April 29, 2009

Whether you call it creative accounting, accounting irregularities or accounting missteps, you need to be on guard!  "On guard!" as in finding out about the things that you don't know.  When all's said and done, it's those things that you don't know you need to know about which can harm your business.

You know cash, because that's what is left in your pockets at the end of the day.  But do you have as close an eye on your financial reporting results?  You know status and progress reports that keep your sales and production teams in gear, but do you know what's in the reports your bankers, creditors, suppliers, shareholders and customers are interested in?   If you need to file financial results for regulatory purposes, then you need to be "on guard"!

Beware of these common mistakes, as the one in charge you are held responsible.

• Revenue which is not really revenue.
• Recognizing revenue too early or inflating it for amounts not actually earned or collected are common irregularities.
• Accounts Receivable (A/R) which is not really an asset.
  Be careful not to inflate A/R assets with amounts the company either does not expect to be settled or with items which are not a direct result of the sales / earning process.
• Accounts Payable (A/P) which is not complete or properly classified. Do not try to classify A/P debt obligations which are really financing obligations. Don't create an accounting misstep by understating A/P with obligations which should be accrued and disclosed.
• Inventory and Fixed Assets which cannot be physically verified or are not worth what you think they are worth.
• Owners Equity which is negative, because too much has been taken out of the business

Revenue which is not really revenue.  According to generally accepted accounting principles (GAAP); revenue is not considered earned until ALL of the following criteria have been met:

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1. Persuasive evidence of an arrangement exists (e.g. a contract duly signed by both the customer and the Company).
   
2. Delivery has occurred or services have been fully rendered, and risk of loss has been passed to the customer.
   
3. The sales price is fixed or determinable (e.g. no right to cancel or receive refunds for price or other concessions outside the Company's standard sales terms).
   
4. Collectibility of the sale is probable.

Beware of the following pitfalls as they relate to the revenue recognition criteria:

1. Verbal and/or written side letters or agreements which may alter or otherwise dilute or negate the meaning of the contract or agreement.  If there is any ambiguity in what you will deliver and for how much and when, then persuasive evidence has not occurred.
   
2. Risk of loss and/or acceptance by the customer must be proved.  If there is any indication that there is more to deliver, or a contingency that "you will make it right", then delivery has not occurred.  Beware of product return policies, future product deliverables, or promised upgrades.
   
3. Although it may not be part of the contract, beware of pricing arrangements that in practice may exist; such as: product rebates, trade in or upgrade allowances.  If the customer can negotiate a price reduction for paying the A/R early that could be deemed a price concession with revenue recognition delayed until the cash has been collected.
   
4. Customers must be assessed as to their credit worthiness prior to the revenue being recognized for collectability to be reasonably assured.  In order to support the assessment, it is wise to have a standard set of credit assessment criteria documented for each customer.

Accounts Receivable (A/R) which is not really an asset.  To qualify as an asset in accordance with GAAP, the A/R asset must be held as part of the normal course of business with credit extended to valid third party customers.

A/R is part of the "order-to cash" process; therefore the expectation is that the A/R balance shall be settled to complete the earnings process. A/R from third party trade must not include cash extended to shareholders, employees, subsidiaries or non-customers. Do not overstate the A/R with advances and/or investments. Do not overstate the A/R with items which are not expected to be settled, i.e., exchange and/or barter arrangements. On the Balance Sheet, A/R must be recognized as net, that is the A/R must be reduced by an amount equal to those specific accounts where anticipated collectability issues may result as well as a universal reserve to allow for unknown collection events. The A/R policy and procedure identifies A/R terms and conditions which are communicated to customers and expected to be enforced. The terms and conditions must be periodically evaluated to ensure they continue to add value to the sales process and the bottom line. The A/R process is monitored and controlled to ensure complete, accurate and timely representation, reporting and disclosure. A/R process is made up of credit assessment, billing and invoicing, collections, cash applications and the allowance for doubtful accounts. Use of reports such as "shipped and not billed" and the "A/R aging report" are deployed to monitor and control this important asset and its effect on cash.

Accounts Payable (A/P) which is not complete. To qualify as a liability according to GAAP, A/P must be held as part of the normal course of business with the obligation accepted from third party vendors or suppliers. The expectation is that the A/P balance shall be settled to complete the purchasing process.

Do not understate A/P with advances and/or investments from shareholders and/or creditors. A/P is expected to be settled with cash. Adjust A/P for amounts returned to vendors/suppliers. The A/P policy and procedure identifies purchasing and payment terms and conditions which are communicated to suppliers / vendors and are expected to be enforced. The terms and conditions shall be periodically evaluated to ensure they continue to add value to the purchasing process and the bottom line. The A/P process is monitored and controlled to ensure complete, accurate and timely representation, reporting and disclosure. A/P is part of the "procure-to-pay" process and includes purchasing, goods receipt and/or service acceptance, invoice validation and approval and check / cash disbursement. Use of reports such as "A/P aging report" is deployed to monitor and control this important obligation and its effect on cash.

Accruals must be prepared when a Company is on the accrual basis of accounting and the obligation is "likely" to occur and can be "reasonably estimated".

The "likely-to-occur" condition exists when the company has assumed title or acceptance of goods and/or services for which a payment obligation exists. Actual expense amounts must be used if known, however if not known, can the expense be reasonably estimated based on vendor/supplier contracts agreements, historically recorded values or other relevant and valid estimation methodologies.

Inventory and Fixed Assets which cannot be verified. You and your creditors think of these as collateral for advances, loans, funding obligations and letters of credit; but when was the last time you actually verified those assets are still there and have the value you think they have.

Historically, accounting records depended on keeping track of an asset's historic and actual cost.  However as the current accounting landscape moves toward more transparency, you need to prove that the assets are valued at or near fair market value.  We have all been fooled by the "shell game" and "bait and switch" campaigns.  Whether done with malice and intent or not, you need to have a plan to physically count, monitor movement of assets and evaluate how much the assets are really worth.

As an added bonus, apply a formula to identify the return on that controllable asset (ROCA) and compare it to other controllable assets.  Using ROCA strategically could change the way you look at your balance sheet.

Negative Owner's Equity.  Yes, believe it or not, you can have negative owner's equity.  The accounting equation is that Assets equal Liabilities plus Owner's Equity.  That means the value of assets must equal the amount of obligations plus the residual value the owner's have invested in the company. When the value of your liabilities is greater than the assets there is negative owner's equity.

It becomes a song and dance when you are filing regulatory reports and applying for extended credit. As owners, consider investing more into the business or correcting the disparity between assets and liabilities.  Negative Owner's Equity is not an ingredient for long term continuity.

Be on guard! As the CEO, ensure your CFO and accounting team are aware of the pitfalls; be proactive in monitoring, controlling, analyzing and testing the transactions; and build vigilance into the process.  Know the rules, anticipate the changes, review the reports and use them for decision making.

Address these concerns with checks and balances embedded into process and documentation.  Get a head start by customizing the samples and templates found within Accounting and Finance Policies and Procedures and Internal Controls Policies and Procedures manuals published by John Wiley and Sons and available on Amazon.  Or ask for an effectiveness and efficiency assessment of your finance and accounting processes.

About the Author
Rose Hightower is an accountant, professor, author and owner of IDEAL Consulting Solutions International, LLC.  IDEAL is a firm specializing in consulting in implementation of accounting and finance process and documentation programs. As a consultant she and her staff, provide practical lessons and simple solutions for any size company.  She is known as ‘The Policy Guru' and works with clients via website www.idealpolicy.com,