Financial Statements, So What? PART III

In Part I, of this series I discussed Compiled Financial Statements and in PART II I went over the salient facts of Reviewed Financial Statements. Here we will take a very brief view of Audited Financial Statements.

An Audit can be performed on the most common basis of accounting used in Compiled and Reviewed Financial statements. Modified Cash, GAAP and the Income Tax Basis of accounting and in some cases where the financials are prepared based on industry or other regulatory accounting rules -Statutory Basis may be used. However, unlike Compiled and Reviewed financial statements, here in the United States, the most common basis of accounting for Audits is GAAP. Perhaps, followed by Statutory Basis financials. Why? Simply put GAAP is the basis of accounting that is most used by public corporations that are traded by stock exchanges and is the United States financial reporting standard. The exception are insurance companies, utilities and other industry specific companies that have a regulatory basis of accounting.  GAAP is a “rules based” method of accounting that is many, many years in the making with very precise and specific rules to aid, among many factors, in comparing financials among companies in an industry. Increasing demand and a trend towards allowing “IFRS” or International Financial Reporting Standards are well underway, for multinational public companies and foreign companies. IFRS is not rules based but more broad “principles based” form of accounting. This gives a great deal of flexibility but still maintains critical reporting standards. Where GAAP is based on historical costs, IFRS allows for fair market value reporting. This can be a very valuable contribution to financial reporting.

An audit is by far the most complicated set of financial statements that CPA’s prepare. Again, here too the financials are the assertions of management and the accountants render an opinion as to whether the financials, including the notes and other supplementary information, present fairly, the results of operations, financial position and cash flows of the company. Further CPA’s must be independent in order to render an opinion. The financials are not the responsibility of the CPA’s, only the opinion they render is the responsibility of the CPA’s. This is worth noting as it is a common misunderstanding of the general public.

An “Audit Program” is the game plan that accountants use in order to audit the company’s books and records. Some of the tools CPA’s use include trend analysis, industry metrics, observations, testing of transactions and internal controls and confirmations of accounts and notes receivables and  accounts and notes payables. Physical observations and counts are performed on assets and inventories to make sure they not only exist but they are valued correctly. Inquiries are made of the company’s lawyers to determine law suits or potential lawsuits and claims. An accounting of uncertain tax positions are made to determine potential liabilities. Mathematical statistics and sampling techniques are applied and used extensively to make inferences as to the value of certain accounts. A great deal of professional judgment is applied as to whether the Audit Program is sufficient, as to whether the conclusions are correct, and simply as to whether all aspects of the company are properly accounted for and disclosed either in the body of the financial statements, supplementary information or in the notes and disclosures.

Audit services are extremely important to a capitalist market such as our own. I believe it safe to say, Wall Street would not be the center of financial power and wealth if it where not for the audited financial reports that auditors render opinions on. In other words, if you couldn’t compare companies on the same set of accounting rules and or you could not trust the financial statements of companies that trade their stocks, bonds and other financial instruments traded on Wall Street; bankers, investment funds, investors, brokerage houses and the public at large could not make good financial decisions. Essentially, capitalism would come to a screeching halt. Jobs would be lost, lending would dry up and a recession followed by a depression would follow only to be superseded by a global financial collapse.  We got a bad taste of that in 2008, when the United States and the world lost faith in the United States. Not because the accounting was bad, but because it was good enough so that everyone could see that the underlying value of loans and real estate, on corporate books was no longer there and all the companies involved essentially plummeted in value. It was the beginning of a financial collapse.

The most common misunderstanding about audits are that that they are designed to detect fraud, theft and the misappropriation of funds. Audits do sometimes detect these matters. However, an audit has to be specifically designed to detect these types of matters. Even then, audits rely on the honesty of the management. If management is involved in fraud, theft or the misappropriation of funds it is often very difficult to detect. This is why audits rely heavily on internal controls and various other safeguards. It’s a lot harder to get away with any wrongdoing if it requires various levels of management to get away with it.

Audits are expensive simply because of the risk auditors take and because of the amount of work that needs to get done. For many small companies audits are cost prohibitive. Some small poorly run small companies may not even be auditable.

Although I do not perform audits, during the past years my firm has been involved in a number of audits either in preparing clients for audits,  securing auditors, or assisting management who undergo an audit.  For small and medium size companies that do not have internal auditors, having an external CPA is a valuable asset and company resource. It’s possible a relationship with my firm can save your company a great deal of money if you undergo an audit.

IRS Revokes Tax Exempt Status of 275,000 Groups

News Flash! Decision of the IRS to revoke the tax exempt status of 275,000 tax exempt organizations. Yikes! That sounds like a lot of organizations. The reality is that the number is really not surprising.  Many Not-For-Profit (NPO) Tax-Exempt organizations are created by heart and soul people who have a vested interest to do some good in the world but simply fail to recognize how challenging if not daunting it is to (1) raise donations and (2) keep up with the regulatory requirements of running an NPO.

The old IRS law allowed NPO’s to not file a return if their gross receipts fell bellow a certain level. In 2006, the IRS changed the law and now all NPO’s must file a return, with the simplest form of return (990-N) being a very basic information return that essentially says, I am here, I am alive.  Of the 275,000 I suspect a few couldn’t manage that simple reporting as the IRS had given an extension of 5 months to accomplish the task and at that time 50,000 somehow managed to file a return.

There is an NPO for just about every imaginable and conceivable purpose. From saving trees or whales to helping the elderly and children to creating cultural diversity and sustaining art forms. In 2010 the IRS showed 1.8 million NPO’s. Of these roughly 66% were religious organizations.  I once heard that in Miami Dade and Broward counties there were some 8,000 NPO’s. All competing for donated funds and grants from other NPO’s and local, state and federal governments. Without question the work NPO’s perform enrich our lives in every conceivable way. This is because many NPO’s are very cost effective. One of the primary jobs of an NPO is to create administrative capacity through the work of community volunteers. These volunteers help run the organizations and are in fact the people that raise money, run the back office and even provide the programs and services NPO’s bring forward. If you think it’s hard to compete with third world wage levels try free labor!

NPO’s fill the gaps where government can not accomplish the task and puts money to work to serve the disadvantaged, to create a sense of community, to advance democracy through business leagues, social and recreation clubs. It supports education, the arts, healthcare and the homeless, just to name a few of the missions they carry out.  NPO’s are priceless organizations that form the fabric of the United States goodwill and span the globe.

Managing an NPO is a bit tricky. In fact it’s harder to run an NPO than it is a typical small or even medium sized business. There are a number of key considerations in simply forming an NPO.  In addition the management of any NPO organization is best accomplished not just by someone who has run a business before but, someone who specifically has experience with NPO’s. Firstly, there are a number of types of NPO’s, each with a distinct set of operating rules and even allowable deduction rules for those that donate funds. The accounting is more complex, and the tax returns are just as complex.

If you run an NPO, or are thinking of starting one. Get a qualified CPA or tax attorney that knows about NPO’s to advise you. If your heart and soul is tied to that NPO it’s not only to your advantage to do it right, but it also protects the credibility of every NPO that has an important mission to carry out.

Financial Statements, So What? Part II

In PART I, I discussed some important factors regarding “canned” accounting package financials and the simplest form of financial statements which are Compiled Financial Statements, which a CPA prepares. In this Section I will discuss some general items in regards to Reviewed Financial Statements.

Just as in Compiled Financials the most common basis of accounting used in reviewed financial statements are either Modified Cash, GAAP and the Income Tax Basis of accounting. In some cases where the financials are prepared based on industry or other regulatory accounting rules -Statutory Basis may be used.

The basic methodology used in the preparation of reviewed financials is similar to compiled financial statements. There are many rules which must be observed for the proper disclosure and the fair presentation of financial information. In addition there are the minimum set of financials that are typically reported on. The underlying accounting and the financial statements themselves are the assertions of management. As such management is responsible for the contents of the financial information. The difference from Compiled financials is that analytical procedures and professional analysis and judgment are applied to gain an additional level of assurance that the financial statements present fairly management’s assertions. Some of these procedures might involve calculation of financial ratios, comparison to past historical financials to current financials or industry standard metrics. Review of accounting records, statement line items and other reconciliations. Additionally, inquiries are made of management to make sure all the relevant facts regarding the company and its financial affairs are either presented in the body of the financial statements or in the notes and other disclosures that may be provided.  This inquiry is later confirmed by management to the CPA by means of a “Management Representation Letter” which details all these "representations”  and is signed by management for the benefit of the CPA’s. A fair amount of work is involved for a CPA to issue reviewed financial information. Yet it is not as much or as extensive as those procedures employed in an audit. For that reason Reviewed financials are regarded as an intermediate type of financial statement to audited statements. In fact many auditors might require that at minimum a new client have at least Reviewed financials prior to having audited financials. This is because it provides a good base from which to perform audit work.  However, not having Reviewed financials would not necessarily preclude you from being auditable. An important point is that CPA’s must be independent in order to issue a Reviewed financial. This means they generally can not audit their own accounting, or be so involved with the client in providing additional services so as to audit their own work.

The reason for undergoing a review typically is a matter of compliance. It is possible some user of your financial information may require you to undergo this process in order to satisfy a condition of their involvement with the company. For example, investors often make Reviews a condition in the operating agreement of a company, banking institutions might require it also as part of a loan agreement. Likewise bonding companies, which provide for different types of insurance and many regulatory and licensing agencies also may require at minimum Reviewed financial statements. In some cases it can be triggered because some event in a company causes an interested party to force the company to undergo a Review. For instance a dissatisfied investor or partner or even a divorce. Given the state of the financial markets, Reviews may become much more common or even a requirement as many banks and lenders try to reduce their lending risks by requiring CPA prepared financials that are prepared on higher standards.  

A Review is a valuable exercise for any company who attains a level of success. It does require that a formal accounting system be in place and that management has some system of internal control.  For many first time companies, it is an exercise that prepares the company and its management for even higher standards of financial reporting.

A company that is planning to undergo a Review might hire another CPA firm, such as mine, to make preparations for the Review process. This has the potential of reducing Review costs and fees and also to address weaknesses the company might have in its accounting systems and controls.

In the next part of this series I will address Audited financials.

Business Intelligence PART III

In PART I, I made the Statement that all businesses are in the information and technology business. In PART II, I explained that the important factor to realize is how to leverage that information to create business opportunity. Now in this PART III, I want to illustrate a simple case study of a “Shoe Shine” business that is in the information and technology business.

Case:

            A shoe shine business operator leases a small 6 Ft. by 12 Ft. space in the lobby of an office building. The building is a prominent business location with plenty of lobby traffic. The business operator; we will call him “Ira” does well in his business and he is very well liked because of his people skills. He also has the daily paper, and current magazines for his patrons to read while he performs his shoe shine services. Over the years he has made many friends in the building and he always asks for a business card so that if any of his patrons leave anything behind he can always call them to let them know. Besides you never know when you might need a good insurance man, lawyer or accountant who work in the building. Ira acquired a simple “non smart” cell phone.  As he learned how to use it he realized he can input all is business card contacts into his cell phone directory. In doing this he realized that a small percentage of clients were from the surrounding office building but by far most of his clients where from the businesses that operated in his building. (Here Ira analyzes data!)

            Ira, is an entrepreneur who is always busy thinking, He asks the building owner if he can place a sign outside to advertise his business after he recalled many of his clients comment; they had no idea he was in the building and that only by chance did they stop in on business and notice his stand. However, the city won’t allow him to put a sign outside and the building owner was not willing to allow him to affix a sign on the building wall for fear of damage.

            Ira kept thinking about the customers in other buildings that came very infrequently. He realized there was a whole untapped source of clients he wanted to serve. On a slow day he started looking at the directory and came across some executives he knew from other buildings. He decided to call them and asked a simple question;  Would you be interested in a shoe shine while you sit in your office and have lunch or make phone calls? Essentially, Ira let his clients know he would come to them on a schedule convenient to them. The answer was a loud YES!,  from almost all of those executives. (Here Ira has leveraged data into useful information to increase sales)

            By scheduling visits, on one day every other week Ira was able to triple his income and increase traffic to his lobby. As word spread more people would stop by and visit his building. In addition he started a pick up and delivery service. He would pick up shoes when he visited the other buildings, shine and repair shoes, and either deliver them on his next round or call his new customers for a pick up when they were done.  (Here Ira differentiated his business from other shoe shine businesses)  His business picked up so much he had to hire an apprentice. Soon Ira had so many clients he had to figure out how to group his contact list on his cell phone by building. Ira is in fact in the information and technology business by the simple fact that he used a simple cell phone database and leveraged that information to generate more business.

Conclusion:

            The Economist, a business magazine, published an article on January 27^th, 2011; “Not Just Talk”, commenting on the use of cell phones and simple text capability for many business uses in non developed countries. The uses included providing market rates and quantities for common commodities by use of text messaging. An informal market of demand and supply allowing subscribers to find goods for sale by various vendors and locals. Another was a texting service where codes could be texted into a database system which would validate the authenticity of prescription drugs. A system designed to thwart drug counterfeiters. Even simple “non smart” phones have boundless capabilities in their use.

            A qualified external CPA, with an operations approach, can take a fresh look at your business and provide valuable support. But looking beyond the numbers is skill set that takes years in the making.

Financial Statements, So What? PART I

With the proliferation of accounting systems which come with “canned” financial statements many business owners are absent minded about financial statements prepared by the CPA. In all honesty, if you don’t need to pay for CPA prepared financial statements, don’t spend the money.  With one caveat; do you really understand what they mean? Do you trust your internal accountants to tell you what you “don’t” want to hear? CPA’s prepare three general kinds of financial statements:

(1)   Compiled Financial Statements.

(2)   Reviewed Financial Statements.

(3)   Audited Financial Statements.

Compiled:

            Many people have the belief that compiled financial statements is accomplished by taking those “canned” financials that come out of your accounting system and simply placing them on CPA stationary. Nothing could be further from the truth. In fact there are volumes of standards and rules which must be diligently followed by a CPA to conform to Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accounting. These standards provide for the presentation, disclosures, basis of accounting, the basic set of financial statements to be presented and a variety of other provisions that must be adhered to in order to issue a report. Compiled financial statements are typically the cheapest form of financial statements many CPA’s prepare simply because they do not require the labor of examination, confirmation and other attestation procedures performed under reviewed or audited financial statements. But in no terms does that mean a CPA can prepare them blindly. Generally, for many businesses  the basis of accounting most frequently used are Modified Cash Basis, Income Tax Basis and GAAP. In some cases where the financials are prepared based on industry or other regulatory accounting rules -Statutory Basis may be used.

            Year after year I find all kinds of mistakes on “internally” prepared financial statements. Often, I find financials that overstate Gross Profit Margin, leaving owners to believe their profit margin is higher than they thought.  I have even found financials that omitted some line items of expenses all together. Balance Sheets that don’t balance. Most amazing is the enormous percentage of businesses that do not employ a Cash Flow statement.  Everyone knows Cash is King right? The simple truth is many bookkeepers do not know how to prepare even a simple cash flow statement, or how to use the system report generator. Some report generators can be tricky devils. Owners and managers need to be aware today’s accounting systems allow you to prepare financials in any which way you can dream of thanks to flexible report generators. This is a great thing, but un-managed and un-checked can lead users of these reports to very wrong conclusions. For this very reason many outside users require that financial statements be submitted only if they are prepared by a CPA. Simply put, more sophisticated users know that although the financials are not reviewed or audited, due care was taken by a professional to present fairly financial information.

            One last note, every set of financial statements issued by a company is the responsibility of management. This is to say that even if a CPA prepared those financials the underlying information is the representation of management and therefore they are responsible for that information. This is true even of financial statements which have been audited by outside independent accountants. Just take a look a Dow Chemical, Ford Motor Company or any large organization and the auditor’s report clearly sates that fact.

            I will continue this news segment with the other two types of financial statements “reviewed” and “audited” financial statements.

Business Intelligence PART II

In PART I of this discussion I made the argument that every business is in the information and technology business. Yes, I realize that giving some thought to that concept, everyone that focuses on that statement tries to come up with a business that can’t possibly be in the information and technology business.  So, I will say this: Even the Shoeshine guy or gal is in the technology and information business, and I can prove it. But, I will leave that to the end.

            Let’s just assume that you happen to be in a line of business that does produce or have access to information. What’s next? The answer is in knowing how to harness that information to gain additional revenues, decrease costs, or simply stay competitive. These days with mounting pressure from every angle its not just enough to have terabytes of information, it’s about leveraging data so that the information it provides makes you better able to make a sale, to create operating efficiency, or simply to stay ahead of the curve. You have to really look at the data that you have and extrapolate its meaning. Of course there are many ways to do this but, I typically start with two simple approaches. I look at those types of information that tells me about the environment I operate in and, secondly I look at those types of information that tell me about how well my business is doing. Some business analysts say this is the “External” and “Internal” point of view. In some cases you may hear the terms “Macro view” vs. the “Micro view”, respectively. Yet another way, is to look at information you can not control, vs. information on things you can control. So let’s take a quick look at that. Say you are in the business of automotive replacement parts. Some of the areas you might want to look at and why they are important to you are as follows:

The External Information:

(1)   Look at trends of how long people are keeping their cars, or perhaps whether automobile consumers are buying or leasing vehicles.

It may not seem obvious but, during this recession owners, and businesses were holding on to their vehicles slightly longer. Partly, due to tight credit markets, but also because of high unemployment and job security issues, compounded by doubts about the automobile industry.

Why is this important? It means your sales should be going up as owners who plan to keep their auto’s longer tend to fix and repair their autos as they plan to hold on to them longer. If your sales have shown no increases, your marketing efforts are off, your pricing structure may be wrong and this is a sign management needs to pay close attention to this.

(2)   Who is your competition? What is their pricing? What value added features do they have?

You can rest assured that it is very likely your customers know they have alternatives. They too are users of information. And the best way to compete is to know what your competitors are doing, and find a way to differentiate yourself from them.

What can you do? Analyze if you can offer free delivery for large orders. If you use the same suppliers, why aren’t you getting a better price? Is there a service you can offer that your competition can not? An analysis of all of these questions may lead to some action that could mean a better bottom line.

The Internal Information:

(1)   What are the top 200 items purchased? What are the top 150 items with the highest profit margin?

Every business should know what their bread and butter is. Knowing how to leverage these items gives you insight in how best to manage the products and services you offer. They give you the answers you need to maximize the platform that gives you a stable base and allows you to innovate and try new things that either grow your business with additional sales or makes you more competitive.

What can you do?  Try to negotiate a better price and or get a volume discount with your supplier. Pass the savings on to your customers if they make larger purchases. Offer promotions geared towards grabbing market share from competitors.

(2)   What is my inventory turnover rate? What is the relationship of storage space required for the slowest moving inventory items?

Inventory is very capital intensive. In other words, it takes a lot of money to keep that inventory on the floor ready for a sale. It’s not just the cost of the products itself, but also the cost of storage, waste, breakage, theft. Inventory is also real estate intensive. The larger the product you sell the bigger the real estate you need to store that product.

            What can you do? Change how you buy inventory. It might be cheaper to pay additional delivery fees than to pay high cost real estate to store items. It might be cheaper to special order large inventory items, and perhaps your clients don’t mind either, than to store slow moving, large items that do not sell quickly.

Clearly, the most profitable and successful businesses look at every angle. After many years of dealing with businesses, all too often I see management that is stuck in a rut of simply selling for a higher price than cost and simply making sure that the right product gets to the client. Of course this is a substantial challenge all on its own but, in today’s business environment it’s not enough.

Of course service industry’s can use the same methodology to analyze external and internal factors that affect their business.

It’s is very difficult for many companies to find the right type of employees that know how to analyze and prepare information. It’s even more of a challenge to find talented people that are capable of making the cause and effect type relationship analysis to solve business problems.

Business advisory services provided by qualified CPA’s is a very valuable service. Sometimes, it is the best way to bring innovation into an organization that needs to get to that next level. If you are one of those businesses, maybe we need to talk.

Buy Sell Agreements

For those of you who are business owners, with partners, you should pay close attention. Whenever I mention a "Buy-Sell Agreement" many business owners think I am talking about a contract to buy and sell a business. That's partially correct but it gets better. A properly structured buy sell agreement gives you the money to buy and sell that business, or a portion of it.  Here is a typical candidate:

John is a 41 year old 50/50 partner in a specialty paint and body shop with Harry who is age 60. Both are in excellent health. John is the business minded and organizing force of the business that makes sure the business runs right, aside from being very skilled in auto repairs. John is married has two kids and his wife knows very little about the business. Harry is legend in the business, has helped the company earn a solid reputation for excellent work and his extensive contacts has landed very valuable long term contracts. He's a real workaholic but, he hates numbers, can't manage a check book and spends almost everything he earns. His wife of 36 years has medical problems and his only son, a bright engineer not only hates the business, but seems to have a drinking problem.

John loves his partner because they make a great team. But he knows that in the next 10 to 15 years Harry would like to retire. Worse yet he may just die working on the Job! If something happens to Harry his wife would inherit the stock in the company. Being that she has health problems and she doesn't understand the business, John doesn't want her as a partner. An even worse scenario is if Harry's wife gifts the stock to her son, who she believes can do no wrong. In that case John could have a partner with a drinking problem.

 John and Harry are willing to enter into a buy sell agreement in advance should anything happen to Harry. All Harry wants is that the proceeds for his share of the business go towards taking care of his wife if he's not around. The problem is John can't figure out how to pay Harry's estate for his 50% interest. The business does well but not enough to buy Harry out at a potential future cost of $950,000.

Solution:  If the buy sell agreement is tied to a life insurance policy on Harry's life, and John or the business can afford to pay for the monthly premiums, then the payout of his partner's 50% interest is guaranteed by the proceeds of the life insurance.

The essential elements of this buy sell agreement is a properly drafted and enforceable legal document prepared by an attorney, and a life insurance product from a knowledgeable insurance agent. In addition the work of a qualified certified business valuation accountant may be required.

There are various tax implications for this type of scenario, which I will not discuss simply to keep it short. Further, there are lots of possibilities in how to structure the deal.

If you want to know more about how to establish a succession plan please give me a call. Your business is a very big part of your life. Don't just manage it day to day. Having an outside CPA that offers advisory services helps you look outside your field of vision and prepare for the future.