Long-Term Cash Flow Forecasts (#328)

Is it possible to construct a viable long-term cash forecast? Answering this requires some clarification of how a cash forecast should be constructed.

The Receipts and Disbursements Method

A cash forecast has three distinctly different formulations, depending on how far out you want to go into the future. The most predictable cash forecast only goes out about a month, and is based on a detailed accumulation of data from a couple of sources within the company. Most of it comes from the accounts receivable, accounts payable, and payroll records, though some other significant sources are the treasurer, for financing activities, and even the corporate secretary, for scheduled dividend payments. Since this part of the forecast is based on detailed itemizations of cash inflows and outflows, it’s sometimes called the receipts and disbursements method.

The short-term forecast is quite reliable, though even here there can be some uncertainty, since payments from customers don’t always arrive when you expect them. And if those cash inflows are not as predictable as you’d like, then outbound cash payments might be delayed to minimize the risk of running out of cash.

The Medium-Term Cash Forecast

Next, we have the medium-term cash forecast, which begins at the end of the short-term forecast. The components of the medium-term forecast mostly come from formulas, rather than the very specific data inputs used for a short-term forecast. For example, cash outflows related to the cost of goods sold might be based on an estimated percentage of sales, with a time lag based on the average supplier payment terms. Or, the sales forecast can be used to estimate changes in production headcount, which in turn can be used to derive payroll payments. Or, cash receipts from customers are based on a standard time lag between the billing date and the payment date.

The concept of a formula-filled cash forecast that automatically generates cash balance information breaks down in some parts of the forecast. For example, some expenses are based on contracts, such as rent payments, and so are set up with specific cash payouts on specific dates. Or, some expenses are only associated with specific events, like the company Christmas party, and so have to be manually added to the forecast.

And, one of the biggest manual additions is any type of step cost. A step cost is an expense that is constant for a given level of activity, but which takes a large step upward when an activity threshold is crossed. For example, if projected sales surpass a certain point, then the cash forecast has to include additional expenditures to staff up a new production line, or maybe to rent more facility space.

The methods used to construct a medium-term cash forecast are inherently less accurate than the more precise information used to derive a short-term forecast. The problem is that much of the information in the medium-term forecast is derived from the estimated revenue figure, which declines in accuracy just a few months into the future. For that reason, it’s dangerous to develop a cash forecast that extends very far out. And on top of that, there’s an immediate decline in forecasting accuracy as soon as you switch from the short-term forecast to the medium-term forecast.

The Long-Term Cash Forecast

Since I mentioned a medium-term forecast, of course there has to be a long-term forecast, too. This can be used to extend the forecast out for a year or two past the end of the medium-term forecast. The information for the long-term forecast comes from the corporate budget, so it’s only going to be as reliable as the budget – which might not be reliable at all. Long-term cash forecasts are only approximate representations of what will actually happen, so they shouldn’t be used as the basis for any specific management actions. That being said, a long-term forecast can give you a general idea of where your cash balance might be in the future, so it can be a guide for approximately when you might have a cash shortfall, which might require some financing activities.

Whether to Issue a Long-Term Cash Forecast

So, does it make sense to issue a long-term cash forecast? If you do, be sure to point out that the quality of the data declines at specific points – which are one month out, when you switch to the medium-term calculation method, and again further out, when you base the forecast entirely on the budget. If someone insists on a long-term cash forecast, then they have to understand the quality of the information they’re receiving.

Related Courses

Corporate Cash Management

Converting to the Accrual Basis (#327)

How do you convert from the cash basis of accounting to the accrual basis Under the cash basis, you recognize revenue when cash is received, and expenses when cash is paid. Under the accrual basis, you recognize revenue when it’s earned, and expenses when they’re incurred. So, the timing of revenue and expense recognition can be totally different.

Doing the conversion from the cash basis to the accrual basis is pretty common, since small businesses typically start with the cash basis, and then flip over to the accrual basis when they get larger. You might need the accrual basis in order to convince a lender to issue a loan, or maybe because an acquirer wants to see your financials prepared under the accrual basis.

Step 1. Add Accrued Expenses to the Financials

The conversion involves six steps. First, you have to add accrued expenses to the financials. This means adding back all expenses for which the business has received a benefit but hasn’t yet paid the other party. You should accrue for all types of expenses, such as wages earned but unpaid, direct materials received but unpaid, office supplies received but unpaid, and so on.

Step 2. Subtract Cash Payments

The second step is to subtract cash payments. This means subtracting out cash expenditures made for expenses that should have been recorded in the preceding accounting period. It also means reducing the beginning retained earnings balance, which thereby incorporates these expenses into the earlier period.

Step 3. Add Prepaid Expenses

The third step is to add prepaid expenses. Some cash payments might relate to assets that haven’t yet been consumed, such as rent deposits. You should review expenditures made during the accounting period to see if there are any prepaid expenses, and move the unused portion into an asset account. If you want to do the same for expenditures made in prior periods, then adjust the beginning retained earnings balance to remove the expenses that are now being shifted into a prepaid expenses asset account.

Step 4. Add Accounts Receivable

The fourth step is to add accounts receivable. This means recording accounts receivable and sales for all billings issued to customers and for which no cash has yet been received. This can be time-consuming, depending on sales volume.

Step 5. Subtract Cash Receipts

The fifth step is to subtract cash receipts. This is because some sales originating within a prior period might have been recorded in the current period, because the related cash was received in the current period. If so, reverse the sale transaction and record it instead as a sale and account receivable in the preceding period. To do this, you’ll need to adjust the beginning retained earnings balance.

Step 6. Subtract Customer Prepayments

And the last step is to subtract customer prepayments. You may not have to worry about this one at all, but customers might have paid in advance for their orders, which would have been recorded as sales under the cash basis of accounting. You should record them as a liability until the related goods have been shipped.

Additional Conversion Issues

So, that’s obviously a lot of work. And it’s worse than you think, because you might not catch everything that needs to be converted. The only way to be certain is to examine every single transaction during the year being converted, and in the final quarter of the preceding year. Which might be a huge amount of work.

To make things even more difficult, a small business tends to not have an overly well-run accounting department, which means that its accounting records aren’t exactly well documented. Which makes it more difficult to figure out if a transaction needs some kind of adjusting entry.

So, what is the strategy for this? How do you go about actually doing the conversion? There’s clearly a lot of work involved, and you might not have enough staff to do it. A couple of options are available.

One is to hire an accounting firm to go through your records and figure out the entries that need to be made, and then make a bunch of one-time entries to flip over to the accrual system. I recommend this approach, because you’re getting people to do it who have – hopefully – done it before, and so are less likely to make mistakes. It also means that you’ll be able to start with a fairly reliable set of accrual basis financials as of a designated date.

Another possibility is to work your way into it gradually. This could work if you want to do everything in-house, which might even be the only option if you can’t afford to have an accounting firm do it for you.

This might sound a bit unorthodox – and it is – but a possibility is to slowly go through each of those six steps that I outlined, and gradually convert over. What that means is that the final year under the cash basis of accounting would actually be done in accordance with a hybrid of the cash and accrual systems, which is not allowed by any accounting framework. But, if you just want to take your time and slowly roll out the conversion, and no one is especially concerned about the results you’re posting during that transition period, then you could try this option. The main advantage is that you can get by with the minimum amount of resources over a more extended period of time.

The final option is to keep the work in-house, do the research in advance of the conversion date, and run the same journal entries that an outside accounting firm would use if you had hired them instead. The benefit here is that you’re not paying the fees of the outside accountants. The downside is that – presumably – no one on staff has done this before, so the risk of making a mistake is higher.

To avoid the mistakes associated with any type of in-house conversion, you might consider hiring an accounting firm just to check your proposed entries, to see if anything is wrong or missing. There will be a fairly hefty billing for doing this, but it’ll be much smaller than if you hired the accounting firm to do the entire project.

Related Courses

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The Formula 1 Accounting World Championships (#326)

The topic of this episode comes from Christian Horner, who is not a listener, and it is the Formula 1 accounting world championships. He stated recently that the new budget caps that have been imposed on the Formula 1 teams are so complicated that they might actually decide who wins the championship. And in cases where the points total is close, he might have a point.

But first, for some background. Yes, I am a Formula 1 nutcase, and check on the latest Formula 1 news every single day. I also just got back from watching the Canadian Grand Prix, which is held every year at a race track outside of Montreal. Very cool. Also very, very expensive. And as a side benefit, I caught COVID while I was there. Already recovered, no worries.

So, who is Christian Horner? He runs Red Bull Racing, which is currently leading both the team championship and the individual championship. And they’ll probably win the whole thing this year.

The Formula 1 Cost Cap

And what is he so concerned about? How on earth does accounting enter into the Formula 1 championship? Well. The main problem with Formula 1 is that there are 10 teams, but only three of them usually have enough money build a car that’s good enough to actually win the championship. Those teams are Red Bull, Ferrari, and Mercedes. The other seven just don’t have the cash. So, to make things more competitive, Formula 1 imposed a cost cap on the teams that starts in 2022. Under the new rules, you can’t spend more than $140 million dollars for the entire season for 21 races. If an extra race is added, then the cost cap goes up by $1.2 million, which tells you how much money a team spends to move to a new venue and operate its cars there for four days.

Also, the cost cap goes down even more for the 2023 race season, with a cap of $135 million.

This creates some issues. One is that freight costs have gone up astronomically this year, so that transferring the cars and everything else from one race to the next costs three times more than they expected. And that’s a lot when you’re shipping by air freight. Horner guessed that costs have gone up so much this year that a majority of the teams might not even be able to compete by the end of the year, because they hit the cost cap.

So there’s one issue, which is a loss of competition due to the new cost cap rules – which is the exact opposite of what the cap was intended to do. But there’s more.

Cost Cap Rules

So. The $140 million cap does not include any financing or marketing or human resources costs, or the amounts paid to the drivers, or the travel costs of those drivers. And there are lots of other exclusions, like entertainment expenses and foreign exchange gain and losses. Which means that there’s lots of room for interpretation.

There are also pages and pages of rules about how to account for inter-team transactions. For example, Ferrari sells its engines to the Alfa Romeo and Haas teams, while Mercedes sells its engines to the McLaren, Aston Martin, and Williams teams. If you dig into Formula 1 at all, you’ll find that it’s quite incestuous. All of the seven other teams are interrelated with the Red Bull, Ferrari, or Mercedes teams in some way. Which also means that there’s room for some interpretation of where costs were charged.

There’s also an issue with redundant inventory, which most people would call obsolete inventory. The cost of redundant inventory goes against the current year cost cap, so of course there will be arguments about whether something is redundant.

And believe me, I’m only mentioning a sliver of the total costing rules.

Cost Cap Administration

There’s a group within Formula 1 called the Cost Cap Administration that issues guidance on how to interpret all of the cost cap rules. Sounds an awful lot like the Financial Accounting Standards Board, except that it only applies to Formula 1. The Cost Cap Administration reviews the reporting documentation that has to be submitted by each team, and can bring in an outside audit firm to conduct investigations.

And here’s a key item. The Cost Cap Administration can investigate a reporting year at any time within the following five years. So lets talk about some of the implications.

If the adjudication panel of the Cost Cap Administration finds that a team has made a procedural breach of the rules – like making a late report submission – then it can impose a financial penalty. Not a big deal.

Cost Cap Penalties

If a team goes over the cost cap by no more than five percent, that’s considered a minor breach. Which will result in a financial penalty and maybe also something called a minor sporting penalty. Despite the name, that minor sporting penalty can be a big deal, since it can include a deduction from the championship points total, and maybe exclusion from a race.

And if a team goes over the cost cap by more than five percent, then it’s committed a material overspend breach, in which case a championship points deduction is required – not optional – along with a financial penalty. And a team might even be kicked out of the championship entirely.

So let’s get back to that five year limitation on auditing the books. The Cost Cap Administration could hear from an insider that a reporting breach occurred a couple of years prior. Its investigation concludes that there was either a minor sporting penalty or a material overspend breach. If so, the resulting point deduction could strip a team of a championship that was awarded a couple of years ago.

If you’ve ever watched the Netflix series Drive to Survive, you’ll know that the top teams in particular are always filing complaints against each other for all sorts of perceived infractions. After all, these races can be decided by very small amounts, so anything that gives a team an advantage seems to be worth pursuing.

Will this now include arguments over the cost cap? Very likely. And it sounds like the squabbles could continue for years after a racing season has supposedly been decided. The only thing that’s certain is that Formula 1 teams will be hiring cost accountants.

Special Purpose Acquisition Companies (#325)

What is a SPAC?

A SPAC is a special purpose acquisition company. It’s a shell company, which means that it has no revenue or operating history at all. Instead, it’s designed to buy another business, using money that it raised through an initial public offering, or IPO, and which is initially stored in an escrow account. Depending on how a SPAC is designated when it’s formed, at least 80 percent of the money raised through an IPO usually has to be spent on an acquisition within two years. If not, then it has to dissolve and return the cash to investors.

If a SPAC is dissolved, the investors don’t get back any of the money earned while the cash was held in escrow, since those earnings are used to pay for operating expenses.

These arrangements certainly might not work out, since the operators of a SPAC might not even know which businesses they want to acquire when they take the business public. Instead, they’re just sitting on a pile of cash, and looking around for opportunities. And, even if they find a possible acquisition target, the purchase is put to a shareholder vote – which might turn down the proposal. Alternatively, the investors might approve of an acquisition, in which case the cash is released from escrow, and the target company is purchased.

If a shareholder votes against an acquisition, then that person can get his funds back that were held in escrow. On the other hand, if the share price of the SPAC has gone up since the date of the IPO, it can make more sense for a shareholder to vote in favor of the deal, and then sell his shares to someone else on a stock exchange at a higher price.

The Cost of a SPAC

What about the cost of a SPAC? This is its main advantage. It usually incurs a 2% underwriting fee at the time of the IPO, and then another 3.5% underwriting fee when an acquisition is completed. Compare that to the 7% fee usually charged on the funds raised through a traditional IPO. Of course, if an acquisition never occurs, then the 2% underwriting fee is essentially lost.

The SPAC Sponsor

So, who starts a SPAC? The party that starts one is a pre-IPO investor, and is called a sponsor. This might be an investment fund, which links up with someone with lots of experience in the industry where the SPAC is going to look for investments. Investment funds like to engage in SPACs, because they have an easy exit – they can just sell their shares on a stock exchange, which is a lot easier than trying to sell off the shares of a private company.

Sponsors have to provide a small amount of pre-IPO capital, usually a few million dollars. In exchange, they receive founder shares in the SPAC. On the day of the IPO, these founder shares are converted into somewhere in the range of 20% to 25% the common stock of the SPAC. Pretty sweet deal for the sponsors.

On top of that, the sponsors receive a warrant for each share of sponsor capital, which allows them to buy an additional share of the SPAC following a successful acquisition. The usual arrangement is that the share price of an IPO is $10 per share, and the warrants have an exercise price 15% higher than that, which is $11.50. It would only make sense to exercise a warrant if the market price of the stock exceeds the $11.50 exercise price. Or, a warrant holder could just sell the warrant to another investor.

Based on these compensation arrangements, it doesn’t make much sense to invest in the IPO of a SPAC – the sponsors are taking such a large ownership interest in the entity.

Accounting for a SPAC

So, what about the accounting for a SPAC? Initially, there’s not much to do. It reports some minor operating expenses, with most of it related to its required quarterly reports to the SEC. If an acquisition is completed, then the owners of the acquiree may be paid in cash, or in SPAC shares, or a combination of the two.

In an acquisition, the SPAC might be considered the acquiring entity, which means that it records the assets and liabilities of the acquired entity at their market values. If the total payout exceeds the net value of these assets, then the residual is recorded as a goodwill asset. When the SPAC is the acquirer, the financial results of the acquired business are recorded starting on the acquisition date.

Or, depending on the circumstances, the acquired entity might be classified as the acquiring entity. This happens when the shareholders of the acquired entity receive a majority of the voting shares of the SPAC, rather than being paid in cash. When this is the case, it’s called a reverse acquisition – where financial statements are issued under the name of the SPAC, but the financials are essentially a continuation of the financial statements of the acquiree.

Some lesser accounting issues are recording the value of the warrants issued to sponsors, and the cash flowing into and out of the escrow account.

Accounting for Buying Commissions (#324)

This episode covers the accounting treatment for buying commissions paid by an importer to an agent on goods imported. A buying commission is a fee paid by an importing buyer to its agent for the service of representing it abroad in the purchase of goods. Representation might involve searching the market for the best available prices, negotiating with suppliers, conducting quality inspections, and making payments on behalf of the buyer.

There is nothing in the accounting standards that specifically covers buying commissions. On the other hand, there’s a great deal about it in the rules and regulations for any country that charges a customs duty on the value of imported goods. The basic question from a customs duty standpoint is whether the value of the buying commission is part of the purchased goods, and so gets to be whacked with a customs duty. The importer obviously wants to avoid the duty, and so tries to keep the buying commission separate from the stated value of the goods.

From an accounting perspective, we don’t care about all the arguments pertaining to customs duties, since they all vary by country anyways. Instead, we can rely on the accounting rules pertaining to the cost of goods sold – which we just happen to have covered in the last episode. The main rule is that an expense is included in the cost of goods sold if it’s clearly a cost of the goods that are sold. Therefore, the key question is, could the importer obtain the imported goods without paying the buying commission? The answer is – no, it could not, because the agent will not represent the buyer if it is not paid this commission.

Also, the buying commission is usually a percentage of the goods being purchased, which closely ties the expense to the cost of goods sold. This also means that the commission can be considered a direct cost, because it’s only incurred if goods are purchased. Being a direct cost is a prime determinant of being classified within the cost of goods sold. So there you have it, cost of goods sold all the way.

What is the presentation of this expense in the income statement? The answer is, within the cost of goods sold section. Unless you’re breaking out lots of line items on the income statement, it’s probably going to be aggregated into the main cost of goods sold line item.

The Cost of Goods Sold (#323)

The topic of this episode is, what goes into the cost of goods sold. This might seem obvious, but that’s not always the case. The topic sort of came from a listener, who was wondering about what might go into the cost of goods sold for a software as a service company. That topic was too narrow for the podcast, but it seems worthwhile to back up for a minute and discuss the criteria for what should go into the cost of goods sold.

Accounting Rules of the Cost of Goods Sold

The accounting rules for the cost of sales and services is described in section 705 of the accounting standards codification, which covers generally accepted accounting principles. The funny thing is – there’s literally nothing in it. Section 705 just refers you out to specialized areas, like agriculture and federal government contractors, for more information.

So, what we have here is a presentation issue for which there really isn’t any guidance – what goes into the cost of goods sold, as stated on the income statement?

Criteria for the Cost of Goods Sold

One possible rule is to include in the cost of goods sold anything that’s a direct cost of sales. This means that a cost is only incurred if a sale occurs. The obvious items here are direct labor and direct materials, which everyone puts in the cost of goods sold. But what about credit card fees, and sales commissions? These expenses only happen if there’s a sale, so shouldn’t they also be presented within the cost of goods sold?

Both items might very well be listed lower down in the income statement, with credit card fees listed within the bank expenses line item for the accounting department. And you might find sales commissions within the sales department’s expenses, as part of compensation.

So, you could include these items in the cost of goods sold, though general practice places them lower down in the income statement. A possible reason for not including them in the cost of goods sold is that jamming them into the cost of goods sold lowers the reported gross margin. If you happen to be a public company, then this could be a problem, because your reported gross margin would then be lower than what everyone else in the industry is reporting.

To muddy the waters even further, consider this scenario. During the pandemic, a lot of tenants couldn’t pay their rent, so they struck deals with their landlords to pay them a portion of their revenues instead of the usual fixed rent payments. Should these payments be included in the cost of goods sold? Variable rent payments are a direct cost of sales – but they have nothing whatever to do with the cost of the goods that are being sold. So, no – variable lease payments are an administrative expense.

So, my possible first rule of what to include in the cost of goods sold doesn’t seem to work that well. Let’s try a second rule, which is to base the decision on the name of the line item in the income statement – the cost of the goods that are sold.

This sounds a bit more traditional. Under this logic, we can include the cost of direct labor, and direct materials, and factory overhead – pretty much what you’d normally see in any income statement. This sounds great – for a manufacturing company, where tangible goods are being sold. Lots of companies don’t do business that way, which makes the situation more difficult.

For example, let’s go back to the original question posed by a listener, which was – what goes into the cost of goods sold for a software as a service company? In this case, subscribers are accessing the provider’s software online in exchange for a monthly subscription fee. What is the cost of goods sold?

Well, the service being provided is the software and database combination that customers use. This certainly means that the computer system hosting cost falls within the cost of goods sold. On top of that, the cost of the people who keep the hosting environment running should be included. Also, if you’re paying royalties for the software being offered to customers, then that would be a cost of goods sold. And for that matter, if the company is helping its customers with implementation – to start using the service – then that could be considered a cost of goods sold.

So as you can see, the presentation decision varies enormously, depending on your industry.

At this point, I’ll offer a third rule for how to clarify the situation, which is rather than assuming that everything belongs within the cost of goods sold, do the reverse and assume that it belongs elsewhere else, and review the pros and cons. It might result in a change in classification.

Fourth rule. Look at accepted industry practice. You can hardly go wrong with the auditors if everyone else is already doing it. And, of course – fifth rule – just ask the auditors. They will probably be quite definitive about the key components of the cost of goods sold, but might leave some gray areas around the edges, where you can either include some expenses, or not.

A final thought is that, whatever you decide to do, stick with it for a long time. If you keep moving items in and out of the cost of goods sold, then it’s too difficult to figure out a trend line of the gross margin percentage. And management needs that number to run the business.

Related Courses

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Open Book Management (#322)

The topic of this episode is open book management. The general concept is to formally share your financial information with employees on a regular basis. Ideally, you’d provide training to employees about what all the numbers mean, and then do a presentation each month to talk about the company’s results, so they can ask questions.

Advantages of Open Book Management

The main reason for doing so is to get employees more directly involved in running the business. The thinking goes that if everyone understands the situation, they’ll be more likely to pitch in. This means contributing more ideas about how to improve operations.

 It might work especially well in start-up companies or in businesses that are in trouble, since everyone would know how dire the situation is, and be more likely to help. And it could be useful when employee pay is linked to the performance of the business, as would be the case with profit sharing.

Disadvantages of Open Book Management

 Based on that logic, you’d think everyone would use open book management. But it’s not used much at all. In fact, I’ve proposed it to every CEO I ever worked for, and got laughed out of the room every time. Their viewpoint is a bit different.

 There are a couple of arguments against it. First, if the company is losing money or its sales are going down and employees know this, then they might be more likely to leave. Whereas, if you didn’t tell them about the financial situation, they’d be more likely to stay.

 Another reason is that employees would be more likely to demand pay increases if the company was wildly profitable. I suppose there might be some validity to this, though I’ve run through the financials of hundreds of companies, and I can’t think of any that were doing that well. Most organizations are just scraping by or making modest profits.

 A continuation of that logic is that, if management doesn’t increase employee pay, then their reaction will be to work less, since they’ll feel they’re being undervalued by management.

 And another argument against open book management is that, once you start providing financial information to employees, it’s pretty hard to turn off the information flow. If you do, then employees will think that you’re hiding something.

 In essence, if you’re an optimist who believes in the better side of human nature, then you might be more inclined to try open book management. If you’re the reverse, then only threat of certain death will convince you to do this. In my experience, most senior managers are in the second camp. No amount of arguing will convince them that this is a good idea.

 And we’re not done yet, because you also need to consider the reaction of investors to this approach. Their main concern is how it will impact their return on investment. Again, it depends on their mindset about its impact. Having dealt with a lot of investors over the years, I think they’d only approve of the idea if you could prove a positive outcome in advance, which is pretty hard to do.

How to Implement Open Book Management

 So, a few suggestions. If you’re going to try open book management, start off at an extremely high level. That means just the sales numbers for the quarterly financial statements. You could get into all aspects of sales, so that employees understand things like the seasonality of the business, and which regions generate the most sales, and which products sell the best. At this level of information, employees are not being told about profits, so they can’t draw any conclusions about how their compensation fits into the financial situation of the company.

 Run the project at this level for quite a while – maybe a year – and see if it results in any additional employee engagement, such as more improvement ideas. If there’s a way to quantify it, then do so. If the results are good, then move down the income statement a little more, to include the cost of goods sold and the gross margin.

 At this level of information sharing, employees learn about what products cost and how much the company makes from each individual product sale. You could even get into details like the impact of volume purchasing discounts on raw material costs, and how much product returns cost the company.

 Again, if the results are positive, then consider moving down the income statement again, and talking about operating expenses and profits. This is a more incremental approach, which makes it easier to stop at any point.

 Also, by discussing information just once a quarter, you’re not getting employees overly accustomed to these discussions. That means you could pull out of the whole arrangement if there’s not enough support from senior management, and the employees may not notice.

Responsibility Accounting

 Another option is to use responsibility accounting instead. This involves only reporting financial information to employees for their areas of responsibility. For example, you’d send maintenance expense information to the maintenance manager, and sales data for the western sales region to the sales manager for that region. The presentation format is usually accompanied by their budget information, so they can see budget versus actual information.

 I’ve done this in every company I’ve worked for, and it always had total senior management support. The difference here is that information is specifically being provided so that you can hold people accountable for their areas of responsibility. People are expected to take action to fix whatever problems appear in those reports. Senior managers understand this.

 Compare it to the reasoning behind open book management, which is that employees might be more supportive if they know more about the company’s financial situation. The argument supporting it is inherently weaker. In short, I certainly recommend responsibility accounting, and suggest that you roll out open book management with just sales information to start with, to see how it goes. Then proceed based on what happens.

Accounts Receivable Financing (#321)

What is Accounts Receivable Financing?

The topic of this episode is to describe how accounts receivable financing works. Under receivables financing, a business uses its accounts receivable as collateral for a short-term loan. The loan has to be short-term, because the duration of the loan needs to match the underlying collateral, which is the accounts receivable. A business can essentially extend the term of the loan by constantly creating a new set of accounts receivable that then becomes the collateral on the loan as the earlier receivables are paid by customers. So, as long as the company can sustain the amount of receivables outstanding, it can keep borrowing about the same amount of money from the lender.

 A business uses accounts receivable financing when it needs cash sooner than the receivable payment terms. For example, if you need cash in five days, but the invoice payment terms are 30 days, then you have a problem. In this case, the loan from accounts receivable financing is intended to essentially accelerate the receipt of cash from the receivables.

Understanding Accounts Receivable Financing

 There are two ways in which accounts receivable financing can be set up. Under the first approach, the lender advances a percentage of the receivables balance to the borrower, and commits to collect the receivables. The lender monitors all receivables due from customers, and has payments sent to the lender’s designated location, which is usually a bank lock box.

 The amount loaned will be less than the amount of the receivables being used as collateral, possibly as much as 90% of their face value. When customers send their payments to the lender, it extracts the amount of its loan and any associated fees and interest charges, and then forwards the residual amount to the borrower.

 Since the lender is involved in collection activities, it may cherry pick which customer invoices it will include in the borrowing arrangement. That means it only takes invoices issued to the highest-quality customers, and probably only for larger amounts. This makes it more efficient for the lender to collect the invoices.

  Under this approach, it’s in the best interests of the lender to have customers send all accounts receivable payments directly to it, bypassing the borrower, so that it can be assured of being paid. This is not a small issue, since companies using receivables financing may be having financial problems, and could go under. If they do go bankrupt, the lender still has the accounts receivable as collateral, but it may take quite a while to extract its money from the bankrupt business.

 The problem for the borrower is that having customers send their payments to a new address gives customers the impression that the business is on a shaky financing footing – which might very well be the case – so they may be inclined to buy from someone else in the future. So in short, there’s an inherent tension between the lender and borrower about where the customer payments should go.

 The second approach to receivables financing is for the receivables to essentially be used as collateral on a cash advance from the lender, but where the borrower maintains control over the receivables and collects from customers. This approach is least visible to customers, so it favors the borrower.

The Cost of Accounts Receivable Financing

 There’s obviously a lot of paperwork associated with receivables financing, so lenders charge a pretty high interest rate. In addition, they charge an upfront fee to reimburse their underwriting and origination expenses. This fee can increase in size if the arrangement is a large or complex one. And on top of that, the borrower has to pay a processing fee every time a customer pays an invoice, which might be calculated as a percentage of the face amount of the invoice. Individual lenders have different rate structures, usually because they’re trying to attract different types of customers. So, it makes sense to shop around.

 All in all, this one of the more expensive financing options. Lenders claim that this is because the cost of administering these loans is unusually high, but I don’t buy it. If you check the cost per click for a Google ad for “accounts receivable financing,” it’s $70 – per click. The cost per click for “receivable financing” is $75. And the cost per click for “receivable factoring” is $80. When lenders are willing to pay that much for one lousy click on one of their ads, that tells me that plenty of profits are being made.

 So, why on earth would anyone pay these fees? Because they have nowhere else to go. Businesses that use receivable financing have been turned down by traditional lenders, probably because they’re not profitable or they don’t have any other collateral, or the founders don’t want to back up a loan with a personal guarantee.

 Because of the high fees, it makes no sense to use this type of financing if your margins are already low – the fees will just eat up your profits, and then you’ll go out of business.

When to Use Accounts Receivable Financing

That being said, there are a couple of situations in which it makes sense to use it. The first case is when a business has very little cash but is growing fast. It needs to finance an expanding amount of receivables, but doesn’t have the cash to pay for the underlying inventory. In this situation, use receivables financing as long as sales are going up fast, and stop using it as soon as sales level out.

 The other situation where it can make sense is when the company’s invoice terms are really long. This usually happens when a small company is forced by a large customer, such as a retail chain, to accept long payment terms, like 90 days. In this case, the business uses the receivables as collateral to get an immediate cash loan from the lender.

 There are a couple of lesser advantages to receivables financing. One is that you can qualify for financing a lot quicker than a typical bank loan, so if you need cash now, this is a good way to go. The other reason is that, if the lender is taking on the task of collecting receivables, the borrower can cut back on its own collection activities.

How to Apply for Accounts Receivable Financing

 So, let’s say you want to proceed with a receivables financing arrangement. The first step is to create a cash forecast for the next few months, to estimate the size of your shortfall. Next, review your list of outstanding invoices, and strip out any for which the probability of collection is low. The remaining invoices will be reviewed by the lenders. Then, assemble the company’s most recent bank statements and tax returns, as well as its business license, because the lenders will want to review this information as part of their credit analysis. After that, it will take a couple of weeks for them to review the information and decide whether to enter into a lending arrangement. Once approved, funding can be arranged within a few days.

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Consulting After the Pandemic (#320)

This episode discusses how consulting has changed after the pandemic. In other words, after the pandemic, do you really have to go back on the road to be a consultant? It depends on the situation. It will probably require somewhat less travel, but generally speaking, consultants need to be on the road. There are some good reasons for this.

Let’s start with consulting partners. They need to be on the road. Period. The number one responsibility of a consulting partner is to drum up more business, because – unlike auditing – consulting projects are not recurring. Once a project is completed, it’s not coming back. This means that partners have to be constantly networking, which means meeting with people. In person. And on top of that, someone who is about to spend millions on a consulting project is more likely to award the job to someone that he has a personal connection with, which – again – supports the need for partners to be on the road, meeting people. All the time.

The need to be on the road also depends on the type of project. For example, if you’re dealing with a technical issue, such as installing software for a client, that doesn’t necessarily require a lot of direct interaction with the client. It still requires some interaction, such as when you need to talk to them about how they want to configure the software. So in this case, you might be able to do the bulk of the work remotely, just using Zoom or Skype calls. Though, realistically, some time will still be needed on site.

And then we have change management projects. Consultants get called in a lot to work client employees through all sorts of transitions. For example, consultants might be brought in to overhaul a process, which means interviewing people to see how the current system works, and then going through brainstorming sessions to find a better way, and then implementing the new system. Or, a client might be conducting a large layoff, and needs consultants on-site to figure out how to reallocate the work among the people who are left.

In these cases, the work needs to be entirely in front of client employees, every day. I don’t really see how much of this work can be shifted off-site.

And then we have benchmarking and best practices consulting. These projects are focused on making client operations better. They involve going on site and measuring how well a targeted operation works, and then comparing it to performance benchmarks from some other best-in-class company. In this case, the work is intensively hands-on. Opportunities for off-site consulting would be few and far between.

There’s also controls consulting. This involves going through processes in detail, figuring out where controls are installed, how well those controls are working, and whether more controls should be added. This work can only be done on site. There’s just no way to see if a control is working properly when you’re parked on the other end of a Zoom call.

The impression I’m trying to convey here is that consulting is intended to be on-site. Yes, there are some limited technical situations where you might be able to do some work from home, but for most consultants, it means travelling to the client to help them at their location.

Realistically, the only consulting positions that will be able to mostly avoid travel will be low-level staff positions that are highly technical. This is really a support role, so if you want to advance into a managerial position, then expect to be sitting on airplanes and sleeping in hotel rooms – a lot. I really don’t see the pandemic changing the situation. This is just the nature of consulting.

Bank Feeds (#319)

Bank Feeds in Accounting Systems

Some accounting software packages allow you to download transactions from your bank directly into your accounting system, so you don’t have to record them manually. Or, if you’re using Paypal or Stripe to process payments, they can be accessed for a bank feed. For example, Quickbooks has a bank feeds feature that pulls in these types of transactions.

Advantages of Bank Feeds

There are some advantages to doing this. First, it’s really convenient. Once you’ve got it set up, it’s quite easy to import the transactions. Depending on the software, you may not have to manually log in to the bank’s system. Again, depending on the software, the bank transactions are imported into a holding account, where you can review them and decide whether to grant permission to import them. If you have a lot of bank transactions, then this can be a decent time saver. That’s the good news.

Disadvantages of Bank Feeds

There are also some downsides. The main issue relates to transactions for receivables and payables. In both cases, don’t accept whatever suggestion the software makes for how to apply it. Instead, manually apply incoming cash payments to specific open invoices, and manually apply outgoing cash payments to accounts payable. Otherwise, you can get some really screwy transactions in the system that you might have to track down and fix months later.

Also, in general, it’s too easy to skim through the suggested transactions recommended by the system, press the accept button, and then realize that some of the recommendations weren’t exactly what you wanted. And then you have to go into the system, find them, and fix them. Which takes way more time to fix than the time savings you generated from setting up the bank feed in the first place.

The real worst case occurs when you don’t spot an incorrectly recorded bank transaction, and the auditors find it at year-end instead. This can be quite a shock if you’ve created the year-end financial statements and think you have a good case for a certain profit number, and are then embarrassed when the auditors spot your mistake.

When to Use a Bank Feed

So, there are the pros and cons. My suggestion is, if you only have one bank account and not many transactions are running through it, then the efficiency gain from a bank feed is pretty minimal. In that case, just stick with manual entries. On the other hand, if you have to record a lot of bank transactions on a recurring basis, then it makes more sense to set up a bank feed. If you choose to do so, then conduct a 100%, very detailed review of all proposed transactions for the first few months, just to make sure that the system is working properly. Then switch over to a scheduled spot check every few months to see if the transactions are still being recorded correctly. If you spot anything wrong, then immediately schedule a detailed analysis to figure out what happened, and make corrections as needed.

And on top of those reviews, conduct a leisurely examination of all transactions proposed by the accounting system for bank feeds. And to keep people from reviewing them too fast and making mistakes, include bank feed accuracy in the performance criteria for whoever is put in charge of it. And one more thought is to put a senior accountant in charge of this who has a solid understanding of the transactions running through the bank feed.

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New Controller Tasks (#318)

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

The Need for Cash Forecasting

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

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

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

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

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

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

Set Up a Measurement Tracking System

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

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

Investigate the Accounting Department

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

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

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

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

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

Review Reports

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

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

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

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

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Accounting for Crypto Mining (#317)

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

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

Accounting for Crypto Mining Costs

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

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

Accounting for Crypto Mining Currency

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

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

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

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

Application of Section 179 to Crypto Mining

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

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The Paperless Accounting Office (#316)

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

Benefits of a Paperless Office

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

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

Paperless Office Enhancements

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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The Financial Reporting Manager (#315)

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

The Financial Reporting Manager in a Public Company

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

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

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

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

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

The Financial Reporting Manager in a Private Company

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

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

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

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

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

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

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

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

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

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

The Payables Address (#314)

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

Overview of the Payables Email Address

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

Implementing a Payables Email Address

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

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

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

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

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

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

Direct Invoice Entry

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

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Payables Management

The Negative Impact of Policies (#313)

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

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

Examples of Excessive Policy Usage

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

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

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

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

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

When to Create a Policy

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

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

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Making Accounting Decisions (#312)

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

How to Resolve Operational Challenges

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

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

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

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

Example of Decision-Making

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

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

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

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

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

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

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

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

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

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

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

Managing Controls

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

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

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

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

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

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

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

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How to Check for Accounting Mistakes (#311)

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

Step 1: Idiot Proof Accounting Positions

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

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

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

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

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

Step 2: Train the Staff

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

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

Step 3: Find Errors with Audits

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

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

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

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

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

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Performance Targets for Accountants (#310)

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

The Need for Quantity and Quality Targets

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

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

Performance Targets for Clerks

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

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

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

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

Performance Targets for Skilled Positions

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

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

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

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

Performance Targets for Intermediate Positions

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

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

Summary

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

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Public Utility Accounting (#309)

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

What is a Public Utility?

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

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

How to Classify Public Utility Accounting Transactions

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

Public Utility Rate Structures

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

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

The Uniform System of Accounts

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

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

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

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

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

Public Utility Work Orders

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

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

Retirement Units

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

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

Asset Retirement Obligations

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

Bond Transactions

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

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

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Public Utility Accounting