If you like many businesses are going through a workout, turnaround or reorganization, either out-of-court or pursuant to a Chapter 11 petition be sure to consider the impact of cancellation of debt income in your workout plan. Loan forgiveness or modifications can give rise to cancellation of debt income which can result in negative income tax consequences for your business or in the case of a pass-through entity at the shareholder level. However several opportunities to exclude or defer this income exist which should be factored into your workout strategy. In developing any cash flow projections or pro formas consideration needs to be given to the income tax implications depending on whether exclusion of CODI is an option or if deferred that the appropriate deferred tax liability is recognized as part of the income tax provision. For pass-throughs it  is equally important to take this under consideration so as not to undermine or negate the benefits of the workout plan.

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If you work with or are an organizations that enter into leasing transactions as lessors you may find the following method of recording leases in Quickbooks helpful. This is appropriate for leasing companies with 50 or fewer tenants who have not already invested in ledger software specific to that industry. Consider this for organizations that own small office buildings, office parks, retail outlets or shopping centers.

Quickbooks includes the memorize transaction function for setting up recurring entries which can be accessed from the edit menu. What I have found works well is that you can create a recurring invoice which posts automatically on the 1st of each month which can be used to record the rents associated with the lease and can also be used for billing purposes. To create the recurring transaction select to create a new invoice and select the appropriate tenant. Date the invoice for the next month and set the due date to the fifth day of the month or as appropriate under the lease terms. I then itemize the invoice by rents, utility charges, CAM charges, marketing charges, etc. Once the structure of the invoice has been setup I select memorize transaction from the edit menu. From there you need to select to automatically enter. In the how often field select monthly. For next date select the month following the month selected when setting up the invoice. For number remaining, refer to the lease to determine when the last payment under the lease is due.  Also if the lease calls for escalations or concession period then only count through the beginning of the next escalation period. You will then set up a separate recurring transaction for each escalation period using the method above. The last step is to enter how many days in advance to enter the memorized transaction, which I use two weeks before the rent is due to provide for time for billings to go out and then save the transaction. Also be sure to check the ‘To be printed’ box on the invoice. By doing this, after the memorized transactions batch post you can then simply select to print batch and the entire monthly tenant billing will run.

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Designing internal control procedures is often met with much reluctance. It can be hard to see the long term payoff of implementing a procedure when faced with the upfront time investment. This is especial true when comparing the costs of implementation to the individual transactions themselves which may each be highly immaterial. However, the payback has to be viewed in the aggregate to appreciate what the long run gains in efficiency that designing and implementing controls provide.   If you are going to take the time to design and implement a control here is some advice on how to create a bullet proof procedure that will help your organization reduce errors, fraud and wasted time and resources.

The elements that your bullet proof procedure should have are:

1. It should not be reliant on someone having to remember to do something. What this really means is that every action or step in the process should have a ‘triggering’ event or source document. That may appear obvious but I have seen too many accounting procedures manuals with things like ‘the bookkeeper runs a weekly AP report to determine what items to pay’. The bookkeeper shouldn’t run anything. Instead the accounting system should use scheduling software or a reminder system (this is already built into Quickbooks) to notify the bookkeeper.
2. Make workarounds less convenient or more annoying. It is human nature to resist change or to try and find shortcuts. If staff circumvent controls then the effectiveness of the procedure will be undermined. Your control should be designed to be preferable to alternative workarounds to provide incentives for your staff to use the process you have created. If the workaround appears more appealing you may need to take a critical look at the design of your control. It may be your control is inefficient and the workaround is better!
3. Multiple independent verifications or authorizations. This is similar in concept to the need for segregation of duties in your internal controls. The idea is that you need to have multiple opportunities built into the procedure to identify errors. For example with a triple match system (purchase order-receiving report-invoice) you get three opportunities to root out problems. If you believe that your organization is too small, consider that this is a good opportunity to incorporate staff outside the accounting function into the process. Can someone from marketing get involved with customer collections/receipting for instance to follow up on outstanding items? Could be an opportunity to reach out to customers and hear any complaints that might have lead to a late or non-payment.
4. Exception handling. Similar to number 3 above except here we are looking at the need for a failsafe. Exceptions will occur and things will fall through the cracks or get lost. Is there a procedure in place to make sure these exceptions get to someone who can direct them back into the standard workflow? For instance if you receive vendor invoices via email is there an email catchall and is someone responsible for checking that catchall folder for invoices that get directed to general company addresses?
5. Automation. Simply put, automate everything you can. Bill payment, automate it. Journal entires, automate them. Reports writing, automate it. One important warning here. If you set up recurring/automated payments, entries, etc. make sure to use the ‘end by’ functions of these tools. It is easy to setup a recurring payment to run forever. However, check the contract and if the payment should end after say 30 payments, build that into the payment structure.

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Internal controls are one of those things in accounting and finance that are almost guaranteed to cause an immediate loss of attention when presented to small business owners. Bare with me though, as I have a good reason why you should pay attention to them other than the commonly cited prevention of fraud. When it comes to internal control procedures there are actually benefits outside of preventing and detecting fraud. Controls are often viewed as a source of additional work and overhead. But just like any other process or procedure controls can and should be designed to actually improve the efficiency of your business and the effectiveness of its operations. As any good entrepreneur knows, one key to developing a successful and scalable business is being able to identify a repeatable process for delivering the goods or services of the business in an efficient manner. Similarly a well designed internal control process can yield cost and time savings in the organization.

One example is the tried and true triple match of a Purchase Order, Receiving Report and Vendor Invoice prior to issuing payment to a vendor. At first this might appear less efficient in that three separate forms must be accumulated and handled before rendering payment to a vendor rather than just paying upon presentation of the invoice from the vendor (ignoring for the moment that almost all modern accounting systems build in an automated function to handle this). But the reality is that most businesses that rely on nothing more than the vendor invoice end up wasting significant amounts of time searching back through records and emails for where they originally ordered the invoiced items. Depending on the volume of transactions time may be spent trying to determine whether the good or services were received. Many small business owners will argue that because they are so invested in the daily operations of their business they can do this on the fly. Experience has shown me that this never works and either the owner spends inordinate amounts of time chasing down vendors and missed payments or doesn’t spend enough time on it and ends up making duplicate payments or payments for goods and services not received. The triple match system alleviates all these issues by creating a structured and efficient workflow where the person processing the transaction doesn’t have to track in their head the details of every outstanding vendor transaction. Instead they can let the flow of source documents drive the transactions and next steps in the process avoiding not only error but wasted time.

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A frequent complaint I here when working with small business owners and not-for-profits is that GAAP accounting is too academic and doesn’t provide any practical value to their organization. This typically comes up in conversation concerning stock option expensing, straight-lining rents or discount pledges receivables. Granted many of the more esoteric aspects of GAAP do come across as academic even to accounting professionals. For time pressured business owners, managers and directors trying to gain an understanding of some of the more complex treatments for recording transactions in accordance with GAAP is next to impossible. This very problem is what has spurred the debate for big and little GAAP standards. One thing I try to point out to my clients though is that even though some of the accounting treatments under GAAP may at first appear academic, many of these standards provide both meaningful and practical information about the business for better decision making.

A good example is the percentage-of-completion method for recognizing revenue on long-term contracts. Many contractors at first may believe that cash basis is not only the simplest way to track their revenue and expense under long-term contracts but that it is the best. Under GAAP these contracts should be recognized using percentage-of-completion, which to many contractors may come across as onerous. But cash basis can result in extremely misleading financial statements which if the business owner relies on for decision making could result in costly or even disastrous results. One such example is the habit for many cash basis contractors to accelerate cash expenditures at or near year-end in order to reduce their income. Basically the financials show income so business owners rush to expend cash in an attempt to accelerate deductions to reduce income for tax purposes. They also try to delay receipts until after year-end to further reduce income. The combination can result in significant cash flow gaps hurting the organizations liquidity as well as potentially increasing bad debts from the deferred receivables. This is a good example where not using GAAP and a separate issue regarding a lack of knowledge about what tax reporting options are available for long-term contracts can have a negative impact on the financial health of an organization.

A second example relates to the concept of over and under billings. When presenting cash basis financials a large bank balance would likely lead a business owner to the conclusion that their organization is healthy. However, this same organization can look very different when GAAP’s percentage of completion is applied. Percentage of completion requires recognition of the liability of overbilling on contracts. Assume the following, a contractor has one long-term contract valued at $3 million which they anticipate costs of $2.4 million to complete. The contractor has progress billed the client for $2.6 million to date. So under cash basis for example, a contractor might report $1 million in cash in the bank but under GAAP there may be $1.8 million in contract work that has been previously billed for but for which no actual work has been done yet. In other words, an organization has overbilled their customers for $1.8 million in work is now liable for delivering on the contract with only $400,000 left to progress bill. The reality in the example above is that this company is actually insolvent and they just don’t know it yet! That’s hardly academic and is about the most practical dose of reality a business owner can get.

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As a follow up to my post early this week regarding the need for business owners to make monitoring their financial statements a priority I wanted to specifically address the issue as it relates to business start-ups.  I have worked with many entrepreneurs so I understand that in the early stages of a start-up all of the attention gets focused on developing the market, making sales, promotion and so on. Many small companies just starting out let this be an excuse for shoddy recordkeeping and a general disregard for monitoring their finances. It’s an easy trap to fall into, after all there usually isn’t all that much money to track early on so do you really need to monitor it? Of course, the answer is yes and not only that but the obligations you are incurring, equity and capital transactions that are being entered into and a whole host of accounting issues specific to starting a new business. The Small Business Administration has cited for years that one of the top reasons small businesses fail is a lack of adequate accounting systems. What they are seeing here is a lack of monitoring of the organizations finances at one of the most critical stages in the organizations lifecycle!

Ok, so that sounds good and everything but your small business venture is cash strapped so what are you supposed to do. First off you need to be honest with yourself and ask, how good could your business plan be if it doesn’t even contemplate the cost of having to keep records and prepare income tax and payroll filings. Can you really say you have adequately identified your capital needs if professional fees for accounting and income taxes haven’t been included in your cash flow projection. What you say, you don’t have a cash flow projection for your new business venture? You say you couldn’t afford to hire an accountant to help you prepare one? Have you really thought this through? If you can’t afford to hire a professional to assist, then you need to consider whether you can either accomplish this by bootstrapping and learning to do it yourself (highly advise against this one), seeking debt financing or raising equity. Depending on the relationship with your prospective accountant there might even be an opportunity to bring them in as an equity stakeholder in lieu of payment. Most entrepreneurial ventures that fail to adequately plan and which deny the need for professional accounting help will ultimately fail. If they survive it is rarely due to any special business acumen or insight. For them it will simply boil down to luck.

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It would seem elementary that monitoring the accounting and finances of your business is an essential control for effective management. But why then are so many business owners guilty of having no idea of the financial position of their company? I see case after case of business owners who are shocked to find that their company is insolvent, that obligations which they personal guaranteed are in default and that they are liable for an assortment of unpaid trust fund payroll taxes? My inquiries with these individuals has lead me to the conclusion that it all comes down to a simple failure in basic internal control procedures; nobodies monitoring the financials. In response to my inquiries I get justifications such as, “Well, I reviewed the bank account balance daily”, “I pay a controller to watch that?” or  ”I got annual financial statements from my CPA”. In response to the first I explain that bank balances don’t show you your liabilities, to the second I ask “so who’s watching him?”, and to the third I question, “What do you look at for the rest of the year?”. A recent client whose business we just finished winding down told me that he didn’t feel like he needed to monitor his business. He was acting largely in a limited capacity providing the capital for the business while another partner acted as the managing member. I asked my client whether he ever received any financials from the managing partner. His response was no, he was relying on the managing partner to review those. So I asked the managing partner whether he was reviewing the financials. His response was no, the other partner never asked for them so he never bothered. Can you have a more obvious example of “the blind leading the blind”?

Business owners need to put a strong monitoring system of their finance and accounting at the top of the list of priorities. Monitoring is the first step in understanding the true financial position of your organization. If your idea of monitoring is checking the bank balance each morning you need to consider implementing or hiring someone to implement an actual accounting and reporting system. If you already pay someone (controller, CFO, bookkeeper, etc.) to monitor your organizations finances you need to have procedures in place to hold them accountable and verify that monitoring of the financial is in place. A good start would be monthly budget-to-actuals and variance reports. Finally, if you are looking to your annual financial statement audit as your source of monitoring (ah hem, listen up here board members) then understand that for 364 days of the year you are completely in the dark. Why not engage your CPA to provide monthly compiled financials if you don’t have the internal resources to do it. In any case, if you ignore this vital organizational control don’t feign shock when delinquent notices, tax liens, default and foreclosure letters, etc. start showing up and you suddenly find out that business isn’t as rosy as your bank balance may have lead you to believe.

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When I talk with clients regarding why they have not implemented certain internal controls over their accounting system a common response I get is that they implicitly trust their employees. Trust is not a replacement for internal controls (see Trust But Verify ) however many times that is not a compelling argument for business owners. So here is another reason I use to explain why ethical and responsible owners and managers should implement internal control procedures. The reason is simple. Your employees want you to! It is an absolute certainty that accounting errors and mistake will occur in your organization. Your employees do not want to become the scapegoat for these errors just because you haven’t put procedures in place to assign accountability over the organizations assets.

A perfect example I recently encountered was a business client where no cash handling procedures had been put in place over receipts at the register. After talking with the staff I got the same story from every one of them. They were all terrified and highly dissatisfied that there was a complete lack of control or accountability over the cash drawer. They all felt, quite correctly, that because no controls over cash handling had been implemented, they were powerless to prevent errors or theft  from the cash drawer and yet they would be held responsible if errors or theft occurred. Not a very good or fair situation to put your employees in. Case in point, $50 had gone missing from the cash drawer a few weeks prior and suspicion had been cast on all the employees by the owner since they could all access the drawer. This put everyone in an uncomfortable position that hurt the morale of the business. The owner later remembered that he himself had taken the $50 out of the drawer, but since they performed no petty cash reconciliation it had been forgotten.

The common consensus regarding internal control procedures is that they are for preventing or detecting fraud. That however, is only one value add proposition for implementing strong internal control procedures. From the perspective of the employees, the value is that the internal controls that have been implemented are the evidence to exonerate them from misdirected accusation or suspicion when something goes wrong. Without controls and segregation of duties over custody, recordkeeping and authorization it is not possible to assign accountability or responsibility over transactions and assets which puts everyone at risk. Your employees appreciate your trust in them but they do not appreciate being put at risk for all the accounting errors of your organization. Don’t make your employees your scapegoats.

It has always been one of my greatest pet peeves to hear highly intelligent CEOs and CFOs proclaim “We don’t do accrual basis except for the audit, we’re a cash basis company” or any  other ridiculous statement to the same effect. It as if they think that by uttering this nonsense that suddenly all of their legal obligations, commitments and contingencies just disappear. Of course the reality is that this kind of statement is the result of years of business schools teaching their MBAs and undergrads the ‘cash is king’ mantra. Since accrual basis accounting and GAAP in particular, from a technical standpoint are generally alien to these individuals the result is to bury one’s head in the sand and ignore economic realities. Of course for many companies this often proves fatal to the continuity of the business enterprise. My disdain for this kind of statement is not an attempt to somehow place accrual basis above cash, modified cash or tax basis accounting either. Each basis has its own role and importance. Cash for day to day operations, accrual for forecasting cash flows and determining financial health, tax for regulatory reporting, etc. Most off the shelf accounting software allows for seamless reporting between cash and accrual so there is almost no excuse for not using both to manage your business.

What it comes down to is that is that many CEOs and CFOs of SMBs don’t know how to interpret accrual basis (or GAAP) and so they ignore what they don’t understand. Your CPA (practitioners pay attention here) should be assisting you in understanding your accrual basis financials and the significance of what is contained within those statements and the footnotes. They should be coaching you on why you need to monitor these statements throughout the year, not just for year-end reporting associated with a financial statement audit. Your organizations ability to grow and avoid financial pitfalls is only half complete without both the cash and accrual picture. I have recently worked on a number of bankruptcy cases and what they all had in common is that none of the business owners truly understood the extent to which they were behind on their financial obligations. All of them had CPAs advising them. After I finished unwinding what had transpired and the extent of the damage all of the owners had a similar question: “Why was it that I, someone they had known for less than a month was telling them this rather than the CPA who they had known and worked with for years?”. Good question.

This weeks ethics case is focused on evaluating the proper use of grant funding and expenditures during the course of an audit engagement. Evaluating the appropriateness of an expenditure under a government or private grant can be subjective in nature and professional skepticism can create a situation where the auditor and the client may not agree on the propriety of a grant expenditure. Who is ultimately right? Who are the stakeholders that must be considered? What is the auditor’s responsibility?

You have been working on an audit engagement for a not-for-profit organization that is primarily supported by various governmental grants for specific program activities. Up until now the audit has gone very smoothly. The client has maintained excellent records which has facilitated the audit process. You have been working through testing compliance with the various governmental grants. Once again the client has provided excellent record keeping which is more than sufficient for supporting the various expenditures under the grants. However, you have come across two expenditures for which you have some uncertainty as to whether they are appropriate.

One of the grant funded programs of the organization is an awareness and outreach campaign. In connection with that campaign the grant budget included $25,000 for printing of various flyers and promotional materials. Throughout the year the organization spent $10,000 on printing costs for these flyers. In the last month of the fiscal year the organization made two orders for additional flyers at a cost of $15,000 which are the two invoices you are now questioning. It is not uncommon for not-for-profit organizations to spend out grant funds at the end of the grant period to avoid having to return the unexpended grant funds and also to avoid a reduction in funding in the next fiscal period. What has raised your concern, is that when you inquired about the expenditures the Executive Director indicated that as of today all of the flyers are still sitting in the boxes they were shipped in from the printers in a storage closet in the back of the office. Upon further investigation you find approximately $13,000 of flyers for the same program that were order in the prior fiscal period that have not yet been distributed.

Aside from the possible accounting error and adjustment to treat these as supplies inventory if material, what is the auditor’s responsibility regarding these expenditures? You delicately discuss the concern with the client and their stance is that they will eventually use the flyers and that they are allowed under the grant therefore the expenditures are appropriate. Are they appropriate or is this a case of waste and abuse of government funding? 

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