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Month: March 2017

Entrepreneurship and Accounting

Entrepreneurship and Accounting

So you have a great idea for a new product or service, or you have a novel way to revolutionize an industry, great, but remember not every great idea always succeeds just on it’s novelty or uniqueness.  Some of the best businesses have gone under during their first iteration, and often it’s solely based on not understanding some simple accounting principles.  This blog will help you understand how to think about your burgeoning business from an accounting standpoint to help you succeed.

First, before you actually incorporate and start selling, no matter if it’s a product or service, take the time to write a complete business plan.  Not only will this help to organize your thoughts and ideas, but a business plan should include a start up budget and a break-even analysis.  Emphasis here is on the break-even analysis, this is because most entrepreneurs have a great idea, know their demographic and the price point, but sometimes they do not fully know their cost structure.  A break even analysis will help determine your fixed, costs that do not change based on production levels, and variable costs that are increased or decreased by level of production.  For example, if you have to travel to every client you meet with, gas is a variable cost, it will fluctuate with the number of clients you meet with.  Understanding these costs and your break-even analysis will give you an idea of how much of product X you need to produce in order to cover costs before you start making a profit.

Another potential pitfall of entrepreneurs is not maintaining set of books.  A lot of people make the mistake of thinking everything is going just fine because they paid X number of dollars for something to be produced and sold it for a profit, but often this leads them to be surprised when they aren’t making as much money as they expected, or they are unsure of their tax position at the end of the year.  Maintaining your companies books, or ledgers, can be somewhat tedious (if you’re not in the business of accounting and don’t love it) but it is a great source of information that should help drive the decision making going forward with your business.

Lastly, and probably one of the most difficult principles to get entrepreneurs and small businesses to understand is an old saying “you gotta spend money to make money.”  For this point let me give you an analogy to help drive home the point.  At two different times in my life I worked for the consumer electronics store Circuit City, each stint 4 years apart.  The first time was in 2003 when the company had an emphasis on coverage, meaning their was a number of well trained, knowledgeable staff dedicated to their department to cover large flows of consumers.  It worked well, the company made a great deal of profit despite their enormous personnel costs, and they had highly successful customer service scores.  In 2007 I worked as a supervisor and it was drastically different, the company was focused on cutting costs every opportunity, they began by cross-training every employee to be able to sell in each department, which seems like a phenomenal idea until you understand that consumer electronics covers a spectrum of products that is a daunting task for almost anyone to be an expert in, instead everyone was an expert in one thing and just barely able to understand the technologies on everything else slightly better than the consumer.  Secondly, now that everyone was cross-trained, less staff was needed, or so corporate thought.  But instead of maintaining sales while cutting costs, Circuit City’s sales plummeted, and going back to the break-even analysis we discussed earlier, this meant that fixed overhead costs were no longer being covered. BAM! Bankruptcy.  Cutting costs sounds like a great idea to increase your profit, but remember the most successful companies in the world don’t cut costs to make more money, they increase expenditures in the areas that correlate the most to increased revenue.

Hopefully this has been helpful for those entertaining the idea of going into business but have little to know understanding of accounting.  If you are really in the dark and still need more info my recommendation is to take the opportunity to sit down with a CPA, often it is worth the investment to get some quality consultation from someone with expertise.

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Pay for Play – College Athletics and Amateurism

Pay for Play – College Athletics and Amateurism

Amateurism rules were defined by the NCAA as far back as 1916 and have been held up by multiple court decisions throughout the years.  Yet it continues to be a very contentious and divisive topic among fans of college athletics.  Should we pay college athletes?

At the heart of the debate is couple different arguments; does a full ride scholarship not qualify as a form of compensation; what happens to the smaller schools if we start paying them; and how do you pay them in competition with professional leagues.

5647809356_5610585af0_bFirst of all, we should start with the mandatory obligation to amateurism in most sports, for example basketball requires that a player be at least on year removed from high school, and unless they’re willing to play overseas, then that means a trip to college.  Without getting into a long discussion about free market economics and the ability to negotiate on the open market with your labor lets just say that we should at least keep this in mind when talking about scholarships.  To answer this question, yes, from an accounting standpoint a scholarship is a form of compensation, the problem is that for some athletes it does not compare to what they could get on the open market for their services, nor does it correlate to the revenue they bring to the university.

A lot of those opposed to paying college athletes suggest that what little parity exist now will completely diminish because the larger schools will be able get the biggest names and the rest will be left behind.  If you think that national television exposure, prestige of school, facilities, and coaching staff, tangibles that are already maintained by an elite few schools, does not weigh in on and attract a lot of the higher caliber players already then you’re not paying attention.  The pay for play compensation idea actually gives the little guy a better chance.  There are only a number of spots on a team, and in any model that compensates players there must be one that pays more to certain players than others.  This means the smaller school can probably offer a close enough compensation package to the larger school for players that are of lower tier (4-star instead of 5-star), where as that player may have never considered a smaller school otherwise.  A lot of what motivates college students, athlete or not, in the first place is compensation or future compensation.

Lastly, it is important to recognize that there is no way to compete with professional sports, but professional athletes make more money because they are the most talented of their peers.  Most schools will not get close to compensating players on the same level as professional teams, but this is okay because the professional leagues are stacked with developed talent, their are very few athletes that could potentially make the jump from high school to a professional league.  So paying them on par with the professional leagues should not be an issue.

In my professional opinion college athletes are the labor that drives the revenue of a multi-billion dollar industry in college sports, yet they are receiving mere pennies on the dollar in compensation from scholarships while risking permanent injury and not having the opportunity to bargain with their labor.  If we are going to recognize that they provide these schools with millions in revenue then we need to recognize their propensity to be paid for their services.

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Accounting Theory for Baseball Contracts

Accounting Theory for Baseball Contracts

baseball-1091211_1920As baseball season, or what I like to call my favorite time of the year, rapidly approaches I want to write about something I have thought a lot about regarding contracts for athletes, especially baseball players.  Baseball, unlike other sports, is unique in the way they approach free agency, players have a service time clock that keeps them from entering the free agent market where they can capitalize on their hard work.  Without going into the details of service, which can be extensive, simply put a team has the exclusive rights to a player for the first six years (in service times year, roughly 172 days) he is on the MLB roster.

So what happens when they actually hit free market, if they are in the upper echelon of players they will command a price tag upwards of $20 million per year.  Sometimes a player will sign a long term contract with a team before he has reached the 6 full years of service time.  This is a win for both the team and the player, he can capitalize on 3-4 years of solid performance and get a hefty guaranteed contract well before he normally would, instead of playing for mere pocket change.  Arbitration after a little more than 2 years of service time can provide a salary between roughly $900,000 upwards of $8 million, but this is a small percentage of what they would earn if they were to get market value.

As we have seen in the past players and teams come to terms well before free agency to keep a player around on that team a lot longer, for example the St. Louis Cardinals gave Albert Pujols a $116 million contract for a 7 year period well before he was a guarantee to perform as he did for more than a decade in St. Louis, in retrospect we can easily say he was worth every dollar, plus even more to the Cardinals in terms of the revenue they gained based on his production.  The problem at the root of this blog is what should happen to players who have never hit free agency, spend their entire career with one team, and are nearing the end of their careers where they do not produce as they had in their prime?

In my opinion (which will not be popular I’m sure) this presents a unique opportunity for teams to compensate players after the fact for the economic value they provided above what they were expected to.  Basically, for a lack of a better term, a ‘nostalgia premium’.  Should the player receive an amount significantly above market value, not necessarily, but should the team be willing to pay at least, if not more, than the highest bidder, absolutely.  In my eyes this is like the goodwill provided from one company buying another, the fans are pleased because this usually keeps around a fan favorite, and the team is rewarded by the fans loyalty through continued revenue.  This is the antithesis of the perceived ‘home team discount’ that players are supposed to give a team that has kept them their entire career up to that point.

Obviously this is not the perfect situation for teams trying to compete and tight on funds, but if they truly recognize the economic value of what is basically an asset, they should absolutely compensate it as such.  Because of the awkward nature of how baseball players are compensated, many of them will be trying to receive a contract after their best performing years have passed, eliminating them from receiving the true market value of the product they provided.

Side note to this, I believe service time requirements should also be renegotiated in the players favor during the next collective bargaining agreement, as to eliminate the lengthy time a team has contract over a player potentially in their prime.

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How External Audits Fail to Detect Fraud

How External Audits Fail to Detect Fraud

Despite being the number one anti-fraud control employed by organizations, when it comes to those who discover fraud the external auditor ranks as one of the lowest, at 3.8% according to the ACFE’s Report to The Nations 2016, and in the United States alone it is 4%.  There are a number of factors for why the external auditor is typically ineffective in

Photo Credit:

discovering fraud including breadth of the engagement, number of transactions, number of accounts, and the cunning of the perpetrators, especially if there is collusion.  Trying to overcome these factors has always been a hurdle for accounting firms, and despite the prescriptions of SAS 99, which requires auditors to employ analytical techniques during the planning phase, fraud is not typically the main focus of an audit.

The number one reason auditors do not discover fraud is because they do not actually believe it is their obligation to do so.  The truth is, as part of the professional standards auditors adhere to (AU 316), external auditors should consider risks for fraud and maintain a professional skepticism towards fraud throughout the engagement.  Unfortunately for auditors there is an emphasis on efficiency and discovering fraud can be a lengthy, tedious process, mostly because the fraudster has almost surely gone through steps to ensure fraud is not found.  Secondly many firms will explicitly tell their auditors not to worry about fraud, mostly because of reason number three, lack of training.  Most auditors are not trained in fraud detection and therefor asking them to do such during the audit is a fruitless effort and a waste of billable hours in the eyes of audit managers.

As your organization grows, and the risk of internal control breakdown increases, you should begin to consider an external auditor that emphasizes fraud detection.  None of them will guarantee the discovery of fraud if it exists but they can employ auditors who have the training in fraud detection and forensic audits, as well as being versed in types of data analysis used to detect fraud.  If your organization is one that requires an external audit then despite the added cost, if there is one, it might be more a better investment to hire an audit group that is committed to detecting fraud within reason instead of a group that is less expensive but does not help increase the chances fraud is detected.

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How a Loss Can Be Seen As A Win

How a Loss Can Be Seen As A Win

Injured Piggy Bank WIth CrutchesDuring my undergraduate studies I had a professor that asked us to find a company on a large stock exchange that had posted a loss in the previous fiscal year and give a mock presentation about selling the shareholders on not dumping the stock or to even to buy more.  By the end of my presentation I had students telling me they actually planned to purchase the stock I mentioned, which was smart.  So what did I look for when choosing a company that had posted a loss?


The number one thing I was looking for was a company that had expended a large amount of funding in research and development in a thriving industry.  There can be a lot of candidates for this, but I had one in mind, pharmaceuticals.  There are plenty other analogs for this as well, it doesn’t have to be research and development, for example mining companies that have recently purchased large swaths of land and equipment, developers purchasing land, and building on that land.  Basically I was looking for an activity that caused the loss in the current year that would produce revenue in the future.

The truth is, investors, creditors, and management see a loss of this type as the halo effect.  This is because it is driving future business.  Most R&D can take years before it develops into a market-ready product, especially in the pharmaceutical industry where costs to bring a drug to market are extremely expensive but also heavily protected by bureaucratic red tape and huge barriers to entry in the market, not to mention patent rights.  The same can be said about a mining company that has purchased a mineral rich plot of land and the equipment to develop it, despite the fact that depletion and depreciation expenses may not occur in the current year, they may not have a product ready for sale for a number of years, as is the case in most diamond mines.

This doesn’t mean we should always look at a company that posts losses or marginally small profits as a good company, but there is a silver lining when certain companies post a loss, and if you understand financial statements enough you should be able to decipher when the loss is probably a good thing for the future of that company.

I’m sure you’re wondering what company it was that I had chosen. It was Seattle Genetics, a pharmaceutical company that solely makes gene targeting cancer treatment drugs, who in 2014 (the year prior to the presentation) had posted a $77 million loss, and had posted a loss every year since inception. What I saw was that their R&D costs were $230 million versus $286 million in sales revenue.  At the time of the presentation their stock price was around $37.00 per share, today their stock price is $67.96 per share, despite posting another $120 million loss in 2015.

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Tone at the Top

Tone at the Top

ethicsTone at the top is a very interesting predicament for management.  It means to create an environment where illicit activity is not only frowned upon but constantly discouraged by the upper management of an organization.  The tricky part is having an environment that discourages illegal or fraudulent activity while creating a culture that employees enjoy being a part of.  Tone at the top also means an environment that encourages employees to feel comfortable enough to come forward with claims of fraud.  It’s not hard to see the dilemma for upper management in this situation.

Regardless of the size of your organization the benefits of a strong tone at the top are plentiful and immeasurable.  Auditors are extremely cognizant of the relationship between tone at the top and risk factors for fraud, or unintentional material misstatement.  More importantly a strong tone at the top sets the table for the behaviors of every employee in an organization and ensure ethical behavior.  Ensuring that your organization has a strong tone at the top is not overly difficult, especially in comparison to the benefits you can objectively observe.  The ACFE wrote a wonderful research paper on tone at the top here.

The big question is how to behave as a manager so that you ensure a strong tone at the top.  First, you have to, obviously, walk the walk.  Telling someone how to act is one thing, but leading by example is another.  Tone at the top means that you have to behave with respect and act with integrity.  It also means you have to take every report of fraud seriously but treat it with professionalism and procedural justice.  In order to have great tone at the top your employees should observe you behaving in the manner in which you’d want them to behave.  Lastly, in order to ensure a strong tone at the top is to avoid the appearance of preference, bias, or impropriety regarding the aspects of the organization and its employees.

For information on testing you organizations tone at the top, check out this article by Deloitte/Wall Street Journal on measuring tone at the top.

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The Importance of Internal Controls to Organizations Regardless of Size

The Importance of Internal Controls to Organizations Regardless of Size

All large organizations are familiar with and have internal controls implemented within their organizations, especially those that are required to undergo external audits.  Despite the fact that most of them are required to, a lot of them do it because of the protection from fraud and serious material errors.  The problem is a lot of small companies forgo internal controls because they believe they are either not susceptible to the issues mentioned above, or that it will be too costly to implement.  Both of those assumptions would be incorrect.

To understand why internal controls are so important we need not look any further than the ACFE 2016 Report to the Nations that states 83.5% of all frauds are asset misappropriation.  Asset misappropriation includes frauds such as check tampering, billing, cash larceny, expense reimbursements, skimming, and payroll.  The majority of

Info-graphic credit: Association of Certified Fraud Examiners

these fraud schemes are done through created physical documents, altered physical documents, altered transactions in the accounting systems, fraudulent transactions in the accounting system and so forth.  The common denominator among all of these schemes is they either require two people to commit them in the presence of internal controls or they are committed in the absence of internal controls where internal controls would have prevented them.  According to the ACFE report lack of internal controls was the primary internal control weakness among victim organizations at 29.3%, and the second most frequent weakness observed was override of existing internal controls at 20.3%.

How can your organization implement a strong set of internal controls without breaking the bank?  The first rule of thumb is separation of duties, if someone receives the checks they should not be the same one cashing it.  Usually in this case you can have a shared spreadsheet that logs checks, the person who receives it logs it, the person who will be depositing it verifies the amount that is logged.  This also means the depositor should not be the signor, or there should be a second signor.  Another fantastic control to keep in mind a double approval system; for example, if your organization pays for travel or other expense reimbursements, never underestimate the possibility for collusion or management override.  If you require that two people other than the person submitting the reimbursement request must review and sign off on the reimbursement, you have significantly decreased the possibility of fraud or errors.  Something that absolutely cannot be overstated when it comes to internal controls is managements review and oversight.  If you own your company or are the principal manager you should never assume that the internal controls are working perfectly just because they are in place, think like an auditor, test the controls, assume the role of a fraudster and think of ways that you can possibly beat the internal controls.  After you’ve done this discuss it with the accounting staff, let them answer questions on hypotheticals and how they would respond, you will find that your accounting staff may have some great ideas for improving your internal controls, or they will at least let you know where there is a possibility for the controls to break down.

Preventing fraud is a very large part of the battle, and as long as there are people out there who are trying to outsmart the system there will always be the possibility for internal control failure, but we also know that fraud is much less likely in the presence of internal controls.  The second portion of fraud is detection once it is happening, I wrote a blog about this a few weeks ago and I encourage you to also take a look at that on some ideas for detecting fraud if it is indeed happening in your organization.  The combination of internal controls and fraud detection practices can significantly decrease an organizations exposure to fraud.

Please subscribe to this blog and take the chance to read the ACFE 2016 Report to the Nations for more detailed information on fraud rates throughout the world.  As always, if you have any questions or any content you might like to see in the future feel free to comment below or send me an email.

Benford’s Law: An Important Tool in the Auditors Toolbag

Benford’s Law: An Important Tool in the Auditors Toolbag

fullsizerenderWhen it comes to those who discover fraud the external auditor ranks as one of the lowest, at 3.8% according to the ACFE’s Report to The Nations 2016, and in the United States alone it is 4%.  There are a number of factors for why the external auditor is typically ineffective in discovering fraud including breadth of the engagement, number of transactions, number of accounts, and, in cases such as Enron, the cunning of the perpetrators.  Trying to overcome these factors has always been a hurdle for accounting firms, and despite the prescriptions of SAS 99, which requires auditors to employ analytical techniques during the planning phase, fraud is not typically the main focus of an audit.  These failures by auditors exemplify the need for a quick and effective analysis that can shine light on potential wrongdoings or fraud.  Benford’s analysis gives auditors the ability to digitally analyze transactions for the possible presence of fraud.  It can shine a light on areas of potential wrongdoing in a relatively short period of time, making it attractive for auditors to employ as the number of transactions gets larger, which increases the probability that those transactions should conform to Benford’s law.

Benford’s law, or first digit law, was first discovered in 1881 by Simon Newcomb, an astronomer and mathematician, who observed that the pages of logarithm books were unevenly worn on pages that contained lower digits logarithms more so than pages with higher digits logarithms.  Newcomb noted his discovery and created a mathematical formula to explain the formula that was published in the American Journal of Mathematics.  Newcomb did not offer a theory to explain why the phenomenon existed, and his discovery went relatively unnoticed for 50 years.  Ironically, in the 1930’s, Frank Benford discovered the same phenomenon while also searching through books of logarithms, exactly as Newcomb had.  He spent years testing the hypothesis against more than 20,000 data samples, including populations of cities in the United States, surface areas of major rivers and streams, even the numbers appearing in Readers Digest.  Benford’s findings were published in 1938, titled The Law of anomalous numbers in the publication Proceedings of the American Philosophical Society.

The application of Benford’s law is relatively simple, straightforward, and becomes easier with the use of a computer and software to aid in digital analysis.  It is the analysis of first digit occurrences in natural data sets, for example sets of numbers that result from a mathematical combination of numbers such as accounts receivable (quantity sold multiplied by price), or transaction level data such as expenses.  It is important to remember that Benford’s does not apply to small data sets and typically conforms better over larger data sets.  This also means it is best to use all of the data in an account rather than sampling.

The expected distribution of any set of numbers is defined mathematically as:


Where D is the digit (1,2…9);
And P is the Probability.

The expected probabilities for the first digit of any number based on Benford’s law are as follows.

1 – .30103
2 – .17609
3 – .12494
4 – .09691
5 – .07918
6 – .06695
7 – .05799
8 – .05115
9 – .04576

Practically speaking, this means that based on Benford’s law the distribution the number 1 as the first digit of all numbers in a tested set should be roughly 30.103%, the number 2 should be 17.609% and so forth.  It is worth noting that Benford’s can be applied beyond the first digit to the second or third digits, as well it can apply to two digit combinations.  Benford’s law is scale invariant, which means it is independent of the unites that the data is expressed in.  An example is that the list of lengths should have the same distribution whether the unit of measurement is feet, yards, inches, and so on.

Although forensic data analysis is a relatively new concept, mostly with the advent of computers and software able to handle such processes, Benford’s analysis is an old an proven equation for successful audits.  There are numerous reasons for an auditor to employ Benford’s analysis, and as suggested in this blog, to employ it early into the audit.  Benford’s helps an auditor to maintain a vigilance towards discovering fraud, and puts into perspective whether or not fraud could exist outside of a Benford’s analysis as well.  Benford’s is atypical because it does not conform to the human notion of randomness in transactions, and has the ability to catch fraudsters who have gone through the effort to try and hide their crimes with intentionally random transactions.

Here is a great article written by one of the foremost experts on utilizings Benford’s law to discover fraud from 1999 in the Journal of Accountancy.  Please follow my blog and/or comment below, and feel free to email me any suggestions for topics you might like to see or other questions regarding Benford’s law.