is my number one source for books to read. I buy at least a dozen books every year just based on their book recommendations. And – they’re all over the place. As a few examples of recent purchases, I bought Pandemic 1918, about the Spanish flu, Where the Party Rules, about the Chinese communist party, Tunisia – An Arab Anomaly, which is pretty much explained by the title, Brave New Arctic, about global warming, Putinomics, about the economics of staying in power in Russia, and Saudi, Inc., about how Saudi Arabia is run as a business. In short, Foreign Affairs does an incredibly good job of sorting through book releases and recommending some really fine nonfiction.

How to Search for Lessons in What You Read

I have one further recommendation, which builds on those Foreign Affairs book listings, which is to search around within a book for additional points that the author was not necessarily trying to make as his or her main point. By doing so, I find that I’m really paying attention. That’s a pretty vague recommendation, so here are a couple of examples.

One Foreign Affairs recommendation was The Saboteur, by Paul Kix, which was about the exploits of a French Resistance fighter during World War II. The author’s main point was to just follow along behind the resistance fighter while he did all the usual things, like blowing up railroad tracks. But then he also mentioned, at different places in the book, that 2% of the French population were in the resistance, while 20% of the population collaborated with the Nazi occupiers. And this is in France, arguably the proudest country on earth. Makes you wonder about how easy it is to subvert a population.

Or here’s another one. In The Fate of Rome, by Kyle Harper, the author’s main point is that some really massive plagues swept through the Roman empire and wiped out millions. But interspersed between the points being made is that several times over the life of the Empire, a massive volcanic eruption did exactly the same thing. They ejected enough dust into the atmosphere to lower crop yields, which starved an incredible number of people. And today, we might be about to stop a pandemic – after all, we have the World Health Organization and the Centers for Disease Control – but how do you protect subsistence farmers from the after-effects of a major eruption? I’m not sure we can.

And my final point – which is a long one - comes from a book called Where the Party Rules, by Daniel Koss. It’s a very difficult read, but it’s basically about anomalies in membership levels in the communist party across China. Which sounds dull – and it really is dull. But, the author made this incredibly interesting point that I’ve started to see elsewhere quite a bit. His point was that the Chinese communist party is much more highly represented as a percentage of the population in areas that were under the control of the Japanese army during World War II. Initially, this was because the communist party was active behind enemy lines during that time, and fought back against the Japanese pretty hard – and that is something that the local population doesn’t forget. So they kept on supporting the communist party for years afterwards. And this is where it gets interesting, because he calculated that the statistical half-life of this anomaly appears likely to last for 80 years. Which implies that the impact of supporting the local population will have a statistically significant impact on communist party membership for a total of 160 years.

In short, the lesson to be learned here is that memories are long. Really long. Knowledge gets handed down from one generation to the next, and it has an impact on decision making for far longer than you would imagine is possible.

This same effect comes up in Tunisia: An Arab Anomaly, by Safwan Masri. It’s one of the best books I’ve read in the past ten years. It’s all about what makes Tunisia a success when most of the Middle East has been comprehensively screwed up for decades. The author points out that Tunisia has mandated a secular education for everyone since the 1950s, where there’s an emphasis on critical thinking. Everywhere else in the Middle East, there’s a much higher infusion of religion into the educational system, which results in lots of people having a narrow view of what is right and what is wrong.

So in Tunisia’s case, because of the educational system, which results in a more broad-minded population, they’ve been able to construct an economy and a political system that just functions better. This does not mean that Tunisia is a paradise – they have all kinds of problems – but they at least have a chance of success. So how does this tie into my earlier point about long-term effects? The author specifically points out that success has been based on an educational system that’s been in place for seven decades. It takes that long to develop multiple generations of a population that aren’t going to go tearing off in a religious fundamentalist direction.

And a third supporting source is an article that just came out in the Economist, about voting patterns in southwestern Germany – right where I went to school during a semester in high school, by the way. It turns out that this area has consistently voted in the most conservative manner out of all parts of Germany for a very long time, and the reason appears to be that the population there has experienced the least population turnover in the country. People from elsewhere just don’t go there to live. In essence, it means that voting patterns stay the same across multiple generations. So once again, memories run far longer through a population than you would think is humanly possible.

This issue does suggest a foreign policy direction for the United States, which is that it doesn’t make a whole lot of sense to introduce democracy into a country and assume that it will take root right away. You need to keep up the educational process for fifty years, a hundred years, who knows? Can the United States realistically do that? Probably not. But what it can do, and has been doing for a long time, is maintain the best possible university system, and encourage foreigners to come here and learn about – everything. How Americans think, what we value, and how the system works. If they take that knowledge back home and use it to make positive changes – then, great.

Which means that the United States needs to massively support its system of higher education, and also offer visas to pretty much anyone who wants to come here to get an education. The long-term effects could be quite acceptable, and this is an approach that’s easy to support over the long term.

So how does all of this relate back to accounting? It doesn’t, of course. But by reading the Economist and Foreign Affairs, and digging through the Foreign Affairs book recommendations, you can develop a really deep view of how the world works – and being a more well-rounded person strikes me as being quite a good goal to shoot for.

Activity-Based Management (#267)

In this podcast episode, we discuss the activity-based management (ABM) concept. Key points made are noted below.

Overview of Activity-Based Management

ABM is all about using activity-based costing information to improve the operations of a business, usually through an ongoing process of fine-tuning existing processes. I talked about activity-based costing in the preceding episode.

So, how does ABM work? It can be rolled out in several ways. One of the better ways is to get rid of non-value-added activities. Examples of non-value-added activities are product rework, paperwork approvals, material movements, batch setups, and inventory counts. They don’t do anything to enhance value. There are a lot of these activities in the typical business, and paying attention to them can really reduce expenditures.

Time Reduction with ABM

For example, an insurer might want to cut down on the amount of time required to process an insurance claim. So, it commissions an activity-based costing study that identifies every activity associated with the claims processing staff, calculates the cost of each activity, and how heavily those activities are used. Now that the ABC information is available, ABM is used to create some results. You could examine the list of activities to see if any are unrelated to the basic task of processing a claim. Whenever there is one, such as moving paperwork to another person for more processing, that’s non-value-added move time and queue time, and it should be eliminated, or at least reduced. By doing so, the claims processing staff will have more time available to work on claims, which increases the capacity of the business while at the same time reducing the costs associated with those non-value-added activities.

As another example, an ABC analysis finds that the production staff is spending a total of $10,000 worth of time filling out timesheets. Management decides that the resulting information is pretty useless, and so changes over to a simple in-and-out timekeeping system that uses bar coded employee badges. The time saved increases the effective capacity of the production staff.

Cost Reduction with ABM

Another possible use is just general cost reduction. An ABC analysis might discover that a lot of the activities in the production area are associated with the rework of returned goods. The company has some very sophisticated products with lots of features, and customers tend to break them. So, an ABM analysis concludes that the company can eliminate most of the rework activities just be creating simpler products that don’t have so many complicated features.

Another possibility is that it costs a lot of money to fill each individual customer order. The activity cost is just really high. When this is the case, a logical outcome is to encourage customers to place a smaller number of larger orders, rather than a lot of small orders, maybe by rewarding them with volume purchase discounts.

As another example, an ABM analysis finds that the order entry department is expensive; it uses a lot of resources. If so, a possible option is to set up an online order placement system, so that customers can enter their own orders directly into the company’s production planning system. A small discount might be offered to anyone who uses the new system. The outcome is reduced order entry expenditures.

Or, let’s look at ABM from the perspective of the sales department. An analysis finds that its very expensive to have the sales staff visit customers in person. So, change the type of sales calls made to customers to a lower-cost form, such as switching from an in-person meeting to a phone call. A variation is to increase the interval between sales calls, or to mix in-person contacts with phone calls.

Let’s try another one. An ABM analysis finds all kinds of costs associated with expediting orders through the production process, since it lays waste to the orderly flow of work. Since the analysis comes up with an actual cost associated with expediting, management now knows how big a fee to impose whenever anyone wants to expedite another order through the company.

Profit Enhancement with ABM

ABM is really useful when a company is producing a mix of really complicated and quite simple products, because there’s a good chance that too many costs are being allocated to the simple products and too few to the complicated ones. This means that the profits associated with the simple products are probably being reported lower than they should be, with the reverse being the case for the complex products. By using ABM to figure out which products are actually consuming activities, you can either stop producing some of the more complicated products, or at least raise their prices.

It might also be possible to encourage customers to shift their purchases from lower-profit to higher-products, perhaps with coupon offers or some adjustments to prices.

Customer Service Improvements with ABM

Another way to use ABM is to focus on customer service. This usually means compressing the time required to complete a customer order. So, the emphasis is on analyzing every activity involved with taking a customer order, scheduling production, ordering materials, storing completed goods, and shipping them out. By focusing on eliminating or streamlining every activity in this process, customers can receive deliveries much sooner than had previously been the case. So the emphasis here is not on cost reduction, but rather on time reduction.

Summary of ABM Benefits

In short, this analysis can pick up enormous savings. Even when you think a process is pretty efficient, there’s a good chance that an ABM analysis can strip out another 20% of the cost. This analysis can generate some major results throughout the organization – in accounting, production, sales, product development – everywhere. Some organizations use this one tool as the basis for most of their cost reduction activities.

Problems with ABM Analysis

While ABM might sound like the perfect tool for increasing profits, it can cause an expectation that costs will be reduced when that’s not actually what happens. The trouble is that overhead costs are usually incurred as step costs, so that it takes a large activity reduction to yield any actual cost reduction – though when it occurs, the cost reduction comes in a big lump.

For example, management might figure out that it can reduce the number of phone calls being handled by the customer service department, maybe by eliminating some issues with its products. And by doing so, it manages to actually reduce the number of incoming phone calls by 2%. The problem is that there’s no way to eliminate a customer service staff position unless the number of income phone calls can be reduced by 3%. In the meantime, there aren’t any savings. The activity volume has dropped, but not by enough to trigger a staffing reduction. So unless there’s a way to reduce phone calls even more, the company won’t save any money. This can happen a lot with ABM projects, so be aware of the volume of activity reductions needed to trigger an actual cost reduction. Otherwise, there’ll be lots of disappointment.

Related Courses

Activity-Based Costing

Activity-Based Management

Activity-Based Costing (#266)

In this podcast episode, we discuss activity-based costing. Key points made are noted below.

Overview of Activity-Based Costing

As the name implies, this is the concept of tracing costs to specific activities within a business. Now, why would you do that? Consider that a business normally tracks its costs at the level of expense type, such as rent expense, or utilities expense, or compensation expense. When you’re trying to improve the performance of a business, just looking at an income statement with these expenses listed on it doesn’t really provide you with any information about how the business actually operates. So, if you decide to arbitrarily decrease one of these expenses, such as compensation, you really don’t know what impact that will have on the business.

But if the existing system for tracking expenses doesn’t give us much actionable information, then why do we use it? The main reason is that the typical accounting system is designed to accumulate data as quickly and easily as possible, in order to produce financial statements. The emphasis is on doing accounting at the lowest possible cost.

This is where ABC comes in. The emphasis is entirely on producing actionable information, where you can tell how much it costs to engage in any of a large number of activities within a business. And there can be hundreds of activities, such as making sales calls, or processing customer orders, or scheduling production jobs, or maintaining equipment, or training employees. Or, just within the accounting department, examples of activities are issuing customer invoices, processing cash receipts, and processing supplier invoices.

The Effort Needed for an ABC System

If you really want to accumulate the cost of each of these activities, the cost is monumental, because there has to be a tracking system for each one. For example, just tracking the cost of the sales call activity means having everyone in the sales department start logging their hours associated with sales calls, plus travel expenditures just for this specific activity. If you were to expand this level of activity tracking to every significant activity within a business, you could be looking at expanding the administrative work within a company by many multiples. Which is why you don’t hear about a whole lot of successful ABC installations. Someone in management gets enthusiastic about the concept and tries to roll out a company-wide system, which could take years. Because setting up the data collection systems takes so long, pretty much everyone gets frustrated with the project, and it gets dropped before it ever has a chance to produce any information that management can use.

How to Make an ABC Project Succeed

This does not mean that ABC is a bad idea. Far from it. You just have to be careful to target it very specifically, so that the existing data collection systems don’t have to be adjusted all that much, and in a way that doesn’t interfere with the normal work of employees. That means a successful ABC project might only involve a couple of extra data collection activities.

To make the project even more likely to succeed, it should be initially set up as a short-term project, where there’s data collection, and a final report that summarizes cost information – and that’s it. The data collection is then stopped and the project ends. By doing it this way, ABC is not considered to be a long-term administrative burden on the company. Instead, it’s expected to last just a few months, which most people will find tolerable. For example, management might want to look at which customers are taking up too much activity to be profitable, so the cost accountant tracks customer usage of activities like the processing of returned goods, the processing of bad debts, and customer service calls. And after that she delivers a final report that identifies a list of customers that should either be dropped or have their prices increased. The company may not need to revisit this topic for another five or ten years, so the project is terminated.

That does not mean that every ABC project has a short life. If management finds that the results from a particular project is giving it actionable information over a long period of time, then the data collection systems associated with it need to be made permanent, which means installing some automated data collection systems, and adding formal procedures and revising job descriptions to embed the process into the company. But this is rare. You can expect that if a company runs 20 ABC projects, maybe one of them will end up being part of the permanent systems of the organization.

Cost Object Analysis

So, moving along – management has targeted a focused project area, and there’s a cost accountant collecting data about the cost of activities. Now what? This is where the concept of a cost object comes in. A cost object is any item for which a cost is compiled. There’re lots of cost objects in a business, such as products and services, one-time projects, distribution channels, sales regions, and customers.

Ultimately, the whole point of an ABC project is to figure out how much each cost object is costing the business, so a request from management will probably not be to figure out, for example, the cost of each customer service call – which is an activity. A more likely management request is to figure out the total cost of each customer, of which customer service calls are only a small part. Therefore, the cost accountant receives a request from management to determine the amount of a cost object, and then determines which activities need to be tracked, so that the cost of these activities can be traced back to the cost object.

Data Collection Activities

This means that yet more data collection needs to be performed, to determine activity usage by cost objects. For example, the cost of a manufactured product includes ten minutes of machining at a computerized lathe. The cost accountant has to track a bunch of things to arrive at the cost of the activity, which is machining time, and then has to track the amount of time required to run the product through that activity. Only after both steps have been taken can we arrive at the final cost assignment for the product, which is the cost object.

Project Setup Decisions

When setting up one of these ABC projects, the cost accountant needs to make a few additional decisions, which could make the project either more or less complex. When making these decisions, the accountant has to balance the additional amount of work required against how valuable the incremental improvement in information will be.

For example, the accountant needs to decide how many activities to track for an ABC project. Let’s say that the full range of activities associated with a distribution channel cost object is 30 activities. That’s a lot of activities. The accountant might throw out half of them, because the data collection is too difficult, or it may not even be possible to collect the data, or the data collected will be too unreliable, or maybe there’s not enough funding for a full-blown project. This is a significant issue, so the accountant may spend a lot of time sorting through the various activities and deciding which ones to keep and which ones to throw out.

Summary

And that’s it. My intent was to give just a taste of what ABC is about, because it’s a complicated process, and delving into it in detail could take hours. A major takeaway is that ABC is useful, but only if it’s precisely targeted. Conversely, it’ll probably fail if you try for a broad, company-wide rollout of the concept.

Related Courses

Activity-Based Costing

Activity-Based Management

Accounting for Franchises (#265)

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

Overview of Franchising

A franchise is a privilege granted to a third party to market a product or service, usually under a trademarked name. The franchisor is the party that grants business rights related to a franchise to the franchisee, which is the party that commits to operate the franchised entity. In return, the franchisee pays a fee to the franchisor, which is usually based on a percentage of the sales generated by the franchisee.

There may be a single unit arrangement with a franchisee, where the franchisee becomes the hands-on manager of a franchise that covers a specific geographic region. The agreement may be for a specific period of time, such as ten years. If the franchisee wants to renew at the end of the current contract period, it will need to pay a renewal fee. Or, there may be an area development franchising arrangement, where the franchisee gets the right to develop a certain number of units within a specific territory, such as a county or a state. This entity then enters into a separate arrangement with the franchisor for each unit constructed within that territory.

A variation on the concept is the master franchising agreement, where the franchisor grants the master franchisee the right to sub-franchise to an additional level of franchisees. A master franchising agreement tends to cover a larger region than you normally see for an area development franchise.

There are several ways to build a franchise operation. One approach is for the franchisor to provide the franchisee with a turnkey solution, where the franchisor finds a location, builds it out, stocks it with inventory, and then hands everything over to the franchisee. In return, the franchisee pays quite a large up-front fee to the franchisor. A variation is for the franchisor to also operate the unit for a period of time, and then hand it over to the franchisee, just to make sure that everything is running properly.

Yet another approach is for the franchisee to be directly involved in the development process, with the oversight of the franchisor. This approach increases the risk of failure, since the location of the unit is untested. A final possibility is for a pre-existing, independent business to enter into a franchisee relationship, where it agrees to operate under the logo of the franchisor. In this last case, the franchisee already knows that the selected location will succeed, since it’s already been in operation for some time.

Business Development Expenditures

So, as you might expect, these arrangements can trigger some accounting issues. First up is what the franchisor is supposed to do with its business development expenditures. It might spend millions developing its franchise concept. Even though these expenditures might lead to lots of franchising revenue somewhere down the road, they’re still considered to be research and development costs, and those costs are charged to expense as incurred.

Facility Construction

Next, let’s assume that the franchisor is constructing facilities on behalf of its franchisees, with the franchisees paying advances as the work proceeds. In addition, the franchisor may charge the franchisee a fee to manage the construction process. The franchisor records these incoming payments in a development fund liability account, which the construction billings are then charged against.

Franchise Fee

After that, there’s the accounting for the continuing franchise fee, which is based on a percentage of the franchisee’s sales. When the franchisor incurs expenses related to these continuing fees, it should charge them to expense as incurred. These expenses include pretty much every operating cost of the business, such as general, selling, and administrative expenses.

Cooperative Advertising Fund

A franchisor might require its franchisees to pay into a cooperative advertising fund, which it then uses to advertise on behalf of the franchisees. Advertising funds are usually collected first and then paid out; this means that the funds collected are initially a liability of the franchisor. In the reverse situation, where the franchisor first pays for the advertising and then collects the money from franchisees, the franchisor might charge interest on the funds that it’s already expended.

Franchise Buy-Back

So, what if a franchisor buys a franchise back from a franchisee? The accounting for it depends on the intent of the franchisee. If the intent is to close it, the franchisor apportions the purchase price among the acquired assets and liabilities and writes off any residual amount. But if the intent is to keep running the business, the same approach applies, except that any residual amount is now allocated to the goodwill intangible asset, because now the transaction is treated as a business combination. Which leaves us with a third possibility, which is that the franchisor intends to turn around and sell the operation to a new franchisee. In this case, reacquired assets are classified as held for sale, which allows the franchisor to hold the assets without depreciating them; the assets are then included in the cost of the eventual sale to a new franchisee.

Franchisee Accounting

Now let’s look at things from the perspective of the franchisee. When a franchisee pays an initial franchise fee to the franchisor, the payment can be considered an intangible asset. The franchisee can recognize this payout as an asset; if so, it should amortize the amount over its estimated useful life, which is probably the term of the franchise agreement. The asset should be tested for impairment at least once a year, so if its carrying amount is greater than its fair value, the franchisee has to take a write down. The judgment of what constitutes fair value is based on things like changes in revenues or expenses, regulatory changes, litigation, or maybe the loss of key personnel.

And what if the franchisee decides to pay a renewal fee when the initial franchise period expires? In that case, the fee is again treated as an intangible asset and amortized over the life of the new agreement.

It’s possible that a franchisee may sell out to a replacement franchisee, which usually calls for the payment of a transfer fee to the franchisor. The outgoing franchisee can account for this fee as a cost of selling the business, so it’s deducted from the gross proceeds of the sale.

Related Courses

Franchise Accounting

How to Get Financing from a Bank (#264)

In this podcast episode, we discuss how to obtain financing from a bank. Key points made are noted below.

Overview of Lending

Banks prefer to lend to companies that don’t actually need the money, because they’re in such solid financial positions already. Banks mostly – but not entirely – base their lending decisions on two criteria. The first is the cash flows of the borrower. You need to have a history of generating enough cash flow to pay back the loan. This presents two problems. If you have a history of solid positive cash flow, then why would you bother to apply for a loan? And second, if you’re with a new company with no financial history at all, then there’s no way to prove that you have any cash flow. So just based on this first criterion, you can see that banks are going to limit their lending to well-established and fairly successful businesses, which means that their preferred lending arrangement is for something like a company with seasonal sales that only needs the cash to pay for its peak season receivables, or maybe to a larger company to pay for a new headquarters building. Banks are not interested in giving money to a startup company that only has a business plan.

The second criterion that a bank uses for its lending decisions is whether the company has enough assets to pay for the loan if its cash flows don’t materialize. Banks will legally attach these assets to the loan as part of the lending agreement, so that if you don’t pay on time, they can seize the assets and sell them in order to get back the remaining balance on the loan. If the company goes bankrupt because they seized the assets, that is not their concern. They just want their money back.

Collateral

And to be really safe, they’ll try to attach every single asset in the company, which is called the collateral on the loan. When they do that, and then you want to take out another loan – you can’t, because there aren’t any assets left for the next lender to use as collateral on the next loan.

There are three additional issues related to collateral.  One is that, whenever a bank wants to use all company assets as collateral, you have to get into a dogfight with them to narrow the number of assets to be used as collateral down to the absolute minimum. Otherwise, as I just pointed out, you have nothing left to use for any later loans. This can be next to impossible if the company is fairly new, because the bank will classify the company as being high risk, and so will want to scoop up every asset in sight.

The second issue is that the bank will be really interested in taking the company’s most liquid assets as collateral – so it will be most interested in your cash and receivable balances. If you can’t pay back a loan, the cash balance will probably be quite low, but the receivable asset may be very high. If so, customers will probably pay off their receivable balances within a month or so, and then the bank will have its money back.

Working Capital Loans and Lines of Credit

If the loan is structured as a working capital loan or line of credit, the total amount of the loan is capped at the amount of cash and receivables on hand, usually reduced by some sort of a discount factor on the receivables. For example, if you have $100,000 of receivables, and $10,000 of that amount is more than 90 days overdue, then you can only use $90,000 of the asset base that supports the loan. And on top of that, the bank will only allow a percentage of the remaining balance in its calculation of the maximum amount of the loan that can be outstanding. So out of that initial $100,000 of receivables, if the bank only accepts 70% of the allowable receivables, then the maximum loan balance would be $63,000. If the remaining loan balance is higher than the amount of collateral on hand, you have to pay back the difference right away – which can be difficult.

Borrowing Base Certificate

For this type of loan, the bank requires that you create what’s called a borrowing base certificate at the end of each month and send it to the bank. This certificate states all of the ending balances for the asset classes being used as collateral, reduced by any deductions mandated by the lending arrangement.

It also subtracts out the ending balance on the loan, so that the bottom line on the certificate states either the available amount of the loan that has not yet been used, or the excess amount of the loan that has to be paid back. You have to sign the certificate, which means that you can be legally on the hook for fraudulent reporting if you put incorrect information in the certificate.

When You Have Few Liquid Assets

What if your company has less liquid assets, like inventory or buildings? In that case, the bank may not be so interested in granting a loan, because it could take a long time to convert these assets into cash – and the bank may be forced to accept a lot less than book value for them. What this means that the company could have a massive amount of less liquid assets, and find that no banks want to deal with it.

Personal Guarantees

Which leaves us with the third collateral issue, which is that the bank may not be satisfied with just the assets held by the company – it may also want a personal guarantee by the owners, or whoever else is willing to guarantee the loan. So if the company goes under, and the company’s collateral is not sufficient, the bank will seize the owner’s assets too. And, depending on the lending arrangement, if the bank thinks it’s easier to get its cash back by going straight to the owner’s assets and ignoring the company’s assets, then that’s what it will do.

Lender Risk Aversion

In short, a bank is not really in the business of issuing loans. It’s really in the business of making a profit, so it’s highly risk averse. If there’s any hint of a problem in the financial history of a company, or if its asset base isn’t sufficient, then don’t expect to get a loan. In case you hadn’t noticed, I have a fairly negative attitude when it comes to banks. While working for a series of startup companies, I’ve always had trouble getting loans from them.

The only cases in which we managed to secure bank financing were when we had a rich investor who was willing to guarantee the full amount of a loan. In those cases, the bank pretty much took the attitude that it was making a personal loan to the investor, who happened to then be forwarding the cash to the company. Of course, the bank insisted on taking the company’s assets as collateral, too – even though the investor had more than enough cash to pay back the full amount of the loan.

Related Courses

Corporate Cash Management

Corporate Finance

Treasurer’s Guidebook

Accounting Career Advice (#263)

In this podcast episode, we discuss a number of listener requests about accounting careers. Key points made are noted below.

Moving from Public Accounting to Private Accounting

The first comment comes from Weston, and it is, I don’t want to stay in public accounting my whole life, but would rather go elsewhere and track for a CFO position. Please talk about careers outside of public accounting that accountants who start there can branch out into, and the type of firm that I would learn the most for doing something like that?

I’m surprised no one has asked this question before, because almost everyone in public accounting ends up somewhere else – and the chief financial officer position is a great target, since I think it’s the most interesting job out there. A pretty common career transfer is from being an auditor to being a company controller. Once you’re a controller, the next promotion is to CFO, so that’s a great track to follow. The trick is to stay in auditing long enough to qualify for a controller position somewhere else. That usually means hanging in there long enough to make it to audit manager, and then staying in that position for a couple of years. If you just can’t stomach being an auditor long enough to make manager, then keep in mind that shifting out of a more junior auditor position will land you in a more junior corporate job, too – like assistant controller or general ledger accountant.

As for the question about the type of firm that you’d learn the most from – it’s more a matter of the size of the audit firm. A big audit firm has a larger alumni network and a bigger client list, which makes it easier to network your way into a good job somewhere else. So in short, bigger is generally better. That does not mean that you absolutely have to work for a Big Four audit firm. It’s also quite acceptable to work for a large local or regional firm.

The Differences Between Finance and Accounting

The next comment comes from Nathaniel, who says, I’m interested in a career in finance or accounting. Please discuss the differences. Also, please describe the characteristics of a good accountant. I’ve been describing accounting on this podcast for the last ten years, so I’ll assume you’ve figured out that part. Finance is a bit more of a gray area for accountants. It’s essentially about tracking cash, organizing cash, and - of course - getting more of it. So that means setting up bank account structures to collect cash, aggregating the cash in those accounts into investment accounts, and investing the cash. It also means conducting a lot of cash forecasts, and working with lenders and investors to pull in more cash when you need it. On the one hand, this is an incredibly valuable job, since a company can go under if no one is watching the cash. On the other hand, it’s completely intangible – there’s nothing you can see, so you might not get an overwhelming sense of satisfaction from working in finance. Of course, you could say the same thing about accounting.

Another issue with finance is that smaller firms don’t have these positions. Instead, this is handled within the accounting department. So, there just aren’t as many finance jobs as accounting jobs.

As for the characteristics of a good accountant, I’ll focus on just one thing, which is the ability to see both the big picture and be detail oriented – at the same time. Most people think that great accountants just dig into the details and make sure that every transaction is accounted for perfectly. The accounting standards are followed and the correct accounts are used. That is a baseline requirement for the job, but if that’s all you are, then you’re more of a really good clerk than an accountant.

That’s where the big picture part comes in. A really great accountant is also able to see which informational items really matter to a business, and which ones can be ignored. For example, the great accountant will zero in on variances that could be leading indicators of a major problem, like an uptick in the number of customer returns that could indicate a product flaw, and will investigate it in detail. Management needs to know about that kind of information. At the same time, that accountant will completely ignore a jump in office supplies expense, because in the greater scheme of things, it just doesn’t matter. Not many accountants have both of those attributes, especially the big picture view. It’s worth pursuing.

Career Paths for Tax People in CPA Firms

The next comment comes from Tyler, who asks, please talk about the career paths of people who work in tax at a large CPA firm. The range of options available to a tax person is not that broad. If you really like taxation – and yes, some people do – then your best bet is to stay at the CPA firm for as long as you can. By doing so, you get to deal with more clients, each having a different set of tax problems that you can get your kicks out of solving. If you get hired away by a large company to do their tax work, you may find that the work is more boring, because you’re now dealing with the tax issues of just a single client.

And your final option is to go into business for yourself. In this case, you’ll probably end up doing tax work for smaller clients or individuals, since the big CPA firms tend to scoop up the tax work for the largest companies. You may find that these smaller tax jobs aren’t all that interesting; on the other hand, there are plenty of smaller firms out there, so you could develop a large group of clients. But give it time. Creating your own tax practice can take years of networking before you’re maxed out.

Why it is So Difficult to Get a Financial Analyst Job

And our final comment comes from Jason. It’s a long comment, so I’ll summarize it to say, how come it’s so difficult to get a job as a financial analyst? There are a couple of issues here. The financial analyst job is a hybrid between accounting and finance, and only large companies even have the position. This causes a couple of problems. First, you may need degrees in both accounting and finance to be fully qualified to do the work – though if you have a choice, get the accounting degree first – it’s more relevant. And second, because the position is only offered at large companies, you have to be willing to work where those companies are located, which usually means larger cities.

One variation on the financial analyst position is that it’s also commonly used in funding companies, like investment banking and private equity firms. They use these positions to calculate future cash flows for their clients, which is then used as one basis for deciding whether to invest in them. The same analysis can be used to convince investors to put money into a startup company. So if you want to make a lot of money, have virtually no time off, and experience an incredibly stressed life while flying business class, then consider pursuing one of those positions. But keep in mind, investment bankers usually only hire from the top 25 business schools.

Purchase Order Clearing (#262)

In this podcast episode, we discuss purchase order clearing. Key points made are noted below.

Overview of Purchase Order Clearing

Purchase order clearing is based on a standard report that’s located in the purchasing module of your accounting software. It lists all purchase orders for which there’s either no associated receipt or no associated supplier invoice – or both. For each of these open purchase orders, the report states everything you need to track down what’s going on, such as the purchase order number, the number of units originally stated on the order, the number of units received, and the number of units billed to the company.

Examples of Purchase Order Clearing

For example, let’s say that the report indicates an original order quantity of 1,000 units, and that zero units were received or invoiced to the company, and that the purchase order was issued several months ago. A reasonable assumption is that the purchase order was not actually issued, or the supplier rejected or lost it. In this case, the likely follow-up action is to check with the purchasing department to see if they plan to formally cancel the purchase order, which will remove it from the report.

Now let’s change the facts, so that the report indicates that 950 units were received and invoiced to the company. This is pretty common. The supplier shipped a bit less than the full amount, and will either ship the remainder later, or the purchasing department should get around to formally cancelling the remaining amount. No issues for the accountant here.

The remaining two variations are more interesting. Let’s assume the same 950 units were received, but the report indicates that the supplier never issued an invoice – or at least, it was never logged into your accounting system. In this case there’s a problem, because the inventory has been logged into the system as an inventory asset, with an offsetting credit going to the purchases clearing account, which is a liability account. The amount in the clearing account will stay there until you can log in the supplier’s invoice, which hasn’t arrived. So, you need to contact the supplier, figure out what happened to the invoice, and get a copy of it. When you enter the supplier’s missing invoice into the payables module, it references the purchase order number, which notifies the system to move the credit in the purchases clearing account over to the payables account.

Purchase Order Clearing in Accounting

In short, the purchases clearing account is a short-term parking spot for received goods, which indicates that a supplier invoice should be on its way soon. As the accountant, you should be scanning through the purchases clearing report for any cases in which goods have been received, but no invoice, and tracking down the invoices. To save work, you can certainly wait until a week has passed since the receipt of goods, since some suppliers take a while to issue invoices. After that, assume that there’s a problem.

And then we have the other variation, where the clearing report shows that a supplier invoice was received, but the goods were not. In this case, either the supplier has somehow mistakenly issued the invoice but not the goods, or the goods were shipped somewhere else, or your receiving department didn’t log in the receipt. You can address all of these options by asking the supplier for a proof of delivery document, such as a FedEx or UPS signature from the recipient. If there’s no proof of delivery, then the supplier probably screwed up and never sent the goods. That is not likely.

It’s much more likely that the goods were delivered, in which case you have to find them and then persuade the receiving staff to log the receipt into the system. By doing that, the receipt is matched with the supplier invoice and the whole thing is flushed out of the purchases clearing account.

So why do we use the purchase order clearing process? First, it ensures that the book balance for inventory items is as accurate as possible. Second, it ensures that supplier invoices are always posted to the system, so that payments to suppliers go out on time. This tends to improve supplier relations, and also gives you more time to take advantage of early payment discounts. And finally, this clearing process improves the accuracy of both the ending inventory and accounts payable balances, which is useful for closing the books and producing accurate financial statements.

Frequency of Review

How frequently should you review the clearing report and the clearing account? It depends. If your company issues a lot of purchase orders and the process is a bit buggy, then you might have to do it every day. In the reverse situation, once or twice a month might be enough. In the latter case, I suggest doing a review a few days prior to the end of the month. That’s because it may take a few days to investigate what’s wrong and then correct the inventory and payables records in time for month-end. A good way to see if there’s something wrong is to plot the total dollar amount in the purchases clearing account on a trend line. If the balance in the account is perpetually going up, then you probably have a lot of issues clogging up the account.

Trend Line Analysis

But. There’re two cases in which an increasing trend line does not necessarily indicate a problem. One is when the company is growing rapidly. In that case, you can expect the clearing account to grow at about the same rate as the growth rate for sales – or, more accurately, the growth rate for purchases. And the second case where the trend line can be justifiably going up is when the purchasing department decides to use purchase orders to buy a larger proportion of the goods being purchased. In that case, the clearing account will probably increase in size.

Reconciliation Difficulty

One final note is that the clearing report is simply a status report. The information in the report should represent the detail in the clearing account. However, the report may not even have a grand total stated anywhere on it, so you can’t necessarily reconcile the report to the clearing account.

Related Courses

Payables Management

Purchasing Guidebook

Accounting for Mining (#261)

In this podcast episode, we discuss some aspects of the accounting for mining. Key points made are noted below.

Mine Exploration Activities

One issue with the accounting for mining is that a mine operator first has to engage in exploration activities in order to even figure out where to develop a mine. Then it has to decide whether it would be economical to build the mine, and only then can it begin developing the property. In these early stages, there isn’t necessarily any prospect of having a viable business, so all of the expenses incurred have to be charged to expense as incurred.

Mine Development

The situation changes when you actually start to develop the mine. At this point, management has decided that commercially recoverable mineral reserves actually exist, and so has decided to proceed with construction. There can be a lot of development costs, such as building roads to get to the mine site, and sinking shafts, and removing something called overburden, which is the rock or soil that lies on top of a mineral deposit. All of these costs are capitalized during the development stage.

Sustainable Production Phase

That development stage ends when sustainable production begins. At that point, you can start amortizing the costs that were capitalized during the development stage. The amortization method used is the units of production method, which is not used all that much elsewhere. Under this approach, you estimate the total output expected from the mine, and then amortize the proportion of the total output actually mined.

So, if the capitalized amount of development costs is $1 million, and the mine has just produced 2% of the total amount of expected ore, then you can charge 2% of that $1 million to expense in the current reporting period. If there’s no production from the mine, then there’s no amortization.

Inventory Valuation

The next phase in the life of a mine is the production phase, which should last a fairly long time. The most unique accounting issue in this phase is inventory valuation, because it isn’t necessarily all that precise. For example, a mine could engage in something called heap leaching. This means the company has laid out some sort of impermeable pad and dumped a massive amount of low-grade ore onto it.

Then it drizzles some fairly nasty chemicals onto the heap, like sulfuric acid or cyanide, which dissolves out the metals being mined. The dissolved metals are then collected and subjected to further treatment in a processing plant. The accountant recognizes an inventory asset from the ore stacked on the pad by measuring the size of the heap and then factoring in the proportion of expected metal recovery. Or, a mine could simply pile up its output into a stockpile. For example, coal from a coal mine could be heaped up into a stockpile. If so, the accountant needs to measure the pile to determine the amount of inventory to recognize.

Royalty Payments

Yet another inventory issue is that the mine might very well have to pay a royalty to the owner of the land. If so, the cost of the royalty should be capitalized into inventory, so that it gets charged to expense when the inventory is sold.

Asset Retirement Obligations

And the final unique accounting issue for a mine is the costs that arise towards the end of its useful life. There are two of them. One is any asset retirement obligations, should as landscaping an open pit mine after it’s been closed. This can be a massive cost, running well into the millions of dollars. The mine needs to accrue for a liability for this cost as soon as it has a reasonable understanding of the amounts involved. This number is likely to change, as the closure date of the mine approaches and the company clarifies just how much it’ll need to spend; so the related liability will also change. The accountant may find that this is the largest liability on the balance sheet, so it pays to keep close track of the amount of the liability, and how it’s been calculated.

Environmental Obligations

The other cost that can come up later in the life of a mine is environmental obligations. If there’re any environmentally hazardous conditions at a mine site, the mining company may be seriously liable under a bunch of federal laws. If so, it may be responsible for things like feasibility studies, cleanup costs, legal fees, and restoration costs. The accountant needs to accrue for an environmental obligation if it appears that the business bears some responsibility for a past event, and it’s probable that the outcome will be unfavorable for the business.

It’s not that easy to figure out the amount of this cost, because the mining company might end up sharing responsibility for the obligation with other parties. For example, a mining company buys a mine from another mine operator, and then the Environmental Protection Agency declares the area a Superfund site. In this case, both the current and former owners share responsibility for the cleanup.

In this case, you need to estimate the likelihood that the other party will pay its fair share of the liability, because if it doesn’t then your company may be tagged with the full amount of the cleanup. Consequently, the amount of the environmental cleanup obligation will vary not just based on the latest cost estimate, but also on the ability of the other responsible parties to pay for their shares of the bill. This is a moving target for the accountant, who can expect to issue revisions to this accrued liability on a very regular basis.

Related Courses

Accounting for Mining

Money Laundering (#260)

In this podcast episode, we discuss how money laundering works. Key points made are noted below.

Money laundering is all about making money that you shouldn’t have look legitimate. If it looks legitimate, then the government won’t take it. That seems like a worthwhile goal for someone involved in illegal activities, so how can we do it?

Money Laundering Process

The basic money laundering process involves three steps. The first is to get the money into a bank. By doing so, you’ve converted bills into digital money, which is way easier to move around. Though it is possible to smuggle the money overseas and deposit it in a foreign bank, the usual approach is to break up the cash into small amounts and deposit it all over the place. This can mean setting up lots of bank accounts at different banks, and then spending your day driving from bank to bank, making small deposits everywhere. The reason for the small deposits is that a bank is required to send the government a Currency Transaction Report if it receives at least $10,000 of cash in a single transaction.

So, assuming the cash is now in a bank, you need to move it around, perhaps to banks in other countries that have bank secrecy laws. By doing that, an investigator can’t follow the trail of wire transfers past the first foreign bank. So, if you keep splitting up the amounts and wiring it around to different banks, there’s no way for anyone to figure out where the cash went.

And the final step is to convert the cash into assets that you can use, such as real estate or maybe buying a legitimate business. So, the intent is to take dirty money that you can’t explain and shift it into a new form that you can now use.

Loaning Yourself Money

Of course, there’s still a problem with having more assets than it appears that you can justify, given your apparent income. For example, a politician who accepts bribes may only be making $50,000 a year, and yet somehow owns a $1,000,000 house. People might ask questions. Luckily for the money launderer, there are a few methods for improving the situation. One is to loan yourself the money. Let’s say that you’ve shifted cash into a foreign shell corporation. You can apply to a bank for a big loan, and have that shell company put up the cash for collateral against the loan. Then you use the loan to buy a local business, and use the cash flow from the business to pay back the loan. In essence, you’re loaning yourself the money, by way of a banking intermediary that makes the loan paperwork look nice and clean. And on top of that, you get a tax deduction on the interest paid on the loan.

Selling a Business to a Fake Buyer

And to take the concept one step further, let’s say that you’ve used the cash flow from the business you bought to pay back the entire amount of the loan. Now you can set up a fake buyer for the business, and pay yourself from the fake buyer to acquire the business from you. Now you legitimately have the sale price of the business sitting in your bank account – nice and clean. And you still own the business, though now it’s through an intermediary. Just don’t set too high a price, or you’ll have to pay taxes on the gain from selling the business.

Use of High-Cash Flow Businesses

Now let’s get back to that business you bought. Money launderers like to buy businesses that deal with lots of cash, like used car lots, and restaurants, and night clubs. When you own a business like that, you can fake lots of additional sales and pay for them with money from your pile of cash. On the books of the business, it just looks like you’re having an unusually good year. An extra benefit is that the business can pay you a salary, so you have some legitimate income to report to the tax authorities. And on top of that, you may be able to run your business from the premises. Like running a gambling operation from the basement.

Fake Invoicing Schemes

Let’s try a different angle, which is fake invoicing schemes. A money launderer owns two businesses that supposedly sell goods or services to each other. One is in the United States, and the other is overseas. If the money launderer wants to move money out of the United States, he creates a fake sale from the overseas corporation to the local business, and overbills for whatever is being sold. The local business pays the bill. By doing so, the excess amount paid represents a transfer of cash out of the country.

It’s quite possible to do the reverse, where the invoiced amount is underpriced. In that case, the overseas company is transferring value into the United States in the form of the goods shipped, which means that money is flowing into the country.

Black Market Peso Exchange

And here’s another scheme – a really clever one. It goes by the name of the black market peso exchange, and it was created by the Colombian drug cartels, which needed a system to bring their dollar profits from the United States back into Colombia. Let’s say that a drug cartel earns $1 million dollars from drug sales in the U.S. It contacts a Colombian peso broker, which offers to buy the dollars in the United States, minus a commission, and to pay the cartel in Colombian pesos in Colombia. This means that the dollars are still in the U.S. and the pesos never leave Colombia.

The broker then uses a group of associates to break up the $1 million into smaller amounts, and deposits it in a bunch of bank accounts – still in the U.S. Next, the broker lines up some actual, legitimate Colombian businesses that want to buy goods from companies in the United States. With these orders in hand, the broker goes ahead and buys them from U.S. companies, acting as the middleman. This means that the U.S. companies who are selling the goods are paid from that stash of $1 million that’s still sitting in the U.S. Meanwhile, the Colombian companies have paid the broker in Colombian pesos – in Colombia. That stash of pesos is now available for the next time the broker wants to buy dollars from a drug cartel.

In short, the money in this scheme never crosses a national border, which makes it so difficult to spot. Instead, there’s a flow of goods between the two countries that represents the actual flow of value out of the U.S. and into Colombia.

The Hawala System

Let’s do one more. This last scheme is really about shifting money out of the country in an undetectable manner. It’s not really about shifting the cash back into the country at a later date, though that may happen. This approach involves an informal money transfer system. It’s generally called the hawala system, but it goes under different names, depending on where you are in the world. In essence, you go to your local hawala broker, who usually operates out of a small storefront, and ask to send money to somebody somewhere else in the world. The broker takes your money, and then calls a contact close to where your recipient is, and asks that the broker on that end deliver the money as requested. The two brokers can settle up later, maybe with a wire transfer, and maybe by sending goods to each other that are priced in favor of whoever is owed money. This is actually a legitimate system. It’s mostly used to send money between family members. But it can also be used to launder money, simply by paying the money to a broker and having the broker arrange for payment at the other end to an associate. The brokers usually only keep enough records to make sure that they settle up with each other eventually, and after that they may chuck out the records, which makes it incredibly difficult to track down these kinds of money transfers.

Summary

In general, the most successful money launderers are the ones who use multiple methods to hide their cash, and who use accountants and lawyers to help them set up new schemes all the time. The ones who are caught are usually the small-time operators who aren’t so sophisticated.

Related Courses

Fraud Schemes

How to Audit for Fraud

Money Laundering

Screening and Interviewing Techniques (#259)

In this podcast episode, we discuss screening and interviewing techniques for new hires. Key points made are noted below.

Screening Activities

First off, screening. The intent here is to minimize your investment in interviews by talking to job candidates on the phone first, to figure out as quickly as you can whether someone is worth the effort of a full interview. There are a couple of areas to really dig into during a screening call that can help with this. First, clarify exactly what they’re doing in their current job. In quite a few cases, what they’ve stated on their resume is an inflated version of their actual job, so it can help to walk through what they do in a typical day. By doing this, you can get around an inflated job title and figure out, for example, that someone is not really a controller, but instead is actually a bookkeeper.

It also helps to talk about the scale of the person’s employer. If they’re quite small, like a $10 million company, then chances are, the person doesn’t have enough experience in some of the more advanced topics that you might see in a much larger company, like accounting for derivatives or pension plans.

In addition, if you need a very specific skill set, like someone with a deep knowledge of inventory accounting, then talk through every possible aspect of that area, until you’re satisfied that the person meets your basic criteria.

And finally, this is a good time to talk about salary expectations. If the person wants a compensation level that’s well above what you can pay, then this pretty much shuts down the person as a viable candidate.

So, screening is designed to focus on the minimum criteria that a candidate has to have. It’s not a wide ranging interview, and this is not the time to sell the candidate on company benefits or anything like that. This is not a sales job, it’s a weeding out job.

Interviewing Activities

And then we have the actual interview. Let’s start with red flags. These are statements made by a candidate that could be indicative of problems. For example, he blames his last boss for everything. Sure, the last boss could have been awful, but it’s more likely that the candidate shared some of the blame, and is not willing to take responsibility. Expect more of the same if you hire him.

A slight variation is when the person acts like a victim, always having been put upon by others. Chances are, he has a very low capacity for dealing with adversity. This is the kind of person who will not take the initiative on the job, and who could quit suddenly if there’s any kind of dispute.

Or, probe carefully to see if the person is just looking for a job change in order to make more money, and nothing else. You can consider this person to be a mercenary, who’s only going to stick around for one or two years and then move on to an even higher-paying job with someone else. The obvious indicator is having been through many jobs, with a short tenure in each one.

Another red flag is complaints about the number of hours worked in previous jobs. If you know that the open position is probably going to call for a fair amount of overtime, then focus on this during the interview – a lot – the person might decide not to continue with the interviewing process, in which case that’s one less person to evaluate.

And here’s one that bothers me more than anything else, which is passiveness. There’s no indication of any substantial accomplishments in the person’s background, or even outside of work, like being a competitive cyclist or writing novels on the side. This may be someone who simply shows up for work, without displaying any aggressive behavior to improve the business. If you hire someone like this, expect them to complete their assigned tasks and then dawdle on their computer, rather than coming to you to ask for more work.

Other than red flags to watch for, the rest of the interview is mostly about what I would call essay questions. The objectives are to see how a person thinks, what level of knowledge he has, how much initiative he has, and how well he’s likely to get along with other employees. So for example, a question targeted at how a person thinks might be:

“Let’s say that we acquire another company with messy books. How would you go about cleaning up the situation?”

Or, a question targeted at a person’s level of knowledge might be:

“What types of controls would you like to see in an accounts payable operation?”

Questions about a person’s initiative are more difficult. You could ask about their prior accomplishments, which is one of those standard questions that they’re probably prepared for. It might be more fun to catch them off guard with a different kind of question. For example:

“This position involves running the collections department. Let’s say that I want you to improve the effectiveness of the department in driving down bad debts. Go ahead and grill me with questions about what’s going on in the department right now, and then give me recommendations for what you’d improve.”

Now, that sounds pretty rough for an interview, but how else are you going to find out if the candidate actually has what it takes to improve your operations? In other words, you need to involve the person in current company problems to see if there’s any chance that he has enough knowledge to figure out viable solutions.

And then there’s the issue of figuring out how well the candidate will get along with other employees. This is another tough one, since he’s obviously on his best behavior during an interview. You might be able to gain some insights by poking around with some situational questions. For example:

“Let’s say that the financials have to be completed over the weekend to secure financing, and your general ledger accountant wants the weekend off to deal with a sick parent. What do you say to the accountant?”

Or, “Let’s say that one employee accuses another one of theft, and the accuser is a friend of yours. How do you handle it?”

Or, “Let’s say that you’re competing with someone else in the department for a promotion, and you get the promotion. What do you say to the other person?”

None of these questions are designed to have an easy answer. The point is to put the candidate on the spot and just see what he does. This gives you much richer information that can then be used to make a hiring decision.

Related Courses

Recruiting and Hiring

Property Management Accounting (#258)

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

The Property Manager

A property manager is an independent manager of properties that does so on behalf of property owners. For example, a vacation property has a hundred condominiums in it, each of which is owned by a different family. They all rent out their condominiums when they’re not using the units, and the property manager for the entire complex does so on their behalf. The same situation occurs for an office building – where perhaps a pension fund owns the building and contracts out the property management to a third party. The property manager takes care of everything on behalf of the property owners, which includes advertising, maintenance, risk management, and accounting for the results.

The property manager acts in a fiduciary role on behalf of the property owners, which means that the manager has to act with proper diligence in managing the property, and in reporting the results of its activities back to the owners. As an agent for the owners, the property manager is usually required by state law to maintain accurate accounting records for each of the properties under management. This means that a separate set of accounting records is maintained for each property owner. Given that there could be a lot of property owners, it makes sense for the property manager to maintain exactly the same chart of accounts for each property, though this may not always be possible if a large property owner demands that its chart of accounts be used instead.

Property Management Chart of Accounts

The chart of accounts used by a property manager mostly differs in the area of revenue tracking. The manager may want to separately identify income from rent, late fees, utilities, laundry, vending machines, storage units, parking, and even renter assistance payments from the government.

Property Management Accounting Entries

So, what kinds of accounting entries is a property manager likely to make? There will certainly be entries for rent payments and security deposits, as well as withholdings from security deposits to pay for damage to rental units. Property owners may also be required to make reserve payments, which are accumulated to pay for major property repairs. There may also be pass-through charges, such as when the property manager pays to have the carpeting cleaned in a rental property, and the cleaning fee is then passed along to the tenant. Another possibility is an entry for contingent rent, which is usually based on the future sales or profits of the tenant. This arrangement is most common for retail stores, where part of the rent is a percentage of a store’s sales. And of course, the property manager charges a fairly substantial monthly management fee to each property owner.

Funds Held in Trust

When a property manager is handling money on behalf of a property owner, these funds are considered to be held in trust. For example, rent payments and security deposits cannot be mixed in with the funds of the property manager. Under most state laws, trust funds have to be held in a bank account that’s identified as a trust account, which makes it more difficult for a property manager to inadvertently misappropriate the funds.

Pooled Trust Account

One problem with using separate bank accounts is that the property may need to deal with a massive number of bank accounts in situations where there are many property owners. To get around this problem, the property manager can use a pooled trust account, where all property owner funds are kept in a single bank account, with the accounting system being used to identify the funds held by each property owner.

This doesn’t necessarily mean that just one pooled account is being used for a property. There may be three. One is the operating account, which handles incoming rent payments, and which is used to pay for most day-to-day expenses. The second is the security deposit account, which – obviously – contains all of the security deposits paid in by tenants. And the third is a reserve fund account, which contains funds that will be used for capital expenditures, such as repaving the parking lot or replacing the roof. This money comes from the property owners.

Property Management Reporting

Property managers are expected to periodically issue a reporting package to property owners. There’s no standard report configuration, but it usually includes a rent roll, which is a detailed listing of the rent earned from each property. There is usually also a summary of operations that matches expenses against revenues, so that owners can see the net income from operations. Owners also want to see a summary of the activity in the reserve account, so that they can see the amount of funds that have been added, the amount taken out to pay for various items, and the ending balance.

The information for the rent roll comes from the rental ledger, which stores a complete set of information about each tenant, including balances owed, payments made, security deposits, and pass-through charges.

Operating Expense Ratio

Property owners will probably calculate the operating expense ratio for their properties. This is operating expenses divided by gross income, and is a good measure of the ability of the property manager to keep expenses under control. However, it can be also misleading, since operating expenses go up over time, as a property ages. Also, the ratio doesn’t differentiate between fixed and variable operating expenses. This is not minor, since variable expenses will probably change along with the occupancy level, while fixed expenses, such as property taxes, will still be incurred, even if a property is completely empty.

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Property Management Accounting

How to Present Cost Control Information (#257)

In this podcast episode, we discuss how to present cost control information to management. Key points made are noted below.

How to Select Costs for Reduction

Reporting on cost control means presenting an argument to cut expenses. My general rule on presenting any argument is that you should spend 25 percent of your time compiling the information, and 75 percent figuring out how to make a persuasive case. So, let’s say that you’ve identified a way to control costs. In fact, let’s say that you’ve identified several dozen ways to do so. Which is quite likely. There can be cost control opportunities all over the business. Your first step is to sort through them all to see which ones should be presented – which implies that not all cost control activities are a good idea.

For example, consider the company culture. It may have been designed to foster employee interaction, maybe through offering a beer bash on Friday afternoons, or expensive bonuses for the goofiest ideas to make fun of the company president. Sure, these could be cost reduction opportunities, but they’re also an essential part of the underlying structure of the business. If you suggest that these costs should be cut, you’re going to look like a clueless idiot who’s out of touch with the rest of the organization.

As another example, consider the company strategy. It’s quite possible that management wants to spend lots more money in areas where it wants to expand the business. From the perspective of the accountant, this could look like a profligate use of funds, but from the perspective of management, these are necessary expenditures. For example, the commission rate on new sales might be doubled for a new sales territory, because there’s a push to expand into new geographic areas, and management wants to give the sales staff an incentive to sell in these new areas. The doubled commission rate might look crazy from a cost control perspective, but it’s perfectly rational from a strategic perspective.

As yet another example, consider production capacity. The production manager might be keeping a number of old machines lying around unused, and it just bugs you that this equipment could be sold off right now to generate some cash.

But from the perspective of the production manager, those old machines could be brought back into use if sales exceed production capacity – which makes perfect sense, especially if those additional sales would otherwise be lost.

Based on these examples, you can see that presenting cost control information to management first requires a fair degree of knowledge about how the business operates and how it intends to compete – which may mean that you don’t report anything for a while, until you’ve built up some background information about the business.

Consideration of How Suggestions Are Received

And then it’s time to think about how your suggestions will be received. Most managers have protected areas that they don’t want to go after, as well as areas that they’re more than happy to cut back on. Maybe they want to deliver a hefty expense reduction to announce at the next shareholder meeting. Or, maybe it’s time to shave back those bastards in the marketing department. And, maybe they have a built-in aversion to certain types of expense cuts, such as doing layoffs. The way to learn about these tendencies is to spend some time getting to know the person who’s going to receive your recommendations.

This could mean having lunch with them on a regular basis, or attending the same meetings, or pretty much anything that allows the manager to chat in a general way about what he wants to do, and how he views the company. With this information in hand, you can tailor your recommendations to the manager. By doing so, what you recommend is much more likely to be implemented, because the manager is seeing cost management proposals that he inherently wants to implement.

Building a Case for Cost Reduction

Now, making recommendations in this manner also means that you’re leaving out all kinds of perfectly good cost reduction suggestions. That’s because you need to take a more circuitous path with those other ideas to gain acceptance. For example, let’s say that there’s a clear problem with a new product that also just happens to be a manager’s pet project. He doesn’t believe that it can possibly fail, even though you have solid information that it is. How to proceed? It depends on how the manager reacts to having a core belief jumped on. In a lot of cases, he will shoot the messenger, and since you’re the messenger, this can be painful.

There’re a couple of ways to deal with the situation. One is to gradually build a case over a period of time. During one meeting, you could mention that you’re going to evaluate all product sales, and in the next meeting, present a report that shows sales for all products, which just happens to include his favorite product. When he complains that the sales figures must be wrong, come back with a detailed sales analysis, and regretfully point out that the numbers are correct. The intent here is to engage in a gradual let-down, so that the manager gets used to an idea that he might reject if you just hit him with it all at once. Call it managing your manager.

Of course, this approach takes time, and if the expense situation is getting out of hand, you can’t afford to wait. If so, another option is to present several cost control suggestions, and mix it in with the other items. Then walk the manager through every item on the list in a fair amount of detail. By doing so, the manager will be so buried in information that he’s less likely to react negatively to that one specific issue. But, be aware that this approach doesn’t focus the attention of the manager on that one specific issue, so there’s a risk that you have to keep bringing it up.

Focusing Attention on Proposed Cost Reductions

No matter how you choose to make a cost control suggestion, it’s critical to only bring up a few at a time – maybe just one or two. That focuses the manager’s attention on thoroughly implementing those specific suggestions. It also means that you can spend more time developing additional information to back up your position, so that the case for implementation is overwhelming.

After the implementation is complete, you can dole out one or two more suggestions, and so on. It might seem like this approach is painfully slow, but the rate of successful implementation is actually higher than if you had dumped a massive 20-point list on the manager’s desk. In the latter case, the manager would have probably just picked a couple of items from the list and ignored everything else.

Related Courses

Cost Management Guidebook

How to Derive a Product Cost (#256)

In this episode, we discuss how to derive a product cost. Key points made are noted below.

Problems with Developing Product Costs

Coming up with a product cost doesn’t sound all that hard – or is it? There are a bunch of issues to consider. First, a cost accountant can’t begin to do this alone. You have to talk to the engineering department about the components that supposedly went into the product. They should have a bill of materials that goes along with the design drawings, but that list may not be entirely correct. Still, it’s a good starting point. Then, take that bill of materials over to the materials management staff and have them verify it. They have to order the parts or have them made in-house, so they should have a pretty good idea of what goes into the product.

Bill of Materials Verification

Or, do they? In some companies, fittings and fasteners aren’t included in the bill of materials. Instead, these items are bought in bulk and are available in bins on the shop floor for anyone to use, so no one thinks there’s any need to record them in the bill of materials. So, you have to look into that. If you miss it, your product cost will be too low. If you have to adjust the bill of materials for these missing items, take it back to the engineering department and have them verify it. There’s a fair chance that there’s still something wrong, so the extra meeting is worth your time.

Cost Identification by Volume

So far, you’ve only identified the components – there’s no costing associated with them. Now for the fun part. Unit costs vary by volume, so you need to identify at what point the unit cost goes up or down, depending on how many units are purchased. For example, a widget that goes into a product might cost a dollar if you buy it in quantities of at least a thousand, but it costs three dollars if you buy it in smaller quantities. So, your next trip is to the production scheduler, to talk about production volumes.

Volume Purchasing Considerations

So, let’s say that the production scheduler thinks that 2,000 of those widgets will be needed in the next year. Does that mean you can automatically assume that the product cost will include one dollar’s worth of a widget? Not necessarily. It’s possible that the purchasing department plans to buy in smaller quantities in order to reduce the inventory investment. Or, maybe they want to buy in really large quantities, because that widget can be used in multiple products. If so, they could be able to buy the widget for a lot less than a dollar per unit.

If this sounds like a lot of interviewing to do, you can cut through everything and just look up the supplier invoice to see what unit price is being charged to the company.

Impact of Future Decisions

Another point to consider is that the unit price might change depending on future decisions. For example, if management intends to push this product really hard in the marketplace with a big ad campaign, it might be useful for them to know that the product cost will decline if unit sales increase past a certain point.

The Need for Multiple Versions of Product Costs

So, what all of this means is that you really need to come up with a couple of variations on the product cost. The main one is for the production volume that everyone expects, and you might want to consider deriving a cost that applies to a low level of production, as well as to a high level of production. As the production volume declines, the unit cost will increase, and as the production volume goes up, the unit cost will drop.

Consideration of the Scrap Rate

Of course, we’re not done yet. There’s also a scrap rate to build into the product cost. This can be difficult when you’re using components that have never been used before, since there’s no history for them. That means you may have to make an educated guess at the amount of scrap, and then come back after one or two production runs to see if the estimated scrap rate turned out to be correct, or if you need to adjust it. In general, you probably ought to issue a preliminary product cost, and then discuss it with the production manager after there’s some experience with actually manufacturing the product, and decide whether another version of the costing should be issued.

Fixed Nature of Labor Costs

And then we have labor. It can be considered a fixed cost, rather than a variable cost, like materials, because there usually has to be a minimum crew size to man a production line, no matter how much volume runs through the production line. That being said, I’ll assume that you’re adding the cost of labor to the product cost.

There are a couple of problems with deriving a labor cost. The first issue is that the cost of the labor itself keeps changing. The people working on a product may be getting paid at different hourly rates, based on their seniority or skill level, and the people assigned to producing the product may change, even within a single day. The usual solution is to use the average hourly rate for everyone in the production area. The next issue is that labor rates tend to increase over time, as people gradually get bumps in pay, so you have to go back from time to time and see if your average labor rates built into the product cost are still correct.

And a third issue is that the industrial engineering staff is always looking for ways to automate parts of the production process, so it’s entirely possible that the total amount of labor hours assigned to a product will gradually go down.

My main points in regard to labor cost are that you need to use an average labor rate, you need to update the calculation of that rate on a regular basis, and you need to update your assumptions regarding how many hours it still takes to make the product.

Overhead Costs

And finally, we have the cost of overhead. No matter how well you try to refine the allocation of overhead to a product, keep in mind that it’s still an estimate. And on top of that, the overhead may still be there even if the product is never manufactured, so there’s a pretty reasonable argument that you shouldn’t even include it in the product cost.

But let’s say that you do. If so, break it out from the rest of the cost. For example, put the materials cost in a subtotal that’s in bold and maybe in a bright color, so that management knows that this is the real variable cost of the product. Then layer on a line item for labor, which is a reasonably valid inclusion. And then insert a couple of blank rows to really give it some separation, and then state the assigned overhead cost. Just trying to put the costing emphasis where it belongs.

Summary

In summary, product costing is more complex than you might initially think. It can vary by production volumes, it needs to be adjusted over time to account for estimates and cost changes, and some of the elements in the report maybe shouldn’t even be there, depending on how you intend to use the information.

Related Courses

Cost Accounting Fundamentals

Accounting for Vineyards and Wineries (#255)

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

The Basis of Accounting

In the United States, a farm is nearly always allowed to use the cash basis of accounting, no matter how big it is, and a vineyard is classified as a farm – so, vineyards usually use the cash basis of accounting. Doing so allows them to somewhat defer the recognition of income, so they can delay paying income taxes. A winery is not classified as a farm, since it’s more of a production operation, so wineries usually use the accrual basis of accounting. This difference means that a vineyard and a winery are set up as two separate entities, with the vineyard using the cash basis and the winery using the accrual basis. So, the accountant for a combined operation needs to be conversant with both approaches, and will need to maintain two sets of books.

Expenditure Capitalization

Even though a vineyard is on the cash basis, it needs to capitalize quite a lot of its initial expenditures. The problem is that it can easily be a half-decade – usually longer – before it begins to produce grapes in commercial quantities. That’s because it takes time for a site survey to figure out how to configure the vineyard, and decide on what types of vines to plant, and then extract rocks, and grade the land, and possibly fumigate the soil, and add fertilizer, and drill wells, and lay down an irrigation system – and that’s before planting any vines. And then there’s vine planting, and setting up windbreaks, and installing a trellis system, and training the vines to grow on the trellis system – and so on. The up-front investment is pretty incredible, which is why mostly rich folks own vineyards. At any rate, most of these expenditures are capitalized, up to the point when commercial production begins.

Winery Operations

Which brings us to the winery. So, a winery has four main operations. There’s the crush phase, where the grapes are crushed. Then there’s the cellar operation, where the juice is kept in tanks to let the sediment drop out, followed by fermentation, and then bulk aging in oak barrels or stainless steel tanks. The next step is bottling, which involves filling the bottles and adding labels and a cork or a screw-top cap. And finally, the bottles are left in storage for a period of months for further aging. Of these four steps, the crush and bottling phases are quite short, while the other two can be very long.

Cost Accounting Issues

This makes for an interesting cost accounting situation, since the various products spend differing amounts of time in the cellar or bottle storage. For example, a white wine or a red wine with lower production values could spend far less time in the process than a high-grade red wine. So, logically, a high-grade red wine should accumulate a lot more indirect costs than a product that spends less time in the winery.

And there are a lot of indirect costs. There’s the depreciation on the production facility and equipment, and the labor by the winemaster and the rest of the staff, and utilities, and production supplies, and testing expenses, and so on. So, the wineries have come up with a variation on activity-based costing, where they assign expenses to each of the functional areas in the winery, and then allocate the costs of these functional areas to what they call gallon/months of each wine product. So, for example, if 1,000 gallons of Merlot are aged in barrels for six months, then that is 6,000 gallon/months of Merlot. And, if the cellar operation accumulates a half million dollars of costs in a year, that cost is assigned to the Merlot based on its proportion of the total gallon/months of wine kept in the cellar. The same approach works when allocating the cost of bottle storage.

So this can get a little complicated. And it gets worse, for several reasons. First, wines could be kept in storage for more than one year, so you have to allocate costs not just to several types of wine, but also to several vintages of each varietal. And on top of that, the winemaster might decide to engage in blending activities somewhere in the production process, which mixes wines together, and, of course, complicates the cost accounting. And, there can be wine shrinkage, where the wine evaporates while it’s aging in the oak barrels. And furthermore, the winery may choose to sell off some wine in bulk before it reaches the bottling process, so that a good chunk of the wine volume never makes it to the end of the process.

Now, you might ask if this cost accounting is a little excessive. No, it’s not. For two reasons. First, most wine sales go through distributors, who demand some really aggressive pricing deals, to the point where a winery will probably only make a 20% gross profit on its distributor sales. This is opposed to the much smaller sales volume a winery generates through its tasting room or wine clubs, where the gross margins can be in the 70% range. So, because of the crappy profits on distributor sales, the winery really needs to know how much its products cost.

And the second reason for a good cost accounting system is that the Internal Revenue Service demands it. The IRS wants to see the profit levels for each product sold, and proof for the calculations. And on top of that, the IRS wants wineries to allocate interest costs to wine when the production process takes at least two years, so there’s another cost accounting step.

And if you think that’s enough cost accounting for one day, no – not even close. The wineries prefer to use last in, first out costing to value their ending inventory, since it matches their latest costs against revenue, which should lower their taxable income. The trouble is that calculating LIFO is kind of tough on a per-unit basis. So, what they do is use the dollar-value LIFO system, where the ending inventory valuation is based on a conversion price index. This index is based on a comparison of the base year cost of the inventory and the current year cost, which is then converted into a percentage and used to value the ending inventory.

This is a fairly complicated calculation, so the wineries want to limit it to just two types of inventory, which are bulk wine and cased goods. The IRS doesn’t think that’s good enough, so they want to see separate calculations that are broken down into more groups, such as by the type of wine, the source of the grapes, the length of the aging process, and even the size of the storage containers being used. This can result in a small war with the IRS if a winery gets audited.

Sales Tax Exemptions

Of course, there are other accounting issues that are specific to vineyards and wineries. For example, there are sales tax exemptions for oak barrels, and for wine labels and fertilizer, since these items are all involved in either the grape growing or production processes. The assumption is that the final consumer will pay for the sales tax on these items, not the winery.

Charitable Donations

Here’s another issue – charitable donations. Wineries are always being asked to contribute their wine to charity auctions. The simplest way to account for these donations is not to do anything at all. The donated bottled are just not in stock at the next physical inventory count, so they’re charged to the cost of goods sold at the end of the month.

Depletion Allowance

And a final topic is the depletion allowance. Wineries sometimes offer a discount of a certain amount for each case that their distributors sell through to retailers. This is a depletion of a distributor’s inventory, which is where the name comes from.

The problem is that the distributors have to report the amount of cases sold back to the winery, usually in the form of a bill-back, so the winery ends up paying the distributor. This is an issue at month-end, when the winery is closing its books, since distributors may not report back about the number of cases sold for several weeks. And if you’re trying to close the books, this means that the amount of the depletion allowance has to be accrued, and it’s pretty much a guess. And if you’re wrong on the accrual, then the adjustment falls into the next month. Which introduces some inaccuracy into the financial statements.

Related Courses

Accounting for Breweries

Accounting for Vineyards and Wineries

Merger Integration for the Accounting Department (#254)

In this podcast episode, we discuss the integration process for the accounting department after a merger has been completed. Key points made are noted below.

Issues Relating to Merger Integration

There is no best way to integrate two accounting departments. You don’t necessarily have to go through a long and involved process of working towards two accounting departments that exactly mirror each other. It all depends on the intent of the acquiring company’s management team. If the intent is to let the acquired company operate on its own, then there isn’t a great deal to do. On the other hand, if the intent is to buy a bunch of companies and basically make each one an exact copy of the corporate parent, then there’s a lot of work to do, since you have to rip out and replace the existing systems.

The Low-Integration Option

So let’s start with the assumption that the acquiree is going to continue to operate with minimal interference from the parent. If so, the only critical integration item is making sure that every account in the acquiree’s general ledger is matched up with specific line items in the parent’s financial statements. This is called mapping, and it’s needed to make sure that you can add the acquiree’s financial statements to the parent’s financial statements to generate consolidated financial statements.

There are a couple of related activities. One is to have the acquiree notify you whenever they add another general ledger account, so that you can map the new account to the parent’s financial statements. Another item is to agree on a standard set of definitions for each account, so that each firm is recording the same types of transactions in the same accounts. Otherwise, there can be problems with account names looking the same, but the contents of the accounts are different. And if the corporate parent does a lot of acquisitions, there isn’t much debate about those definitions – whatever the parent says is the official account definition is going to be the definition. There’s just no time to argue with each new acquiree about it.

Another item to address is accounting policies. Both the parent and the acquiree should be dealing with transactions in the same way. For example, both parties should have the same capitalization limit, so that each one accounts for an asset purchase in the same way. And depreciation methods should be similar.

And they should deal with revenue recognition issues in the same way. And so on. Ultimately, the accounting policies should be so similar that each subsidiary of the business will deal with a transaction in exactly the same way.

Another integration item is accounting controls. You really can’t afford to make an expensive acquisition and then have it leak money because some key controls are missing. Those controls don’t necessarily have to be the same as the ones used by the parent company, since the processes used by the acquiree may be different. The main point is just to have a solid set of controls.

And the final really essential integration item is making sure that the acquiree understands the parent company’s month-end closing schedule, so it knows when information is supposed to be submitted and what information will be provided.

Believe it or not, that’s all you need for the simplest possible accounting integration, and it should only take a week or so, along with some occasional follow-up.

The High-Integration Option

Integrations can be monumentally more difficult when the intent is to use the same accounting system across the entire organization, since this involves loading the acquiree’s accounting records into the new system, as well as training everyone to use the new system. The real question is, is it really necessary to do this?

It might be warranted in some very specific situations. For example, if the accounting department of the acquiree appears to be fairly weak, using a central system allows the corporate parent to keep a close eye on what they’re doing. Or, if the parent wants to save money by cutting administrative costs, it can probably do so by centralizing as much of the accounting as possible. And another reason is to have tighter controls by centralizing everything. Of course, those reasons sound good, but is the parent company willing to spend some really serious money to make that happen? You might need to work through a cost-benefit analysis to see if it’s worthwhile.

Cold Turkey Integration

If senior management still wants to centralize accounting, then you have three choices for how to do it. One is the cold turkey approach, which means you turn off the old system and turn on the new system on the same day, and really, really hope that the new system works as planned. This is usually a bad idea. Sometimes, it can be in the really bad idea category, because there’ll be some unanticipated problems that no one sees until the new system has gone live. Management tends to push this approach because the conversion appears to cost less than the other alternatives – at least until everything falls apart.

Parallel Processing

The next option is parallel processing, where you run both the new and the old systems at the same time. This means that the accounting staff has to enter every transaction in both systems, which is wildly inefficient. On the plus side, you can compare the results coming out of the two systems and see if they match. If not, keep tweaking the new system until it works properly, and then shift entirely to the new system. This approach is much less risky and much more inefficient.

Convert One Module at a Time

A midway approach is converting over one accounting module at a time. For example, you could switch just the payroll module to the new system, and then payables, and then billings, and so forth. This approach chops up the conversion process into smaller pieces, which makes it easier to handle. However, the process as a whole takes longer, and also you need to write lots of custom interfaces. The problem is that each accounting module shares information with the other accounting modules, so when you switch to a new module on the new accounting software, you have to write interfaces from that new module back to the remaining modules in the old accounting system, to keep the information sharing going.

Selective Standardization

A variation on these concepts is to convince management that only a few accounting functions need to be standardized, and only concentrate on them, leaving everything else alone. For example, if there’s a centralized treasury department, they may want to control every bank account in the business, so that they can centralize funds for more efficient investing. If so, there can be an implementation process for converting an acquiree’s bank accounts to different ones at the parent company’s preferred bank. This means that only a few, very specific accounting areas are of importance to the parent company, so only those few are addressed. Everything else is left alone.

Concluding Thoughts

In general, I advocate using just those few integration steps that I mentioned at the beginning. Doing so addresses the main goal of the parent company, which is to produce consolidated financial statements.

If management really wants to conduct a massive accounting overhaul at every acquiree, try to convince them to focus on just one or two areas, which greatly reduces the effort.

After all, management always has the option to come back in later years and re-address the integration issue, if it wasn’t completely addressed right after the acquisition. And there’s a side benefit of engaging in a brief set of integration activities, which is that it gives the parent company the ability to move on to another acquisition within a few weeks. And if the parent is trying to roll up a bunch of acquisition targets, that could be a good reason to go easy on the comprehensive integration strategy.

Related Courses

Accounting Information Systems

Mergers and Acquisitions

Switching from Accounting to Solo Consulting (#253)

In this podcast episode, we discuss the issues associated with switching from an accounting career to solo consulting. Key points made are noted below.

The Switch to Consulting

This is a common wish for senior managers who’ve been in the same type of position for years, and the job just doesn’t seem that exciting anymore. Even with a different company, you can count on engaging in pretty much the same activities, over and over again. And, in a corporation, the pressures on a manager can be intense, especially when the company is publicly-held. So consulting can seem like nirvana.

Problems with Consulting

It’s not quite that easy. The first obstacle is marketing. How are you going to get the word out that you’re available for consulting projects? Just setting up a website is not good enough. Instead, you need to be targeting your specific area of expertise, which means figuring out where your ideal group of customers is, and then going out and meeting them. That could mean networking at industry events, or giving speeches at those same events. It means handing out business cards all the time. It will probably not be enough to just call a few friends and expect to have high-end consulting work drop into your lap. It doesn’t work that way. Instead, you’re going to be looking at a lot of your time in marketing drudgery. Many accountants are introverts, so this is monumentally hard for them.

Service Aspects of Consulting

If you feel confident that you can handle the marketing end of things, then it’s time to consider the flexibility aspect of consulting. In short, when a client calls, you answer. The consulting business is all about service. So if a project needs to be done right away, expect to cancel that vacation you’d already planned. If the client needs a report by tomorrow morning, expect to work some long hours to finish it. In other words, expect some periods when you’re under a lot of pressure.

The Highest-Value Services

Now, what about targeting an area that can make you a pile of money? The highest paying consulting work is value priced, which means that you’re not charging by the hour, but rather by the outcome. A good example of this is in the legal profession, where lawyers know that a client will pay them whatever it takes to keep them out of jail. So, if you apply the same thinking in the accounting field, that means targeting outcomes that are really important to the client. For example, provide consulting services for taking a company public, or assist with a bond offering, or provide advice about buying a public shell company for a reverse acquisition. In all three cases, the client is trying to raise money – probably a lot of it – so helping them raise the money can translate into a major consulting fee.

The same goes for mergers and acquisitions. These are major events that can make or break a company, so management needs the best possible advice in lots of areas. For example, you could provide due diligence services for acquisitions, or maybe in specific areas of the due diligence, like whether the target company has an adequate system of controls. Or, the area of emphasis could be in negotiating acquisition deals, or maybe in the fund raising needed to pay for an acquisition. Another option is to assist with searches for possible acquisition targets.

Another possibility is working on acquisition integration after the deal is done, like merging the accounting systems of the buyer and the target company. But, keep in mind that all of these high-value services usually have a short timeline on them, so expect to work some serious hours within a short period of time.

Less-Valuable Services

Now, let’s move down a notch to somewhat less valuable services, where you’ll probably have to bill by the hour. These services are more competitive, because there are more people out there with similar skills. For example, there’s reviewing the system of controls for any weaknesses, or writing accounting procedures, or helping to install accounting software, or helping to set up an inventory tracking system. It’s especially hard to break into the software installation business, because all of the large consulting firms consider this to be one of their core areas of expertise. At best, you might end up working as a contractor for one of the other consulting firms. The billable rates for these “lesser” activities can actually be quite good, but they also call for very specific skill sets, which a senior-level manager may not have.

Another concern is that the target market for consulting services is not smaller firms. They just don’t have the money to pay for a lot of consulting, so you might find yourself spending all kinds of time marketing to them, and then find that the resulting project is only worth a few thousand dollars. Instead, the sweet spot in the consulting market is larger firms. Unfortunately, all of the other consultants know that, too – so they’re all trying to sell to a fairly small number of potential clients.

This can be a real problem in a smaller city where there aren’t many large companies. In that case, you may find that your target clients are located a long ways away – so be prepared to spend a good chunk of your consulting career living in a hotel room, and only getting home on weekends.

Summary

I’ve made the situation look pretty grim. That doesn’t mean it’s impossible, just that there’s a lot more work involved than you might think, because of the marketing and the rush nature of the work. It’s quite uncommon for someone new to the business to immediately land a consulting contract, sit around all day ladling out advice, and get back home for an early dinner with the family. Instead, it may be months before you get any work at all, and it’ll be more likely that you end up subcontracting through a larger consulting firm, probably with no benefits.

My advice is not necessarily to avoid consulting, but to think through exactly how you’re going to do it, how you’re going to market yourself, what services to offer, how much to charge, and how much you’re willing to be away from home. An old friend of mine is a classic example of a consultant, who believed that if you weren’t interest in traveling, you shouldn’t be a consultant. It turned out that his next project was in Egypt – and he stayed there for years – a long ways from home.

The Compilation Engagement (#252)

In this podcast episode, we discuss how a compilation engagement works. Key points made are noted below.

The Full Audit

Most people are familiar with the full audit, since lenders usually require that a borrower have one each year. A full audit is quite detailed, and involves an examination of the client’s books and control systems. A review is a notch down from an audit, and mostly concentrates on analytical procedures, which means comparing financial and operational information to see if it makes sense. If it doesn’t make sense, the auditor has a discussion with management about it. Reviews are mostly used by publicly-held companies, which are required to have a review at the end of each fiscal quarter, plus an audit for the full year.

The Compilation Engagement

And then we have compilations, which are really just a service to assist a client in preparing its financial statements. The auditor doesn’t engage in any of the audit work that’s found in a full audit or a review, so there’s no examination of controls, or walk-throughs of transactions, or tracing account balances back to the supporting documentation. In short, a compilation isn’t designed to provide any assurance about the information contained within the financial statements.

Compilations don’t have to be for a complete set of financial statements. They could be just for a portion of the financials, such as the income statement, or for a budget or a forecast, or maybe just for a supporting schedule, such as a royalty schedule.

Compilation Activities

What does the auditor do in a compilation, since so far I’ve only mentioned what the auditor doesn’t do. First, the auditor reads the financial statements, checking to see if they’re in the correct form, and whether there are any obvious misstatements. This means the financials should be free of mathematical mistakes and errors in how the accounting standards are applied.

The auditor can also go down into one extra level of detail, and scan the supporting trial balance for unusual items. The same goes for the general ledger, where the auditor looks for things like unusual journal entry descriptions, or unusually large transactions, or one-time transactions, or recurring entries that seem to be missing in a few periods.

In other words, the auditor is looking for anomalies that don’t make sense. If so, there’s a discussion with management. Depending on the outcome of that discussion, the auditor can propose some adjusting journal entries. Once those changes are made, the auditor takes another look at the financial statements to see if they meet the requirements of generally accepted accounting principles, or international accounting standards, or whichever other accounting framework is being used.

Next up, the auditor reads the disclosures that accompany the financial statements, and makes improvement suggestions whenever there appears to be a missing disclosure or when something isn’t entirely clear.

If this examination uncovers an issue where the financial statements depart from the reporting framework, then the auditor needs to decide whether this departure is being adequately described in the disclosures. If not, the departure may need to go into the auditor’s compilation report.

Now, as the auditor works through this process, she may find situations in which records are incorrect or incomplete, or where the judgments used by management in regard to accounting issues are not correct in some way. If so, these issues have to be brought to the attention of management, along with a request to correct the situation.

Another possibility is that the auditor may find that the client can’t continue as a going concern, which is to say that it may go bankrupt. If so, another suggestion has to be made to disclose this possibility in the financial statements, since they’ll otherwise be misleading.

Material Misstatements

If an auditor starts a compilation engagement and begins to suspect that the financial statements may be materially misstated, she should investigate further, to see if this is the case. If it’s not possible to obtain the needed information, then the auditor should withdraw from the engagement. Or, if the auditor has proposed revisions to the financial statements that the client didn’t make, then it’s also a good idea to withdraw from the engagement.

Compilation Reporting

Once the financial statements have been completed, the auditor writes a report that the client should attach to the financial statements, which points out that this was not an audit or a review, so the auditor is not expressing an opinion about the financial statements, and is not providing any assurance that the financial statements are correct. The report can also point out any cases in which the financial statements depart from the related accounting framework.

Reasons Why Clients Want a Compilation

So why would a client want a compilation? Because it’s cheap. Or, knowing how expensive auditors can be, let’s call it the least expensive option. However, the users of a company’s financial statements might not want a compilation, because it doesn’t give them any assurance that the financial statements are correct. So, from the client’s perspective, it makes a lot of sense to check with the users to see if they’ll go along with a compilation. There’s a good chance they won’t.

Summary

In summary, to view a compilation from a high level, it’s essentially a consulting engagement for the auditor, who conducts a modest inspection of the books to see if any anomalies pop up. The auditor can then make suggestions to management for improving the financial statements; if management decides not to do so, then the auditor has grounds to pull out of the engagement.

Related Courses

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Accounting for Oil and Gas (#251)

In this podcast episode, we discuss the accounting for oil and gas operations. Key points made are noted below.

Reporting of Reserves

In this industry, the real value generated by a business is underground, which means that the main focus of attention is on the amount of reported reserves. In general, reserves are considered to be the amount of commercially recoverable oil and gas. Within that general concept are two subdivisions, which are proved reserves and unproved reserves. The main focus of attention from an accounting perspective is proved reserves, which are those oil and gas reserves that can be reasonably estimated to be commercially recoverable from known reservoirs. In other words, you know it’s there, and it’s cost-effective to extract it at current market prices.

The reported level of reserves keeps changing. It’s not that the amount in the ground keeps changing. When a reservoir is first discovered, there’s a certain amount of oil and gas in there, but not all of it is recoverable. The situation differs by reservoir, but let’s say that it’s only feasible to extract half of what’s in a reservoir at the current market price. But then if prices go up, it becomes cost-effective to use more expensive techniques, like injecting steam into the ground. So as the price goes up, a larger proportion of the reservoir becomes available – maybe that brings you to 60% that can be extracted. Or, someone invents a new technique for extracting oil, such as fracking. Whenever something like this happens, even more of a reservoir becomes accessible – maybe the accessible portion goes up to 70%. So what all of this means is that reported reserve levels can fluctuate – a lot.

Depreciation, Depletion, and Amortization

Another unique thing about oil and gas is the concept of DD&A – which stands for depreciation, depletion, and amortization. In this industry, there are lots of tangible assets, like wells, and pumps, and storage tanks – but there are also intangible assets, like the cost to lease mineral rights from a property owner. So, someone figured out years ago that they’d lump all of these assets together and use a standard depletion calculation to charge everything to expense. And therefore, we get the term DD&A, since it combines elements of depreciation, depletion, and amortization.

The way it works is called the unit of production method, where you divide the capitalized cost by the total estimated amount of the reserve – there’s that reserve concept again – and multiply by the number of units produced. So basically, the amount amortized in each period is directly related to the amount produced, so if the production level increases, so does the amortization expense.

But of course, it’s not that simple. There are two schools of thought regarding which expenses to capitalize. Under the successful efforts method, if you drill a dry hole – which means you didn’t find any oil or gas – then the costs associated with that well are charged to expense right away. That’s nice and conservative, since expenses are more likely to be recognized up front.

The other approach is the full cost method, which takes the position that you can’t drill successful wells without also drilling some dry holes. And based on that logic, you pretty much capitalize everything, even if you’re suffering through a string of dry holes. So as you might expect, a business using the full cost method will have more assets on its books than another firm that’s using the successful efforts method.

Asset Impairment

Which brings up the issue of whether these assets can ever be impaired. The main concern is with companies using the full cost method, since they tend to overload their balance sheets with assets. The solution is called the ceiling test, which starts with the present value of future cash flows from the firm’s producing properties, and then subtracts out the cost or fair value of those properties, along with income tax effects. The result is then compared to the net book value of the assets being tested, to see if a write down is needed. So it’s a bit different from the impairment testing system used in other industries.

Impairment is a very big deal in the oil and gas industry, because projected cash flows can vary all over the place. For example, cash flows can drop catastrophically along with the usual gyrations in the prices of oil and gas. Or, the government that controls the drilling production process decides to alter tax rates, or it alters the requirements to restore well sites after production is done. What this means is that an oil and gas firm could appear to have perfectly reasonable asset levels in one year, and finds itself writing off a good chunk of those assets in the next year.

Severance Taxes

And then we have the interesting issue of severance taxes. These are taxes on production that’s levied by the government. So, you produce a $1,000 of gas, you have to pay a portion of that to the government. The main problem is that a producing property usually has more than one party that gets paid for the revenue from a producing well, so the government could be faced with the collection of severance taxes from a bunch of entities.

For example, the Smith family owns the mineral rights underneath a property, and they lease out those rights to an oil and gas firm in exchange for a royalty. And on top of that, the oil and gas firm needs to raise money to pay for drilling wells, so it sells half of its interest in the lease to someone else, in exchange for cash. That means there are now three parties that owe severance tax to the government.

There are two ways to make this more efficient. One is that the buyer of the oil or gas pays the government, so it’s essentially acting like an agent, withholding the amount of the tax from what it would otherwise have paid to the interest owners. The second option is that the operator of the property is paid the entire amount by the purchaser of the oil or gas, and then the operator pays the tax to the government on behalf of the other interest owners. In a way, these arrangements are somewhat similar to how sales taxes are handled in other industries.

Revenue Recognition

And there are lots of issues related to revenue. For example, what if a well site extracts oil or gas and then turns around and uses some of it to power the machinery at the well site? How do you account for that? Turns out, you don’t – the government doesn’t tax it, and the interest owners don’t receive a royalty, on the grounds that you otherwise would have had to bring in the fuel from somewhere else, which counterbalances the lost revenue.

But then things get more complicated. What if you then shift that oil or gas to a nearby property and use it to power the equipment over there? That other property may have different ownership percentages, and perhaps some of the interest owners over there aren’t even the same folks as the ones involved with the first property. So now, you have to record the oil and gas coming out of the source well as revenue, and pay royalties and taxes on it, and then charge it to expense at the receiving site.  It’s issues like this that keep accountants employed.

Another revenue issue is take-or-pay arrangements. This is where a pipeline owner commits to taking a minimum amount of gas from a well site each month. But it may not take the gas during the warmer months, when gas demand goes way down. In that case, as the name of the arrangement implies, the pipeline has to pay the producer anyways. The accounting treatment for these payments is that they’re recorded as a deferred credit, which is used to reduce the amount of payments made in other months when the pipeline takes more gas from the well site. Once again, full employment for accountants.

Interest Capitalization

And a parting thought. On top of what I’ve mentioned here, oil and gas companies also capitalize their interest on drilling projects, and they can potentially have massive liabilities for asset retirement obligations, like restoring drilling sites to their original condition. All of these issues mean that oil and gas accountants have to deal with the full range of accounting issues, practically on a daily basis. In short, this is one of the more technically challenging accounting areas in the world.

Related Courses

Oil and Gas Accounting

The Burn Rate (#250)

In this podcast episode, we discuss the burn rate. Key points made are noted below.

When We Use the Burn Rate

The burn rate measures the amount of cash being used up per month, which you can then use to estimate the amount of time it’s going to take for a business to spend its remaining cash reserves – and then presumably go out of business. This is an important concept for a startup company, which has been given a fixed amount of cash to get things going, and only has a certain amount of time to create a product and start generating sales, before the cash is gone. This isn’t just a financing issue. It’s also a concern for the auditor, who needs to figure out if a business is a going concern. Because if it’s not, that’s kind of a major disclosure issue.

Example of the Burn Rate

The burn rate is based on the amount of negative cash flow per month, which is divided into the amount of cash on hand. For example, if a business’ bank account balance is dropping by $50,000 per month, it’s said to have a burn rate of $50,000 per month. If it has $1,000,000 of cash in the bank, then it should be able to last 20 months until its cash runs out.

Issues with the Burn Rate

Of course, things are never quite that simple. The first issue is that the burn rate is not the same thing as expenses. So, a startup company might have operating expenses of $50,000 per month, but it’s also paying for computers for its staff, and rent deposits, and office furniture – none of which are classified as expenses. Those extra items are all classified as assets. So when figuring out the burn rate, you have to look at every possible kind of expenditure being made.

The second issue is that companies are a lot looser with their expenditures when they’ve just received a pile of funding, and a lot stingier when the last few dollars are about to be drained out of the account. That’s for two reasons. One is that a company needs to spend more money up front when the business is just getting starting, to pay for things like legal expenses, just to get properly organized. The other reason is psychological. When there’re many months remaining before the cash runs out, people tend to worry about it less than when the whole enterprise is about to close its doors.

So when the cash is nearly gone, management tends to scale back on purchases, lays people off, cuts pay, and so on. And that makes it a lot more difficult to figure out the burn rate over a long period of time, because the amount of cash being used tends to decline a lot when the end is near.

Another issue is the likelihood of obtaining additional funding. If the business is about to launch a promising new product, there’s some chance that it can line up an additional round of funding and keep things going longer. If management expects more cash, then it’ll be less inclined to scale back its expenditures when the cash balance drops, and instead is more likely to keep going full speed ahead – and might even increase its expenditures, so that the burn rate goes up over time.

This is why you occasionally see a startup company crash and burn very suddenly. They’re hiring more staff right up until the last minute, and then the funding doesn’t come through on time, and it collapses. But that’s still not the only issue with the burn rate. It’s quite possible that management has made promises to its employees and suppliers to hang in there just a bit longer until the next round of financing has been lined up, and then it’ll pay them for amounts owed.

The problem is that the people supplying the next round of financing are doing so based on an extension of the current burn rate. And they’re not too happy when the new funding goes into the company’s account and then there’s an immediate decline in the cash balance in order to pay off those overdue amounts. In essence, what just happened is that management has been disguising a higher burn rate than initially appears to be the case, because of the delayed payments.

And there’s yet another issue, which is whether the burn rate is a valid figure if the founders decide to cut their losses early, shut down the business, and take out their cash. This is based on a review of how well the company’s product development work is going, as well as a realistic review of whether or not it’s possible to get an additional round of financing. If the answer to either one is not good, then it can make sense to lay everyone off and liquidate the business, even though there’s still cash in the bank.

So far, I’ve been talking about additional funding as though that’s a realistic possibility. In many cases, it’s not. There’s going to be one funding round, and if the company can’t get its operations going with that specific amount of cash, then the game is over. And maybe that’s why venture capital folks have a term called the Death Valley curve. It’s a declining curve that shows the amount of remaining cash. At some point, the business runs out of money, and it dies in Death Valley.

The Burn Rate Applied to Older Companies

The burn rate concept is most applicable to new companies, but it can also be useful when an older business has a persistently negative cash flow. In this case, it needs to come up with some sort of strategic or tactical change in order to turn around its cash flow situation. In this case, burn rate is quite useful for telling management just how much time it has in which to make those changes.

But it’s not quite that simple, because the burn rate is supposed to represent a fairly consistent amount of cash being used up each month. And for a business going through a turnaround, that’s just not the case. Instead, it spends a lot of money up front on severance pay to let people go, along with paying for the things it needs to launch it in a new direction. Which may include payments for branding, like advertising to reposition the public image of the company. These payments tend to be lumpy, so the burn rate could vary a lot by month.

A Reason Not to Use the Burn Rate

Which brings me to my final point, which is that maybe the burn rate isn’t such a good measurement to rely on. Instead, it can make more sense to maintain a fairly detailed cash forecast that runs a good ways out into the future, and only tack on the burn rate for periods beyond what’s covered by the cash forecast. That way, you get the best possible visibility into when you’re going to run out of cash.

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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.

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