Differences in Ethics Courses (#358)

What are the differences in ethics course requirements among the state boards of accountancy? Most people are only certified with one state board of accountancy, so they have no idea that there might be a difference. But there is. Quite a lot, actually.

Why is There an Ethics Requirement?

But first, why is there an ethics requirement at all? After all, most states require you to pass an ethics test every time your license renews. There are a couple of reasons. First, the boards of accountancy have to deal - all the time - with CPAs who break the rules. Not all of the Boards publish this information, but if you look at some of their websites, there can be quite a list of offenders for all sorts of reasons – and some of them involve jail time. The Boards have to go through an investigation process for every one of them, which soaks up their time. So, in short, reminding people about the whole concept of ethics reduces the work of the Boards of Accountancy.

The second reason is that a public screw-up by a CPA gives the whole profession a bad name, which doesn’t help any of us. And the third reason is that a lot of CPAs aren’t too familiar with the regulations of the specific Board of Accountancy that certified them. For example, they might not remember the rules for how to name their CPA practice, or how to deal with client workpapers, or – and this is a really common one – the precise rules for how much continuing professional education they’re supposed to get, and which types of training they’re allowed to get.

The Continuum of Ethics Courses

With all that being said, what are the differences in ethics course requirements? Well, think of this as a continuum, where one state requires no ethics course at all – that’s South Dakota – while at the other extreme, New Jersey requires you to take it in person or through a webcast. If you’re from New Jersey, you have my sympathies, because there aren’t many webcast options available, so you have to keep taking the same ones, over and over again.

State-Level Ethics Training

But there’s a lot in between those two extremes. The majority of the Boards just say that you have to take four hours of ethics training, and that’s about it. However, a fair number of Boards are getting annoyed that their own CPAs don’t seem to have a very good idea about what their rules and regulations are, so they require one or two hours of training in their state-level regulations. I sympathize with these Boards, because they just want their people to read the blasted rules.

But there’s a problem, because some of the course authors out there don’t put a whole lot of state-level regulations into their courses. And there’s a reason why they do this, because it’s a massive pain for the authors to review the regulations for all of the Boards of Accountancy every year, and make sure that they have the latest regulations in their courses. So, these authors put in maybe a half-dozen pages of state-specific regulations, and then fill the rest of their courses with generic ethics topics. Which doesn’t really address the intent of the boards of accountancy. An example of this case is Colorado, which publishes a list of what it wants in a state-specific ethics course, but the Board doesn’t have the money to certify any course providers – so it doesn’t.

Which brings us to the next level of Board involvement. The only way that a board of accountancy can make sure that there’s enough state-level regulations in a course is to review it themselves. Which is a pain, and it’s expensive. There are a couple of ways for them to do this. For example, Florida charges a few hundred dollars review fee to approve a Florida ethics course. Most course providers don’t care, because there are a lot of CPAs in Florida. So, everyone writes a course for Florida. That’s not the case in Wyoming, which charges the same amount of money, but there aren’t many CPAs. The result is very few ethics courses for Wyoming CPAs, because it’s not cost-effective to write a course for that state. In my case, I pretty much hand over all of my profits to the Wyoming Board every two years to pay for the next review fee.

Texas Ethics Regulations

Here's another example. Texas always markets itself as being the most free-market state in the country, and yet it’s actually the least free-market when it comes to ethics courses. Somewhere along the line, somebody managed to insert into their regulations that, in order to write a Texas ethics course, you have to be a current Texas CPA, and have taken college-level ethics courses, and taught ethics courses in person. No other board has these requirements. So, this means that a lot of course authors can’t write an ethics course for Texas. As a result, Texas CPAs have very few choices for who they can use. As a personal example, I’ve written 53 ethics courses, and yet I’m not qualified to write one for Texas. Go figure.

Other State Ethics Issues

Here's another example – the State of Washington. Their goal is to have the best CPA certification in the country, so they’re constantly changing their rules, which have to be reflected in their state-specific ethics course. They do not charge a review fee, but they’re very, very picky about the ethics courses that get submitted to them. I get rejected at least once every year, when it’s time for a new course update. It’s annoying for the authors, but that’s what they want.

And then we have Louisiana. Their board wants to refresh the ethics courses for their CPAs, so they encourage course providers to write them a proposal for a new course every few years. If you’re accepted, then you’re one of the few approved course providers for the next three years. The problem is that if you’re rejected – which is quite common – then you’re out. The result is that a lot of course providers – including me – don’t bother to submit new course proposals to the Louisiana Board.

And then we have what I think is perhaps the best approach. The Board of Accountancy for Virginia decided to create its own video that covers the essential points of its regulations. It’s pretty stylish. They then approve pretty much anyone who includes that video in their course materials, subject to a few restrictions. It’s not a bad approach. The Virginia Board is guaranteed to have the right content presented to Virginia CPAs, while also pushing the testing work onto the outside education providers. The only downside for the Board is that it has to pay for a new video production every year, which must be fairly expensive – it’s a nice video. Still, I’d say that’s the most effective approach I’ve seen for getting the really essential ethics information into the hands of CPAs, year in and year out.

Wedding Gown Depreciation (#357)

Wedding Gown Depreciation

What is the accounting for rented wedding gowns – specifically, the depreciation? The case study is as follows:

“We depreciate gowns over three years, but this means depreciating some dresses that have not been rented out in a year, so we are overstating our expenses and understating profits. After the end of the gown life, we will have a dress that is still in the shop and still being hired, at which point we will be recognizing revenue without any cost of sales, which will overstate profits and understate expenses.”

The reason this is so interesting is that there aren’t really any other expenses. You buy the wedding gown and then rent it out, and presumably charge the customer for the dry cleaning afterwards, and maybe for any repairs to the gown. So, the cost of goods sold is pretty much the depreciation – which is very unusual. If you conduct a normal depreciation routine, you guesstimate what the useful life will be – and I can’t help pointing out that it’s gown life, not useful life – awesome new accounting terminology there – and then charge a standard amount to expense in each month. If a dress never rents out, then the charge is still there, and really messes up your profits.

The Matching Principle

This is a good example of the matching principle not working. Under that principle, you’re supposed to recognize all revenues and expenses associated with a sale transaction in the same reporting period. But in this case, there may very well be months when there’s no revenue, and yet that pesky depreciation charge keeps coming up.

Usage-Based Depreciation

So what can be done? A possibility is to only recognize depreciation when a wedding gown is rented. This means that you’d have to estimate the likely gown life, not in terms of years, but in terms of rentals. There must be some standard point at which a gown is too beat up to be rented any more, and you have to retire it. I have no idea what that number is, but let’s call it fifty rentals. And let’s say that the gown originally cost $3,000 to purchase. In this case, you’d have to charge $60 to depreciation every time you rented out the gown.

By taking this approach, you’d be doing a better job of matching the rental revenue with depreciation. But that does not mean that this is a perfect solution, for a couple of reasons.

Problems with Usage-Based Depreciation

First, this involves extra accounting. Instead of just making the same old depreciation entry every month, you’d have to track gown rentals, and then calculate the depreciation for each individual gown for each month – which could be pretty time-consuming.

The second issue is that this system doesn’t work too well if a gown is rarely rented out. You could go years with maybe just a couple of rentals. So, to guard against this, you’d have to do an impairment review of the fair value of the gowns, to see if any of their fair values have declined below their book values. If they have, you’d need to write them down to their fair values, which could involve a fairly hefty charge. Some of the gowns might have to be written off entirely.

A Justification for Usage-Based Depreciation

And yet, I’d still say that a usage-based depreciation scheme is the way to go, for one reason – and that is the Pareto principle, which in this case states that 80% of all gown rentals will probably come from 20% of the gowns. This means that a small number of gowns are probably getting worn out fast, while the rest probably have a long tail on the distribution – which is to say that some gowns are very, very rarely rented. And so, based on that principle, this really is a case where depreciation should probably be based on usage.

The Net Worth of a Big Four Partner (#356)

Before you embark on a lifelong path toward becoming a Big Four partner, you might want to consider whether it is going to be worth the effort. To be exact, what is the value of a partner’s investment assets?

This is one of those topics that – in a way – is impossible to figure out, because it’s going to vary for every single partner. You have to make a guess at how much the average Big 4 partner makes, how old they are when they make partner, how long they stay in the job, what their average annual rate of return is, their tax rate, and – a very important item – how much they save.

Partner Net Worth Assumptions

All of that being said, I made a bunch of guesses. And here are those guesses. I’m assuming that a Big 4 partner starts off making a half million dollars a year and stays that way for the first five years. Then the pay goes up to 750,000 for the next five years, followed by a million a year for the next five years, and so on. Once they get to one and a quarter million, I figure that they top out and stay at that level until retirement. And by the way, the precise figures aren’t published anywhere, so I had to go with the information listed on message boards.

Next, I assumed that the average person makes partner at age 35, and retires at 60. Which is a bit rough, since lots of partners quit before then, or are forced to retire early.

Next, I assumed that income taxes would cut those income figures by thirty-five percent. That covers both federal and state income taxes. This one is extremely rough, since we can safely assume that Big Four partners, of all people, have some good ideas about how to avoid or at least defer paying income taxes.

The next big guess is their savings rate. I’m assuming they’ll save thirty percent of their income during their first five years, which is when they have the least income, after which it goes to a forty percent savings rate for the next five years, and then a fifty percent savings rate from there on out. This is a tough one to estimate, because some partners are going to be prudent with their expenditures, and some are going to blow the money. I ran across one reference to a partner who has a gambling problem and four ex-wives, so that one’s a good guess to have a savings rate of zero. Overall, I may be too optimistic on this one.

And finally, I assumed an average rate of return on investment of five percent per year. Of course, you can dig around for better investments, but they’ll also have a higher risk level. I think this number is prudent, and maybe a bit low, but I think the stock market is fully valued, if not over-valued, so there’s not as much room for it to grow as used to be the case.

Partner Net Worth Outcomes

What did I find out? Let’s take a first-year partner who’s earning $500,000. At a 35% tax rate, you have $325,000 of take-home pay, and a 30% savings rate leaves you with savings of about $97,000. Now move forward five years, when you’re earning $750,000. Now your take-home pay is about $487,000 and a 40% savings rate leaves you with $195,000 in savings. Let’s keep moving forward another five years, and your take-home pay from $1 million of gross pay is $650,000. If you save half of that, your savings are $325,000. Let’s run it forward one more time by another five years, where your income of $1.25 million ends up being savings of about $406,000, assuming the usual tax rate and a 50% savings rate.

Given all of this information, how much should a Big Four partner have in the bank after five years? Not much, only $538,000. At this point, you’re earning at a fairly low level in comparison to what’s still coming in the future, and you can’t afford to save as much, because you’re not making that much. After all, at this point you’re presumably 40 years old, and are married with kids. And kids are expensive.

Let’s move forward five years. You’re now 45, and your net worth has increased to $1.7 million. Not bad, but not enough to retire on. So after ten years of grinding away as a partner, you have a modest nest egg, but your big net worth years are still to come. I know this because – I ran the numbers!

Five years later, at age fifty, your net worth has gone up to just over $4 million, while at age 55, it’s $7.4 million. And at age 60, your net worth is about $9.5 million. Which is a solid retirement fund.

Lessons Learned

So, what else can we extract from this information? First, it really, really pays to stick it out as a partner for as long as humanly possible, since your big income years are well out along the partner track. You don’t really earn enough early on to pile up a whole lot of money. In fact, your net worth should go up in your final five years as a partner by about as much as your net worth went up in your first 11 years as a partner.

Another massive issue is that you have to invest a lot of your money to get into this range of net worth. Plenty of partners decide that they want a vacation home, and a couple of fancy cars, and maybe put their kids through private school – and the next thing you know, the amount you’re saving is way down. And so is your net worth.

And a final point – divorce. The overall divorce rate for the U.S. population is about 50%. I haven’t found any reliable information about divorce rates for Big 4 partners, but it would be reasonable to say that the number is not lower than 50%. This is a tough lifestyle, and you’re working long hours, and that would put a strain on any marriage. So, if you do get a divorce, there goes half of your net worth. And if you get married again, and divorced again, then your net worth keeps getting cut in half.

In short, you might work like crazy for years and years, but if you’re not prudent in your spending – and your investments – and your marriage arrangements – you’re just not going to end up with that massive nest egg that you thought you’d have.

Partner Pensions

And one more item. Net worth is not the only source of wealth for Big 4 partners. They also get a really nice pension. There’s not a lot of detailed information about it, but Price Waterhouse stated in a report in Australia a few years ago that it pays its retired partners about $140,000 per year. So, you’re not just relying on your net worth for retirement income. There’s additional cash coming in.

Real Estate Accounting (#355)

Preacquisition Costs

First up is preacquisition costs. These are expenditures relating to a specific property, but before you actually acquire it. This includes things like appraisal fees, engineering fees, feasibility studies, and title searches. You can capitalize these costs only if they’re directly associated with a specific property, and it’s probable that you’re going to buy it. Otherwise, you have to charge it to expense as incurred.

Selling Costs

And then there are selling costs. If you have a reasonable expectation of recovering selling costs, such as by selling the real estate, then you can capitalize those costs. The types of selling costs that you can treat in this way include the costs of model units, model furnishings, and signage. Conversely, there are several types of selling costs that are charged straight to expense, and they include advertising, grand openings, and sales brochures.

Project Expenditures

Next up, we have real estate project expenditures. This is what you’re spending money on after acquiring a property, and it includes things like demolition, permitting fees, construction, construction administration, and even project cost accounting. These costs are capitalized when they’re directly associated with the project. Otherwise, charge them to expense as incurred.

In particular, if the developer incurs any real estate taxes or has to pay for property insurance during the construction phase, then it’s acceptable to capitalize those costs. But, once the property is ready for its intended use, then these items have to be charged to expense as incurred.

Capitalization of Interest

Another issue is the debt funding used to pay for the construction. You should capitalize the related interest expense during the entire property development period, but no longer than that. The amount of interest you should capitalize is that amount of interest that the developer would have avoided by not developing the property.

Accounting for Phases of Work

Now, a big issue for larger developments is to separate out the accounting for successive phases of the work. For example, the earliest phase might have been completed and sold long before the last phase is even started. To do this correctly, the capitalization of real estate should be stopped as soon as it’s been linked to a real estate owners’ association, or been put up for sale.

Cost Assignment

So, when capitalization happens, how do you assign costs? The best approach is the specific identification method, when a cost is directly linked to a specific property. If that’s not possible, then you use the relative value method. Under this approach, the cost of the land and any common costs are allocated to land parcels based on their relative fair values before construction.

Then the costs of construction are allocated to individual units based on their relative sales values. And if it’s not possible to do an allocation based on relative sales values, then allocate costs based on their relative square footage. In short, there’s always a reasonable way to allocate costs.

Donated Property Accounting

Next up, how do you account for real estate that’s been donated to the local government by the developer? For example, the developer might intend that a certain parcel should be treated as open space, which is to be managed by the government. In this case, the cost of the donated real estate is a common cost of the project, so you should allocate its cost to the various components of the project.

Incidental Operations Accounting

You might also have incidental operations for a project, where the intent is to rent some space to offset the cost of developing a property. To account for these operations, the first step is to net the rental revenues against any related costs. If there’s anything left, then subtract it from capitalized project costs.

Real Estate Amenities

And then we have real estate amenities. These are features that improve the attractiveness of a property, such as a swimming pool or a clubhouse. The accounting here is to allocate their cost among those land parcels that benefit from the amenities.

Project Abandonment

So, what about those cases in which a project is abandoned? For example, economic conditions might change, and it’s no longer profitable to continue with a project. If so, you should calculate the recoverable amount of the costs, which is usually from selling the property to someone else. Then subtract this amount from the capitalized cost total, and charge the difference to expense in the current period.

Time Share Accounting

And now for a special case, and everyone’s favorite – time shares. Under these arrangements, the developer sells the right to occupy a property for a certain period of time on a repeating basis.

In a normal real estate transaction, you would charge to expense the costs associated with a specific property. You can’t do that with a time share, because there could be dozens of interval sales associated with a single unit. So instead, the cost of sales is determined with the relative sales value method.

In essence, you divide the estimated total project cost by the estimated total project sales, and then multiply that cost percentage by the sales generated in the period. The outcome is the cost of sales that you can recognize within the period. Of course, since that calculation involves lots of estimates, the amount charged to expense in each period could very well be wrong – but at least it sounds rational. Unlike the whole concept of investing in a time share.

Which brings me to the next point, which is the very high proportion of notes payable that time share owners never pay, because they’ve realized that it’s a crappy investment. This means that there’s a high risk that the amount of profit recognized from time share sales is overstated by the amount of these bad debt losses. To minimize this overstatement, you have to recognize an estimate of uncollectibility, which reduces the revenue recognized.

Participating Mortgage Loans

And here’s another special case, which is participating mortgage loans. In these loans, the lender can participate in the results of operations of the real estate development being mortgaged. Or, the lender might take a chunk of any appreciation in the development’s market value.

The borrower accounts for this participation feature by recognizing its fair value as a liability, where the offset is to a debt discount account. If the borrower ends up paying the lender a share of its profits, then charge it to interest expense, with the offset being to the participation liability account. And, the borrower should adjust the participation liability to match the latest fair value of the participation feature. And finally, if the mortgage is extinguished prior to its due date, then recognize a debt extinguishment gain or loss, which is calculated as the difference between the recorded amount of the debt and the amount paid to settle the debt liability.

Related Courses

Real Estate Accounting

Real Estate Investing

Real Estate Tax Guide

The Decline of the CPA (#354)

The Decline of CPAs

According to the AICPA, almost three quarters of all CPAs met the retirement age in 2020. And on top of that, the number of CPA exam candidates has dropped from 50,000 taking the exam in 2010, to about 32,000 now. That’s what I call a problem.

So, why the drop off in CPAs, and why so few new ones? A big issue is that it takes five years of classwork to qualify for the CPA exam, as opposed to the usual four years for most other undergraduate degrees. Given the cost of a college education, that is a big consideration. Do students actually have the funds to pay for this? If not, they look at other career paths, because accounting just too expensive.

Another issue is that the yellow brick road in accounting goes straight through the Big Four audit firms. Everyone wants to go directly from undergrad into one of these four companies, because they’re considered prestigious. And they really are prestigious. If you can make it to audit manager at one of those four firms, you’ll have some very nice career prospects after that. But there’s just one problem, which is that a lot of people find auditing to be an annoying and uncomfortable profession, so the dropout rate is really high.

A common standard is that twenty percent of the first-year hires into a Big Four firm either quit or a forced out within their first year. And the attrition keeps going after that. So, combine the two issues. A college student is looking at investing in an extra year of college, and has a pretty good chance of being bounced out of the Big Four after that. Which makes the investment look pretty crappy.

Now, let’s back up and look at why you need five years of training to sit for the CPA exam. The basic problem is that the accounting standards are massive. You could probably become a halfway decent bookkeeper with one year of training that covers the bulk of the accounting issues that you’re ever likely to face.

But, if you need to learn about all of the generally accepted accounting principles and auditing standards, then you’re looking at source materials that are fifteen inches thick, and that’s on very thin paper – trust me, I just measured it. Which is an astounding amount of material.

The basic problem is that the folks who produce accounting standards keep churning out more and more material, without really thinking about whether there should be so many highly specific technical rules, or whether you could just set some general principles and give people a little room for interpretation. If you’re wondering what I’m talking about, just look at the international financial reporting standards, which focus on general principles, and which are only four and a half inches thick. And which you could easily learn in a four-year program, along with the auditing standards.

Dump GAAP in Favor of IFRS

So, one solution is to dump generally accepted accounting principles right now and switch over to the international standards instead. Will that happen? Probably not, since there are lots of people who make their livings from producing more GAAP standards all the time. This is not just the people at the AICPA. This is also the industry behind it, which is – to be honest – people like me, who create training classes. And the Big Four audit firms, which can charge high fees because the accounting standards are so detailed that no one can follow them. So in short – no, we’re probably stuck with GAAP.

Offer Four-Year Accounting Programs

What other solutions are there? One option is for the business schools to offer a four-year program that skips all auditing subjects, and just instructs in the basics that you need to be an accountant, and not an auditor. They could keep offering a five-year program that you’d have to take if you wanted to also learn about auditing, and then sit for the CPA exam. Will that happen? Maybe. Consider how business schools work.

The Big Four audit firms don’t recruit everywhere. They only recruit at the top schools, so they’ll be putting pressure on those schools to provide lots of graduates from a five-year program. So what about all the other schools, which don’t directly deal with the Big Four? They may have students who want to prep for the CPA exam, and so will demand the extra class hours, but they may also see a lot of pressure to provide a four-year program – so I think that’s a possibility with these lower-tier schools. If that happens, then there’ll be a stream of accountants entering the private sector, just not the CPA profession.

Does that relieve the problem with fewer people becoming CPAs? Of course not, it doesn’t do anything at all, because it’s just making things easier for everyone else. If anything, that will drain away more people who might have stuck it out for the full five years.

Reduce the Hours Required for the CPA Exam

So are there any other options? One is being explored by the Board of Accountancy of Minnesota, which is thinking about reducing the requirement for college classes down from the current 150 hours to 120 hours, which would make it possible for people to take the exam with just four years of college. I think that’s a great idea, because it puts the burden of training incoming accountants onto the Big Four.

But right there, you can see the problem. The Big Four make enormous profits, and part of that comes from putting the burden on students to pay for their own five years of college, rather than having to provide the training themselves. Don’t get me wrong, all four companies invest a lot of money in training already. But, since they’re under a lot of regulatory pressure to raise audit standards, the last thing they want is to support a reduction in the college training requirement.

And another concern is that the AICPA is going against Minnesota, and making noises about having the other state boards of accountancy not accept CPAs who were certified in that state. In other words, it’s pressuring Minnesota to get into line with the other states and support the requirement for the full 150 hours of college training.

My Prediction - More of the Same

So, having said all that, what do I think will actually happen? I think the five-year training standard will stay in place for a long time, which means that the number of CPAs in the United States will continue to decline. The Big Four will still do fine, because everyone wants to work there. The real problem will be outside of the Big Four, where the smaller audit firms will have to really jack up their pay and benefits to attract new auditors. Which will also make them less profitable, so I can see a fair amount of consolidation among the smaller audit firms.

And on top of that, the audit firms will have to keep shifting work onto unlicensed accountants, and also shifting work to low-cost outsourcing operations, probably in India. If that happens, then the risk of audit firms being sued for doing crappy audits will go up, since the staff quality has gone down. And that will drive more CPAs out of the auditing business, because they’ll be under more pressure to put in more hours.

Accounting for Homeowners' Associations (#353)

In a homeowners’ association, the residents all own their own homes, while the HOA owns all the common property. Anyone who buys property within the area controlled by the HOA has to pay dues – which is about all that most people know about HOAs. But there’s quite a bit more.

The Reserve Study

Everything starts with something called a reserve study. This is a study by a third party that inventories all the common property, assesses its condition, estimates its remaining useful life, and then estimates its replacement cost. This report is used to derive the amount that should be in an asset replacement fund, which is used to pay for all of those asset replacements over time. And the recommended size of this fund is what drives part of the assessment that the HOA sends to all of its members. So, if you’re ever wondering why your HOA fees are so high, request a copy of the reserve study.

Operating Expenses

But the reserve study is not the only reason for your HOA fees. The rest of the fee comes from ongoing operating expenses, and that varies by HOA. If your HOA doesn’t provide much in the way of services, then the fee is pretty low. But if that’s not the case, then ongoing operations could add up to a lot of expenses.

Accounting for Assessments

So, the reserve study and ongoing operations are the inputs to your HOA assessment. What’s the accounting like for that? Well. A lot of HOAs bill their members early, so they can get paid as quickly as possible. The trouble is that these bills might be issued a month before the period to which they apply, so any early payments by members have to be recorded as a deferred revenue liability. And then, when the HOA actually enters the correct billing period, the liability is eliminated and the payments are recorded as revenue instead. Sort of.

Actually, the portion of the assessment that relates to current operations is recognized as revenue right away, while the portion that relates to the reserve fund is parked in that fund until it’s actually spent. When the cash is spent, then it’s recognized as revenue.

Another interesting HOA assessment item is that the developer might initially be assessed some of these fees. This is because when a development is still being built out, the amount of assessments collected won’t be enough to pay for all of the HOA expenses, so the developer commits to pay an assessment on the unfinished lots until enough of them have been sold to cover the HOA’s expenses.

Accounting for Late Fee Income

Some of an HOA’s revenues also come from late fees. Sometimes, members might pay assessments really late, which can pile up the fees. This is a particular problem for HOAs, because they have no control over their credit risk. Think about it – an HOA has to collect assessments from anyone who owns property inside of the area that it controls; the HOA has no control at all over who buys this property. So if someone in financial trouble is also a member, then the HOA is going to be spending a lot of time collecting its assessments. And piling up late fees. If it can collect any money at all.

Accounting for Insurance Settlements

Another revenue item is insurance settlements. If an HOA’s assets are damaged in a natural disaster – like the HOA office being flooded – then there’s going to be an insurance settlement. This is classic contingency accounting, where you can’t recognize a recovery claim until the claim receipt is probable and the amount can be reasonably estimated. If the claim is still being litigated, then you can’t recognize anything. And here’s an extra twist; if the payment can be recognized, and the HOA has not capitalized the related assets, then the settlement is recognized as revenue. But, if the HOA had capitalized the related assets, then it has to recognize a gain or a loss on the transaction – probably a loss. If that’s the case, the loss is calculated as the difference between the carrying amount of asset and the settlement received.

Accounting for Utility Pass-Throughs

Here's another sort of revenue-ish item – utility pass-throughs. A utility might install a single master meter to track usage, rather than installing individual metering for each unit. In that case, the HOA pays the bill, and then turns around and bills the members for their usage. This usage might be a simple allocation, such as for Internet usage, or it might require individual metering for each unit by the HOA, such as for electricity.

An HOA might record these pass-through amounts as revenue, and then record offsetting member payments in an expense account. Or, it can net the revenues and expenses together, which should result in a pretty small net amount that’s made up of unpaid billings to members.

Accounting for Cable Television Marketing Fees

Here’s another revenue item. A cable television provider might pay an HOA an up-front fee to get exclusive access to its residents. This fee is paid in advance, usually for a multi-year period. When that’s the case, the HOA has to spread out the revenue recognition over the term of the agreement, which could easily be for five years.

Accounting for Developer Contributions

There’s one unique fixed asset area that you’ll only find in an HOA. When a development is completed, the developer will probably transfer some common area assets over to the HOA. This might be things like roads, swimming pools, fences, and drainage systems. When the HOA receives these assets, it records them at their fair value as of the acquisition date. It can be difficult to derive fair value, so an HOA could at least take the developer’s costs into consideration when it’s compiling fair values.

Accounting for Asset Retirement Obligations

Here's another HOA item. It might actually have to record an asset retirement obligation. This is pretty rare for most businesses, but it’s a possibility for an HOA, especially if it has fuel tanks somewhere on the premises that will have to be removed someday. And if that seems unlikely, consider that an HOA might run a golf course for its members, and that golf course might have a buried fuel tank for its maintenance vehicles.

Interfund Accounting

Another accounting area is interfund accounting. An HOA might record its operating activities in one fund, and its capital replacement activities in another fund. There might be a lot more funds than just those two, since you might want a separate fund if the HOA is also running a golf course, or another one for settlement proceeds, if the HOA is involved in insurance payouts and lawsuit settlements. Sometimes, it might pay from one fund for an expenditure that related to a different fund. When this happens, you create a receivable for the paying fund and a payable for the other one. So, the interfund accounting can get pretty tangled.

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Islamic Accounting (#352)

The Nature of Islamic Accounting

Islamic countries all use international financial reporting standards. But, they do it with a few differences. The key underlying issue is the extent to which an Islamic business is supposed to be operated in an ethical manner. Islamic law emphasizes the welfare of the community over that of the individual, so it places an emphasis on investments that help the community. You’ll see what I’m talking about in a minute.

Accounting for Zakat

The first accounting issue where this arises is in the payment of zakat. This is a type of alms that’s required for any Muslim who has wealth that exceeds a certain minimum threshold. Zakat is applied at a rate of 2.5% of a person’s wealth above that threshold, and it’s calculated and paid annually. Now, having just said that the zakat rate is 2.5%, I’m going to walk that back a bit. There are higher rates of zakat, depending on the nature of your wealth, and in one case it can go as high as 20%. So, this is not a minor item.

Zakat is payable by all qualifying businesses and individuals. So, from the perspective of the accountant, you need to compute exactly what constitutes the basis for the calculation, and then pay it. The payment is usually made to a national agency that’s in charge of collecting and disbursing the funds. If you don’t pay it, then there’s a fine, and you might even end up in jail.

The basis for Zakat is governed by all kinds of rules. For example, the “wealth” of a business is considered to be its growing capital, which is defined as its inventories and any capital assets that are not being leased. And, any investments classified as trading securities are subject to Zakat, while available-for-sale securities are not. And, prepaid assets are not subject to Zakat, since the underlying asset is not fully controlled by the business. There are many more rules, but your main takeaway is that you actually need an accountant to figure it out. Sounds like a light version of the U.S. tax code.

The next Zakat issue is when to pay it. It’s supposed to be paid at the end of one lunar year, which has a duration of 354 days. However, a business is more likely to follow the normal calendar year, which has 11 more days. And to account for these extra 11 days, a business pays a higher Zakat rate of 2.5775 percent. Lots of complexity.

Zakat payments made by a business are classified as an expense, while any unpaid Zakat balance is classified as a liability. However, if the firm’s shareholders require the business to pay Zakat on their behalf, then these payments are treated as a deduction from their share of the firm’s distributable profits. And if there are not enough distributable profits to cover the Zakat payments, then the firm records a receivable due from the shareholders for the difference. So you can see that Zakat appears in lots of unexpected places.

The payment of Zakat also triggers a completely unique financial statement that you don’t see outside of Islamic accounting. This is the Statement of Sources and Uses of Funds in the Zakat and Charity Funds. This itemizes the sources of funds, which are the Zakat payable by the company and any other donations that were paid out. It also itemizes the uses of the Zakat and charity funds, which are aggregated into categories that are mandated under Islamic law. Example line items are Zakat for the poor and needy, Zakat for the wayfarer, and Zakat for the heavily indebted and freedom of slaves. The report also notes any fund balance remaining at the end of the reporting period.

As I mentioned earlier, this statement is based on the belief that businesses are supposed to help the community. I can’t help thinking that something like this would be awesome for Western corporations – maybe just a statement of charitable donations.

Accounting for Sukuk

The next Islamic accounting issue arises from the prohibition on charging interest. The reason for this is the idea that a person’s wealth should not be used to generate interest, which requires no work, and which would tend to concentrate wealth. When you think about it, it’s not actually a bad thought.

This means that a business cannot issue bonds that pay interest to investors. What they do instead is issue a sukuk, which is an Islamic financial certificate. The issuer uses the proceeds to purchase an asset, in which the investors have an ownership interest. In addition, the issuer has an obligation to buy back the certificate at a future date at its par value. This type of bond structure means that investors are sharing in the risks and rewards of the underlying asset, rather than being paid interest.

There are a couple of variations on this. For example, the issuer could use the proceeds from a sukuk issuance to acquire assets and transfer them into a special purpose vehicle, in which the investors have an ownership interest. This entity then leases the assets back to the issuer. As the issuer makes scheduled lease payments to the special purpose vehicle, these payments are distributed to the investors.

Here's another variation. A manufacturer of goods issues sukuk certificates, which represent ownership interests in goods that have not yet been produced. The money is used to pay for their production. Once the goods have been sold, the investors receive a portion of the proceeds.

These issues might appear to be just finance-related, but consider the amount of accounting involved. You have to track ownership interests in each of these deals, and then issue payouts based on the proceeds. And if there are a lot of separate deals, each one using a different profit-sharing arrangement, then the accounting could become really complicated.

The Value-Added Statement

And finally, we have another financial report that’s unique to Islamic accounting. This one is the value-added statement, which focuses on how the funds generated by a business are distributed to its various stakeholders, rather than on how much profit it generates. It essentially shows where payments come from – which is revenues – and where it all goes, which is wage payments to employees, taxes paid to the government, and payments made to charities – plus whatever profit is left over that the business elects to keep in-house. In other words, the report shows how much a business is paying back into the community. Something worth thinking about.

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Accounting for Car Dealerships (#351)

Dealership Profit Centers

The biggest accounting issue for a car dealership is the need for profit centers. The chart of accounts needs to be structured so that you can track profitability for new car sales, and used car sales, and for servicing, and the parts counter. And if you have an in-house paint and body shop, then that will need a profit center too. And if there’s a quick service department for oil changes, then that’s another profit center.

The ramification for the accountant is pretty major, because you have to assign revenues and expenses correctly, so that they go to the right profit center. That’s not so easy, especially in the case of expense assignments, so the accounting procedures will need a heavy orientation towards transactions by profit center.

Contracts in Transit

The next accounting issue is contracts in transit. A dealership enters into a contract with a lender whenever a customer wants to use a loan from the lender to buy a vehicle. The entry for it is to record a receivable for the contract, since it takes a few days for the lender to forward funds to the dealership. And in addition, it has to record a dealership reserve, which is the commission that the dealership earns from the lender in exchange for directing its customer to the lender.

Extended Warranties

And as part of a sale, the salesperson might convince a customer to buy an extended warranty. In this case, the dealership records revenue in the amount of the warranty, while it also records a payable to the car manufacturer, since it’s the manufacturer that’s providing the actual warranty. The dealership is just a go-between, and pockets the difference between the price of the warranty and the fee charged by the manufacturer.

Car Insurance Commission

So, what if a customer doesn’t have car insurance? The dealership can refer the person to an insurance company, in exchange for yet another commission. So when a customer uses the referred insurer, the dealership records a commission receivable from the insurer.

Warranty Claims

And then we have warranty claims. When a customer brings in a car for repairs that are under warranty, the dealership compiles the full cost of the repair, and then bills the manufacturer for it. The manufacturer then reviews the amount of the claim, and might not pay all of it. If so, the accountant has to subtract the amount not paid from the original claim revenue.

Demonstrator Accounting

And then we have demonstrators. These are the cars you drive around when you’re evaluating whether to buy one. These cars come out of the regular dealership inventory and are recognized as fixed assets, which means that they have to be depreciated. Eventually, they’re sold off as used cars, which means that their remaining book value – after depreciation – is dropped into the used car inventory, and then they’re sold.

Used Car Accounting

Which brings us to used cars. When a used car is accepted by a dealership, it’s first examined for problems, which may result in repairs being made to it. If so, the cost of the parts and labor used in the repairs is added to the cost of the car. After that, the car might be sitting in inventory for an extended period of time. If so, the accountant may have to write down its book value to the lower of its cost or its appraised wholesale value. In this case, the cost of the vehicle is its purchase price, plus the cost of any upgrades made to it, plus the auction fee to acquire it, plus any travel expenditures incurred while acquiring it.

Labor Accounting

And then we have labor. This is a very big deal in a car dealership, since it usually employs a lot of people. At a high level, the accountant needs to charge their cost to the appropriate profit center, which is handled with the basic payroll entry. That’s the easy part.

The more difficult part is billable hours. These are initially charged to work-in-process labor, which is an asset account. If some of these hours turn out to not be billable, then they’re charged to expense in the current period. All other hours are charged to specific customer jobs. When that happens, the labor is taken out of the work-in-process inventory account and charged to the cost of sales. As you might expect, there’s a lot of accounting to be done in this area, and the work-in-process account needs to be examined all the time to make sure there aren’t any hours in there that aren’t really going to be billed to customers.

Parts Counter Accounting

And on top of everything else, there’s the parts counter. This one is actually fairly easy. The parts counter is treated as a profit center, so it gets credit for all parts sales, though the cost of the parts counter staff is also charged to it. And there will be physical inventory counts of the parts inventory – so if there are any obsolete parts or missing parts to be written off, they’re charged against the parts counter profit center.

Dealership Expenses

There are also dealership expenses. I won’t go into the standard items, but there are some expense categories that are worth discussing. The first is advertising.

That may not seem so unique, but the amount of it is, especially compared with other industries. Car dealerships can spend a lot on advertising, and it covers everything – billboards, television ads, radio ads, direct mail pieces – everything. They might also sponsor local sports teams, and also give away all sorts of things, like branded coffee cups and key fobs.

Another item is dealership vehicle expense. The dealership has to service its demonstrators and company cars, which includes labor and parts, as well as car washes and gas refills, and licensing and registration. The amount is not exceptional, but you don’t see this expense anywhere else.

Here’s another one – delivery expense. This includes all expenses incurred to prepare a vehicle for delivery to a customer. This can include filling the tank with gas, detailing labor, detailing supplies consumed, safety inspection labor, and even the cost to remove accessories that the buyer doesn’t want.

A big expense is floorplan interest expense. A dealership usually maintains a lot of vehicle inventory on the premises, and they’re usually financed with asset-backed loans that are called floorplan loans. Under these arrangements, the debt must be paid back when the underlying vehicle is sold. For the period when the vehicle has not yet been sold, the dealership has to pay floorplan interest expense to the lender. Though, if the lender also happens to be the manufacturer, it can issue a credit to offset the interest charges, which encourages the dealership to acquire more vehicles from it.

Here's one more – policy work. A dealership might decide to provide parts or service to a customer for free, to keep the customer happy. This usually happens when a customer complains about service work or the quality of the parts purchased from the dealership. The dealership has no expectation of billing the manufacturer for the costs incurred. Instead, these costs are charged to expense.

As you can see from all of these issues, accounting for a car dealership is not easy. There are many kinds of transactions, and the transaction volume can be really high, especially in regard to billable time. That’s why it takes a whole team of accountants to run a car dealership.

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Calculating How Long Your Cash Will Last (#350)

How do you determine how long your cash will last? First of all, don’t expect to find this information in your financial statements. It won’t be there. The focus of the financials is on how much money you made, your financial position, and how you’ve already used cash. There’s nothing about a cash forecast in there.

Model Cash Flows

Instead, you’re going to need to build a cash flow model, and it’s going to have to be very detailed, because if you want to know how long your cash is going to last, it’s a pretty good bet that you’re on the edge of bankruptcy. So, be as specific as possible. That means listing your best guess for when every reasonably large receivable is going to be collected. This does not mean that you have to separately list out every single one of them. Just use the 80/20 rule, where you list the 20 percent of customers that constitute 80 percent of your sales. For everything else, lump it into a single cash receipts line item.

Then do the same thing for expenses. Again, use the 80/20 rule, so you’re itemizing the 20 percent of suppliers that constitute 80 percent of your total expenses. Be very specific, and itemize exactly when you plan to pay a supplier for each specific invoice. To make this really comprehensive, include in the model the supplier invoices that you know are coming, but which you haven’t received yet – like the rent invoice, or the electricity bill.

Review Discretionary Expenses

At this point, it’s also a good idea to bring up discretionary expenses. Your goal is to make the cash last as long as possible, so have hard discussions about which expenditures you’re going to stop, such as employee training, and travel, and building maintenance. These need to go away for as long as you’re having cash flow difficulties. Be formal about it, and put out a memo about which expenditures will stop.

This gives you the building blocks for a cash projection. Offset the projected cash inflows against the projected cash outflows, and now you a first pass at when the cash will run out.

Analyze Compensation

But that’s really just a starting point, because if you’re in a fight for survival, you now need to start working through every variable in the projection. Right away, decide whether you can afford to let anyone go, and do it right now. The earlier you do a layoff, the more cash you’ll have available later on. Seeing that compensation is one of the largest expenses of a business, this is a biggie, so don’t wait.

Next, look into pay cuts. This always starts with the management team, because they have to set an example for the rest of the company. If anyone’s going to take a major cut, let it be them. Or, you might offer shares in the business in exchange for salary reductions. That’s an easy one, since if the company might fail anyways, who cares about ownership percentages?

Accelerate Receivables

Then work on accelerating receivables. This means offering a really juicy early payment discount on your billings. And make sure that customers know about it. And on top of that, assign way more staff to collecting overdue invoices. And, once again, the 80/20 rule applies. Focus your collections work on the 20 percent of invoices that make up 80 percent of your accounts receivable. The point here is to be focused on bringing in the cash.

String Out Suppliers

Next up is stringing out supplier payments. If the business is going to go bankrupt anyways, then you can afford to annoy suppliers, and drag out payments. But this needs to be highly targeted. Some suppliers are more important than others, so you may need to pay some of them right on time, while others can be pushed out for weeks or even months.

Update the Model

At this point, you should have a really good idea of how long your cash will last. But keep in mind that the situation will change every single day. So, if you’re really running short of cash, then you’re going to have to set aside time every day to update the model based on cash inflows and outflows, and also what your collections people are telling you about the probabilities of payment for specific invoices.

Set the Time Buckets

Which brings up one final point, which is the size of the time buckets that you’re using in the model. You might be tempted to set up one-day time buckets, but I’d argue that you can’t reasonably expect to predict incoming cash right down to a specific day. So instead, I suggest using a one-week time bucket, and setting up these intervals for as far out in the future as you expect to have any cash. The further time buckets will mostly contain estimates of cash inflows and outflows, and so will be the least accurate. But as those time buckets move closer to the present day, you can swap out the estimates for real incoming and outgoing payments, which increases the accuracy level.

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Cash Flow for Solvency (#349)

The Solvency Conundrum

How can you tell if an operation is sufficiently solvent to pay for its investments and grow the business? There are lots of good issues here. First, can you figure out solvency from the statement of cash flows? Not directly, no. That statement only organizes accounting information about where cash came from and how it was used, so you can see it all on one page. But in terms of judging solvency, not really.

Your best bet for evaluating solvency is to calculate the solvency ratio, which looks at the ability of a business to meet its long-term obligations. The calculation is to divide an adjusted net income figure by the total short-term and long-term obligations of the business. To get to that adjusted net income figure, you’ll have to add all non-cash expenses, such as depreciation, back into the after-tax net income figure. If the resulting percentage is pretty high, then the business can probably pay off its liabilities over an extended period of time.

Budget Model Construction

But did that actually answer the question? No. It doesn’t tell you if an operation is solvent enough to pay for its investments and grow the business. The only way to find that out is to construct a budget that shows your expected cash inflows and outflows, by month, for at least the next year – and preferably longer. Load into that model all expected investments, and the rate of growth that you want.

Now, for this model to be really effective, it has to incorporate the balance sheet, so that you can see how the growth rate you want is impacting the projected working capital of the business – which means that receivables, payables, and inventory will all go up. If you plug in a high growth rate, then the need for working capital is going to go up a lot, which is going to wipe out your cash reserves in no time at all.

Budget Model Accuracy

The problem is getting that model to be as accurate as possible. A good way to keep things realistic is to match it up against your most recent financials and see if all the margin percentages look believable. That means being realistic about the gross margin percentage, and the operating margin, and the net profit margin. As long as you’re essentially copying the company’s historical experience forward into the model, there’s a good chance that what you’re modeling might actually happen.

Budget Model Iterations

At this point, you start doing iterations. On your first pass, your best-case rate of growth, along with all the investment required to make it happen, is probably going to call for a massive financing infusion. This is especially the case if your margins are already pretty low, because the business is not spinning off enough cash to pay for much of anything. For a low-margin business, the piddling amount of cash being generated is always going to put it on the edge of insolvency.

But, if the margins are higher, or if you have a reasonable argument for increasing margins, then more cash can be spun off, which allows you to grow the business a little bit faster without taking on any outside investments or debt. In essence, you use the model to tweak the budgeted growth rate, until you can figure out exactly how much growth you can afford. Try to grow any faster, and you’ll be insolvent. And speaking of which, remember that solvency ratio? Put that in the model too, so you can see – by month – whether the business can pay its bills.

The Investment Requirement

A couple of other thoughts. First and most important is the amount of investment needed to generate more growth. Some business models are pretty asset-light, so you can get by with minimal investment. If so, a moderately low-margin business might still be able to grow fairly quickly. The worst case is when margins are low and you need a lot of incremental investment to increase sales. In which case, sell the business and go look for something else to do.

Sales Variability

Second, lots of businesses don’t have steady sales all year long. There’s probably going to be a slow period, as well as another period in which sales spike. Watch for these periods in your budget, since they’ll impact your ending cash balance. If there’s a sharp drop, that gives you an indication of when you might need to have a line of credit available, and a rough guess as to the amount.

Assumption Modifications

Third, don’t go too crazy on modifying some of your assumptions in the budget model. For example, if customers are used to paying you in thirty days, don’t just assume that you can cut the payment interval to 10 days without getting some customer pushback. And, for that matter, don’t assume that you can massively stretch out payments to suppliers – they don’t like it, either. Instead, it’s pretty likely that you’re stuck with a model that matches how the industry already operates.

Inventory Modifications

Fourth, if there is an area within a business where you might have some room to make changes, it’s inventory. If you tightly manage how much inventory is kept on hand, you might be able to operate with a significantly reduced inventory investment, which frees up cash for more growth. In short, good inventory controls can lead to a bit more rapid growth.

Failure Probabilities

Fifth, assume that something will go wrong. There’s always something beyond your control that reduces your expected cash flow. Maybe a customer goes bankrupt or starts buying from a competitor, or maybe a supplier delivery gets destroyed in an earthquake. Could be anything. So, if you’re relying on that cash to support lots of new hires or store openings, be prepared to be shortchanged. That means you have two choices. Either have a line of credit or some other source of cash in reserve, or scale back your growth plans a bit, so that you have an internally-generated cash reserve to deal with these situations.

A Final Thought

And a final thought on this issue; before you start working on aggressive growth plans, take a really hard look at the company’s historical profit margin percentage and investment requirements. If that margin is pretty low and the investments are high, then you’ll be struggling just to get by, let alone trying to grow the business. So, the real issue with solvency is deciding whether you’re even in the right business. If margins are too low, even your best efforts will probably only raise them a little bit – and that’s not going to allow for much in the way of growth.

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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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