Enrolled Agents (#348)

What is an Enrolled Agent?

What is an enrolled agent? This is a tax expert. The concept goes back quite a ways, to 1884, when Congress got annoyed at lots of claims related to Civil War losses, and decided to regulate the people who represent citizens dealing with the U.S. Treasury Department. After the Civil War, people were making many claims to the Treasury Department for reimbursement for their losses, which included more horses than were actually killed during the war. And strangely enough, most of those claims were for thoroughbred race horses and show horses.

So, Congress realized that it wasn’t your average citizens who were making these claims, because the claims were too consistent. Instead, it was the people representing them, who then took a percentage of whatever the government paid out. The resulting regulation of tax representatives was called the Horse Act of 1884, and it covered moral character, criminal record checks and testing. And that was when the “enrolled agent” term was first used.

But the story gets better. In 2013, a libertarian group sued the federal government, stating that it had no authority to regulate tax return preparers. At an appellate court hearing on the lawsuit, Justice Department Tax Division lawyer Gilbert Rothenberg said, “I hate to beat a dead horse,” but the Horse Act of 1884 provides the government with ample authority to regulate tax return preparers.

Enrolled Agent Requirements

An enrolled agent is someone who’s passed a fairly long three-part IRS test that covers individual and business tax returns. And when I say fairly long, I’m talking about a total of ten and a half hours of testing. Which is not minor. Or, you could qualify by having experience as a former IRS employee. If you have worked for the IRS, then your experience has to include at least five years in a specific role, which includes appeals officer, special agent, revenue officer, revenue agent, tax specialist, tax law specialist, or settlement officer. I’ll bet you didn’t even know all those job titles existed.

And on top of that, you have to go through a suitability check, which includes a criminal background check and a review to see if you’ve filed your own tax returns correctly.

But, on the other hand, there’s no specific education requirement, so you don’t need to have a specialized degree, such as a master’s in taxation.

And if you get the certification, then you have to keep it up with an ongoing continuing professional education requirement of 72 hours of training every three years, and you also have to follow a code of ethics – which includes taking an ethics course.

Enrolled Agent Responsibilities

So, what’s the benefit of doing all this work? Well, you can represent taxpayers before the IRS on any types of tax issues, such as preparing tax returns, collections, audits, and appeals. And, you can do it before any IRS office. Which means that you could initially pick up the certification while living in Texas, and still have it be valid if you move to Minnesota and want to represent clients there. That differs from the situation for a CPA, where licensing is at the state level. For an enrolled agent, licensing is at the federal level; there is no state-level licensing.

There’s also a limited client privilege, which means that communications between the taxpayer and the enrolled agent are confidential, but only under certain conditions. The privilege applies when the taxpayer is being represented in cases involving audits and collection matters. It does not apply when the work involves the preparation and filing of a tax return. The privilege also does not apply to state-level tax matters.

Enrolled Agent Exclusivity

Which brings up the question of how exclusive it is to be an enrolled agent. There are about 54,000 practicing enrolled agents, versus about 665,000 CPAs. That’s about eight percent of the CPA total. Is it worthwhile? That depends on you. As is the case with a CPA, you’ll be successful if you can attract clients. If you’re good at this, then your odds of succeeding as an enrolled agent go up. But, as always, the certification only opens the door; you still have lots of work to do to succeed.

Enrolled Agent Earnings

That being said, how much does the average enrolled agent earn? According to ZipRecruiter, the average annual salary is $59,000, with the bulk of all enrolled agents earning between $45,000 and $69,000. But, if you’re really good, those in the 90th percentile earn in excess of $87,000. This is less than what a CPA earns, but keep in mind that a CPA has to complete all kinds of education and experience requirements before getting licensed, which takes years. So, all in all, the enrolled agent pay is not that bad.

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Chart of Accounts Special Transactions (#347)

Organization of the Chart of Accounts

How should you organize a chart of accounts to separate out non-recurring items and non-taxable items? In essence, how should you store all of those residual, non-conforming transactions in the general ledger? What we’re talking about here is the much less than one percent of total transactions that don’t readily fall into an existing, standard account.

For example, you might want to record a tax credit that’s only going to be recorded once, because it’s only allowed under a tax law that will last for just one year. Or, maybe the company has an extremely unusual one-time expense, like rebuilding after a plague of termites. Where do you record it? And the same goes for a very unusual one-time gain, maybe from an insurance claim when a falling satellite took out a production facility. Where do you record that?

Miscellaneous Accounts

There are some options. The simplest approach to very rare revenue and expense items are the good old miscellaneous revenue and miscellaneous expense accounts. This can be a good choice when you only have a few unusual transactions per year that don’t slot in anywhere else. The problem is that they can turn into a dumping ground, where too much gets stored, and then it can be difficult to find them again.

A better approach is to set up a cluster of these miscellaneous accounts, with each one targeted at something a bit different. For example, you could have a miscellaneous non-taxable revenue account, as well as a miscellaneous services revenue account, and maybe another one for miscellaneous revenue from reworked goods. The best way to figure it out is to go over what kinds of miscellaneous revenue transactions have occurred over the past couple of years, and set up appropriate accounts for them, in retrospect.

The same approach goes for expenses. Chances are, you’ll end up with a small cluster of highly targeted miscellaneous expense accounts, each of which stores a very specific kind of transaction.

This approach might seem excessively fussy, but it can be quite useful when you’re dealing with a rather large amount of these odd transactions. Obviously, if you’re not, then don’t bother with the extra accounts – you’re just bulking up the general ledger for no reason.

An adjacent issue is whether you’re specifically trying to store non-taxable items in certain accounts. If you are, then you can adjust the formatting of the financial statement report writer in your accounting software to create a special version of the income statement that only includes taxable items. This can be really useful, but keep in mind that you have to keep track of which accounts are being excluded from the income statement, because you might forget, and end up with some inaccurate profit and loss information.

A good way to remind yourself that an account is being excluded from the income statement is to say so right on the name of the account. For example, you could include the word “Excluded” or “Not Reported” in the name – maybe in caps – so it’s really obvious.

When to Hire a CFO (#346)

At what stage does a business need both a controller and a CFO, as opposed to just a controller? This is not a small issue, because chief financial officers are expensive, which keeps lots of smaller businesses from hiring one. Instead, they prefer to stick with just a controller for as long as they can.

The Hiring Continuum

A good way to look at the issue is to view this as a continuum, where you have a bookkeeper on one end and a CFO on the other. The continuum is mostly driven by the sales volume of the business. A small business starts with a bookkeeper, and as the business gets more complex, its owners find that they need a controller. That’s someone who can set up and run accounting systems. So the point at which you need a controller is when the level of system complexity gets beyond what your bookkeeper can handle. Maybe that’s at a couple of million dollars of sales. So, let’s say the business keeps getting bigger, but the underlying systems are pretty much adequate for what you need. In that case, only the transaction volume has changed. That means the controller might hire one or two assistant controllers, and keeps adding accounting clerks to handle the load. There isn’t really a need for a CFO.

So, what about a more advanced level of planning, like detailed budgeting, or cash flow forecasting? And, maybe there’s a need for capital budgeting, or some advanced tax planning. These are common requirements when a business gets a little bit bigger, maybe in the range of five or ten million in sales. Well, lots of controllers handle these activities. It’s something that could end up in the job description of a controller or a CFO.

Let’s keep moving along that continuum. At some point, the business will be large enough to have hired a few hundred employees, in which case there’s going to be a human resources department. If this department is just one person, then the function probably stays within the accounting department and reports to the controller. But if the department gets a little bigger, then there starts to be a question about whether this is beyond the scope of the controller’s job. So there’s one factor driving the hiring of a CFO.

Another department that might crop up when the company gets a bit bigger is a treasury function. It might start off with cash concentration and investing activities, and maybe it takes over bank relations – especially if the organization is now dealing with several banks.

The CFO routinely oversees the treasury function, while this is usually considered out-of-bounds for the controller.

And another function is risk management. Sure, the controller could manage the company’s insurance policies, but if it becomes critical to manage risks at a more detailed level, then you’re going to need a separate risk management department – which is something that the CFO oversees. Now, there is no risk management group in lots of industries. But some industries are inherently dangerous, like mining or oil and gas drilling, so for them, risk management is a big deal. And this falls outside of the controller’s traditional area of responsibility.

So you can see where further sales growth, or the type of industry, will result in more departments that a CFO should be managing.

The Need for a CFO on the Management Team

As the company gets bigger, its organizational structure starts to firm up. You’re going to see some formal vice president positions being set up, and maybe a chief operating officer. And these folks are going to be meeting as a management team. This presents a problem for the controller, who’s usually considered to be somewhat below the level of a vice president. Initially, the company president might try to get by with the controller on the management team, but the title is just too junior, so the controller is going to be on the losing side of a lot of arguments. This is a good reason to bring in a CFO, but by itself, it’s not enough to justify the cost.

The CFO and Funding

The area that usually triggers a CFO hiring, though, is when the business has grown to the point where it needs a lot of outside funding. A controller could handle the minor stuff, like a line of credit or a modest term loan, but setting up a bond arrangement or the sale of major amounts of stock is well beyond what a controller should handle. And if the owners want to do an initial public offering, then you can bet that investors are going to demand a CFO. In the public markets, not having a CFO means you’re just not organized in a professional manner.

But the interesting thing about funding is that even a very small business might need a lot of cash – in which case it needs a CFO right away, even if it has no sales at all. For example, consider a startup pharmaceuticals company. It has a promising drug, but it’s going to take years and hundreds of millions of dollars to get the drug approved. In this case, there is no controller-to-CFO continuum. Instead, having a CFO is an accepted part of the business. In short, if you need a lot of funding, then you need a CFO.

Look at it from the perspective of investors. If they’re going to invest a pile of cash with your company, they want a point of contact who understands how the company is doing, both operationally and financially. They want someone they can meet with to discuss the capitalization of the business, and dividend payments, and going public, and the cash forecast. None of these things are what a controller is good at. Instead, the controller needs to be operating in the background, running the accounting system, producing financial reports, and feeding information to the CFO, who’s better at representing the company with the investment community.

How to Make the Hiring Decision

So, what do we have here? Your hiring decision for a CFO could simply be that the company has reached a certain triggering sales level, but that’s not really good enough. The decision is more nuanced than that. Ideally, the CFO hiring comes after the company has added some departments that traditionally report to a CFO, not the controller. The hiring may need to take place when the controller is on the management team, but doesn’t have enough seniority to get support for his or her decisions. But the big one is that you need a CFO when there’s an ongoing need to obtain debt or equity for the business.

This is still not a black-and-white decision. Lots of businesses operate in a gray area where several of these conditions are present. If there’s no CFO yet, then the controller is stretched too thin, and is so swamped that work isn’t getting done. So a reasonable way to make the CFO hiring decision is to just watch your controller. If the person is competent, but completely buried with work, then make inquiries. Will hiring more accounting staff fix the problem, or are the underlying conditions the ones that I’ve already mentioned? If the latter is the case, then hire a CFO.

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The Different Types of Debt (#345)

The Line of Credit

The line of credit is the most essential form of debt for a business. It’s intended for the funding of cash shortfalls caused by periodic changes in your cash flows. So, a seasonal business might draw down cash from a line of credit in order to buy inventory for its peak selling season. Once the inventory has been sold, the company has the cash to pay off the line of credit. The intent here is to completely pay off the line of credit at least once a year, if not more frequently. If you can’t do that, then the lender has granted you too large a line of credit, and will probably scale back the amount to a figure that you can reasonably expect to pay off each year.

A line of credit is designed to be fairly low-risk for the lender, who takes the company’s accounts receivable as collateral, and maybe a bunch of other assets, too.

The Term Loan

Another type of debt is the term loan, which you’re supposed to gradually pay down over a number of years. This loan is designed to fund capital projects. It has a sufficiently long duration so that you can use the cash generated by the funded project to pay off the loan – so the loan duration could be anywhere from three to 10 years, and maybe longer. This arrangement is riskier for the lender, so expect it to charge a higher interest rate, and it might demand personal guarantees from the owners, too.

The Construction Loan

A more specialized loan is the construction loan. This is a short-term loan that’s used to pay for the cost of developing land and constructing buildings. The land and buildings are used as collateral for the loan. This loan is not usually paid out all at once. Instead, payments are made as needed through the construction process, so the cash is dribbled out only to meet immediate needs. Once the property has been completed, the property developer pays off the construction loan with the proceeds from a longer-term financing arrangement.

The Bridge Loan

Which brings us to the next loan, which is the bridge loan. This is a short-term debt that covers the time period between the conclusion of a prior loan and the commencement of another loan. So, the recipient is committing to obtain longer-term financing in the near future that will pay off the bridge loan.

This loan is pretty common when you’re trying to replace a construction loan with a long-term loan that you can pay down over a lot of years. The lender usually wants to use the underlying facilities as collateral, and will charge a pretty high interest rate on the loan.

Subordinated Debt

For a larger business, a good option is subordinated debt. This is a debt obligation that has a lower payment priority than more senior debt – which means that the claims of more senior debt holders must be paid off before the holders of subordinated debt can be paid. If you don’t have the cash to pay off your lenders, then those holding the subordinated debt will be at a greater risk of not being paid. Given the higher risk for these lenders, subordinated debt has a higher interest rate than more senior debt, which compensates them for the higher risk of default. This type of debt is preferred by larger corporations that are financially secure, since lenders are willing to grant them fairly low interest rates. On the other hand, a smaller business with questionable cash flows might not be able to take on any subordinated debt at all.

Convertible Debt

And then we have convertible debt. This is a loan that can be converted into the common stock of the issuer. In essence, it’s a loan with a built-in stock option. The conversion to stock only happens if the lender decides to do so, and it takes place at a predetermined conversion ratio, such as $10 of debt equals one share of common stock. Generally speaking, a business only agrees to convertible debt when it has no other options, because the lender could potentially take a large ownership stake in the business – which you may not want. The duration of convertible debt can be all over the place, and it may or may not involve collateral; that all depends on your level of desperation.

The Demand Loan

Another option is the demand loan. Under this arrangement, the lender can call the loan on short notice, like a few weeks from now. Because of the risk of having to pay back the loan really soon, this is a bad choice for anything but an extremely short-term cash need, such as having to cover a liability for a month or so. Beyond that, this loan is highly not recommended.

Mezzanine Financing

And finally, we have mezzanine financing. This is a form of funding that’s partway between debt and equity financing. So, it might be structured as a convertible loan, or maybe as preferred stock that earns a dividend. In essence, the lender wants to participate in the upside of the business, which means having some access to your equity. There can be all sorts of uses for this type of funding, such as a management buyout, or maybe to provide funding for more growth. You usually have to go to a lender that specializes in mezzanine financing, since traditional lenders don’t handle these arrangements.

So in short, it usually makes sense for a business to get a line of credit first, and then a term loan to finance specific capital projects. If the business grows into something significant, then a good option is subordinated debt. Beyond that, there are all sorts of specialized loan arrangements. It just depends on your specific financial situation.

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Regulation A+ (#344)

The Original Regulation A

Regulation A was completely changed several years ago, and is now referred to as Regulation A+. The original version of Regulation A was designed for companies that had been in business for a while, and which weren’t going to raise much money, with a cap of $5 million per year. They didn’t have to sell shares to accredited investors – which is essentially rich folks – and they didn’t have any ongoing reporting requirements to the Securities and Exchange Commission. And there weren’t any restrictions on the resale of these shares. So, in short, the original version reduced a lot of the bureaucracy associated with fund raising, and really opened up the potential pool of investors, but there was a hard cap on how much money you could raise. It was a mixed bag, so a lot of companies didn’t use it.

Tier 1 of Regulation A+

So, what has changed? A lot. Under the new Regulation A+, a company can issue shares under two tiers. The easier tier is Tier 1, where you can raise up to $20 million per year. Anybody can buy the shares, and the shares will be freely tradable. That’s the good side. On the down side, you’ll have to file some forms with the SEC. And, having dealt with the SEC, I can say that that is not a good thing. You’ll have to create an offering circular and have it reviewed by the SEC. That means you’ll have to hire an attorney to create the document, and this person is a specialist – so the bill will be in the tens of thousands of dollars. The requirements for it are stated on the SEC’s Form 1-A. The list of requirements for this form is 30 pages long, and the form states that it’s estimated to take more than 700 hours to complete. It’s essentially a stripped-down version of the prospectus that you’d issue for an initial public offering. So, pretty painful.

This document has to be submitted to the SEC, and after they review and approve it, you can sell shares. Keep in mind that the SEC might not approve it, in which case you could spend a few months going back and forth with them before they think the paperwork is acceptable.

Then you sell the shares to investors, and when you’re done, you file a Form 1-Z with the SEC. This documents the completion of the offering. And, in a first for the SEC, this form is really short – just two pages, and they estimate that it takes only one-and-a-half hours to complete.

Tier 2 of Regulation A+

And then we have the second option, which is Tier 2. Under this option, you can sell up to $75 million dollars of shares per year. And, the shares will be freely tradable – no restrictions. But there are issues, too. In this case, you’ll still have to file the offering circular with the SEC, and wait for its approval before you can sell any shares. Also, you’ll have to file a Form 1-K annual report with the SEC that includes audited financial statements, so – yes – you’ll have to have your financial statements audited, which increases the expense. The Form1-K is a bit of a pain, because you also have to include a discussion of financial results, and information about the business, and related-party transactions, and share ownership. Which is starting to sound a lot like the Form 10-K that public companies have to file with the SEC once a year. And on top of that, a Tier 2 company has to file a Form 1-SA semi-annual report that includes interim unaudited financial statements, and a discussion of the company’s financial results. And – not done yet – a Tier 2 company also has to file a Form 1-U within four business days of certain events, such as a bankruptcy, a change in the external auditor, or a change in control of the business.

And a further problem is that, under Tier 2, there’s an investment limit for non-accredited investors. Their investments are limited to no more than 10 percent of the greater of their annual income or net worth, with some variations.

If you’ve ever been involved in the reporting for a publicly-held company, you might wonder why they ever came up with the Tier 2 option, because it’s pretty close to the requirements for a regular public company. As I mentioned, the Form 1-K is an awful lot like the Form 10-K, while the Form 1-SA is really similar to the quarterly Form 10-Q that a public company has to issue. And the Form 1-U is really close to a public company’s Form 8-K. All of which I’ve had to file, and they’re a lot of work. So in short, it looks to me as though somebody at the SEC formed a committee to come up with a funding option that has fewer requirements than you need to go public, and ended up with a bastardized version that has most of the bureaucracy and a cap on your annual fund raising. Which doesn’t make a whole of sense. Especially since a Tier 2 company has to keep filing these extra reports, year after year.

A key feature of these stock sales is that shares are freely tradable. This might initially appear to be a really valuable feature for investors. However, because the shares are not being traded on a public exchange, it still may be difficult for them to sell their shares.

Who Can Use Regulation A+

So, who can use Regulation A+? That would be any non-public U.S. or Canadian companies, with a few exceptions, such as investment companies.

Now, who should use this funding option? I would say that the Tier 1 option is reasonably attractive, since there aren’t any ongoing annual reporting requirements, though the Form 1-A is still a pain to create. I would avoid Tier 2, since it would make more sense to just go public, in which case you wouldn’t have to deal with the $75 million annual cap on stock sales.

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Accounting for Music Distributors (#343)

Accounting for Providers of Background Music

What is the accounting for a company that provides background music to other businesses, such as retail stores? The first step is to collect the facts about the transaction. In this case, the company is providing background music, which means that a canned playlist is probably being provided, so there’s probably a fixed charge for the service for a specific period of time. There might also be a minimum contract period, like one year. In this case, you might bill the customer once a month, at the end of the period for which you provided services, and would then record the receivable as revenue right away, since it’s been earned at that point.

If there’s a minimum contract period, you would not record the revenue for the full period in advance. If you billed the full amount in advance, then you’d initially record the customer payment as a liability, since it hasn’t been earned yet. At the end of each month, you’d then recognize a portion of the liability as revenue. So, if the initial billing was for a year, then you’d recognize one-twelfth of the advance payment at the end of each month, until the full amount has been recognized as revenue by the end of the twelve-month period.

And of course, you’d also recognize an allowance for bad debts at the same time, to cover your best guess for the portion of total receivables that won’t be paid by customers.

Accounting for Users of Background Music

Now, let’s look at the situation from the perspective of the company that’s using the background music. They get billed once a month, and charge it straight to expense, since they’re consuming the service right away. Or, if they pay for multiple periods in advance, then they record the payment as a prepaid expense – which is an asset – and then charge off a portion of this prepayment in each month, over the usage period. Pretty basic stuff, really.

Accounting for Music Streaming Businesses

Now, let’s look at the situation from the perspective of a streaming business, like Spotify.

In this case, the company is paying a fraction of a cent every time a song is played, and the amount paid will probably vary, depending on the licensing agreement with each of the record labels.

So, the streaming service compiles the number of times that a song is played, multiplies this figure by the contractual usage rate, and pays the amount to the record label. There are two accounting problems here. The first is defining what constitutes a song that has actually been played. For example, if someone switches away from a song after 30 seconds, does this constitute a usage of the song for licensing payment purposes? So, the usage tracking database has to recognize when a minimum threshold of time has passed for a song, to decide whether a licensing fee should be paid.

The second issue is that there may be rate changes to the licensing fee, so someone has to make sure that the correct fee is being paid. This means having a solid process in place for updating the licensing fee system with the latest contract rate. And this may not be so simple. For example, a record label might charge a higher fee if a song has just been released, and then allows a lower rate after a year has passed. So the system has to accommodate that. I could certainly see the need for an internal audit staff to review the licensing fees being paid, to make sure that there aren’t any issues.

Accounting for Record Label Advances

That pretty much covers the question, but I’ll keep going and address a related issue, which is the accounting by a record label for any advances paid to an artist. There is an accounting standard for this. When the record label pays an advance, it records this amount as an asset, but only as long as the past performance and current popularity of the artist provides a reasonable basis for estimating whether the advance can be recovered from future royalties. When this is not possible, then the remaining amount of the advance is charged to expense. Or, if the popularity of an artist suddenly drops off a cliff, then that means future royalties will decline, which makes it more difficult to recover the advance from future royalties – which will result in a write-off of some part of the advance.

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Hidden Reserves (#342)

The Nature of a Hidden Reserve

What is a hidden reserve? It sounds kind of sneaky, like some sort of fraud scheme, but that’s usually not the case. A hidden reserve is present whenever assets are stated on the balance sheet at an amount that’s lower than their current market value. And the same thing goes for liabilities – there’s a hidden reserve when liabilities are stated on the balance sheet at an amount that’s higher than their actual value. This is fairly rare with short-term assets and liabilities, but it happens all the time with long-term ones. For example, you own some land and record it at the purchase price. Ten years later, someone wants to build a stadium next door, and presto, the land is worth multiples of what you paid for it – and that difference is a hidden reserve. Once you sell the land, then a profit is recognized, but the increase in value never appears on the balance sheet, because it’s not allowed under generally accepted accounting principles. Now, it is allowed as an option under international financial reporting standards, but even then, it’s just an option.

Let’s try another example. You’re supposed to depreciate an asset over its useful life, which means that at some point, the asset is recorded on your books at just its salvage value. Well, at that point its market value could very well be higher than the salvage value, and the difference is a hidden reserve.

There’s also a discretionary issue in that last example that can result in a hidden reserve. Let’s say that you assume the useful life of a fixed asset is ten years, but it’s really twenty years. If so, you’ve completely written off the value of the asset after ten years, but it still has some value for another ten years – and during that time, there’ll be a hidden reserve. So, sometimes using more conservative estimates for how assets are recorded can result in hidden reserves.

And for another example, internally generated intangible assets cannot be capitalized. So, if you spent a billion dollars on the research for an anti-gravity generator, the whole thing would have to be charged to expense as incurred, even though anti-gravity might have a lot of valuable applications. So when it comes to these kinds of assets, you could have a huge hidden reserve. In fact, because the accounting standards force a business to charge these expenditures straight to expense, they’re actually being forced to create hidden reserves. They don’t have any choice, because they can’t capitalize these expenditures into assets.

The concept also applies to liabilities, but it tends to be a lot smaller. For example, a nuclear power plant has recorded a massive asset retirement obligation for when it eventually shuts down, and has to dismantle the facility. After a few years, a new estimate says that the cost to dismantle has gone down. Until that new estimate is actually included in the retirement obligation, you’ve got another hidden reserve.

Or, as another example of a liability, you might build up a large reserve to pay for income taxes. But then the tax laws change, and you only owe half as much. The excess reserve is a hidden reserve, at least until you decide to reduce it.

Now keep in mind that a hidden reserve is just a theoretical value. No one has formally appraised it - the reserve just happened because market values diverged from book values. Also, keep in mind that hidden reserves eventually go away. For example, in regard to that piece of land that I was just talking about, the owner will eventually sell it, which generates a gain that now appears on the owner’s income statement as a profit. And in regard to the asset retirement obligation, the nuclear power plant is supposed to periodically adjust its recorded retirement obligation, so the difference only arises between adjustments.

The only case in which a hidden reserve does not go away is when the asset in question is never sold. So, for example, if a business owns a massive amount of land near a major city and chooses not to sell it off, then the land just keeps gaining in value as the city grows around it. But that’s rare. In most cases, the owners will realize that they can earn a pile of money by selling off the asset, so they do.

Hidden reserves can be interesting from the perspective of an acquirer. They’re always looking for target companies that have hidden reserves locked away, and which their managers may not even realize that they have. So, the acquirers spot these anomalies, buy the targets, and take advantage of the reserves.

Hidden Reserve Disclosures

So, what about disclosures? Are you supposed to report hidden reserves in the financial statement footnotes? Well, no. There’s no accounting standard that forces a business to continually re-appraise its long-term assets or long-term liabilities and report a hidden reserve. There is a requirement for the reverse, which is to test assets for impairment and write them down. But nothing in the opposite direction.

Hidden Reserve Examinations by Auditors

And for that matter, there’s no requirement for outside auditors to look for hidden reserves. And there’s a good reason for this. Accounting rules are based on being conservative, so auditors are always looking for assets that are over valued or liabilities that are undervalued – not the reverse. They simply have no incentive or requirement to look for these reserves.

Hidden Reserve Fraud

Now, having already stated that hidden reserves are not a fraud scheme, that can sometimes be the case. Some company owners want to reduce the amount of reported taxable income, so they can defer paying income taxes. An easy way to do this is to deliberately charge capital expenditures straight to expense. It might even look legitimate, if the company has an extremely high capitalization limit. So, for example, a formal cap limit of $100,000 might result in pretty much every expenditure being charged straight to expense, rather than being recognized as a fixed asset. Of course, when this is really blatant, the auditors are going to protest. But if there aren’t any auditors, a business owner might very well get away with it.

While this might sound like a dreadful breach of the law, it’s actually only a deferral of income tax payments; it’s not like they’re being avoided entirely.

So, in short, hidden reserves are really just a normal part of doing business. Most organizations will have some modest hidden reserves out there, while others might have massive ones. It just depends on how the market values and book values of its assets and liabilities differ over time.

Accounting for Life Insurance (#341)

What is the accounting for life insurance for owners and key personnel?

Types of Life Insurance

To begin, there are two main types of life insurance. One is term life insurance, and the other is permanent life insurance. Term life is purchased for a specific period of time, after which the policy expires with no residual benefit. If you keep taking out successive term life policies, the price will keep going up as you age, because your risk of death increases.

Permanent life insurance charges a steady rate over the life of the policy, which is supposed to cover the entire life of the person being covered. Insurers can charge the same rate over time, because they level out the fees; you’re basically paying more than the rate for a term life policy during the early years of the policy, and you’re paying less than that rate during later years. The other big feature of permanent life insurance is that it gradually builds up a residual cash value over time. Early on, this residual value is pretty small, but it can be substantial after a couple of decades.

So, why would a business take out life insurance on its owners or key personnel? Well, that’s because it might need the cash to keep operations running if one of these people dies. For example, if your top salesperson dies, sales might very well drop until you can find a replacement, which might take a long time.

If you’re going to take out a life insurance policy on one of these people, which policy type should you choose? Generally, that would be term life insurance, because you’re only expecting to need the policy for the next few years, while the person is still an employee.

However, the owner of the business might insist on a permanent life insurance arrangement, because he’s planning to stick around for the rest of his life. Or, the owner might make his own family the beneficiary of the policy, rather than the business.

Accounting for Life Insurance

So, how do we account for these variations? We’ll start with the easy one. Any premiums paid for a temporary life policy are charged to expense. Since the premium is usually paid just once, at the start of the coverage period, it’s initially recorded as a prepaid expense – which is actually an asset. Then, you charge off a sliver of it to expense in each month of the coverage period. By the time the coverage period is over, you’ll have charged the entire amount to expense.

So let’s move to a permanent life insurance policy, where the owner is the beneficiary. The organization is only allowed to record an asset when the asset provides it with a future benefit. Since both the death benefit and the residual cash value go to the owner, the company is not receiving any asset at all. This is really just a benefit expense for the company. That means you’d charge the payment to insurance expense, though a case could be made for charging it to benefits expense, instead.

Now, what about cases in which the business controls the life insurance asset and will be provided by it with a future economic benefit? The death benefit proceeds can be considered a future economic benefit, but there’s uncertainty about when the insured person will die, and whether the policy will remain in force. Given this uncertainty, it’s not possible to recognize the death benefit until it’s actually received, which could be years in the future. However, the cash surrender value of the policy provides a future economic benefit, since it’s the amount that can be realized if the policy is surrendered—and this amount can be calculated.

Therefore, the business records the initial cash surrender value of the policy, and then adjusts this recorded value over time, as the underlying cash surrender value also changes. The difference between the premiums paid during the reporting period and any increase in cash surrender value is recorded as insurance expense. Towards the end of the policy period, which may be years from now, the increase in cash surrender value could be greater than the amount of the premium paid, in which case the difference is reported as income.

Then, once the insured party dies, the company receives the policy payout from the insurer. The excess of this payout over the amount recorded as an asset is reported as income, while the life insurance asset is removed from the balance sheet.

For example, a company takes out a half million-dollar life insurance policy on its founder, where the initial annual payment is for $16,000. Of that amount, $6,000 is recorded as a cash surrender value asset, and the rest as insurance expense. Now, let’s roll forward a couple of decades, when the cash surrender value asset has increased to $150,000, at which point the founder dies, and the company receives the half million-dollar death benefit. In this case, the final entry is a half million-dollar debit to cash, a $150,000 credit to eliminate the cash surrender value asset, and a recorded gain of $350,000, which is a credit.

And that covers all of the variations on how a business accounts for life insurance.

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Transferring into the Treasury Department (#340)

Comparison of Accounting to Treasury

A lot of people think that accounting and treasury are adjacent fields. And, to some extent, that’s true. After all, people in these fields are deeply concerned with money. But there are significant differences. At least for a CPA, accounting is really about memorizing a lot of rules and figuring out their real-world application. Which sounds a lot closer to the legal profession than it does to treasury.

And for someone like a bookkeeper, the emphasis is more on process, so that you complete the same transaction the same way, every single time, with no mistakes. Which sounds a lot closer to the process engineering profession than it does to treasury. So in short, switching over to treasury could take you somewhat out of your comfort zone.

In treasury, the emphasis is on tracking cash going in and cash going out, and deciding how to manage it while you have the cash in-house. And you can throw in some fund raising and risk management, too. These are not traditional accounting activities, though you might see some of this going on in a smaller accounting department – and really just because the business is too small to afford a separate treasury function.

So, your first consideration is whether you think you can adapt to some job requirements that may vary quite a lot from what you were doing before. For example, consider a situation in which you’re hired into the treasury department, and all you’re doing is forecasting cash receipts for a bunch of retail stores. Is that what you want to do? Or, what if you’re given responsibility for hedging the company’s foreign exchange positions? Is that inside your comfort zone? Or, maybe the task is fund raising, and you’re sent out to do road shows along with the CFO and investor relations officer. Is that OK? I can’t answer any of these questions for you. You need to figure out your own comfort level. Just be aware that you can’t just switch over into treasury and think that you’ll be deep in your comfort zone. Because you might not be.

So, my tone just then was a bit cautious. Let’s look at this from a more optimistic viewpoint. If your target is to eventually become a CFO, then a tour through the treasury department is a good idea. After all, the CFO oversees the treasury department, so you’re going to need to know what it does.

The Treasury Tour

But, if that’s the case, your goal is to get an actual tour through the department, which means some sort of arrangement where you’re guaranteed a certain minimum amount of time in each treasury function, after which you move into the next slot in the department, and the next slot, and so on. You might be there for just a couple of years. The problem is that the treasurer isn’t going to agree to this arrangement, because from his or her perspective, it’s not efficient for you to keep moving around in the department. The treasurer just wants you to stay in one place and get good at one job.

So, how do you get one of these tours of duty? That’s by being recognized by senior management as an up-and-coming star, who needs to be moved through the organization to soak up as much experience as possible. If you’re not in that situation – and most of us are not – then you’re not going to get a tour of duty in treasury. Instead, if you switch into treasury, then the treasurer expects you to stay there for a number of years.

Reasons to Switch to Treasury

So, let’s assume that you want to switch into treasury and stay there. Why would you do that? A good reason is that you’ve topped out in the accounting department, and it doesn’t look like there are any more promotions coming. If so, why not try something new?

Another good reason is that the compensation levels in treasury can be higher than in accounting. That depends on a lot of things, like your geographic region, and whether you have the right skills, and whether there’s lots of demand and not much supply for the specific job you’re targeting. But if all of that aligns, then – yes – you can possibly make more money in treasury. If you’re driven by money, then that’s a good reason to switch over.

Now, here’s a reason not to. With very few exceptions, only larger organizations have treasury departments. So if you want to make a career out of treasury, just keep in mind that you’re now limiting your employer choices to pretty large businesses. Getting a treasury job in a small company just isn’t an option. That has a couple of ramifications. One is that there are simply fewer treasury jobs than there are accounting jobs. A lot fewer. So in a tight job market, you might have a really hard time finding employment. You might think that you can just switch back into accounting if you have to, but if you spend a bunch of years in treasury, then any employer will look at your resume and think that maybe your accounting skills are a bit dated.

Another issue is that these large companies are mostly located in large cities – which means that you’re going to have to move there. Are you comfortable doing that? If you like the rural lifestyle, treasury could be a difficult career choice. And this isn’t one of those professions where you can do it entirely from home. You’re actually going to have to go into the office from time to time.

So in short, switching into treasury is an interesting idea, but you need to think through all of the pluses and minuses before taking that step.

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Reconciling Customer Payments (#339)

The Cash Receipt Reconciliation Problem

The cash receipts clerk can have major problems reconciling the payments received from customers. This occurs when you receive a payment from a customer, but you don’t know how to apply it to your open invoices, because either there’s no accompanying detail, or the detail is wrong. For example, someone might be incorrectly paying an invoice for a second time, or maybe is not paying the sales tax portion of the invoice, or maybe has elected to only pay a small part of the invoice – this might happen when they’re protesting part of your billing, so they’re only paying for the part that they agree with. Or, they might have recorded the wrong invoice number in their system, so the reference number you’re seeing on the remittance advice doesn’t match anything in your system.

Cash Receipt Reconciliation Solutions

What can you do, other than open a bottle of scotch and ponder your career choices? The first action is to not make the situation any worse. This means not trying to force-allocate the payment onto particular invoices when you really have no idea what the customer was thinking. Instead, only allocate the cash to what you’re absolutely certain is the correct invoice. Then record the rest as an unallocated general receipt for that customer, and document what you’ve done.

The documentation should state the total amount of cash received, and which invoices you’ve allocated the cash to, as well as the amount of cash that hasn’t yet been allocated. And if the payment was made by check, go ahead and cash the check at the bank. Don’t let these issues get in the way of your cash flows. If you want to be careful, make a photocopy of the check before you cash it, and attach the copy to the rest of your documentation.

The next step is to contact the customer, and the sooner the better. These receivable allocation issues can really pile up over time, so it makes sense to get them cleared as fast as you can. So, this will be one of your higher-priority items.

It can sometimes be difficult to contact the accounts payable person on the customer’s side who sent you the payment. They’re busy, so they don’t always answer the phone.

You might want to do a runaround through your sales department, to see if the assigned salesperson can contact the person. Or, you can summarize the issue and send the payables person an email, and hope for the best. Another option, which may work a bit better, is to contact the customer’s controller; they tend to be a bit more responsive. Or, you could send an actual letter, that states the issue, and begs them to respond. Just making that initial contact can really be a tough one.

However you make the contact, walk the person through the issue, jointly figure out what happened, and then allocate the remaining cash to the correct outstanding invoices.

As you can see, this is a really time-consuming process. It’s not easy to completely fix the issue, unless you want to make everyone pay in advance, which isn’t usually possible. But there are some ways to reduce the issue.

Every time you talk to one of these payables people, try to figure out why the problem came up. For example, if the person had trouble figuring out where your invoice number was located on the invoice, it’s time to restructure the invoice. It needs to be at the top of the invoice, in large font, in bold, with a box around it. If you can install a blinking arrow on the invoice that points to the invoice number, then do that, too.

The same issue arises if you’re sending someone an electronic invoice. It still needs to be legible.

Here’s a second item. A few customers refuse to pay sales tax. They may claim that the tax doesn’t apply to them, that there’s some sort of exemption. That may be a valid claim, but if they don’t have an exemption certificate, you still have to charge them sales tax. If they continue to not pay the tax, then you have to decide whether you should be doing business with them, since somebody has to pay the tax, and if the customer isn’t doing it, then you are. Which cuts into your profits.

Here's a third item. The customer might be short paying you for some sort of problem with your products or services. OK, that happens. But, you’re the person applying cash to open receivables. You shouldn’t be the first person to be hearing about this. If the customer has a problem, there has to be a communication back to your customer service people, so that they can issue a credit memo to the customer.

This problem could be with the customer, who’s too screwed up to notify your company about the issue. Or, the problem could be with your customer service department, which isn’t issuing credit memos in a timely manner.

If the problem is with the customer, your sales department needs to talk to them about how to deal with these issues. And if the customer is too difficult deal with, it might be necessary to drop them. But, if your own customer service department is the issue, have your controller take the issue to senior management. See if they can resolve the problem.

In short, there’s usually a pattern to these botched customer payments. You can detect it by keeping a list of causes, based on your calls to customers. Some of the reasons are within the control of your company, so they can be fixed internally. And other reasons lie with customers. In the latter case, you may be able to work with customers to fix the issue. In a very few cases, customers may be so difficult that you can’t do business with them any longer. And unfortunately, in some cases the sales with a screwed-up customer are so profitable that upper management overrides everything and tells you to just put up with it. So, this is not always a resolvable issue, but it is possible to reduce it.

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The Role of a Bookkeeper in an Accounting Department (#338)

Where do the job duties of a bookkeeper end and the duties of a financial accountant begin? It’s unclear what duties would change if a bookkeeper becomes a staff accountant.

Position of the Bookkeeper in an Accounting Department

First, and just to be clear, a bookkeeper is not part of the normal hierarchy of an accounting department. Either you have a bookkeeper who mostly works alone or with the assistance of an outside CPA, or you have a controller running things, along with maybe an assistant controller and some accounting clerks. So, if you have a bookkeeper title being used within a larger accounting department, then you probably need to give a new title to the person being called the bookkeeper.

That being said, where does the person formerly known as the bookkeeper end up within a larger accounting department? Well, consider how an accounting department usually evolves. It begins with just the bookkeeper, who handles almost everything, and only handing off to an outside CPA for the more difficult activities. Once the company gets a bit larger, management brings in someone with more expertise to be the controller, which means that the bookkeeper is pushed down in the organizational structure. A good initial spot for the former bookkeeper is the assistant controller position, because at this point the bookkeeper has a broad knowledge of everything, and so can offer advice to the controller.

Whether the former bookkeeper can stay in that position as the company continues to expand depends entirely on whether he or she can adapt to the increasing complexity of the business. If not, it’s entirely possible that the former bookkeeper keeps getting pushed down within the structure of the department, and probably ends up specializing in one of the major sub-areas, like payroll, or customer billings, or accounts payable.

It's much less likely that this person ends up in one of the specialized positions, like general ledger clerk, or cost accountant, or public company reporting specialist. Those positions are more likely to have a bachelor’s degree in accounting and may also have a CPA certification, which is usually not the case for a bookkeeper.

Risk of Bookkeeper Departure

And unfortunately, there’s a pretty high risk that the former bookkeeper will leave the company, and possibly fairly soon after the controller is hired. The reason is obvious. Would you want to stick around if you’ve gone from running your own department to having reduced responsibilities?

Having the bookkeeper leave is usually not a good thing, at least for the next few years. The trouble is that the bookkeeper is the central repository of information about accounting transactions, and will remain that way for a while. So, it makes sense to coddle the former bookkeeper for multiple months and maybe a year, until it’s clear that enough knowledge has been transferred to other people within the department.

Summary

So, to go back to the original question, it’s hard to say exactly how the duties of a bookkeeper will change once the person becomes a staff accountant. A fairly weak bookkeeper will be pushed down within the department’s organizational structure pretty quickly, whereas someone with a significant amount of skill could very well become the assistant controller, and stay there. It all depends on the person’s experience, knowledge level, and willingness to adapt to the increasing complexity of the business.

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Form W-9 Best Practices (#337)

The Form W-9

The topic of this episode is best practices for the Form W-9. This is a form that the payer of funds is supposed to send to the receiver of funds, or the payee. The reason for the form is to collect the name and taxpayer identification number of the payee, as well as its form of organization, such as a C corporation or a partnership. After the end of the year, the payer then uses this information to compile a Form 1099, which goes to the IRS and the payee, and which states the total amount that the payer paid to the payee.

Another issue arising from the W-9 is that, in some cases, the payer has to withhold a percentage of the amount paid and send it to the IRS instead of the payee. Which is deeply annoying for all parties concerned. Except the IRS.

So, the W-9 can cause a lot of grief for the payer, because if the information on it is wrong, the IRS will eventually send it a notice, saying that the name and taxpayer identification number on its Form 1099 are incorrect. And this means that the payer needs to keep bugging the payee for more accurate information, in the form of what are called “B” notices. And if the payee doesn’t comply, then the payer needs to start withholding funds from any new payments to the payee. This is a lot of administrative grief that wastes the time of the accounting department. So, what are some best practices for keeping this data collection process as streamlined as possible?

Form W-9 Best Practices

The best option is to require a payee to hand over a completed W-9 up front, before the payer sends it any payment at all. This is the only point at which the payer has leverage over the payee, so it almost sounds like a hostage deal. You give me the completed form, and I give you the money. Lots of companies already do this.

But that is not good enough. The trouble is that the information on the form might be incorrect, in which case the payer is still going to be notified by the IRS of an incorrect 1099. The way to resolve this problem is to go to the IRS’ TIN matching program, which it offers free of charge on its website. Basically, you enter the name and taxpayer identification number into the IRS’s website, and it tells you if you’ve entered a valid match.

If it’s not a valid match, then go straight back to the payee and ask for another W-9 that contains the correct information.

These two steps need to be done up-front, before any payments are made. Otherwise, don’t expect a lot of cooperation from the payee.

A decent third option relates to how the information on the W-9 is laid out. Line 1 of the form contains the name shown on the payee’s income tax return. Line 2 contains a business name, or a doing-business-as name. You should always issue check payments to the name provided in Line 1, not the name in Line 2, since Line 1 is associated with the IRS TIN match, and Line 2 is not. So, if you never use the name in Line 2 in your accounting records, there won’t be a risk of issuing a Form 1099 to that name, and then having the IRS bounce it back at you.

Those are the three absolutely must-do best practices for the W-9. But there are other ones to consider. In particular, watch out for payees that are limited liability companies. If an LLC is a single-member LLC, then the IRS ignores it for federal tax purposes, and assumes that the owner is the actual entity being paid. So, when one of these W-9s comes in, be especially sure to do a TIN match.

And the next LLC problem is… LLCs that are treated as corporations. An LLC can indicate on the W-9 that it wants to be treated for tax purposes as a corporation. If so, that makes it exempt from backup withholding. The problem is, you can’t tell if the LLC has actually filed with the IRS for tax treatment as a corporation. And the only way to find out is to ask for a copy of their Form 8832, which is the Entity Classification Election. Only by getting a copy of that does the payer have proof that no backup withholding is actually required.

Next up is the individual taxpayer identification number, or ITIN. This number is issued to individuals who are required to have a U.S. taxpayer identification number but don’t have a social security number. Historically, there’s been a much higher probability that these numbers will not pass a TIN match, so always do the TIN match when you run across one. And in case you’re wondering how to spot one, an ITIN has nine numbers in the same format as a social security number, but it always begins with the number 9. Also, the fourth and fifth digits are always within the range of 70 through 88.

On top of that, issue a notice to all payees once a year, just to remind them to provide a replacement W-9 whenever their ownership or legal structure has changed. So for example, if a sole proprietorship has converted into a C corporation, this would be grounds for a new W-9.

There’s also a best practice that applies to the payee. If the information stated on a newly-revised W-9 differs from the one the payer already has on file, the payee should write the word NEW at the top of the replacement form. In caps, and maybe in red ink. Doing so increases the odds that the payer will review the form in detail for changes.

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Accounting for Truckers (#336)

Most of the accounting for a trucking operation is fairly standard, so I’ll skip that and just focus on the unusual parts. Of which the most unusual is the financing arrangements. It can take quite a while for a trucker to get paid – usually in the range of 30 to 90 days from the billing date. This is a big problem, because most trucking expenses, such as compensation and fuel, have to be paid within a week or two. This results in a massive working capital problem, for which the solution is freight factoring.

Freight Factoring

Factoring is the sale of your receivables in order to get immediate cash. There’s an entire industry of factoring companies that just service truckers, and what they offer is called freight factoring, and it allows truckers to get almost-immediate cash after they bill a client. In exchange for a factoring fee, of course. So, one accounting task is recording the sale of receivables.

Compensation

Another accounting issue is compensation. A trucking firm either pays contractors who use their own trucks, or it maintains its own staff of drivers, or it uses a mix of the two. This means the accountant has to record contractor billings and pay them through the accounts payable system, or track driver hours and pay them through the payroll system – depending on which type of driver arrangement they have. In the latter case, this also means that drivers may be on the road when you need to collect their hours worked information, so there needs to be a system for collecting the hours.

Fuel Cards

The next accounting issue is fuel cards. These cards are used to buy fuel at wholesale rates. They’re not really credit cards. Instead, fuel charges are compiled into an invoice, and payments are automatically deducted from the trucker’s bank account, usually once a week. So, the accountant needs to record the fuel invoice, and verify that the same amount is deducted from the company’s bank account.

Driving School Expenditures

Here's another issue, which is driving school expenditures. Some trucking firms offer to pay the fees for driving school for drivers who are just getting into the trucking business. So, do you charge these expenditures off to expense right away, or write them off over time? That depends on the arrangement with the drivers. If you can force a driver to pay back these fees if he leaves the company early, then you might have grounds for recording the fees as a prepaid expense, and then write off a portion of it each month.

Trucking Permits and Fees

And then we have permits and fees. Lots of permits and fees. The accountant needs to record the annual Department of Transportation fee, which is paid to the state government in which the trucker is located. And then there’s the international registration plan tag, which is a license plate that’s issued by the state’s Department of Transportation. This tag allows the firm’s trucks to operate across state lines. And on top of that, there’s the heavy highway vehicle use tax, which has to be paid to the federal government when you have a vehicle that weighs more than 55,000 pounds. That tax pays for highway infrastructure and road maintenance. But – not done yet – there are also oversize and overweight vehicle permits. All of these permits and fees can really add up, so you might consider recording them in separate accounts, to keep better track of where the money is going.

Driver Per Diem Payments

Another fairly common accounting issue is making per diem payments to drivers. This happens when drivers are expected to be on the road for an extended period of time, so the firm pays them a daily stipend that’s supposed to cover their meals and lodging. Of course, some of them sleep in the truck, if it has a sleeper compartment, in which case the per diem only covers meals.

Truck Depreciation

As you might expect, the trucking business involves very large investments in trucks, so the depreciation of fixed assets is a major issue. Depreciation calculations always include salvage value, since trucks are sold off after a certain amount of time. Depreciation expense is a large number on the income statement, so these calculations have to be right.

Insurance Expenses

And then there’s insurance. When your entire business involves driving large and heavy vehicles that can tip over and cause a lot of damage, of course there’s going to be insurance. There’s general liability insurance, and cargo insurance, and commercial property insurance. And other types of insurance riders, depending on just how hazardous the cargos are. For these reasons, the insurance expense in the trucking business tends to be a lot higher than in other industries.

Accounting Reports

Which brings me to the most important activity for the accountant, which is reporting. Trucking is a miserable business. Margins are low, and cash flows are worse. So, bankruptcy prevention is a pretty big deal. This means knowing the breakeven point of the business, so they can focus on keeping sales above that level. It also means tracking the cost of every job, to see if the business is generating a profit. This means tracking fuel, per diems, compensation, tolls, and parking charges for every single job. If you don’t do this, then management will not understand where profits and losses are coming from, and the business will probably fail.

This also means reporting on the cost of deadhead miles, which is the miles driven without a load. There’s no revenue associated with these miles, so it’s pure cost. The accountant is not responsible for reducing the number of these miles, but management needs to understand their cost, so routes can be restructured to reduce deadhead miles.

And there are lots of metrics to compile. The accountant can report on things like revenue per mile, cost per mile, and profit per mile. There’s also fuel cost per gallon, as well as days sales outstanding, which is driven by the quality of the company’s customers and how well the accountant is collecting overdue invoices.

In short, this is a tough industry, so the accountant has to focus on every possible reporting option that highlights where profits and losses are being generated. The general ledger has to be structured with the same goal in mind, so that information is summarized to support the reporting function. To be blunt, if the accountant does not provide good reporting, the company will not be around for long.

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A Return to the Formula 1 Accounting World Championships (#335)

Accounting Penalties in Formula 1

The topic of this episode is a return to the Formula 1 accounting world championships, which I talked about in June, in Episode 326. To refresh your memory, I talked about the new cost cap rules in Formula 1 racing, where if your team spent too much money, you could be penalized for it. So, it’s worth returning to the topic, because what I talked about back then has happened. The violating party was Red Bull Racing, which inaccurately excluded some expenditures from its cost cap. The total amount by which they exceeded the cost cap was 1.6 percent, or two and a quarter million dollars.

Under the rules, this is considered a minor overspend breach, for which the penalty should be fairly minor. However, the Cost Cap Administration Committee tagged them with a seven million dollar fine, and – probably more importantly – a reduction in the amount of wind tunnel testing they can do for the next 12 months.

I’m looking at the full report on the cost cap breach right now, and I would guess that the reason for getting whacked so hard is that this wasn’t just one case of not following the rules. It was actually thirteen cases, including things like not properly accounting for social security contributions, the accounting for bonuses, travel expenditures, and even how fixed assets are disposed of. So, it sounds like Red Bull had some significant accounting control issues throughout the organization.

Though, to be fair, I’m going to include some testimony from Red Bull’s team principal, Christian Horner. He held a press conference about this, and noted that Red Bull took some aggressive stances on which expenses should be included in the cost cap, and which ones should be excluded. And he may have a point, because there are some gray areas in the rules, and those rules are extensive. So, maybe we have some control issues, and maybe we have some management decision issues.

Wind Tunnel Testing

So, getting back to the wind tunnel testing. This is really important, because, on a per-lap basis, there isn’t really that much of a speed difference between the cars. If your car has a one-second advantage per lap, that’s enormous. In the front of the pack, a reasonable difference in lap times is more like one or two tenths of a second. So, the teams have got to put their cars into wind tunnels for hours and hours to test various configurations.

Back before Formula 1 decided to make things more competitive, the top couple of teams would spend tens of millions of dollars each year on wind tunnel testing, pretty much doing it around the clock. So, as the season progressed and they gained more experience with the cars, the best teams would keep making adjustments and eventually pull away from everyone else.

But under the new rules, the team that did the worst in the preceding year – which was Williams Racing – is now allowed the most time in the wind tunnel, while the winner – which was Red Bull Racing – is now allowed the least time in the wind tunnel. It’s sort of like the draft order in American football, where the worst team gets the top draft pick for the next season.

So, now that Red Bull has won the 2022 championship, not only does it get the least wind tunnel time for its next car, but it’s now being fined ten percent of the reduced time that it was already allocated.

There’s a bit more to it than that. The total wind tunnel allowance covers a period of 12 months, so Red Bull could – and probably will – front-end load its testing, to verify that its initial design works well by the first race of next season, which is in Bahrain on March fifth. And I wouldn’t be surprised if Red Bull starts off at the front of the pack. But where you’re likely to see degradation in performance is over the rest of the season, where Red Bull won’t be able to do as much testing as everyone else, so their modifications to the car won’t keep up.

This doesn’t mean that Red Bull won’t win the entire season, but it’s likely to be a much closer contest than it was in 2022.

So, to summarize, it appears that a lack of accounting controls within the Formula 1 teams might actually have an impact on the race results. Who ever expected that?

Valuing Intangible Assets (#334)

What is an Intangible Asset?

Intangible assets have no physical substance, so their value is derived from any associated legal rights. For example, the value of a broadcasting license is the legal right to keep anyone else from using the associated radio frequency. It should generate some sort of value for you, such as when the owner of a taxi license rents it out in order to generate an inflow of rental payments.

There are lots of examples of intangible assets, such as Internet domain names, copyrights, royalty agreements, trademarks, and mining rights.

Why Value an Intangible Asset?

There are several good reasons why you might want to place a value on an intangible asset. For example, you might want to account for an asset acquired in an acquisition, or maybe you want to know how much to sell it for, or maybe to set a transfer price when you want to shift it between subsidiaries. From the perspective of an accountant, the most likely reason for valuing an intangible asset is because you acquired it as part of a business combination.

How to Value an Intangible Asset

The accounting standards say that the asset should be recorded at its fair value. Fair value is defined as the estimated price at which an asset can be sold in an orderly transaction to a third party under current market conditions. An orderly transaction means that there’s no pressure to sell.

Well, that’s a nice accounting definition, but when it comes to intangible assets, a valuation can be pretty hard to do. So, within that concept of fair value, what are your options? There are three, and they are the market approach, the income approach, and the cost approach.

Under the market approach, you use the prices associated with actual market transactions for similar assets. Under the income approach, you derive a value from estimated future cash flows. And under the cost approach, you derive an estimate of the cost to replace the asset.

So, when would you pick one method over another? The market approach might be the best choice when there’s an active market for the sale of similar assets, such as the sale of franchises or perhaps broadcast licenses. It’s an especially good idea when there have been similar sales or licensing transactions recently, and especially when there have been a lot of them. With lots of this type of information on hand, it’s easier to defend any valuation you might derive.

On the other hand, the market approach is probably a bad idea when the other transactions in the marketplace are for assets that are quite a bit different from your intangible asset. In this case, you’d have to make such a large adjustment to the market data that your conclusion could be questioned. Or, the market data involves the sale of a bundle of assets, which makes it too difficult to tease out the value of just the one asset that you’re interested in.

The income approach might be a better option when the asset produces either operating income or licensing income. This would be a good choice for valuing franchise agreements, where there’s a clearly discernible cash flow associated with each one.

And then we have the cost approach, which is basically for everything else. It’s especially useful when you intend to keep using the asset, because if you didn’t have the asset already, you’d have to create a substitute for it or obtain the use of such an asset from someone else, probably in exchange for a royalty payment. On the other hand, the cost approach should not be used to value older intangible assets, since they might not have much of a useful life left.

In short, the valuation method chosen will depend on a lot of factors. For an especially valuable asset, you might need to use several methods, and then derive a midpoint valuation based on the results.

Now, how do they work? For the market approach, you have three options. First, you could search for information about the sales of similar assets outside the company, or the rates at which comparable assets are being licensed to third parties. You might be able to find this information in online databases, though you may have to pay an access fee. Another option is to run a comparison of the profit margins being earned by similar businesses that do and do not own a similar asset, where the difference is assumed to be profit generated by the asset.

That’s a tough one to justify, since there are lots of reasons for that profit differential – including the competence of management and the experience level of the work force. And finally, you could use the relief from royalty method, which is based on the royalty rate that the organization would otherwise have to pay a third party to use a similar asset. That last one is a distinct possibility, if there are licensing deals available. In short, the method used depends on the circumstances.

Moving along, how would the income approach work? That has three components. First, you need to estimate the income directly associated with the asset. For example, a patent could be used to generate a flat fee from a licensee, or a percentage of revenue, or maybe a profit split. Or, when it’s not possible to directly measure the income generated by an asset, you could compare the owner’s actual income to a benchmark measure, such as the industry’s average profitability level. Any income generated above that benchmark amount is assumed to be due to the asset.

There’s also a more complicated variation on the income approach, where you first identify all assets that contribute to the generation of income, such as working capital, real estate, and fixed assets. Then you assign a reasonable rate of return to each one. All income still left after these returns are subtracted out is assumed to be income associated with the intangible asset. This is obviously complicated, so it’s only used when there is no simpler method available.

On top of all that, the income approach also requires you to estimate the period of time over which the asset will generate income, since it usually has a limited usable life. To be conservative, you’d normally assume that this period of time is the shortest one over which income can be reasonably expected.

And finally, you’ll need to discount this stream of cash flows to a present value, which is forward-looking, and incorporates your risk of being able to achieve the expected income level. So if your future income estimates for an asset are pretty rough, then it would make sense to use a higher discount rate.

Which leaves us with how to derive a valuation using the cost approach. The typical assumption is that you’re deriving the replacement cost new, which is the cost that would be incurred to create an asset of the same utility level of the current asset, but by using the most modern approach to the work. Taking this approach tends to result in a somewhat lower cost. At a minimum, the costs to include would be all direct and indirect replacement costs. On top of that, you’d add on the developer’s profit, which is the return that the developer expects on funds invested in the development process. This might be calculated as a percentage mark-up, or as a percentage return on the direct and indirect costs.

Once you’ve compiled the asset’s presumed replacement cost, you’ll also need to subtract out a deduction for obsolescence, on the grounds that the asset being valued is usually not new; instead, it may be approaching the end of its useful life, which might call for quite a large obsolescence deduction. Another type of obsolescence to consider is external obsolescence, which is a decline in the value of an asset that’s caused by external events, such as the passage of a law that eliminates the use of taxi licenses in two years. If so, any taxi licenses you own will be completely obsolete as soon as that law goes into effect.

So, that was a lot to stuff into a single episode. The main takeaway is that you’ll need to adjust the valuation method chosen, based on the type of asset and the availability of valuation information. In some cases, this is a major chore, which is best left to a professional appraiser who will charge you a pile of money to prepare a thick report. I suggest that you only use an appraiser when the asset is quite valuable, or when the range of possible values is really broad. In short, when there’s a risk of really screwing up a valuation, dump the work onto a licensed professional.

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Intangible Asset Valuation

Accounting for Pass-Through Funds (#333)

The Nature of Pass-Through Funds

Pass-through funds occur when you’re expected to collect cash from a customer on behalf of a third party – usually a government – and pass along the cash to that third party. The usual example of this is sales taxes, where you’d collect the sales tax on behalf of the applicable government, and then remit the tax to them – usually once a month, but sometimes less frequently. In the listener’s case, the company collects vehicle licensing and registration fees from its customers and then passes them along to the Department of Motor Vehicles.

Accounting for Pass-Through Funds

It doesn’t really matter what the type of fee is, because the underlying accounting concepts don’t change. For example, if you’re collecting a vehicle licensing fee from a customer as part of a vehicle sale, then the sale is charged to a revenue account, while the licensing fee is charged to a liability account. We do this in order to keep the licensing fee from being recorded as revenue.

The listener goes on to ask if the licensing fee could be recorded within revenue and then subtracted out as a cost of goods sold. The answer is no, because you’d be artificially inflating the reported amount of revenue. Also, you’d be inflating the reported cost of goods sold. So, no – these pass-through funds should never appear on the income statement. Instead, they only appear in the liability section of the balance sheet as a short-term liability. When they’re remitted to the government – or some other entity – then the cash balance declines and the liability disappears from the balance sheet.

That’s the basic accounting. On top of that, consider setting up different liability accounts for these pass-throughs, one for each type of liability. For example, if you’re collecting vehicle licensing fees and registration fees on behalf of the Department of Motor Vehicles, you might have to report these amounts on different forms, and remit the funds to different government bank accounts.

Best Practices for Pass-Through Funds

That means using one account to store the licensing fees, and another account to store the registration fees. And on top of that, if your business remits these fees to the agencies of more than one state government, then you’ll need separate accounts for each one. For example, if you were remitting vehicle licensing fees and registration fees to the Department of Motor Vehicles for Washington, Oregon, and California, then you should have a total of six liability accounts in which to store these transactions.

Otherwise, you’ll have this hopelessly muddled single liability account that’s almost impossible to reconcile. And if that calls for a lot of pass-through liability accounts, then so be it.

Another issue is that, sometimes, the amount you collect from the customer will be different from the amount that the government is actually supposed to receive. If the amount collected is greater than the amount you have to remit to the government, then you do not – ever – recognize it as revenue. That money is not yours. Instead, the residual amount goes back to the customer.

What about the reverse case, where the amount you collect is too low? In that case, you’ll have to go back to the customer and try to collect the difference. If that’s too difficult, then your business will have to pay the difference. Governments will not accept a reduced amount, so you can’t just send them a reduced payment. If these shortfalls are minor, then it’s best to write them off as a cost of doing business, since it may be administratively more expensive to pursue the customer for payment. If these shortfalls are for large amounts, then you’d better look at your procedures and employee training, to see if there’re better ways to avoid incorrect customer billings.

Intercompany Eliminations (#332)

The Nature of Intercompany Eliminations

Intercompany eliminations occur when a business has subsidiaries that engage in activities with each other. For example, a manufacturing subsidiary sells some of its widgets to another subsidiary that specializes in selling them to outsiders. The manufacturing subsidiary records a sale and a profit on these transactions. If the buying subsidiary then sells the widgets to an outsider, then the consolidated financials for the combined business will record the sale twice – once for the internal sale and once for the external sale. Which is a great way to generate fake sales. Which is why we have intercompany eliminations. When producing consolidated financial statements for the entire business, including all subsidiaries, these intercompany transactions have to be backed out. In this example, you’d have to reverse the internal sale, including reversing the internal cost of goods sold, which in turn eliminates the internally-generated profit or loss.

When to Use Intercompany Eliminations

So, when do we have to do these intercompany eliminations? The basic rule is that you can only recognize sales or profits when the transaction is with a third party – so any transactions between subsidiaries that generate sales or profits have to be eliminated. Also, any intercompany transactions that move account balances around have to be eliminated. Which calls for an example. Let’s say that a corporate parent loans money to its subsidiaries, and charges them interest for the privilege. When the parent does this, it records interest income, while the subsidiaries record interest expense. This is a wash, since the recorded income and expense offset each other, resulting in no change in the overall profit or loss of the consolidated entity. However, it creates an interest income line item and an interest expense line where there weren’t any before – so these intercompany transactions also have to be eliminated. So those are the two rules of intercompany eliminations.

Examples of Intercompany Eliminations

So let’s apply some examples to these rules. First, what if the corporate parent employs most of the staff, and bills them out to the subsidiaries based on hours worked? This won’t impact reported profits, as long as no profit percentage is added to the intercompany billings, so rule one is not violated. Also, rule two is not violated, since the staffing expense is not being shifted among different financial statement line items – it’s still going to be reported as compensation expense on the consolidated financials. In short, no need for an intercompany elimination.

On the other hand, if the staff were billed out by the parent entity at a profit, then the profit would have to be backed out.

Here’s another example. What if the corporate parent’s overhead expenses are allocated to the subsidiaries? It doesn’t impact profits and it still appears in the same expense line item in the consolidated financials, so there’s no need to do any eliminations.

And one more example. A subsidiary sells some machinery to another subsidiary, and does so at a profit. This is not so good, because you can only recognize a profit if the equipment is sold to a third party. So, the gain on the sale will have to be eliminated. But we’re not done yet, because the purchasing subsidiary has acquired the machinery at a higher price, and so has to depreciate more expense per month than the selling entity was doing. This means that the incremental increase in recognized depreciation also has to be eliminated.

So as you can see, expense allocations across the various entities are generally going to be OK, while sale transactions or anything creating a gain or loss will require an elimination.

Intercompany Payables and Receivables

But no matter what type of transaction it might be, there’s another problem, which is the associated intercompany accounts receivable and accounts payable. For example, if an expense allocation is just handled as an intercompany journal entry, then there’s no receivable or payable on the books of anyone, and so there’s no need to deal with intercompany eliminations. However, if one entity bills another one for these charges and this billing is not paid at month-end, then this creates an account receivable on the books of the billing entity and an account payable on the books of the receiving entity – and those receivables and payables will appear on the consolidated balance sheet – which we don’t want.

What this means is that every unsettled intercompany receivable and payable on the books at the end of a reporting period has to be eliminated before you can create consolidated financial statements.

Now, all of this is quite annoying. It can be all too easy to miss some of these transactions on your books, which the auditors might find at year-end, and require an embarrassing adjusting entry to fix.

Intercompany Elimination Tracking

How can you make sure that all eliminating entries are made? The best approach is to operate the parent business and all of its subsidiaries on the same accounting database, so that every entity in the overall business is automatically flagged by the accounting software, which then takes care of the eliminations for you. If each business is instead operating its own accounting system, then you’re going to have to institute a manual month-end review of all transactions, to see if there are any intercompany transactions that need to be backed out. It’s an annoyance, but that’s what you get with a decentralized accounting system.

Technical Accounting (#331)

The Nature of Technical Accounting

What is technical accounting? A good way to look at this is to separate the general area of accounting expertise into two parts, where the base layer is basic bookkeeping, such as transactional activities like processing payables and payroll. Basically, the type of accounting knowledge that you can pick up from a principles of accounting textbook. Everything above that base layer is technical accounting, especially when you put in the effort to be a seriously high-end expert.

The concept usually applies to financial accounting, like knowing all the accounting standards – in detail – for things like derivatives, or leases, or pensions. But, it can also apply to a deep knowledge of the operational side of accounting, such as being an absolute expert in closing the books, or maintaining a really superlative inventory tracking system.

The concept of technical accounting is really important, even though you may never have heard the term before. It’s because this is where you add value to the organization – by being an expert. And by being an expert, you’ll be recognized for your work, and are more likely to be promoted, and just more visible than someone who doesn’t make the effort to elevate their skills.

You might think that being an expert in every possible area of technical accounting is the way to be recognized within the organization even more, but that’s not really the case. The trouble is that some of these areas can require enormous amounts of time to really learn in detail, so if you try to spread your time across multiple areas, you’ll never be an expert in any one of them.

How to Select a Technical Accounting Field

Which leads to the question of figuring out which technical accounting area you want to jump into. There are a couple of ways to look at it. One, and really the most important one, is simply whether you like the topic. If you really like accounting for derivatives, then great, go for it. If you’re like ninety-nine percent of all accountants and you’re repulsed by the idea of learning more about derivatives, then steer clear of it. Whatever you do is going to require a large time investment, so don’t spend a few thousand hours on a topic you don’t like.

This can be a problem for relatively junior-level auditors, because the audit managers and partners are always trying to force you into a certain audit area, like nonprofit auditing, so that you can be presented to clients as an expert in that area.

Well, that’s fine, but what if you don’t like the direction in which they’re pushing you? It’s best to figure that out early, and see if you can transfer to a different area.

Another view of the situation is looking at it strategically. Try to figure out what the organization really needs, and that will get you recognized, and pursue that area of expertise – as long as you like it.

For example, if your employer is an airline and it’s hedging its fuel costs, maybe you could consider learning all there is to know about the accounting for these types of hedging activities. Whereas learning about the accounting for payroll for that same airline might not get you as much recognition.

Technical Accounting Responsibilities

So if you’ve selected a technical accounting area, what does that mean? Well, if you’ve picked a financial accounting area, which is most common, then you’ll need to keep up-to-date on all new accounting standards pertaining to that topic, and know the existing standards in detail. Your knowledge should be at a level where everyone in the company comes to you for advice, and you might even be considered an expert within the industry. On top of that, you’ll be expected to represent the company’s position if the auditors bring up any issues related to your area of expertise.

On top of book learning, you’ll also be expected to prepare the policies and procedures for your area. And to train others in your area. And provide internal consulting advice. Furthermore, if the company is engaged in any accounting activities in your area that you think are a bit suspect, then you need to point out the problems and present solutions. And finally, if there’s any wiggle room in the accounting standards for how transactions should be treated, then you’re the one who’ll be expected to present the options and recommend which way to go. In short, you’re the expert.

System Conversions (#330)

How do you handle a complete system conversion? Switching to an entirely new accounting system is a massive undertaking, and people screw it up all the time. In fact, controllers lose their jobs over failed conversions.

Initial Considerations

So first, as a guiding principle, this is not an area where you want to be aggressive. You don’t just swap out the accounting software on short notice, because it seems like a good idea. Spend months thinking about, looking at the alternatives, and deciding whether you can keep going with the existing system instead of switching to a new one. Unless there’s a clear benefit to using a new system, you probably want to stick with the old one.

Clean Up Existing Processes

Next, clean up what you’ve already got. If you have complicated accounting processes, you’ll somehow have to switch them over to the new system, which could turn out to be a complete mess. This could be a major concern if you have to conduct custom programming while also installing new software. Instead, try to make your existing systems as simple as possible. That way, you can more easily adapt those systems to how a new accounting software package works. If you try to do the reverse and alter the new software to match your old systems, then the odds of failure just went up.

Select Software

Next up is deciding on which software package to buy. Entire books have been written about this topic, so I’ll focus on just a couple of items. First, never go with a new software provider. You do not want buggy software, because you could get fired if the system doesn’t work. Second, make a list of the functionality that you really, really need, and make your decision based on that. Most accounting software packages contain the same features as all the other ones, so the decision will be based on just a couple of factors.

This could make your decision a lot easier, especially if you’re in a specialized industry where there are only a couple of software packages designed for it. And finally, you’ve got to check references. Preferably, go and see an active software installation. Focus on how the system processes your most important transactions. Ask about the quality of support from the software company, and whether they have a process in place for requesting feature changes.

Convert to the New System

So now you’ve picked the software, you only have the minor task left of converting over to the new system. Chuckle. There are three ways to do it.

You could shut down the old system on one day and start up with the new one on the next day, also known as the cold turkey approach. Or, you could run the old system and the new system in parallel, until you’re sure that the new system works. Or – final choice – you could install one module at a time and construct a custom interface to make it work with the remaining modules in the old system. Then you gradually install new modules over an extended period of time, gradually shutting down the old system.

Remember what I said earlier, this is not an area where you want to be aggressive. So, just shutting down the old system and starting up the new one is generally not a good idea. The only case in which you could pull this off is when your accounting system is very, very simple, with a low volume of transactions, and you can afford to have systems nonoperational for a week or two while you figure out the problems with the new system.

But that’s not possible with a business of any size. In these cases, you really need to use some level of concurrent operations, where some aspects of the old system are still running while you’re getting the new system operating.

I think the best choice is to run the old system concurrently for a few months, while you install the new system. I know, it’s a lot of work – but by doing so, you have a great fallback in case the new system doesn’t work as you expect – and in some respects, it probably won’t. So assign some of your staff to just maintaining operations on the old system, while you run the same transactions through the new system, and test the output against the old system. Then shut down the old system when you’re good and ready.

Now, I also mentioned a third option, which was converting one accounting module at a time. This approach works best for really large companies that might have to switch over the software at multiple locations. In these cases, even a parallel operations approach isn’t really feasible, because it might take them two or three years to complete the conversion. For them, the only option is probably to conduct a very careful conversion, module by module. It’s slow, it's really expensive, and it’s safe. These organizations have to hire a large group of system conversion specialists that works separately from the in-house accounting staff.

When to Use Consultants

Now, a word on consultants. System conversions are all about reducing your risk, and consultants have a lot of knowledge about doing these conversions, so hiring them reduces your risk. They are also insanely expensive. Doesn’t matter. If you’re going to do a big system conversion, you will need consultants, so budget for it.

Also, consultants have their own methodologies for these conversions, which are incredibly detailed, and take a lot of time to complete – so whatever you budgeted for consulting, expect to add a zero to the price. I’m not kidding. This process is expensive.

Department Management

And a word on how to manage the department while a system conversion is going on. Shut down all other projects you might have until the conversion is complete. This is no time to get distracted by unrelated activities. Conversions are career threatening, so treat them like they are the only issue that matters. Because it’s true. You screw up a system conversion, and it’s quite possible that you’ll lose your job. So, focus the department’s attention 100% on converting to the new system. Nothing else matters.

Furthermore, tell the accounting staff in advance that overtime is a distinct possibility, and prohibit all vacations during the conversion period. You’re going to need maximum staff time to make the new system work.

And finally, block out lots of time in advance for the staff to be trained on the new system. This should be intensive, and done right before the conversion work starts. If you skimp on the training or schedule it too far in advance of the actual conversion, then no one’s going to have a clue what’s going on.

Buy a Big Upgrade

One more note on this topic. I’ve pointed out that system conversions are expensive, time consuming, and can get you fired if you screw up. Because of these issues, whenever you do a system conversion, buy into the biggest, most robust accounting system that you possibly can. That way, the company can grow for a long time without having to deal with another conversion. Ideally, acquire a system that can handle the company’s needs even if it’s a big publicly-held company. That way, you never have to worry about doing another conversion.

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The Fixed Asset Policy (#329)

The Nature of a Fixed Asset Policy

This episode covers the main contents for a fixed asset policy. First, what is a fixed asset policy, and why do we need it? It describes how you’re supposed to account for fixed assets. This isn’t minor, because without it, there’s a good chance that you’ll set up a different useful life, depreciation type, and salvage value for every asset you acquire, which can be quite a mess.

Fixed Asset Classifications

The first step in setting up a fixed asset policy is deciding upon how many classifications of fixed assets you’re going to use. For example, you could set up classifications for buildings, furniture and fixtures, vehicles, computer hardware, and production equipment. It all depends on the nature of the business.

The reason for doing this is to assign a standard useful life and depreciation method to each classification, which is then applied to each fixed asset within that classification. So for example, you might assign a seven-year useful life to the furniture and fixtures category, with straight-line depreciation, and no salvage values allowed. That last part is useful for some categories, because there’s rarely any salvage value associated with furniture.

Now, don’t go too deep with the classifications concept. Unless your business has thousands of assets, it doesn’t make a lot of sense to have dozens of classifications. Keep it relatively simple. Ten classifications or less might be fine, and if you go past twenty classifications, you should start to question what the extra level of detail is really achieving.

Then assign useful lives and depreciation methods to each of the classifications. The useful life figure can be calculated from an average of the company’s experience with its own assets. Again, don’t be too anal about it. If your research indicates that the useful life of computer hardware is 3.8 years, then round it up to four years. That’s good enough.

Depreciation Methods

As for depreciation methods, I personally prefer the straight-line method in all cases, because accelerated depreciation tends to skew a bunch of performance ratios, like return on assets. But that’s your call. Whatever method you decide to use, try to apply it consistently across all of the fixed asset classifications. You don’t have to, but consistency of application will make life easier, and you’ll make fewer mistakes when calculating depreciation.

Fixed Asset Salvage Values

As for salvage values, that will vary by individual asset. But I would suggest that you apply a flag to each of the classifications that either allows the application of salvage values, or it does not. By doing so, you don’t have to mess with trying to derive what are probably minor salvage values for most fixed assets. For example, building assets and equipment assets probably have significant salvage values, while furniture, computer hardware, and computer software probably don’t.

The Capitalization Threshold

That covers asset classifications. Next up, include a capitalization threshold in the policy. This is the dollar value for an asset purchase that represents the dividing line between charging the purchase directly to expense, or recording it as a fixed asset. This threshold is used to keep from wasting time recording minor items as fixed assets. For example, a wireless mouse for your computer will be used over several years, and so it could be classified as a fixed asset – but why bother when it only costs a few dollars?

The usual approach is to make a common-sense judgment about what types of purchases you want to keep track of over the long term. Also, if you do an historical analysis of how much various purchases cost, there’s usually a natural dividing line for what appears to constitute a fixed asset. The exact amount will vary by company. A really small firm might set the capitalization level as low as $1,000, while others might use $2,500 or $5,000. A really large firm might decide that $10,000 works for them.

A key point here is that the accounting standards do not state that you can use a capitalization limit. It’s simply allowed through common usage. Auditors will allow it, because charging something off to expense in the current period is always more conservative than capitalizing it and then charging it off through depreciation over a number of years. And auditors like conservative accounting.

Multiple Fixed Asset Purchases

A final item is what to do with lots of assets purchased on a single invoice. For example, you could buy a bunch of chairs that individually fall below the capitalization limit, but which exceed the limit when charged to the company as a group, on a single invoice. My view is that these items can be capitalized – but you can go either way with it. Just include it in the policy, and apply your decision consistently.

Fraudulent Financial Reporting

That covers the basics. Another issue to be aware of is that the fixed asset policy is prime territory for fraudulent financial reporting. That’s because someone could lengthen the useful life for an asset classification in order to delay recognizing depreciation expense. Or, altering the depreciation method from an accelerated method to the straight-line method would do the same thing.

They can make these changes look like standard procedure by altering the fixed asset policy. To keep this from happening, institute a rule that the audit committee has to approve any changes to the fixed asset policy. This rule might not work, since the people making these changes are company managers, and they may just “forget” to inform the committee. Still, you can at least have the rule in place.

The Need for an Exhaustive Fixed Asset Policy

A final thought is in regard to the original listener question, which was about how to develop an “exhaustive” fixed asset policy. It’s that word “exhaustive.” Accountants have a reputation for being too bureaucratic, maybe because we want to have rules in place for everything. That’s not actually necessary. You should only create a rule if an issue keeps coming up. If it only happens once, then there’s no need for a rule. To apply this concept to the fixed asset policy, keep it relatively short and to the point. Only expand the policy if there’s an actual ongoing need for a rule.

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