Posted by: dubaibizniz | May 1, 2008

A day with the auditors

I spent yesterday’s evening with the auditors to go over their report. Mind you, this is my first audit ever, so it had to cover 2 years. In hindsight, I should have done the audit earlier. This is primarily for a few reasons:

  • Tremendous amounts of mistakes could have been avoided
  • An incredible amount of information and knowledge about accounting would have been learned fairly early on (I am still having a hard time with some of the finer concepts like: calculating income on an accrual basis vs. cash basis, etc.)
  • Budgeting would be done from a completely different angle

The last point is perhaps the one I think is most relevant. You can make accounting mistakes and recover from them. You can always learn later (better late than never). However, budgeting would not be a case of: I have 1 million dirhams and I can spend 600k now and bring in 1.2m income. There are many things to consider.

This may not be such a big deal for those who come from a financial background. However, if you come from a completely different discipline, you are going to have to learn about the different types of assets, your share capital, different types of costs and expenses.. the fundamental difference between what’s in the books and your cashflow. There are even legal implications to your total P&L. So, it isn’t just a simple matter of being able to read a Profit and Loss statement. It is the act of knowing what actions need to be taken to make it look better.

You can build a house with the best of foundations, but if you don’t paint it well, it will not look very attractive. I have found that making your books look good is an art in its own right. You would have to be an artist to make your company attractive. Attractive for what?

There are two important groups that need to be considered here:

  • Banks (if/when you need financing of all kinds — overdraft, loans, etc.)
  • Potential buyers (acquisitions, mergers, etc.)

The above groups may have heard of your company. But, their decision to proceed or not will primarily come from your books.

So, yes, your books have gotta look sexy! I am learning, and that is what I’m doing now for 2008.

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Responses

  1. aha! so you’ve been audited 🙂 I’ve been in audit and now M&A over the past 11 years or so.

    Nice read from an auditee’s perspective – I understand what your view.

    Here’s three simple and basic accounting mantras to keep your books on an accrual basis:

    1. Real accounts:
    Dr what comes in
    Cr what goes out

    2. Nominal accounts
    Dr all expenses & losses
    Cr all incomes and revenues

    3. Personal accounts
    Dr the giver
    Cr the receiver

    Anyhoo hope the audit went OK – assume they’d probably had to develop the statements from scratch. Anyway what matters is your cash flow statement is healthy – and that you’ve got at least cash profits.

    btw title reads “auditos” missing the “r” 🙂

  2. Ah, thanks for the tip on the title!

    Oh it went fine. If anything, 2008 is starting to look much better than I had thought.

    I would strongly advise anyone to not put off audits.

  3. Good to know 🙂 Yup an audit helps – though most often I do sense auditors face some defensive clients – some clients display an amount of anxiety etc. However if you have a good auditor, he/she shall help fix things for the better.

    Oh just wanted to add: the basic concept/drive of accrual accounting is to recognize your expenses and income/revenues – when incurred or earned – and not when actually paid out in cash or received in cash.

    Governing bodies took upon this methodology, because people could defer to pay costs/expenses whilst choosing to recognize income/revenues received in cash for a subsequent year in the current year – all in an effort to make profits inaccurately rosier.

    Anhyooo my two fils – don’t mean to bore ya 🙂

  4. Oh never bored! I really appreciate the insights. I admittedly was slightly defensive at the beginning. Opening up your books to complete strangers is hard. But I have a genuine desire to learn what the best practices are and so I am naturally receptive to suggestions. Once I form my own opinions on how things are best done, I would probably be less inclined to listen to auditors. You have to remember, auditors don’t always share the same priorities a business-owner does. So, interests will differ.

    So what you’re saying is, with accrual accounting, you recognize you put down what ‘should’ happen, whereas in cash accounting you put down what ‘actually’ is happening.

    I don’t understand why I wouldn’t be able to say, I’ve invoiced my client $25k for a job in April, instead of putting it in only when they actually pay me the $25k. After all, clients may or may not pay on time.

    And how would I add the income on a second year (or a different period?), because a P&L statement will tell you what your receivables are, vs. cash-in-hand. Doesn’t that sort it out?

  5. hmmm I don’t my last response here….?

  6. “You have to remember, auditors don’t always share the same priorities a business-owner does. So, interests will differ”

    Spot on! Even the toughest/transparent/self proclaimed righteous auditors switch hats, when they become bu sines-owners 🙂

    Re: Invoiced client 25k: well it depends on a few things. Assuming the job was completed from start to finish in April, and you invoiced 25k in April – you should be able to recognize all 25k to revenues. Dr AR i(n Balance sheet) Cr Revenues (in P&L). This is the concept of accrual accounting – you recognize your income in the month “earned” – not when the cash is received.

    In cash accounting you would recognize the 25k only when your client paid you. Say the client paid you in Sept – you’d recognize revenues of 25k in Sept – this practice isn’t in conformity with Generally Accepted Accounting Principles (GAAP)

    Re: income for subsequent years. Well it depends if you actually earned the income in the current year.

    Say you’ve got a 30k project that wrapped up in Nov 07 – however your client paid in Feb 08. In accrual basis you would recognize all 30k to income in Nov 07. It does not matter the client pays you only after 90 days and in the following year.

    Alternatively say you invoiced a client who paid you 30k in Nov 07 (as an advance payment) for a project to be started and completed in the month of Feb 08 – under accrual basis you shall not recognize any revenues in Nov 07 – shall do so on project completion in Feb 08.

    An aggressive firm would take cash received to income even though it wasn’t actually “earned” and perhaps also chose to defer costs. Say they had to pay a major vendor for various costs incurred in Dec 07 – but actually paid the vendor in Feb 08. Such costs should be recognized to P&L in Dec 07 when “incurred” and not when paid out in Feb 08.

  7. P&L statements inform of costs actually incurred and revenues actually earned for the year.

    Your balance sheet shall tell you – revenues that are yet to be received in cash (AR) and costs that are yet to be paid (Accounts Payable).

    Your balance shall also tell you – potential revenues for the following year (Deferred revenue) – i.e. cash paid by clients for a project to be commenced/completed the following month or year.

    Your bank statement shall tell you the cash on hand and your cash flow statement shall tell you – your cash flow situation i.e. is it a net cash inflow or net outflow.

    I realize it’s all perhaps bit too much to follow – however, its quite easy if you look at the 3 basic mantras in conjunction with accrual basis of accounting. Hopefully am making sense 🙂

  8. Not to me, I think I understand what you are saying.

    So you are saying calculating income using cash-basis is not in accordance to Generally Accepted Accounting Principles (GAAP), but in accrual it is? Then why are the auditors recommending that I use cash-basis, citing that I am a professional services company and that is how it should be done? I am doing it as per your ‘3 basic mantras’ 🙂

    They didn’t particularly say I have to change what I’m doing, but they made a point of it.

    Sorry, I feel like I’m asking a lot of questions, but I really am enjoying this exchange.

  9. Hmmm – the auditors recommend you use cash basis? I work with the largest Adv/Media/Holding firm in the world – and all our companies fall under professional services – it’s accrual basis all the way.

    To be honest, am not sure why cash basis – am surprised a bit there. It’s odd – however, perhaps given the size of your firm or perhaps there isn’t much of a difference in the way you keep your books now and via accrual basis.

  10. Perhaps you can extend an example of what particular aspect the auditors recommend you maintain on a cash basis?

  11. rosh,

    The income. Everything else is done on an accrual basis. For example, Internet, rent, etc. are all done on an accrual basis. We used to put the rent on the month it is due, which naturally would cause spikes. They said no, accrue it. Fine. Internet invoices don’t come on time (du is really weird about the timing of their bills) . They said no, even if you don’t get it, estimate how much it will be and then adjust when you actually receive it.

    All this made sense to me. The part about the income didn’t. They listed engineers, doctors, lawyers, etc. (professional services) calculate income on a cash-basis.

    My company is a small one. We are about 20 people, so could that be a reason?

  12. They are correct on rent and other expenses: you’ve got to record in the month expense is incurred, not subsequently when the bills come in.

    Re: income – perhaps given the nature of your business, it is more appropriate to record income when when paid in cash – primarily because there is little time difference in extending services and being paid OR perhaps given revenue recognition factors in your line of business. For instance, if your contract with client states, payment for services is contingent on certain achieveability factors or thresholds (i.e. your marketing plan must meet certain quantitative market criteria etc) – then it’s appropriate to record income only on receipt.

  13. What am saying is – if the marketing plan does not achieve targeted results, then the firm does not get paid – i.e. payment is contingent on subsequent results of a plan delivered to client.


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