How Do Profits and Cash Flow Differ?

Business owners sometimes mistakenly equate profits with cash flow. Here’s how this can lead to surprises when managing day-to-day operations — and why many profitable companies experience cash shortages.

Working capital

Profits are closely related to taxable income. Reported at the bottom of your company’s income statement, they’re essentially the result of revenue less the cost of goods sold and other operating expenses incurred in the accounting period.

Generally Accepted Accounting Principles (GAAP) require companies to “match” costs and expenses to the period in which revenue is recognized. Under accrual-basis accounting, it doesn’t necessarily matter when you receive payments from customers or when you pay expenses.

For example, inventory sitting in a warehouse or retail store can’t be deducted — even though it may have been long paid for (or financed). The expense hits your income statement only when an item is sold or used. Your inventory account contains many cash outflows that are waiting to be expensed.

Other working capital accounts — such as accounts receivable, accrued expenses and trade payables — also represent a difference between the timing of cash flows. As your business grows and prepares for increasing future sales, you invest more in working capital, which temporarily depletes cash.

The reverse also may be true. That is, a mature business may be a “cash cow” that generates ample cash, despite reporting lackluster profits.

Capital expenditures, loan payments and more

Working capital tells only part of the story. Your income statement also includes depreciation and amortization, which are noncash expenses. And it excludes changes in fixed assets, bank financing and owners’ capital accounts, which affect cash that’s on hand.

To illustrate: Suppose your company uses tax depreciation schedules for book purposes. In 2018, you purchased new equipment to take advantage of the expanded Section 179 and bonus depreciation allowances. The entire purchase price of these items was deducted from profits in 2018. However, these purchases were financed with debt. So, actual cash outflows from the investments in 2018 were minimal.

In 2019, your business will make loan payments that will reduce the amount of cash in the company’s checking account. But your profits will be hit with only the interest expense (not the amount of principal that’s being repaid). Plus, there will be no “basis” left in the 2018 purchases to depreciate in 2019. These circumstances will artificially boost profits in 2019, without a proportionate increase in cash.

Look beyond profits

It’s imperative for business owners and management to understand why profits and cash flow may not sync. If your profitable business has insufficient cash on hand to pay employees, suppliers, lenders or even the IRS, contact us to discuss ways to more effectively manage the cash flow cycle.

© 2019

4 Ideas for Fostering a Partnership Between Internal and External Auditors

External audits aren’t required for every business. But whether required or not, they can provide lenders and investors with assurance that your financial statements are free from material misstatement and prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP).

How can you help facilitate efficient, timely audit fieldwork? The keys are frequent communication and coordination between a company’s internal audit department and its external audit firm throughout the year. Here are four ways to foster this partnership.

1. Encourage frequent communication

Scheduling regular meetings between members of the internal and external audit teams sets the stage for a more efficient audit process. You might discuss emerging issues, such as how the company intends to apply a new accounting standard or the status of internal control remediation efforts.

In preparation for an audit, auditors can meet to compare the internal audit department’s workplan to the external auditor’s audit plan. This comparison can help minimize duplication of effort and identify areas where the teams might work together — or at least complement each other’s efforts.

2. Provide access to internal audit reports

The external audit team can’t rely exclusively on the internal audit department’s reports to plan their audit. But sharing in-house findings provides the external audit with a bird’s-eye view of the company’s operations, including high-risk areas that deserve special attention.

Designate an individual on your internal audit team to act as liaison with external auditors. He or she should be charged with sharing reports in a timely manner. This gives external auditors adequate time to review in-house reports and avoids hasty decision making.

3. Help external auditors navigate the organization

During fieldwork, external auditors need access to employees, executives and data dispersed throughout the enterprise. Internal auditors can share key documents compiled during their audit procedures.

Examples include the company’s organization charts, copies of audit reports from previous years, and a schedule of unresolved internal control deficiencies. This information helps educate external auditors and identifies employees to interview during audit inquiries.

4. Conduct joint training sessions

Both internal and external audit teams require continuing professional education (CPE) to maintain their licenses and improve their understanding of issues they might encounter during an audit. For example, training sessions might explain new accounting standards, emerging fraud scams and technology-driven auditing methods.

Joint training sessions help auditors share best practices and forge lasting bonds with members of the other audit team. Plus, it might be more cost-effective for internal and external auditors to share the fixed costs of providing CPE courses.

Win-win situation

These four ideas are just a starting point. Let’s brainstorm additional ways to foster collaboration between your internal audit department and our external auditors. This exercise will allow both teams to improve efficiency and increase the likelihood of producing timely, accurate financial statements.

© 2019

Time to Celebrate! FASB Expands VIE Exception for Private Companies

The Financial Accounting Standards Board (FASB) recently gave private companies long-awaited relief from one of the most complicated aspects of financial reporting — consolidation of variable interest entities (VIEs). Here are the details.

Old rules

Accounting Standards Codification (ASC) Topic 810, Consolidation, was designed to prevent companies from hiding liabilities in off-balance sheet vehicles. It requires businesses to report on their balance sheets holdings they have in other entities when they have a controlling financial interest in those entities.

For years, the decision to consolidate was based largely on whether a business had majority voting rights in a related legal entity. In 2003, in the wake of the Enron scandal, the FASB amended the standard to beef up the guidelines on when to consolidate.

New rules

The updated standard introduced the concept of VIEs. Under the VIE guidance, a business has a controlling financial interest when it has:

  • The power to direct the activities that most significantly affect an entity’s economic performance,
  • The right to receive significant benefits from the entity, and
  • The obligation to absorb losses from the entity.

Private companies contend that some of their most common business relationships could be considered VIEs under ASC 810. These relationships are set up for tax or estate planning purposes — not to trick investors or pump up stock prices.

Private company alternative

Private companies told the FASB that the VIE model forced them to consolidate multiple affiliated and subsidiary businesses onto a parent’s balance sheet. This frustrated lenders and creditors, who wanted cleaner balance sheets. In addition, in companies where ownership is shared among close relatives, determining who holds the power may not always be clear.

In 2014, the FASB issued an updated standard that let private companies ignore the VIE guidance for certain leasing transactions. Private companies applauded this update, but problems persisted with the consolidation guidance for transactions that didn’t involve leases.

So this past October, the FASB issued Accounting Standards Update (ASU) No. 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities, which expands the exception to include all private company VIEs. However, a private company that makes use of the latest amendments to Topic 810 must disclose in its financial statements its involvement with, and exposure to, the legal entity under common control.

Right for you?

The amendments in ASU No. 2018-17 are effective for private companies for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. Early adoption is permitted. Contact us to determine whether this election makes sense for your business — and, if so, when you should adopt the simplified alternative.

© 2018

Conducting an Effective Post – M&A Audit

So, you’re about to merge with another company. What’s next? The integration process typically starts with audited financial statements that reflect the results and financial position of the combined entity. This exercise requires a close partnership between the external audit team and in-house accounting personnel from both companies. Collaboration is key to a seamless transition.

Prepare the audit team

It’s important to notify your audit team about M&A plans long before a transaction takes place — even if there’s still a chance the deal might fall through. This gives the audit team time to pull specialists together who can help you generate timely, accurate postacquisition financial statements.

For example, you’ll need someone with experience applying the business combination rules under U.S. Generally Accepted Accounting Principles (GAAP) and tax experts who know the rules for reporting different types of deal structures under today’s federal and state tax rules. Likewise, if you’re acquiring a company that uses different accounting systems, you’ll need someone who’s familiar with the acquired company’s software, especially if it’s no longer supported by the vendor.

Anticipate auditor needs

Even if your team of specialists has been assembled in advance, once you’ve merged, expect audit fieldwork to take more time than usual. The auditors will review documents associated with the merger, such as due diligence workpapers and legal documents governing the purchase. They’ll also ask to review prior financial statements and audit reports for the acquired company.

The audit partner might even ask to review board minutes discussing the acquisition, as well as minutes from meetings conducted by the team responsible for the integration of the newly acquired entity.

Documents don’t tell the full story, however. The audit team will interview key members of your team, such as accounting personnel and members of the due diligence team. To streamline the process, designate an employee to serve as the audit liaison. He or she will be the primary point of contact to gather your auditor’s requests for information and access to company employees and executives.

Contact us

M&As provide opportunities to enhance your company’s value. But it’s hard to gauge the relative success of a transaction without reliable, timely financial statements. Our auditors can help you allocate the purchase price to acquired assets and liabilities and otherwise report combined financial results in accordance with U.S. GAAP.

© 2018

How to Prepare for Year-End Physical Inventory Counts

As year end approaches, it’s time for calendar-year entities to perform physical inventory counts. This activity is more than a compliance chore. Proactive companies see it as an opportunity to improve operational efficiency.

Inventory basics

Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value. There are three types of inventory:

  1. Raw materials,
  2. Work-in-progress, and
  3. Finished goods.

Estimating the value of inventory may involve subjective judgment calls, especially if your company converts raw materials into finished goods available for sale. The value of work-in-progress inventory can be especially hard to assess, because it includes overhead allocations and, in some cases, may require percentage-of-completion assessments.

Physical counts

A physical inventory count gives a snapshot of how much inventory your company has on hand at year end. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.

Before counting starts, you should consider:

  • Ordering or creating prenumbered tags that identify the part number and location and leave space to add the quantity and person who performed the count,
  • Conducting a dry run a few days before the count to identify any potential roadblocks and determine how many workers to schedule,
  • Assigning two-person teams to count inventory to minimize errors and fraud,
  • Carving the location into “count zones” to ensure full coverage and avoid duplication of efforts,
  • Writing off any unsalable or obsolete items, and
  • Precounting and bagging slow-moving items.

It’s essential that business operations “freeze” while the count takes place. Usually, inventory is counted during off-hours to minimize the disruption to business operations.

Auditor’s role

If your company issues audited financial statements, one or more members of your external audit team will be present during your physical inventory count. They aren’t there to help you count inventory. Instead, they’ll observe the procedures, review written inventory processes, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

Be ready to provide auditors with invoices and shipping/receiving reports. They review these documents to evaluate cutoff procedures for year-end deliveries and confirm the values reported on your inventory listing.

Making counts count

When it comes to physical inventory counts, our auditors have seen the best (and worst) practices over the years. For more information on how to perform an effective inventory count, contact us before year end.

© 2018

Accounting for Overheads Costs

Accurate overhead allocations are essential to understanding financial performance and making informed pricing decisions. Here’s guidance on how to estimate overhead rates to allocate these indirect costs to your products and how to adjust for variances that may occur.

What’s included in overhead?

Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly allocated to production, including:

  • Equipment maintenance and depreciation,
  • Factory and warehouse rent,
  • Building maintenance,
  • Administrative and executive salaries,
  • Taxes,
  • Insurance, and
  • Utilities.

Generally, such indirect costs of production are fixed, meaning they won’t change appreciably whether production increases or diminishes.

How are overhead rates calculated?

The challenge comes in deciding how to allocate these costs to products using an overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future period of time. Then you multiply the rate by the actual number of direct labor hours for each product (or batch of products) to establish the amount of overhead that should be applied.

In some organizations, the rate is applied companywide, across all products. This is particularly appropriate for organizations that make single, standard products — such as bricks — over long periods of time. If your product mix is more complex and customized, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate.

How do you handle variances from actual costs?

There’s one problem with accounting for overhead costs: Variances are almost certain. There are likely to be more variances if you use a simple companywide overhead rate, but even the most carefully thought-out multiple rates won’t always be 100% accurate.

The result? Large accounts that many managers don’t understand and that require constant adjustment. This situation creates opportunities for errors — and for dishonest people to commit fraud. Fortunately, you can reduce the chance of overhead anomalies with strong internal control procedures, such as:

  • Conducting independent reviews of all adjustments to overhead and inventory accounts,
  • Studying significant overhead adjustments over different periods of time to spot anomalies,
  • Discussing complaints about high product costs with nonaccounting managers, and
  • Evaluating your existing overhead allocation and making adjustments as necessary.

Allocating costs more accurately won’t guarantee that you make a profit. To do that, you have to make prudent pricing decisions — based on the production costs and market conditions — and then sell what you produce.

Need help?

Cost accounting can be complex, and indirect overhead costs can be difficult to trace. We can help you understand how to minimize the guesswork in accounting for overhead and identify when it’s time to adjust your allocation rates. Our accounting pros can also suggest ways to monitor cost allocations to prevent errors and mismanagement.

© 2018

Cybersecurity Matters

Investors, lenders and other stakeholders have been vocal in recent years about pushing companies to provide more information in their financial reports about cybersecurity. Could your company do a better job disclosing cyberrisks and recent hacks?

Most public companies could do better, according to recent testimony during congressional hearings by Jay Clayton, Chairman of the Securities and Exchange Commission (SEC). Here are ways his agency is attempting to “refresh” the disclosure guidance.

Updating the guidance

The SEC doesn’t expect to overhaul its Disclosure Guidance: Topic No. 2, Cybersecurity. Rather, it plans to consider whether important information about cybersecurity should be disclosed to stakeholders within the context of the existing rules. For example, companies may need to beef up their management’s discussion and analysis (MD&A) and footnote disclosures to reflect potential cyberrisks and material financial implications of data breaches.

The current guidance on cybersecurity, which was published in 2011, doesn’t include a specific requirement for companies to disclose computer system intrusions. The SEC’s effort to update the guidance comes amid concerns that more public companies have been experiencing attacks to their computer systems, but their disclosures haven’t been timely or informative enough.

Changes in the works

Regulators in the SEC don’t know whether the update will be issued in the form of staff-level guidance or a regulatory release approved by the SEC’s commissioners. But they’ve decided to address two key areas in the update:

  • Financial reporting controls and procedures that identify and disclose cybersecurity threats in a timely manner, and
  • Corporate strategies and policies regarding cybersecurity prevention, detection and breach response.

Many companies welcome additional guidance from the SEC, because it can be difficult to determine the appropriate time to disclose a hack into their systems.

On the one hand, companies feel a responsibility to share relevant information openly and honestly with stakeholders. On the other, they don’t want to prematurely disclose information about a breach before they know the extent of the damage or to release inaccurate information that later needs to be revised. Company insiders may also be working with law enforcement, in which case they don’t want to disclose information that could compromise the investigation.

Team approach

Regardless of whether your business is public or private, it’s important to assemble a team of professional advisors — including legal, insurance and financial experts — to identify risk factors and to handle breach response, measure the impact and mitigate potential losses. We can help you provide transparent and timely information to your stakeholders.

© 2018

4 Steps to Auditing AP

At most companies, the accounts payable (AP) department handles an enormous volume of transactions. So, the AP ledger may be prone to errors or used to bury fraudulent journal entries. How do auditors get a handle on AP? They use four key procedures to evaluate whether this account is free from “material misstatement” and compliant with U.S. Generally Accepted Accounting Principles (GAAP).

1. Examination of SOPs

Standard operating procedures (SOPs) are critical to a properly functioning AP department. However, some companies haven’t written formal SOPs — and others don’t always follow the SOPs they’ve created.

If SOPs exist, the audit team reviews them in detail. They also test a sample of transactions to determine whether payables personnel follow them.

If the AP department hasn’t created SOPs — or if existing SOPs don’t reflect what’s happening in the department — the audit team will temporarily stop fieldwork. Auditors will resume testing once the AP department has issued formal SOPs or updated them as needed.

2. Analysis of paper trails

Auditors use the term “vouching” to refer to the process of tracking a transaction from inception to completion. Analyzing this paper trail requires auditors to review original source documents, such as:

  • Purchase orders,
  • Vendor invoices,
  • Journal entries for AP and inventory, and
  • Bank records.

The audit team may select transactions randomly, as well as based on a transaction’s magnitude or frequency. They’ll also ascertain whether the company has complied with invoice terms and received the appropriate discounts.

3. Confirmations

Auditors may send forms to the company’s vendors asking them to “confirm” the balance owed. Confirmations can either:

  • Include the amount due based on the company’s accounting records, or
  • Leave the balance blank and ask the vendor to complete it.

If the amount confirmed by the vendor doesn’t match the amount recorded in the AP ledger, the audit team will note the exception and inquire about the reason. Unresolved discrepancies may require additional testing procedures and could even be cause for a qualified or adverse audit opinion, depending on the size and nature of the discrepancy.

4. Verification of financial statements

Auditors compare the amounts recorded in the company financial statements to the records maintained by the AP department. This includes reviewing the month-end close process to ensure that items are posted in the correct accounting period (the period in which expenses are incurred).

Auditors also review the process for identifying and recording related-party transactions. And they search for vendor invoices paid with cash and unrecorded liabilities involving goods or services received but yet not processed for payment.

Get it right

These four procedures may be conducted as part of a routine financial statement audit — or you may decide to hire an auditor to specifically target the AP department. Either way, your payables personnel can help streamline fieldwork by having the formal SOPs in place and source documents ready when the audit team arrives. Contact us for more information about what to expect during the coming audit season.

© 2018

LIFO Lessons Learned

You have choices when it comes to reporting inventory costs. One popular technique — the last-in, first-out (LIFO) method — assumes that merchandise is sold in the reverse order it was acquired or produced. That is, it allocates the most recent costs to the cost of sales. Although this method is often preferred for tax purposes, internal accounting personnel may be hesitant to use it for various reasons.

Tax benefits

Assuming your inventory costs generally increase over time, LIFO offers a definite tax advantage over other inventory reporting methods. By allocating the most recent — and, therefore, higher — costs first, LIFO maximizes your cost of goods sold, which minimizes your taxable income.

In contrast, the first-in, first-out (FIFO) method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

Financial reporting challenges

Before you jump headfirst into using LIFO, it’s important to recognize that it’s not permitted under International Financial Reporting Standards. The approach also involves sophisticated record keeping and calculations.

For example, the “LIFO conformity rule” generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching to LIFO may reduce your tax bill, but it could also depress your current earnings and reduce the value of inventories on your balance sheet, thus giving the appearance of a weaker financial position.

LIFO also can create a problem if your inventory levels are declining. As higher inventory costs are used up, you’ll need to start dipping into lower-cost “layers” of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed you to defer.

Moreover, if a C corporation elects S corporation status, the business must include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of your inventory’s value using FIFO over its value using LIFO. Fortunately, you can spread out the tax payments over four years in equal, interest-free installments.

One of the biggest challenges in using LIFO is the need to measure changes in inventory costs. If you currently use LIFO, you may be able to enjoy additional savings by electing to use the inventory price index computation method. It may enable you to reduce administrative costs — and it might even generate greater tax benefits — if you rely on government indexes to calculate LIFO values rather than developing an internal index.

Right for you?

If you’re contemplating a switch to LIFO, there are various issues to address and forms to complete. Contact us to help decide whether it’s right for your business.

© 2018

Audit Opinions: How Your Financial Statements Measure Up

Audit opinions differ depending on the information available, financial viability, errors discovered during audit procedures and other limiting factors. The type of opinion your auditor issues tells stakeholders whether you’re in compliance with accounting rules and likely to continue operating as a going concern.

The basics

To find out what type of audit opinion you’ve received, scan the first page of your financial statements. Known as the “audit opinion letter,” this is where your auditor states whether the financial statements are fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement. But the opinion doesn’t constitute an endorsement or evaluation of the company’s financial results.

Most audit opinion letters consist of three paragraphs. The introductory paragraph identifies the company, accounting period and auditor’s responsibilities. The second discusses the scope of work performed. The third paragraph contains the audit opinion.

In general, there are four types of audit opinions, ranked from most to least desirable.

1. Unqualified. A clean “unqualified” opinion is the most common (and desirable). Here the auditor states that the company’s financial condition, position and operations are fairly presented in the financial statements.

2. Qualified. The auditor expresses a qualified opinion if the financial statements appear to contain a small deviation from GAAP, but are otherwise fairly presented. To illustrate: An auditor will “qualify” his or her opinion if a borrower incorrectly estimates warranty expense, but the exception doesn’t affect the rest of the financial statements.

Qualified opinions are also given if the company’s management limits the scope of audit procedures. For example, a qualified opinion may result if you deny the auditor access to a warehouse to observe year-end inventory counts.

3. Adverse. When an auditor issues an adverse opinion, there are material exceptions to GAAP that affect the financial statements as a whole. Here the auditor indicates that the financial statements aren’t presented fairly. Typically, an adverse opinion letter contains a fourth paragraph that outlines these exceptions.

4. Disclaimer. Even more alarming to lenders and investors is a disclaimer opinion. Disclaimers occur when an auditor gives up midaudit. Reasons for disclaimers may include significant scope limitations, material doubt about the company’s going-concern status and uncertainties within the subject company itself. A disclaimer opinion letter briefly outlines the auditor’s reasons for throwing in the towel.

Ready, set, audit

Before fieldwork starts for the audit of your 2018 financial statements, let’s discuss any foreseeable scope limitations and possible deviations from GAAP. Depending on the situation, we may be able to recommend corrective actions and help you proactively communicate with stakeholders about the reasons for a less-than-perfect audit opinion.

© 2018