What's a SAS 70 review?

November 2011

"My auditor tells me I should have a SAS 70 internal review done. What is this all about?"

Mike: Many companies use outside service organizations for key operating areas, such as payroll processing, trust services, and e-commerce payments. If one of these service providers were to perform poorly, or go out of business, that could have a material adverse impact on the company’s financial statements. SAS 70 reviews (from the “Statement on Auditing Standards No. 70") were proposed by the AICPA about 20 years ago and are audits evaluating the internal controls confirming that these services are in place and operating effectively.

Incidentally, you may have trouble attracting major-league board members if you haven't conducted a SAS 70 review, especially if you outsource your payroll processing.

How can I value phantom stock?

September 2011

"I'd like to set up a 'phantom stock' plan to incent key employees, but I'm stuck on how we value the shares. I don't want to use backward-looking metrics like earnings per share, because we want people to focus on future growth and profitability. How can we link our share prices to performance that hasn't happened yet?"

Mike: The point of those "backward-looking metrics" is that they provide you with a baseline for measuring future performance. For instance, suppose your employees do a great job and achieve 15% net profits. Is this better or worse than last year? Did you double your revenues or perhaps lose sales momentum? Is your balance sheet stronger or weaker? If your phantom stock is going to reflect (and reward) team performance, you need a starting point for valuation that everyone agrees is realistic and fair.

The easiest way to set up a phantom stock model is to start with standard industry comparables, such as multiples of revenue or EBITDA for the trailing twelve months, to establish an initial valuation for your phantom stock. You should also factor in your cash flow outlook for the next three to five years. Then, update the model with your own numbers on an annual basis or whenever there's a game-changing event at the company. That will tell you how much your valuation has improved. (Make sure your employees understand that they don't own "real" stock and you aren't promising to buy their shares if they leave the company.)

Since establishing an initial company valuation involves a fair amount of judgment and technical expertise, you should probably hire a professional to set up your valuation model and handle the updating.

Who owns "loaned" inventory?

July 2011

"We've agreed to send our UK distributor a handful of 'hot replacement' units, to speed up local warranty and repair service. The units would be on loan but kept with stock he's already bought from us. Do we record these units as our own property or as a receivable with extended terms? Or something else?"

Mike: If your distributor isn't going to sell these units, there's no point in sending an invoice with "extended" terms. You should treat them the same way you would spare parts or demo units--that is, write them off as a maintenance or marketing expense.

However, you should also keep track of the serial numbers of these units in your own inventory records. That way, you can make sure your distributor doesn't "accidentally" sell them to regular customers or return them for warranty credit.

Are frequent flyer miles a tangible asset?

September 2011

"Our company has accumulated a big pool of frequent flyer miles, which we plan to use for employee incentives. The CEO thinks this is an asset that we should show on our balance sheet, but I'm not sure how we could determine a cash value. Your thoughts?"

Mike: Very interesting question! Airlines capitalize the liability related to the cost of providing flights for unredeemed frequent flier miles. So, if they have a liability, you should have a bookable asset (something like "pre-paid travel") that you can add to your balance sheet. The problem is that the value of the asset is typically minor and tracking these miles could be a bookkeeping nuisance.

Of course, there's also the sticky question of who "owns" these miles. Most people who fly a lot feel that the miles are their own property, not the company's. If that issue comes up, you could remind your traveling co-workers that you'll need to report their free miles as taxable income (the same is true if you hand out the miles as a bonus). All in all, I'd recommend that you let this issue just fly below the radar (pun intended).

How can I audit a customer's royalty payments?

May 2011

"We have a nice side business selling software utilities on a royalty basis to other vendors, and most of our relationships are trouble-free. However, a major client 'recomputed' three years of payments and now says we owe them money. When I asked for backup, they sent me a meaningless computer printout. What can I do?"

Mike: Before you go any further, you need to have a frank conversation with their CFO to discover what triggered the recalculation. Was there a simple clerical error on a royalty spreadsheet? Were they paying royalties on units shipped that did not include your software? An error that's overlooked for three years suggests some pretty sloppy accounting on their end.

Since the client seems to have made the mistake, you're in a good position to insist on extended terms for refunding their overpayment. For instance, you could offer a credit on future payments of, say, 50% until they reach the amount overpaid.

If the client gives you a hard time and demands immediate payment, that's probably a sign that they no longer see you as a valued vendor. In that case, you have little to lose by getting tough. Hire an independent CPA firm to audit their records (assuming the amount at stake is worth the cost) and don't rush to write a check for the "refund."

What's the best format for expense projections?

November 2010

"My partners and I are arguing about the best way to present our expense projections in a new business plan. They want to list about 25 separate budget line items--things like car rentals, trade show fees, and trade magazine subscriptions. I think it's better to stick with a few broad categories, like marketing and R&D, so investors can compare our numbers against competitive benchmarks. Who's right?"

Mike: Ideally, you should set up a real chart of accounts for the business, all the way down to line item accounts for each department. That way you can roll up your expenses in two different ways--by "natural" categories like compensation, travel, facilities, etc., and by "functional categories," manufacturing, sales and marketing, development, administration. Your department managers will be responsible for the natural expenses within their own departments, and your top management and board can use the functional category numbers to allocate budget dollars
for the whole company.

Of course, this is a lot of work, and many of the numbers will be imaginary (at best). But building a chart of accounts demonstrates to investors that you understand how all the parts of your company work together and how to manage costs in a rational way. These days, that's more important than ever before.

Can I use tax financials for internal reporting?

November 2010

"My new accountant says he wants us to use the same numbers for our internal accounting as we do for our tax returns, because the tax numbers reflect our 'real' profitability. That seems okay, but I wonder why other companies don't seem to use this approach."

Mike: There's a good reason why hardly anyone uses tax-based accounting for their basic financial records. In theory, it's okay to use either tax accounting or some variation of GAAP accounting for internal purposes, as long as the numbers can be reconciled when necessary. The problem with using tax accounting, however, is that you'll have to make adjustments every time you prepare reports for your managers--for instance, a monthly income statement that compares actual results to plan. If you use GAAP accounting principles, you'll need only one reconciliation a year, when your accountant files your tax return.

What do employee benefits really cost?

November 2010

"In my business plan, I add 10% to all salaries for benefits, which I thought was standard. However, a potential investor says this number is 'a joke' and claims it should be closer to 30%--which he says pretty much wipes out my projected profits. Is he right?"

Mike:Your investor is pretty close, though the exact percentage can be tricky to calculate. The employer's share of FICA and Medicare alone now costs an employer 7.65% of payroll, plus unemployment, worker's comp, and other payroll-related charges. Then there's health insurance, perhaps a dental plan, disability, retirement fund matching, and other benefits that you'll probably have to offer to attract quality employees. There's no way the traditional 10% figure will cover even minimal payroll-related benefits these days.

If payroll represents a large part of your cost structure, you should calculate your actual overhead for benefits more exactly. Some of these costs have cutoff points (for instance, you'll pay FICA only on the first $106,800 of an employee's earnings, but Medicare is unlimited). Health insurance--a big cost that's bound to keep growing--also varies widely depending on the plan, employee contribution, family coverage, etc. And when you need to hire temps or extra people to cover key employees who are on vacation or away for extended training, that's another real out-of-pocket cost that should be included in your calculations.

For most companies, the benefits percentage is also much higher for lower-paid employees. If you spend $600 a month for insurance for an employee who earns $24,000 a year, for example, that's a hefty 30% of the employee's payroll just for basic health coverage. As your investor points out, this kind of overhead can have a serious impact on your overall bottom line.

Are late fees and penalties deductible expenses?

August 2010

"My tax accountant tells me that the IRS penalties we paid last year for late filing aren't deductible expenses. Is this just for tax reporting or does it apply to our regular P&L? And what about late fees and interest we pay to vendors?"

Mike: Interest, late fees, and penalties are all considered legitimate business expenses for your financial reports. The IRS penalty, however, isn't deductible on your income tax return (as your accountant pointed out). As a result, the income you show on your tax return will be higher than the income on your financial statement.

But why are you paying the IRS penalties in the first place? If you're filing late because you don't have the cash, you should still submit a return by the deadline--then you'll only owe interest and late fees. Late filing is a symptom of a careless attitude toward financial reporting, and this attitude will eventually cost you much more than a few late fees.

What kind of 'overhead' can we charge?

January 2010

"Is there a formal accounting definition of 'costs' for cost-plus contracts? My CEO wants me to pile on all kinds of overhead expenses that I feel are excessive, but I don't have any contrary evidence for a more conservative approach."

Mike: Typically, these rules are spelled out in the bidding process or in standard contracts, to minimize this kind of ambiguity. (For instance, most government contracts cover the cost-plus question in pretty painful detail.) I'm guessing that you're dealing with an inexperienced or lazy customer who failed to provide guidelines up front. Your problem isn't just with your CEO--you also have a potential here for a fight with the customer over getting paid for any poorly-defined overhead costs.

Your best bet at this point is to refer back to the cost calculations you presented in your original bid, which presumably the customer approved. When you send an invoice, report your overhead expenses with as much detail as possible, and describe these line items using the same language as the bid or contract. This approach should minimize disputes with both your CEO and the customer.