Jan
Welcome to AB cast integrating legal tax accounting and business solutions. I’m Janathan Allen. In this episode, we’re going to discuss why accounting is such an important business discipline.
Neil
Jan, we’re going to use some terms in this podcast that may be a little strange to those who aren’t accountants. Let’s just go through four of them: GAAP – could you tell us what GAAP is?
Jan
GAAP is an, an acronym for Generally Accepted Accounting Principles
Neil
And then AP and AR.
Jan
AP is an, an acronym for accounts payable and AR is an acronym for accounts receivable.
Neil
And how about KPI
Jan
KPI is an acronym for Key Performance Indicators?
Neil
And finally, who is the AICPA
Jan
The AICPA is a governing body that rules the accounting regulatory authorities within each state to the us. It’s the national governing body for all of the local state accounting societies.
Neil
It’s the American Institute of Certified
Jan
Public accountants.
Neil
Jan we’ve often talked about how many owners and executives really underestimate or diminish the value of sound accounting in your mind. How do accounting services integrate with business legal and even tax decisions?
Jan
Accounting is really the underpinning of virtually any business organization. There’s not a decision that can truly be made without the utilization of accounting. And as I’ve expressed many times to many of my clients that accounting is really the unsung hero in terms of business processes, because it gives you the ability to create metrics with which to measure whether or not a business is successful. You can do that in terms of determining a mitigation strategy for a sale or merger and acquisition, particular function and business in general, in terms of what needs to be done in order to make a business more profitable. So accounting really underpins virtually everything we do in business regardless of the type of business.
Neil
And it provides real time data so we can make better decisions.
Jan
Well, hopefully it provides real time data. I can’t tell you how many clients will do their financial statements on a, say a quarterly basis. So oftentimes again, accounting is given short shrift and put aside for more important tasks when in fact maintaining and up to date accounting system and financial statement preparation is probably one of the most important things a business can do.
Neil
And when we’re talking about an accounting strategy, what are the basic elements of any accounting strategy?
Jan
In any accounting strategy? You’re always looking for efficiencies. So if you break the accounting process down into its component pieces, think of it. In terms of accounts receivable, accounts, payable, bank, reconciliations, credit card reconciliations, how do you make those types of functions more efficient and done in a far more, faster and more accurate manner than you may be currently doing them?
Neil
And how would you go about setting up the chart of accounts in the basic elements that you’re trying to capture?
Jan
The creation of the chart of accounts really begins at the beginning of a business. And the chart of accounts goes back and determines what it is that will be measured within the business through the utilization of say financial statements, such as a profit and loss, a balance sheet, or more importantly, generally are the management statements that come from the financial information that is generally garnered for the financial statement process.
Neil
And this is a lot more than just capturing expenses and income. This is about tracking important elements like the supply of inventory, the integration of multiple sources of raw materials or parts and components to create a whole that type of thing. Is that correct?
Jan
It is essentially when you go through to create the financial statement strategy or the financial accounting strategy, again, what you’re looking to do is to really create the KPIs or measurements with what you’re going to go back and compare your business and its outcome as against to what it is that you believe the KPIs should be. So it’s a measurement tool utilizing financial statement information based on the specific business or the type of business that an individual or individuals are running.
Neil
You’ve mentioned a financial statement several times. What is a financial statement and why is it such an important business document?
Jan
Financial statements are better known as the balance sheet or profit and loss and statement of cash flows. And it’s really a series of statements that the AICPA has generated and has utilized for the basis of virtually all credit processes that you may go through. So, for example, if you were to go back and obtain a loan from a bank, you would have to provide financial statements and what the bank does with that information is it goes back and it compares what you are doing within your organization or your business with other like businesses. And to the extent that there is any outliers in the financial statements, you may or may not be able to obtain a loan because of the vagaries of the information that’s contained within the financial statements. There are more important statements than just the profit and loss and balance sheet. The AICPA has done a really good job in promoting those types of statements, because of course that’s what CPA firms provide, but more importantly, CPA firms and your own accountants controllers or CFOs can provide specialized management reports that give you the particularity of the KPI that you may be attempting to measure within your own business, which may not be found in a more generalized profit and loss and balance sheet.
Neil
So how can accounting impact business operational and financial success?
Jan
Accounting is the backbone of virtually everything done in business. And it’s the one element that if it’s utilized properly can go back and provide guidance in terms of where and what should be done and why. And I’ll give you a quick example. We had a client one time and it was during one of the recessions and the recession was just beginning. And I remember going in and we were reviewing the financial statements with this particular client, and he looked at the financial statements and he looked at the marketing line and he said, well, of course, I’m going to have to decrease the marketing expenses, which essentially meant they would go back and they would cut down on travel expense for salesmen. They would do as much advertising. They would go back. And in order to make the financial statement look better, they were going to cut the marketing budget when we went back and we took a look at what the KPIs that I would’ve thought they would’ve measured.
Jan
Would’ve been, what, how are the marketing expenses related to the sales or the increase in sales? Because when you go back and you cut a component such as marketing, that’s a general rule that your sales will plummet as well. So you have to understand what the financial statements and the relationships between the expense that’s being generated and what the return on that expense may be for your business in order to make really good business decisions. And KPIs are a function of the utilization of the financial information with which to assist in making those business decisions.
Neil
And there’s an old saying that if you’re off by a penny, you’re off by a pound, how do accounting systems help you catch when something’s amiss inside your business, or if your, your processes need to be sharpened?
Jan
We generally do that through trend analysis. So a financial statement in and of itself is only a picture in time. And it’s only when you begin to look at several pictures in time that you can discern a trend that could be leading or pointing to a problem that you’re having within the business, that you may not even know that you have. And oftentimes when I go back and I request financial information for clients, for which we’re going to perform some sort of services, I always ask for financial statements that are trended either by year by month, by quarter to see if there are any underlying issues that need to be addressed prior to beginning whatever project that we’re going to do.
Neil
So one of the things that’s a basic is an internal audit. How would you describe an internal audit to one of our clients?
Jan
An internal audit goes back in, it really defines the, again, the functioning of the processes within the accounting strategy itself. So if I were going to go in and if I were going to do an internal audit, I would look at how it is and who it is that is doing the work there needs to be checks and balances. So for example, I wouldn’t go back and have an individual that was opening the mail and obtaining checks that needed to be deposited in the bank. I would not have that individual create the deposit slips, nor would I have that individual go back and make the deposits in the bank. Those three steps should be performed by different people in order to maintain the checks and balances that are necessary in order to ensure that there is no fraud within the organization. The other components of an internal audit would be how the AP function, for example, how the AP function would be deployed when you’re doing AP, the importance of not paying a bill when it’s already been paid, becomes really important of course, the more bills that you pay from several vendors. So in order to deploy an appropriate AP accounting function, one of the processes that we would review is how is it that you are insured, that the bill that you are paying and recording hasn’t been paid before counts receivable is the same sort of process. How is it that you go back and measure what it is that’s been received by the organization? And hasn’t been properly recorded or credited to the individual that owed the outstanding AR. So there’s a variety of different ways in terms of which an internal audit would be deployed, but it’s really specifically based on the functions within the organization to ensure that the information is properly recorded. And if it’s properly recorded, then it’s the old adage. If there’s garbage going in, then there’s garbage coming out. So if it’s recorded properly, then the resulting financial statements or management statements that a company uses or relies on to make business decisions will be more accurate. He, the decisions made by the individuals relying on those statements will be better decisions.
Neil
Of course, what other audit strategies should most companies consider
Jan
When you think of an audit strategy, an audit strategy would really be consistent with maintaining appropriate backup documentation to show how a transaction was generated, who the transaction was generated by and the result of the recording of that transaction by an individual. So it’s really, when you think of an audit process, it’s really the backup information that proves what it is that’s being reported on. A financial statement is accurate. So for example, when we do an audit, even an internal audit on a company, we would go back and we would send out letters to accounts payable, for example, asking the external vendors to verify their accounts at specific periods of time. If those amounts are in agreement than we know that the financial statement is more likely to be accurately reported. If there’s a conflict, then we need to ascertain why. And if there is a certain type of conflict that occurs over and over again, that may point to a deficiency within the AP process that needs to be corrected. The same thing holds true for an account’s receivable process. So when you take a look at your internal organization and you’re looking at doing your own internal audit, then those would be the specific areas that I would point to as a means with which to go back and begin your own internal investigation.
Neil
I think another one of the most common reasons that you point to accounting is the best defense is a good offense. And if we think about this in terms of a tax audit, how can accounting reduce the tax exposure of our business clients?
Jan
What I could say about accounting as it relates to tax audits is that I would say in the controversy work that our firm handles and that’s with all major tax authorities within the state of California and the federal government, that by far and away, the majority of the issues that I find in an audit relate directly to accounting. It relates to some sort of accounting irregularity that causes a tax return to have an outlier that is picked up on a review by an IRS agent that will then go back and cause the company to have to undergo an audit again about, I would say nine times out of 10 of all of the controversy audits that we handle most of the issues arise, because there has been some issue in accounting. The financial statements are inaccurate that leads to an inaccurate tax return, enhance leads to an audit.
Neil
Jan, we’ve spoken about the fact that most IRS auditors aren’t tax experts and they’re not accountants. So a lot of our work is helping the auditor to understand the underlying accounting principles and how we got to the answer we provided. Is that true?
Jan
In a general sense? Yes. I can think of some of the most complex controversy cases that we’ve had and the ones that really were the most difficult to get through were the ones in which the issue underlying the audit was really an accounting issue. And to the extent that you have to be in compliance with gap because our tax regulations are reliant upon generally accepted accounting principles. If the underlying financial statements generated by a business are not gap oriented or are not in gap compliance that can lead to true issues as it relates to the creation of a tax return that are relied and based on those financial statements. So for us, in terms of going back and explaining the need and the necessity of having accurate financial statements to our clients, it’s an issue that I cannot, I cannot go back and over emphasize enough. Accounting is probably one of the most important functions within an organization.
Neil
It’s also going to come into play when you go to sell your company, how does a well-conceived accounting system affect the value of a company?
Jan
The valuation of a company upon sale is predicated on the accuracy of the financial statements themselves. So if you’ve ever found yourself in, uh, mergers and acquisitions or the sale of your company, and you’re going through a due diligence process, the bulk of that due diligence process is proving that what is being reported on the financial statements is accurate to the extent that there are no hiccups. There is nothing that is found that’s untoward in an investigation of those financial statements, the smoother, the merger and acquisition and or sale of the company will be to the extent that there are irregularities or things that cannot be explained or something that has occurred that can go back and create such drama within a merger and acquisition due diligence process that it could cause a potential acquisition or sale to fail.
Neil
And the reverse would also be true if your books are in order. And your minutes in corporate compliance is in order, it’ll increase, increase the value of what you’re going to get for your company and the speed with which you can transact it.
Jan
I can’t speak to the value, but I can speak to the speed. And that’s generally the case. The more issues that are generated because of financial statements are financial information that is inconsistent, the more difficult and the more complex the due diligence process is.
Neil
So Jan, let’s take a little bit of a different perspective here. We’ve been pretty much focused on the business owners perspective. Let’s shift to a minority shareholder or an investor. Accounting is also a great tool for them. What accounting specifics should a minority shareholder access or monitor
Jan
Any minority interest or shareholder should have access to the financial statements of the company in which they are an investor, the financial statements and the tax returns should give that investor a clear picture of what it is that’s going on within the company with which they have invested. So if I were an investor within a company, then the, the two items that I would want to see on a regular basis would be the financial statements, at least on a monthly or quarterly basis. And then of course, the yearly tax returns.
Neil
And how does transactional planning apply to domestic and international accounting procedures?
Jan
Well, that would be a whole blog cast all into itself. but essentially what ends up occurring is there’s a need to harmonize the differing types of accounting that occurs between the us and the rest of the world. And I’ll give you a quick example. If you were to go back and take a look at the financial statements in Europe, they don’t look like what we generate here in the United States for a couple of reasons. And the reasons stem from the rules that are promulgated by the AICPA and those that are generated by out of the us accounting governing bodies in the rest of the world. So for example, we record our, the purchase of assets in this country, and we record them at the fair market value, and we continue to record them at their historical value. So if you were to take a look at, for example, the Disney find natural statements for Anaheim here in California, and you were to go back and take a look at that balance sheet and the P and L you would find that the, the land that was purchased in Anaheim in order to start that what is today a huge complex is on the balance sheet at its fair market value, which is couple hundred thousand dollars in Europe.
Jan
That same transaction would be, if you were to look at the land for the same type of property, it would be reported at fair market value. So there’s a, a clear distinction in terms of how accounting plays out between how things are recorded here in the United States and how they may be recorded in other parts of the world. And what the transactional planning does is it seeks to harmonize these types of transactions so that you’re comparing apples to apples. So it’s not quite fair to take a look at financial statements provided in the United States for say, Disneyland, Anaheim, and then try and compare those to Disneyland France, because the financial statements won’t be comparing apples to apples. It’s the accounting individuals function to drive the differentiation into a standardization that makes appropriate sense for the companies that will be doing business, both in the us and internationally.
Neil
One of the other services we provide is forensic accounting. Jan, how would you describe forensic accounting?
Jan
Forensic accounting is like putting together lots and lots of puzzle pieces. So if you’ve seen like a 10,000 piece puzzle, oftentimes that’s what a forensic accounting is as well. It’s starting with a very small thread. And following that thread to the very end, in order to determine what happened to a transaction and how was it recorded and how the transaction transpired or came to be. It’s very much a puzzle being put together via analytics and the accounting process in order to come to a determination as to what it is that’s happened.
Neil
And I think two of the most common examples of when you would need forensic accounting would be in the context of divorce where you think assets are being hidden or undervalued, or in the case where a business partner, you think they might be stealing from the company, are these good applications for forensic accounting?
Jan
Those are a couple of examples. I think we see more forensic accounting generally in cases involving trusts or people that have passed caregivers. There’s generally some sort of determination made by beneficiaries that something untoward has occurred. And that’s often when we see the request for forensic accounting coming into play, because beneficiaries don’t believe that the trustees or the caregivers of individuals were doing their job.
Neil
So what are some of the biggest accounting challenges or mistakes that you’ve seen when advising business owners?
Jan
I think the, honestly one of the biggest mistakes I’ve seen and accounting challenge is simply finding competent people to do the job. I think most people, a lot of companies, because it is a lost leader in their minds, try to find individuals that are paid a lower hourly rate than they should probably should be for the type of work that they’re being asked to do. Accounting is an art. And I say that in all deference to art, but essentially when someone comes in and believes that accounting is black and white, they really don’t understand the accounting rules, regulations and how it is that it’s supplied at all. Financial statement can be made to say anything it’s similar to statistics. And so when you go back and if the goal is to provide the best financial information for an organization, with which to make important, important business decisions, then you need to ensure that your accounting staff, your accounting, financial statements, and your accounting processes are superior.
Neil
Finally, Jan we’ve often talked about the integration of our accounting tax and legal services. So how is it that what might be a great accounting decision may not be a great legal or business decision?
Jan
Those types of decisions generally occur when an individual or a company may decide to make and a decision based on accounting and not think of perhaps for example, the financial implication of that decision, or even the tax ramification mm-hmm . And I’ll give you an example for that. If in accounting, you’ve decided that you’re going to go back and you’re going to report on an accrual basis. That’s wonderful because accrual of course, is one of the, uh, methods of accounting. That’s recognized by the a, I C P a, but there are more effective and generally cost saving accounting methodologies, such as cash. When you go to prepare a tax return. So decision made at the accounting level to report on the accrual could go back and create complexities when preparing a tax return because of the necessity of having to go and move between two different accounting methodologies that could go back and create issues when they are applied to the preparation of the tax return.
Jan
The other instance that I generally see accounting issues impacting something legal is in a contract, a contract can go back and it can define when it is for example, something’s going to be paid. And when it is that you want it to be paid, the words within a contract can accelerate or DEAC accelerate a payment or an expense predicated on how it’s written. It’s important that we recognize that the acceleration or DEAC acceleration of income or expense within a contract will impact the accounting on how it is that transaction is accounted for. And then hence how it’s reported in a tax return. So they’re all integrated. There isn’t an accounting or illegal, or a tax transaction that isn’t underpinned by really, really superior accounting.
Neil
And the integration of those disciplines is I think the greatest strength that Allen Barron offers to our clients,
Jan
It is it’s what we go back and we pride ourselves on because we integrate those three substantive areas for the benefit of our clients.
Neil
Thanks, Jan,
Jan
You’re welcome. Learn more about our integrated legal tax accounting and business solutions and visit allenbarron.com or call (866) 631-3470 to schedule a free consultation.