Understanding Business Accounting For Dummies, 2nd Edition (118 page)

Investing money in a business or shares issued by a public business involves many risks. The risk of misleading financial statements is just one of many dangers that investors face. A business may have accurate and truthful financial statements but end up in the tank because of bad management, bad products, poor marketing, or just bad luck.

All in all, audited financial statements that carry a clean opinion (the best possible auditor's report) are reliable indicators for investors to use - especially because auditors are held accountable for their reports and can be sued for careless audit procedures. (In fact, accountancy firms have had to pay many millions of pounds in malpractice lawsuit damages over the past 30 years and Arthur Andersen was actually driven out of business.) Make sure that you don't overlook the audit report as a tool for judging the reliability of a business's financial statements. When you read the auditor's report on the annual financial statements from your pension fund manager, hopefully you'll be very reassured! That's your retirement money they're talking about, after all.

Auditors and GAAP

In the course of doing an audit, the accountant often catches certain accounting methods used by the client that violate GAAP, the approved and authoritative methods and standards that businesses must follow in preparing and reporting financial statements. All businesses are subject to these ground rules. An auditor calls to the attention of the business any departures from GAAP, and he or she helps the business make adjustments to put its financial statements back on the GAAP track. Sometimes, a business may not want to make the changes that the auditor suggests because its profit numbers would be deflated. Professional standards demand that the auditor secure a change (assuming that the amount involved is material). If the client refuses to make a change to an acceptable accounting method, the accountant warns the financial report reader in the auditor's report.

Auditors do not allow their good names to be associated with financial reports that they know are misleading if they can possibly help it. Every now and then, we read in the financial press about an audit firm walking away from a client (‘withdraws from the engagement' is the official terminology). As mentioned earlier in this chapter, everything the auditor learns in the course of an audit is confidential and cannot be divulged beyond top management and the board of directors of the business. A
confidential relationship
exists between the auditor and the client - although it is not equal to the privileged communication between lawyers and their clients.

If an auditor discovers a problem, he or she has the responsibility to move up the chain of command in the business organisation to make sure that one level higher than the source of the problem is informed of the problem. But the board of directors is the end of the line. The auditor does not inform the LSE, the SEC, or another regulatory agency of any confidential information learned during the audit.

However, most outside observers will work on the ‘no smoke without fire' principle. No firm, yet alone an accountancy partnership with their partnership profit share on the line, willingly gives up a lucrative client.

Auditors, on the other hand, are frequently being replaced, often for cost reasons - auditing is a negotiable deal too - but also because the firm being audited may have simply outgrown the auditor. This happens fairly frequently when a business is going for a public listing of its shares. The guy round the corner, who was cheap and competent, cuts no ice with the big wheels at the LSE and the placing houses that have to sell the shares. They want a big name auditor to help the PR push.

We can't exaggerate the importance of reliable financial statements that are prepared according to uniform standards and methods for measuring profit and putting values on assets, liabilities, and owners' equity. Not to put too fine a point on it, the flow of capital into businesses and the market prices of shares traded in the public markets (the London Stock Exchange, the New York Stock Exchange, and over the NASDAQ network) depend on the information reported in financial statements.

The US Sarbanes-Oxley Act (known less commonly but better understood as the Public Company Accounting Reforms and Investor Protection Act - 2002) and the UK ‘Companies (Audit, Investigations and Community Enterprise) Act - 2004' were brought in to ensure truthfulness in financial accounting (refer to Chapter 1 for more details about Sarbanes-Oxley). Despite the pain involved for businesses, the end result of complying with the acts will hopefully be a set of audited accounts that outsiders place more reliance on than ever before.

Also, smaller, privately-owned businesses would have a difficult time raising capital from owners and borrowing money from banks if no one could trust their financial statements. Generally accepted accounting principles, in short, are the gold standard for financial reporting. Once financial reporting standards have been put into place, how are the standards enforced? To a large extent, the role of auditors is to do just that - to enforce GAAP. The main purpose of having annual audits, in other words, is to keep businesses on the straight-and-narrow path of GAAP and to prevent businesses from issuing misleading financial statements. Auditors are the guardians of the financial reporting rules. We think most business managers and investors agree that financial reporting would be in a sorry state of affairs if auditors weren't around.

From Audits to Advising

If Accountant Rip van Winkle woke up today after his 20-year sleep, he would be shocked to find that accountancy firms make most of their money not from doing audits but from advising clients. A recent advertisement by one of the Big Four international accountancy firms listed the following services: ‘assurance, business consulting, corporate finance, eBusiness, human capital, legal services, outsourcing, risk consulting, and tax services'. (Now, if the firm could only help you with your back problems!) Do you see audits in this list? No? Well, it's under the first category - assurance. Why have accountancy firms moved so far beyond audits into many different fields of consulting?

We suspect that many businesses do not view audits as adding much value to their financial reports. True, having a clean opinion by an auditor on financial statements adds credibility to a financial report. At the same time, managers tend to view the audit as an intrusion, and an override on their prerogatives regarding how to account for profit and how to present the financial report of the business. Most audits, to be frank about it, involve a certain amount of tension between managers and the audit firm. After all, the essence of an audit is to second-guess the business's accounting methods and financial reporting decisions. So it's quite understandable that accountancy firms have looked to other types of services they can provide to clients that are more value-added and less adversarial - and that are more lucrative.

Nevertheless, many people have argued that accountancy firms should get out of the consulting and advising business - at least to the same clients they audit. For the first years of this millennium, things seemed to be moving in this direction, and new legislation gave them a none-too-gentle prod. Arthur Andersen only just split their consultancy business off before they went under themselves. Luckily, they changed the name of the consulting business from Andersen to Accenture, ditching a fair amount of the bad odour that attached itself to the accountancy practice's name. Now the pendulum is swinging back and big accountancy firms are pushing an integrated approach, arguing that clients don't want to have to explain largely the same business facts to different teams of ‘visiting firemen'. Although the Big Four are back in the consulting game, figures from the Management Consultancies Association suggest that accountancy firms only have 16 per cent of the market for consultancy services, right now at least.

Sometimes we take the pessimistic view that in the long run accountants will abandon audits and do only taxes and consulting. Who will do audits then? Well, a team of governmental auditors could take over the task - but we don't think this would be too popular.

Part V

In this part . . .

T
he Part of Tens contains three shorter chapters: two directed to business managers and the other to business investors. The first chapter presents ten tools and techniques that are useful in running a business and getting the most from your accounting system. These top ten topics are summarised and condensed, and constitute a compact accounting tool kit for managers. The second chapter looks at the range of options available to finance a business and covers the field from international stock markets to government grants. The third chapter provides investors with a checklist of the top ten things they should look for when reading a financial report in order to gain the maximum amount of information in the minimum amount of time.

Chapter 16
:
Ten Ways Savvy Business Managers Use Accounting

In This Chapter

Making better profit decisions

Leveraging - both the operating kind and the financial kind

Putting your finger on the pulse of cash flow

Better budgeting for planning and control

Developing financial controls

Taking charge of the accounting function

Explaining your financial statements to others

S
o how can accounting help make you a better business manager? This is the bottom-line question. Speaking of the bottom line, that's exactly the place to start. Accounting provides the financial information and analysis tools you need for making insightful profit decisions - and stops you from plunging ahead with gut decisions that may feel right but that don't hold water after due-diligent analysis.

Make Better Profit Decisions

Making profit starts with earning margin on each unit sold and then selling enough units to overcome your total fixed expenses for the period (the basic concept that we explain more fully in Chapter 9). We condense the accounting model of profit into the following equation:

(Margin per unit × sales volume) - fixed expenses = profit


Note:
Profit here is
before
corporation tax. Regular corporations pay tax based on the amount of their taxable income; different rates apply to different brackets of taxable income. The bottom-line net income in the profit and loss account of a business is after-tax income. A business may distribute all, part, or none of its profit for the year to its owners.

Insist that your accountant determines the margin per unit for all products you sell. The margin is also called the
contribution margin
to emphasise that it contributes toward the business's fixed expenses. Here's an example for determining the
margin per unit
for a product:

Margin Factors Amount

Sales price £100.00

Less product cost
60.00

Equals gross margin £40.00

Less sales revenue-driven expenses 8.00

Less sales volume-driven expenses
5.00

Equals margin per unit £27.00

We'd bet that your accountant provides the gross margin (also called
gross profit
) on your products. So far, so good. But don't stop at the gross margin line. Push your accountant to determine the two variable expenses for each product. In this example, you don't make £40 per unit sold; you make only £27 from selling the product. Two products may have the same £40 gross profit, but one could provide a £27 margin and the other a £32 margin because the second one's variable expenses are lower.

Have your accountant differentiate between
revenue-
driven and
volume-
driven variable expenses for each product. Suppose you raise the sales price to £110.00, a 10 per cent increase. The sales revenue-driven expense increases by 10 per cent as well, to £8.80, because these expenses (such as sales commission) are a certain
percentage
of the sales price. Your margin increases not £10.00, but only £9.20 (the £10.00 sales price increase minus the £0.80 expense increase). In contrast, the higher sales price by itself does not increase the sales volume-driven expenses (such as shipping costs); these expenses remain at £5.00 per unit unless other factors cause them to increase.