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within the firm that executive management needs to address outside a fi-
nancial context.
360 The Back Office: Efficient Firm Operations

WORK IN PROGRESS. Work in Progress (WIP), sometimes referred to as
unbilled expenses or work in process, ref lects accumulated out-of-pocket ex-
penses made on behalf of a client that have yet to be billed /invoiced. Some
firms also may include the value of staff time at standard billing rates that
include profit in WIP accounts. For expenses to be booked in these accounts,
the firm should have a written agreement with the client that specifically
states that such costs will be reimbursed. Without such an agreement, costs
incurred on behalf of a client should be expensed during the period in which
they were incurred, just like any other operating expense. Once WIP bal-
ances are billed, the balance of the WIP account is reduced by the amount
of the invoice, which in turn increases the A /R balance.
The objective in managing WIP is to maintain the balance at or below
zero. Successful firms are able to do this by entering into prebilling arrange-
ments based on an estimate of expenses to be incurred where the client has
agreed to pay the firm based on that signed estimate and then the firm uses
that money to cover expenses it incurs on the client™s behalf. In those cases,
the firm would credit WIP for the amount billed and as expenses are in-
curred, debit the balance as it would under an arrears-based system. Until
accumulated expenses exceed the amount prebilled, the balance in the ac-
count will be a net credit (negative). Individual arrangements may be negoti-
ated based on the facts and circumstances with each client and project, but
often the balance is reconciled at the end of the project and the difference is
either billed to the client (if a debit) or paid back to the client (if a credit).
The logic behind these types of prebilling arrangements is that the firm is
not a bank, and it should not be responsible for borrowing material amounts
of money to finance client initiatives. However, insignificant sums such as
nominal travel-related expenses normally are financed through the firm™s
working capital.
Separate WIP accounts should be established for each client and, if the
firm has undertaken more than one project for the client, separate accounts
for each of the client™s projects/jobs. As the number of open jobs increases,
so does the risk that amounts included therein may not eventually be col-
lectible from the client. Because these accounts are not part of the P&L,
they traditionally receive little attention from senior management. When lit-
tle attention is paid to these accounts, it is very easy for unbillable amounts
to be charged to them instead of to operating expenses within the period in-
curred. Thus, the opportunity exists for expenses to be hidden and the firm™s
profits to be overstated. Executive management can take action to prevent
this from occurring by:

• Reviewing an aging report for all jobs comprising WIP and investigat-
ing any unusual amount that has not been billed within 30 to 60 days of
being booked. Obviously, the exact number of days and the amount of
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Finance, Accounting, and Human Resources

investigation required will vary by type of firm, but the point here is
that any unusual amount should be resolved as soon as possible.
• Ensuring a signed client agreement is on file that specifically author-
izes the firm to bill the client for the expenses being incurred before
opening the job in the accounting system. However, it may not always
be possible to do this as certain clients may need the firm to move
more quickly than their own internal approval process will allow. In
those cases, a second senior firm manager should authorize the opening
of all such jobs in the accounting system to ensure proper visibility of
the client approval issue.
• Conducting monthly reviews of a report of all open jobs that are not yet
authorized in writing by the client and follow up on those that have
been opened more than a month without the client™s written approval.
• Having the CFO conduct a quarterly review of all aged WIP accounts,
with appropriate follow-up on all unusual amounts.

FIXED ASSETS AND DEPRECIATION. Fixed assets in a professional ser-
vices firm generally consist of leasehold improvements, furniture and fix-
tures, and information technology equipment. To qualify for capitalization
treatment as a fixed asset, an item must be substantial in nature and have a
useful life in excess of one year. Although there is no rule as to the specific
dollar level that must be used, many firms today set a policy that the cutoff
level for capitalization is $1,000 per item purchased since costs to account
for items of lesser value most often outweigh the benefit of capitalization.
Any item that is short-lived (less than one year) or has a unit cost less than
$1,000 should be expensed, unless it is an inseparable part of a project cost-
ing more than $1,000 in total.
The capitalization dollar limit should be applied on a per unit basis and not
the total invoice amount. For example, if two component parts are purchased
for $700 each within the same order, they should be expensed even though
the invoice total is above the $1,000 threshold for capital treatment. Similarly,
this same general rule applies to software. If a perpetual license of a software
program was purchased and the cost was under the $1,000 threshold, the pur-
chase should be expensed. However, if multiple copies are purchased as part
of a major project initiative (e.g., rollout of Windows 2000), the cost should
be bundled and capitalized even though the per unit cost is below the thresh-
old. Annual licenses should be expensed in the year purchased because their
useful life does not extend beyond one year. Training costs normally are ex-
pensed unless bundled within the cost of the base asset. Purchases under
these thresholds should be expensed in the month the cost is incurred.
Depreciation and amortization of these costs are based on estimated use-
ful lives. With respect to leasehold improvements, their useful lives should
362 The Back Office: Efficient Firm Operations

never be longer than the base period remaining on the lease, excluding any
option period. Computer-related equipment normally is depreciated over a
three-year period as technological advances, coupled with wear and tear, par-
ticularly on portable units, leave any longer period misleading. Once useful
lives of assets are established, that schedule should be followed consistently
for all similar items until such time that it is proven that materially shorter or
longer periods are appropriate to ensure consistency in applying the matching
principle. All of the rules that a company decides to follow for capital should
be thoroughly reviewed against IRS regulations by a qualified tax expert.

ACCRUED LIABILITIES. Accrued liabilities are obligations that the firm
owes at the end of an accounting period that have yet to be paid. Under
GAAP, the value of those obligations must be ref lected in the financial state-
ments of the firm even though they have not been paid. When closing the
books each month, well-managed firms employ procedures to ensure that all
material liabilities are properly included in the financial statements in con-
formance with GAAP. When firms are relatively small, owners and book-
keepers are able to track most every liability in their head and easily estimate
them in the financials. But as the firm grows, processes and procedures must
be utilized to formalize the tracking and expense estimation process.
For example, in a firm of 10 to 20 people, the bookkeeper can easily track
the number of business trips made each month and estimate the cost of each
based on the destination and duration of the trip. However, in a firm of 500
professionals, organized within multiple departments and perhaps offices, it
is difficult enough to know all of the names of the staff much less track their
whereabouts and travel expenses throughout the month.
In this example, one process that could be employed to track travel ex-
penses is to compare reports from the travel agency against expense reports
processed to determine the value of trips yet to be accounted for before clos-
ing the books each month. However, if the firm does not require employees
to use a single travel service that can deliver such a report in a timely manner
each month, alternative approval and tracking procedures must be estab-
lished if travel is a material expense for the firm. As firms grow, the probabil-
ity increases significantly that material liabilities will not be included in the
financial statements, thereby overstating profits and balance sheet strength.
To help ensure that the financials include all material liabilities, the firm can
employ a variety of tracking and estimating procedures, including:

• Purchase orders: A firm that successfully implements a purchase order
(PO) system to ensure all purchases are properly approved also creates
an excellent tool to track its liabilities that remain unpaid at the end of
the month. A simple compilation of outstanding POs, organized by
expense type, can provide most of the information necessary to accrue
unrecorded liabilities during the close process.
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Finance, Accounting, and Human Resources

• Account review by vendor: A very useful procedure to employ during
the close process is to review a spreadsheet for each account, which
shows a line for each vendor and the amount of money that the firm
paid that vendor each month during the year (and the prior year if pos-
sible), with a separate column for each month and some basic statistics
such as the average monthly activity for each vendor. By arraying all
this data on a single page for each account, it is very easy to track anom-
alies, which often lead to the discovery of unrecorded liabilities.
For example, assume a firm™s monthly telecommunication expenses
were between $50,000 and $60,000, depending on usage patterns. In
the current month, the trial balance for the firm showed that it in-
curred only $25,000. Under these circumstances, the financial staff
should begin a search for unrecorded liabilities because the variance is
material to the firm™s financial statements. If their financial systems
were designed to deliver a report by vendor and month for each account,
the analyst can search for trends in spending to see which vendor was
showing an abnormally low balance for the month. In this case, the ana-
lyst might have discovered that the long distance bill, which normally
runs between $30,000 and $40,000 of the total, had been booked at only
$15,000. A quick investigation might reveal that the invoice was still on
the IT director ™s desk because the director had been on vacation since it
arrived in the mail and thus it had not yet been processed. The account-
ing staff can then quickly accrue an amount approximately equal to the
bill (if found) or the historical average spending level (if not found) until
the bill is paid, thereby ensuring that the P&L ref lects a full month™s ex-
penses and the balance sheet includes the value of unpaid liabilities.
Even if a PO system is in place, it rarely is used to cover all expenses,
particularly those that are recurring in nature such as utilities, so the
method described earlier represents a parallel process that can be em-
ployed to help ensure that accurate financials are prepared.
• Special valuation estimates: Certain accounts, such as accrued vacation
pay and pension expense, must be valued periodically based on specific
assumptions and the resulting calculated liability. Executive manage-
ment review of the assumptions underlying the calculations is important
to ensure visibility as to the reasonableness of the resulting balances in-
cluded in the financials. For example, in the case of accrued vacation
pay in a state that mandates an employee cannot “lose it,” the liability
should ref lect the total amount that would have to be paid to all em-
ployees as of the end of the accounting period if the firm were shut
down on that day. Accordingly, the number should be based on the actual
unused vacation balance for every employee as of that date multiplied by
his or her respective salary. To do this, the firm must employ a vacation
tracking system that computes the vacation days earned each period,
the number of days taken, and the resulting balance as of the end of the
364 The Back Office: Efficient Firm Operations

period. Further, the system must adhere to any limits as to the total
number of days an employee can accrue in accordance with local law
and firm policy.

Revenue and Expense Recognition: The
Games People Play
In spite of the wide application of GAAP and diligent efforts of the firm™s au-
ditors, many financial statements still are not presented fairly in accordance
with GAAP. Often, this happens because managers who are paid based on
achieving certain revenue or profit levels are motivated to deliver those re-
sults, often without a full understanding of GAAP, relying instead on their
own understanding of the way it should be. Professional firm executives should
be aware of the areas in which financial statements have been misstated in the
past and keep alert for warnings that their statements may include anomalies
that include:

• Booking revenue based on a verbal agreement: It is not unusual for
sales/business development professionals to come to a verbal agreement
with a client. When those agreements come at the end of a reporting
period, they may consider that agreement to be worthy of booking as
revenue since they “closed the deal” in their mind. Rarely could rev-
enue be booked under GAAP if the agreement had not been reduced to
writing and the firm had yet to do the work.
• Booking revenue before it is earned: On contracts that span multiple ac-
counting periods, revenue may be recognized either at the end of the
project or on a rational percentage of completion method. If the firm
estimates its percentage of completion in an arbitrary manner, revenues
may be manipulated to suit certain managers™ desires but may not re-
f lect accurately the actual amount of revenue earned.
• Double booking intercompany revenues: In some cases, different
groups within a firm will work on a client project. In those cases, care
must be taken to ensure that each group records only the revenue to
which it is entitled. For example, if Team A has an annual contract to
provide services to a client and the client needs work from Team B
from within the firm and that work is to be paid from the annual fee
paid to Team A, then Team A must be sure to reduce its normal con-
tractual revenue by an amount agreed on with Team B so that the total
revenue recognized by the firm is not overstated by the amount to be
transferred to Team B. Once a firm has several hundred employees, it
is very easy to misunderstand the billing arrangement and have Team B
recognize revenue to which it is entitled while Team A continues to
book its monthly fee in the same manner as it always has, thereby over-
stating revenues.
365
Finance, Accounting, and Human Resources

• Failing to book intercompany expenses: In some firms, particularly
those with multiple offices and separate accounting teams for each,
managing the intercompany chargeback process can be especially chal-
lenging. If one office invoices another office for goods or services ren-
dered and the receiving office disagrees with the charge, it is unlikely
that that office will record the expense. In the meantime, the office is-
suing the invoice will most likely have booked either revenue in the
amount of the bill or an offset to expense in the same amount; either
way, the consolidated financial statements of the firm will be over-
stated by the amount of the invoice until the receiving office books the
expense. This exact situation resulted in a major, multinatinal advertis-
ing agency, having to restate its earnings in 2002 when it was discovered
that numerous offices failed to record intercompany charges they dis-
agreed with. The total effect of these transactions was to overstate the
firms profits by more than $130 million over several years.

Monthly Close and Financial Statement Review
The monthly close is the process by which transactions booked during the
month are summarized, accruals are made for items not yet booked, and fi-
nancial statements are prepared for management review and analysis. This
process is iterative and is intended to result in a summary of the firm™s fi-
nancial performance that presents fairly its financial position as of the close
date. This doesn™t necessarily mean that the numbers are precise, but rather
fair, in that financial statements, by their very nature, include estimates as
well as actual amounts. Accordingly, a well-managed close process includes:

• Preparation of the trial balance”first cut
• Search for unrecorded revenues
• Search for unrecorded liabilities/expenses
• Preparation of the second draft of the trial balance now ref lecting ac-
cruals for revenues and expenses
• Analysis of the second draft trial balance, which includes a comparison
of all variances from budget, last forecast, and prior year
• Ratio analysis of certain key metrics including gross margin and
salary/compensation expenses as a percent of revenue
• Final adjustments resulting from those analyses and preparation of the
final draft of the financial statements as well as processing of all jour-

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