CategoryUncategorized Archives — Page 10 of 11 — C. Lynn Northrup, CPA, CPIM

A Year for Real Audit Risk

The new audit risk standards SAS no. 104 to SAS no. 111 issued by the AICPA in June 2006 will really come home to roost this year. They will put more pressure on auditors to apply the standards in the spirit they were designed because of the economic downturn. The risk for fraudulent misstatement of financial results will escalate due to the pressure on business owners and managers to report better results. Some of the reasons include avoiding violation of lending covenants and making a business look better in preparation for a possible sale. There can be any number of reasons.Typically auditors follow a checklist, but now they will be required to think and use appropriate judgment about the business. There will changes in management personnel, including key managers. When competent executives and advisors leave it puts the business in a weakened condition just when it is critical to make good decisions. In the past it was easy for management teams to run a company because it was hard to make a mistake. Now tough economic and competitive conditions demand seasoned professionals with good judgment. Many of today’s executives have never been required to deal with the uncertainty they face today.

Many of the audit teams conducting audits never audited publicly traded companies where Sarbanes-Oxley and the PCAOB established the rules. The new audit risk standards apply to privately owned companies and both owners and auditors are in for a surprise. They will have to wake up and smell the coffee and deal with a whole new world of reality.

The checklist days are over because auditors need to make inquiries, observations, in addition to gathering audit evidence to support their conclusions. Brainstorming sessions are mandatory to determine areas where fraud and material misstatements could occur. Assertions about account balances need to be evaluated. Account balances have to exist, the entity must have legal title to assets, accounts must be complete, and they must be properly stated at cost (or market if it is lower).

Cost or market could be a problem because assets may no longer be worth what was paid for them. This is an issue for inventories whose value could have slipped. Accounts receivable will be under pressure since businesses have gone downhill pretty fast and companies might not be able to meet their obligations. Therefore, bad debt write-offs could soar beyond normal ranges. Companies utilizing asset based financing will be put under significantly greater pressure.

Entire industries could be rapidly transformed and be subjected to high levels of stress. Bank covenants will come under significantly greater pressure. In addition, because banks are feeling more pressure they will start paying more attention to internal control risks. This is occurring when many companies have accounting personnel who lack the appropriate level of accounting and financial reporting training and skills.

This is the time for CPAs to go back to basics and focus on providing solid advice to their clients both on the potential risks from internal control weaknesses and on financial management of their business. It is no longer possible to survive just on preparing tax returns and financial statements.

Some Thoughts About Processes

Management is largely getting processes to achieve the goals and objectives of the organization. Managing processes and having them achieve high levels of effectiveness is like herding cats or pushing wet spaghetti noodles. It can be pretty tough. Here are some thoughts on processes that might help.Almost all processes are evolved and not designed. They sort of happen over time and are initiated with the inception of the organization. Processes were developed initially to address a specific problem and then became modified and enhanced over time. Additional controls are then put in place as errors occur. The process tends to get divided among departments as the organization grows and then losses its external focus over time.

Processes are people based and are geared to achieve the entity’s mission. They should evolve based on strategic thinking and planning. However, this doesn’t happen because strategic thinking and planning fails to get done because fire drills in most organizations have a higher priority. There is a critical failure to understand and communicate. This is a prevalent occurrence in every organization. Further, people fail to perform consistently and individual uniqueness gets injected into the process, each with different needs and priorities.

These factors make managing processes a tough job. It is critical to make processes more effective producing the desired results. Processes have to be more efficient which helps to minimize the use of our resources. Processes also need to be adaptable and adjust to changing customer and business needs. This attribute is absolutely necessary in these difficult recessionary times. We need to have the right output at the right time at the right place. We need to be totally focused on meeting and exceeding customer expectations.

Here is an interesting perception relative to the efficiency of processes. The time required for taking an input and transforming it into an output with no wait, transportation and/or checks and balance time is approximately 5 percent of cycle time. Instead of spending effort on eliminating the 95 percent of non-value activities, most effort is instead devoted to speeding up value added activities.

Good enough is no longer good enough. It is absolutely essential to exceed customer expectations. We need to empower people and go beyond the basics of meeting expectations to exceeding them. This requires us to adjust and adapt to changing conditions and be fanatical over the pursuit of continuous improvement.

Why measure? If you can’t measure it, you can’t control it. If you can’t control it, you can’t manage it. If you can’t manage it, you can’t improve it. We have a lot of work to do. The good thing is that we can do it if we plan it and are focused on setting goals and objectives. This sets the bar of excellence for all us to excel and just not be satisfied with good enough.

Profit Focused Accounting

I came up with profit focused accounting back in 2004 because I felt business owners and managers needed a methodology that was understandable and easy to use. Typically financial statements include components and disclosures that are understood only by accountants. When it comes to cost accounting and strategic cost management even the accountants are not all that good at utilizing the techniques and applying them.Profit focused accounting is really throughput accounting or direct costing with some modifications. Another link is to lean accounting. These methodologies are all peas out of the same pod. Let me clarify what lean accounting and direct costing really means and how it works. It is a method where profit is measured by subtracting direct variable costs from sales to show contribution to overhead or fixed costs. Standard costing and allocation of overhead isn’t applied so managers can look at an income statement that is in effect a breakeven analysis.

This approach makes it much easier to determine profitability by product/service line and by customer. It is easier to pin point where your profit is derived and the rate of variable margin. Pricing decisions become much easier to understand and track. When business is slow you have extra capacity and you can reduce prices and still make a contribution to overhead. In these difficult times this becomes a strategy for survival.

Lean accounting and profit focused accounting both utilize actual average costs so cost improvement resulting from lean workflow efforts show up on the income statement. This is not the case with standard costing. Many businesses still want to use standard costing but the future is with profit focused accounting and lean accounting.

The conflict between lean accounting and GAAP accounting is with allocation of overhead for inventory valuation. In reality this doesn’t become a big problem after companies reduce inventory levels and hold them constant. Based on static levels of inventory, the amount of overhead contained in the valuation of inventory will remain steady and not be an issue.

In recessionary times I believe this is the only way companies can effectively cope and manage with a chance of survival.

The Family Business Challenge

I thought it was time for me to do a post on family-owned businesses. I have worked for them, consulted for them and advised them. Yes we even started one of our own. As a CPA I have some advantages that many family businesses aren’t able to access and that is my training and experience as a financial advisor and a controller. Accordingly, I will share some of my observations and experiences.One thing I have observed is that owners of family owned business think they are bullet proof and don’t plan for succession. This represents an area where CPAs and family-owned businesses need to spend more time and effort. Without this type of careful planning, a crisis is sure to happen.

Owners of family-owned businesses tend to go solo and not rely on advisors. The entrepreneurial drive creates success but the difficulty comes in sustaining the success as the business becomes more complex. This is when things start to unravel because an effective management team hasn’t been put in place. The sense of separateness and need for control creates real problems because owners have an over-powering urge to do things their way. This tendency of my way or the highway puts many business owners between a rock and a hard place when things start to hit the wall. Then there is often no way out. My advice to business owners is hire advisors who are smarter than they are and have experience in dealing with tough business issues.

Another trait of many business owners is not engaging in an effective process of strategic thinking and planning. Operating from the center of the circle and not using good advisors to guide them through a solid process of management discipline can prove to be a fatal mistake.

The failure to plan and provide for succession is probably the biggest mistake I see as well as the biggest opportunity to provide for the future. Only about 40% of family businesses make it to the second generation and only 12% make it to the third generation. These aren’t very good odds. The down side of these statistics is that current economic conditions will make it difficult for family businesses to sell and get the value built up after years of hard work. This should be a wakeup call for business owners to address the succession planning issue and face the hard facts of current reality.

There are some steps that can be taken to avoid these problems and we will talk about these in future posts.

Risk Appetite

Risk appetite represents the amount of risk that an entity or person is willing to accept in the pursuit of their goals and objectives. The level of risk will vary from low to medium to high. It depends on how the entity balances its goals for growth, return, and investment. This usually relates to quantitative analysis and applied directly to strategy.

The Enterprise Risk Management framework works to enhance the organization by facilitating risk appetite and strategy. This is a process of linking growth, risk, and return. Using this approach provides a balance for enhancing risk response decisions and helps to minimize operational surprises and losses. It is a great platform for identifying and managing cross-enterprise risks and providing integrated responses to multiple risks. In short, it helps to reduce the downside and increase the upside. This is exactly the approach to apply in the turbulent ecomomic conditions that we face today.

Risk appetite is established by finding an acceptable balance between growth, risk and return. It is a process of finding the right relationship between risk appetite and strategy. The risk management framework assists in the alignment of people, processes, and infrastructure. Essentially strategy guides the process of resource allocation.

Another aspect of understanding risk appetite is dealing with the entity’s tolerance for risk. This boils down to reaching acceptable levels of variation to achievement of objectives. It should be measurable. You want to align the organization to ensure that actual results will fall within an acceptable level of risk tolerance. Operating with an acceptable level of risk tolerance gives management greater assurance that the entity stays within it risk appetite.

You might ask how do we form a defined risk appetite. We need to evaluate the impact of a potential event between low, medium, and high. At the same time we need to consider the likelihood of an event occuring and making a judgment as to whether it is low, medium, or high. Events that have low impact and a low likelihood of occurence will produce a situation falling within risk appetite. On the other hand an event with high likelihood and high impact will exceed our risk appetite.

We need to define events as incidents or occurrences that are internal or external that could affect the implementation of strategy or impair the achievement of goals and objectives. What management needs to do is identify uncertainties that exist and assess when they could occur and what will be the outcome. It is a process of evaluating a range of potential events and ranking them from obvious to obscure. The next step is to measure the potential effect from significant to insignificant. Finally a determination must be made relative to the likelihood of occurrence.

It is really a common sense and straight forward approach to managing the business by following these simple rules. Unfortunately not enough management teams follow this disciplined approach. Instead they follow the methodology of “fire, ready, aim.” This is the probably the best way to lose the game. I think there is a better way as I have described above. It is a lot easier to do it right than suffer the consequences of doing it wrong.

Understanding Risk

The first thing we need to realize is that risk will evolve from either internal or external sources with the potential to affect strategy. Risk represents the possibility that some event will occur. Management’s job is to assess all the risks associated with implementing strategy and achieving the organization’s objectives. It boils down to considering the impact of all the underlying events that might have some impact.

Enterprise Risk Management (ERM) is a framework for aligning risk appetite and strategy. Based on application of the framework, managing risk becomes a process of enhancing our risk management decisions. It is about reducing operational surprises and losses through a process for identifying and managing all of the potential multiple and cross-enterprise risks. It is more than avoiding losses; it is a process for seizing opportunities and looking for ways to improve the deployment of capital.

It is very closely linked to internal control in that is a process that is created and managed by people. It is, or should be, applied in a strategy setting and across the enterprise. It will only provide reasonable assurance and is geared to the achievement of objectives. When we say that risk management is applied in setting strategy is that it sets strategies and then considers risks relative to alternative strategies. It evaluates alternatives and helps decide on a course of action.

Risk management is applied across the entire enterprise and should consider the entire scope of activities at all levels of the organization. You need to consider special projects and new initiatives. Don’t apply the concept too narrowly because taking a portfolio of risks may override the occurrence of a single isolated event. Your assessment should consider both quantitative and qualitative factors in reaching judgments. Also, it is useful to group risks into categories.

Now that we have got you started on the road to understanding risk management we will next take up risk appetite in our next post.

A Tough Road Ahead

It is a nice sunny November day here in Montrose Colorado as I reflect on today’s economic climate. I read that 159,000 jobs were lost in September and another 240,000 in October. At best, things look pretty bleak. In light of all this the American Institute of CPAs, of which I am a member, offered financial advice to people caught in the job loss crunch. It was stark chilling advice of reality. Conserve cash as best you can given the situation. Expect tough times to last longer, create a budget, and carefully assess your financial situation.

This is also good advice for businesses because they are facing rapid and severe changes in their business environment that most have never experienced. My parents and grandparents came out of the depression and were frugal. In my life time, I can’t remember anything like this and I have endured some crises of major proportions. Businesses look to me for advice and I have to tell them that cash is king.

The best advice I can deliver is to have a plan, develop a budget, and be ready to react fast. Take a look at your resources and see what can be converted into cash. The more cash resources you have available the better. Another step is to lock in some type of credit line to cover the “just in case” situations. It is going to be tougher to get and more expensive. But do what you need to do.

Don’t panic because you won’t think clearly and this is when you need a well thought through plan of action. Good planning can uncover opportunities rather than just keep going down the same old road. That road may be a dead end. A focused strategy and an action oriented implementation plan is what most businesses need in light of the current situation. Things aren’t the same and probably never will be. Now is the time to redirect your business in a new direction.

CPAs need to advise clients to realize that things are different now. This is a time when CPAs need to give good advice and shift their focus from preparing financial statements and tax returns to helping clients plan for the future. If they don’t do this they may not have client tax returns to prepare down the road.

My job is to help CPAs and business owners deal with the future and in this economic environment, unfortunately the future is now.

Cash Flow Danger Signals

I thought it would be good to explore some aspects of cash flow beyond the basics of accounts receivable, inventories, accounts payable, and securing lines of credit. All of these areas are critical to making sure your cash flow is flowing and perhaps can be a blog topic for the future.

What I want to point out are a few of the danger signals that might distrupt cash flow from a customer perspective. These are what I call the cash flow danger signals. These tips will help alert you to customer problems and potential bankruptcy. Here are ten tips to keep an eye on so you can be responsive to customers paying you on time:

• Changes in payment habits
• Request for longer terms
• Changes in management – changes or weak management can be signs of potential trouble
• Staff reductions – particularly financial and accounts payable personnel
• Changes in order size – request for larger quantities of goods to cover rainy days
• Financial statement deterioration
• Checks  with nonsufficient funds
• Delays in making payments and taking unjustified deductions
• Unreasonable or uncooperative behavior in attempting to resolve payment issues
• Making payments to only critical vendors and at the same time refusing or delaying payments to other vendors

The key is to maintain and monitor your customers for any signs of deviation from their normal patterns of behavior and payment habits. Being quick and responsive is critical in this difficult economy since businesses are more likely to struggle and encounter difficulties. Keep your eyes open and act quickly to preserve your cash flow.

Future Thoughts and Action

I am having fun writing the new blog and wonder why it didn’t get started sooner. That being said I thought it would be good to let you know where we are going and what we have planned as we get this new web site moving down the road. I will also be developing a bi-monthly newsletter so be sure and sign up to receive it.

I wanted you to know that we are in the process of formalizing all of the BBV tools and work templates so you will have access to these tools to deal with the economic crisis. In the meantime just contact me and ask about any area where you need help or have questions. I have the capability to provide on-line virtual consulting support and training. So if you need or want assistance before I formally complete manuals or training programs, I can still help you using these virtual tools. I can also provide on-line training so you get get access to me, my materials and training just by asking.

In the future I will be providing formal training programs on how to deliver consulting services, conducting operational and strategic assessments, and other services. I will also be developing and offering an accounting and financial basics training program for business owners. In addition I will offer sessions on strategic planning, budgeting, SWOT assessments and how to survive the economic meltdown.

I have been teaching internet courses for some time and decided that this capability would be a good addition to the written material provided in my books, toolkits, and checklists. I can actually interface and communicate with you to respond immediately to your questions and provide PowerPoint presentations so you will receive real time instructional support. You can also receive consulting support and coaching over the internet. All we have to do is schedule a session, provide you with the proper instructions and you will be good to go. I encourage you to contact me via phone or e-mail to take advantage of this support.

Setting Goals and Objectives – Part Two

Objectives are statements of measureable results to be accomplished within the time frame of the next year. A standard of performance represents a level of achievement to be reached and then maintained on an ongoing basis.

Here are some guidelines for setting and writing your objectives:

• An objective should start with the word “to” followed by an action or accomplishment verb.
• An objective should specify a single measureable result to be accomplished.
• An objective should specify a target date or time span for completion.
• An objective should specify maximum cost factors.
• An objective should be as specific and quantitative (measurable and verifiable) as possible.
• An objective should specify only what and the when and not venture into the why and how.
• An objective should  be in direct support of, or comparable, with your strategy and long-range plans.
• An objective should be realistic and attainable, but still represent a significant challenge.

Preparing your Action Plans

Action plans are specific means by which you accomplish your objectives. Action plans serve three purposes:

1. Clearly identify what has to take place.
2. Test and validate your objective.
3. Serve as a communication vehicle for others who need to contribute to or who will be affected by what takes place.

Action plans basically incorporate the following five factors:

1. The specific steps or actions that will be required.
2. The people who will be held accountable for seeing that each step or action is completed.
3. The timetable for carrying out the steps or actions.
4. The resources that will be needed to be allocated in order to carry them out.
5. The feedback mechanisms that will be used to monitor progress within each action step.

A columnar chart can be developed to lay out a meaningful action plan. After stating the objective at the top of the chart, the following columns should be filled out:

1. Objective: The specific objective for which the action plan is being prepared.
2. Action Steps: The five to ten major actions or events required to achieve the objective.
3. Accountability: The specifif individuals who will be held accountable for seeing that each action step is carried out.
4. Schedule: The total time frame within the action step is to be carried out using actual start and completion dates.
5. Resources: The total estimated costs for completing the action steps. Resources should be broken into money and time.
6. Feedback mechanisms: The specific methods that are available (or need to be developed) for providing information needed to track progress within each action step.

Finally, here is a final checklist that should be used to evaluate your action plans to determine if any factors affecting your action plan have been overlooked:

• Strategic and/or tactical plan impact – Are there other portions of your plans that might be positively or negatively impacted by what you do?
• Financial Impact – What are the capital or short-term cash flow implications?
• Resource Availability – Do you have or can you get the necessary personnel, materials, information, and other resources to support your plan?
• Technology – Could changes in technology make your plan obsolete?
• Environmental Conditions – Have you considered climate, weather, natural resources that may have a positive or negative impact on your plan?
• Political – Can you shift your plans quickly in order to respond to major political shifts?
• Contractual – Are there customer or labor contracts that may require a different course of action?
• Contingency Plans – Have you provided for contingency or backup plans in case something unexpected happens?

After you develop your plans it is important to focus on monitoring the few vital factors within the plan that let you know whether or not you are on track and if modifications are necessary. You then need to ask what is likely to change and how to respond to any required changes. The key is continually check your progress and respond accordingly.

One thing with goals and objectives is that if they get written down, they are more likely to be accomplished. Make it a habit and I think you’ll start to see real progress and accomplishment.