An accounting system is only as accurate as the information put into it. If there are significant amounts of information missing from an Accounting System. It causes real life problems. Checking accounts will be overdrawn, Sales will mysteriously bounce around, and the tax preparation will become a lengthy process. Below are some common examples of tardy or misstated items.

Example:   The business owner writes manual checks and does not enter them into accounting system. What usually happens if this process gets out of control, is that the bank account is overdrawn and the accountant/bookkeeper is left scratching their head. Major Cash Flow Drama.

Example: If there are several rental properties being managed by the company, the expenses need to be categorized by property.  If not, there will be a research issue when the yearend paperwork is sent to the tax accountant. 

Example: If there is a large customer return in the works, there should be an accrual for the customer return. If this isn’t done, there could be a huge ‘gotcha’ in the works for the sales reporting. This is also required for GAAP.

Example: Lot Numbering System not in place. This is required for some industries.   However, even if it is not required, it is extremely helpful to track down all of the manufactured product that will disappoint the customers. When there is a potential flaw in manufactured product, this by creating a system to track down the problems and resolve them before they mushroom in size to damage the business’s reputation.

One of the questions that I’m most often asked by business owners, is how do I know if an accountant / bookkeeper is qualified?

Well, this is an interesting question. It depends what question you want answered.

Tax Return/Questions/Planning? Try a TAX CPA or an Enrolled Agent. Ask them if they have prepared business tax returns. Some accountants specialize in individual returns and therefore would be a poor choice for business tax returns.

Is this person really a CPA? Believe or not, there are people who advertise themselves as Certified Public Accountants, who are not currently licensed. Each State Licensing program is slightly different. Washington State Licensing is handled by the Washington State Board of Accountancy. Their website allows you to search a person’s name or license number. (Very bad things can happen to people who do this, there is also a section on the Board’s website to describe past litigation regarding this type of misrepresentation.)

Certified QuickBooks ProAdvisor? What does that mean? QuickBooks sells this certification on how to use the QuickBooks program. The certification test is NOT a proficiency test of accounting skill. 

Have they worked in your Industry before? If they have not worked with non-profits before, don’t let them learn on your dime. If they have only worked in service industries, such as web designers, don’t let them anywhere near your Inventory system for a Manufacturing Company. There are also very specific rules for Software Development, that would make any sane person question the logic of Generally Accepted Accounting Principles (GAAP).

What is business size that they usually work with?   Are you a solopreneaur? Have they only worked with Fortune 500 companies? Quite likely, they will give good advice, but not applicable for your business. Example: Seven layers of internal control would not be appropriate for a three person office.

Google their name. You will be surprised what shows up. Lawsuits, inappropriate chatter on blogs, customer complaints, and the list goes on.

Have another accountant/business advisor interview them. If you don’t have a good background in finance, it could be easy spout off some jargon that sounds somewhat correct to impress people. Others in the industry would be quick to spot it.

ASK FOR REFERENCES!!!!!!!! CALL THEM!!!!! 

As an Accountant one of the first principles learned is The Matching Principle. This simple theory leads to many complex accounting rules or Generally Accepted Accounting Principles or GAAP. It means that the Expenses and Revenues need to be recognized on the Financial Statements in the period earned.  Seems simple enough, but this is a common area of fraud, and has resulted in some the major fraud cases that have dominated the news. 

 As I was writing this article, I received a “Tech Flash” alert about another fraud by a CFO. http://www.techflash.com/seattle/2009/09/sec_charges_former_isilon_cfo_with_securities_fraud.htmlThe SEC is filing charges against the former CFO of Isilon Systems for creating “sham transactions” that artificially boosted revenues. I will let you read that article for the particulars in that case.

Okay, back to the accounting theory, a simple example of the Matching Principle is Rent Expense. Rent should be allocated on a monthly basis.  Notice, that it doesn’t mean that rent checks are written in the same month as the rent is due. It means that the monthly rent expense should be recognized on a monthly basis. This, in some cases, requires a series of journal entries.

In Revenue Recognition, there are some general rules. One is completion of the earnings process and the other is assurance of payment. So this means that any goods that have been sold:  need to have been delivered to the customer; and estimated customer non-payments need to be accrued as Bad Debt Expense; any estimated Warranty expense need to be accrued. (This is a general list, not specific to every industry.)

Many accountants are under pressure from their employers to produce the financial statements with the best financial results. But is important to make sure the most aggressive accounting treatments do not venture into the arena of financial fraud, managing income or smoothing income. It does temporarily improve the books, but it sweeps systemic problems under the rug, and can cause major problems that can turn a temporary loss or shortage of income, into criminal charges for upper management. The simplicity of The Matching Principle must not be forgotten by the CFO’s, even though it has been many years since they read the first page in their introductory accounting class.

Do internal controls prevent employee thefts? No, the enforcement of internal controls helps to reduce employee thefts.   When was the last time that your business took a serious look at the enforcement of internal controls?

Rock solid financial planning includes a good understanding of Marginal Cost.   If you are unaware of how it affects the bottom line, it can turn that boffo box office sale into the dead weight that drags the net income into the dreaded red ink zone.

Month in and month out, an employee and you have been churning out 100 pet rocks per month. However, you get the midnight call from a boutique, they would like an extra 100 pet rocks that month as a thank you gift to their best customers. You are over the moon! You say yes! YES! YES! After you hang up the phone, you do the happy dance. Then the following morning, as you begin contacting your suppliers to purchase the materials, it occurs to you, how much is that going to increase the expenses? Did it really matter that you agreed to a 10% price reduction for the bulk order? Will you be giving those pet rocks away? 

This budget calculation can be complicated, but if you break it down piece by piece it can figured out.

First is the Marginal Revenue which is the amount revenue from selling one additional unit. So in this case, the Marginal Revenue is the ninety percent of the normal selling price. Not too hard to calculate, so let’s move onto Marginal Cost.

Marginal Cost is the tricky part of the equation. It is the cost to produce one more additional unit. Sounds like fancy CPA talk? Doesn’t it?  Let’s break it down into its components.

Marginal Costs are made up of Fixed and Variable Costs. Increases in Fixed Costs are often responsible for most of the red ink, so let’s start with that.

Fixed costs are typically things like Rent, Copier rentals, maintenance agreements, salaried employees, and their payroll taxes, etc. Normally, these items do not vary from month to month.   For example, the rent on your small studio is $500.00 per month. If you produce 100 pet rocks that month, how much more would it cost to produce unit number 101? Zero.  The studio will have the necessary space to manufacture that unit.

Remember the definition above, the increase in cost to produce one more additional unit.   What if at unit number 150 additional space is needed? You negotiate a good price with your neighbor. You can use their studio for $200.00. Therefore, at unit # 150, there is an increase of $4.00 per unit. ($200/50 Units = $4.00/unit) 

Marginal Variable costs increase incrementally with increased production. Examples of variable costs are direct materials, hourly labor, payroll taxes, supplies, and electricity.

An example is an employee who takes one hour to complete one pet rock.   If you produce 4 pet rocks, he works for four hours. If you produce 12 units, he works for 12 hours. (To keep it simple, let’s assume that the one hour per pet rock includes all coffee breaks and lunches.)  After he works 8 hours, he is entitled to overtime. He is willing to work an extra 4 hours that day. So the variable labor costs for those extra four units are 1.5 times the normal hourly rate.   Those four pet rocks with have a higher Margin Variable Cost due to the extra overtime and payroll tax expense.

Variable costs also include direct materials. It requires one rock, paint, glue, and two googly eyes to create one Pet Rock. It also requires cleaning fluid, scrubbing brushes, and other supplies to prepare the rock for painting. Some types of direct material are pretty consistent on a per unit basis, so will require less examination. But, be careful to consider the available supply of direct materials. For instance, if it is required to overnight most of the rocks from the quarry, it would increase the direct material cost. 

Are you still with me? Good! The next part is easier in a spreadsheet. I like envelopes too, but you may run out of room for this.

The first time that you do this, it is easier to label rows one to one hundred in the first column. In the second column enter the Marginal Revenue. In the third column enter the increases in Fixed Marginal Costs. If we use the previous example, enter $4.00 per unit starting at unit #150.   Do you know your normal variable cost? Good! Enter that in the fourth column. In only those units with higher variable costs, in the fifth column enter the increase in variable costs, such as overtime and any associated payroll taxes, etc. 

Calculate the Marginal Profit for each unit by subtracting all of the costs from the Marginal Revenue. Did you notice something? Typically in a large production increase, the last units are the most expensive to manufacture. The trick is to know when the Marginal Profit turns negative, so you can effectively plan a strategy to ramp up production.  This type of analysis will help keep you from being between a rock and a hard place, when you receive the next boffo box office order.

Skimming Bank Deposits is one of the easiest scams that employees use to embezzle from employers. It consists of pocketing cash or checks destined for a bank deposit.  

A place where it can happen is on the way to the bank. I have always thought that people who steal from the deposit are a little bit cheeky. The entire scheduled deposit has already been entered into the Accounting System. The dishonest employees merely take the cash or checks from the deposit bag before it is taken to the bank.   The thieves may even go the trouble of stealing blank deposits slips that they rewrite to match the deposit.  When the bank reconciliation is completed, it can be pretty easy to spot that the actual bank deposit doesn’t match the version in the accounting system. 

The cure for catching employees committing bank deposit skimming is strong internal controls and timely bank reconciliations.

One area which often clouds decision making is Sunk Costs. A Sunk Cost is money that has already been spent. It isn’t possible to undo the cash flow outflow. Only future costs are relevant because only future cash disbursements can be controlled. Therefore, any money already spent should be not part of the decision process.

For instance, your business needs a row boat to go across the lake during windy conditions.   The wooden rowboat is getting along in years and it is getting progressively more expensive to maintain. You are immensely fond of the row boat and have recently spent money having it repainted, holes plugged, and a new set of oars.  However, dear Ol’ Betsy is wearing out and the boat yard has told you that there will have at least one new hole in the bottom each summer.   Without expensive future maintenance, it would not able to row across the lake during windy conditions.

While attending a boat show in your local community, you learn the cost of buying a new metal row boat is $3,000.   According to the salesperson, the projected yearly maintenance is $100.   The brand spanking new row boat tempts you, but the old wooden row boat has a special place in your business.

The business has already spent $3,000 in the past year to fix Ol’ Betsy. The yearly projected cost to keep the current row boat swimming along is $1,000.   Do you purchase the new shiny row boat? Or do you keep Ol’ Betsy? 

Most would pick the leaky row boat over the new one because they have already emotionally invested $3,000 in the old row boat and the immediate yearly cost is less to keep Ol’ Betsy. Also, she has had many years of loyal service. How could you put her in dry dock? However, that $3,000 is a sunk cost. It happened in the past, which is unchangeable, and cannot be added to the value of the wooden row boat. 

A five year budget would look like this for the two options.

 

The short term costs are higher for the new row boat, but the total five year expenditures are $1,500 less than maintaining Ol’ Betsy. Do you have an Ol’ Betsy soaking up cash? Say an old copier, an old delivery truck, or maybe a trusty old laptop that you are especially fond of? Is the cost of maintenance exceeding the cost of a new asset? 

Just how did the bookkeeper buy that $45K motorcycle? 

If an employee is conspicuously living above their means, this could be a clue that company funds are being absconded. Hiding in plain sight is often the biggest tip off that an employee is stealing. It’s the new baby blue convertible, an opulent vacation house on the trendy beach, or the extravagant jewelry that suddenly make an appearance. 

An essential internal control procedure is to tightly control the check signing process. Never have the same person who approves the accounts payable and/or writes the checks be the same person who signs the checks. Ever. 

This internal control process helps prevent innocent mistakes on legitimate invoices. 

It also helps prevent the easiest types of fraud, which are writing checks to fake vendors, falsifying payroll checks, or inflating employee expense reports. Notice that I said, “helps prevent”, truly determined individuals will devise means to circumvent this internal control process.

Further internal control procedures are needed to detect the truly determined thief.

2007 Retained Earnings + 2007 Net Income = 2008 Beginning Retained Earnings

If the beginning balance does not “roll” from the previous year, there is a problem.

Periodic physical audits of Fixed Assets help ensure accurate financial statements. In addition, the audits also help ensure that the Fixed Assets are not walking out the door. 

Because computers become obsolete quite quickly, there is often high turnover. Make sure you are aware of what happens to disposed computers. Are they in the bone pile in the IT room, to be used for spare parts? Or they gifted to employees for home use? Or are they sent to a PC recycler as scrap? In each case, there is a specific accounting treatment that will remove it from the Fixed Asset list.

Personal Property taxes are calculated on the gross value of the fixed assets. If disposed Fixed Assets are not removed from the list, the business may be taxed on assets that no longer exist.

 

 

If there is a financial statement transaction, there should be backup or paperwork for it. The paperwork and the related approvals are an important part of an Internal Control system. For example, accounts payable invoices should show the person who authorized the service, the receipt of the service, and the payment approval. 

When questioned about undocumented transactions, often there are responses like these:

Why are you asking for it? Don’t you trust me?

This doesn’t affect the internal controls. There doesn’t need to be a secondary approval of this type of transaction.

I remember every transaction, so I don’t need to document it.

It’s too much work to document every transaction. Don’t you want us to be efficient?

I didn’t want to bother you with an approval, you are so busy. I was only thinking of you.

And my personal favorite, the external auditors never asked to see this paperwork, therefore it isn’t required.

I’m starting my blog with the goal of educating business owners and fellow accountants with the warning signs of financial information misstatement.

One of the easiest problems to spot is the paper blizzard around the accounts payable desk. When you walk into the accounts payable office, do you wonder how they can find anything? Are there random piles of paper stacked around the office? Do the paper piles have a thick layer of dust on them? Have paid invoices been properly filed after a check run?

These are symptoms of one of the most common problems in accounts payable that invoices are not entered in a timely fashion. This leads to understatement of the company’s liabilities and expenses.  

Ways to spot it:

The amount of expenses as a percentage of revenue is usually stable from period to period. If there is a large drop off in expenses, it might be a good idea to talk to the person entering the accounts payable to see if the data entry is up to date.

A large number of past due calls to the accounts payable person.

If you need information about the accounts payable invoices it takes an inordinate amount of time to be researched and presented to you.

If there was a large expense or fixed asset purchase, it is not reflected on the financial statements.

If you open the accounts payable person’s desk drawer to find a pen, and instead find accounts payable invoices stuffed inside the desk.