Being a CFO and other topics

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Category: Accounting and Reporting

Annual Reports – SEC filings

I started long enough ago that an annual report used to mean the nice marketing annual summary with pictures and a letter to the shareholder and the financials summarized with some graphs and commentary.  Very few companies do that anymore as the Internet allows for a much more direct and continuous medium for communication.  Today, the annual report means the SEC filing – the 10-K or the 20-F (for foreign private issuers).  I have prepared and filed both and there is not much difference between them.

The annual report as filed with the SEC has several main sections.  These are the business description, the risk factors, the management discussion and analysis and the financial statements themselves (which includes the auditor’s report).  As the CFO, you are the person most responsible for the accuracy of the annual report and when you sign and file it, you will be taking significant personal responsibility should it be wrong.  In a larger company you probably will not be preparing the bulk of the report yourself, but you will be reading every page and making changes where relevant.

As an individual shareholder, if you consider yourself to be a fundamental investor, you really should read the annual reports of the companies you invest in or want to invest in.  You don’t have to read every page in detail looking for errors like the CFO has to, but I recommend at least skimming through all the sections.  As I give advice throughout this blog entry to my fellow CFOs, I’ll also have an aside or two on how individual investors can use the information as well.

My first CFO advice is that there are no copyrights on other filings.  WWW.SEC.GOV has the filings from other companies, both in your industry and outside of it.  If you want to see how others word common accounting items or risk factors, you can find it there.  Do not be ashamed to steal shamelessly.  My second CFO advice is that the annual report is not just a required disclosure document, it is a marketing document as well.  It is your chance to clearly explain your strategy, what risks you face, and to clearly present your financial results and what information you think is needed.  You need to get the SEC and legal details right, but the annual report is going to be incorporated by reference into any capital market deal you do and will be read by the counterparts in any private deal you propose, so you might as well get it right.

A typical division of effort of the 4 sections is this:  1) Business section is senior management, investor relations and maybe the marketing department. 2) Risk factors is Legal with senior management review  and 3) and 4) MD&A and Financial statements are Finance, mainly the Controller.   You’ll be project managing the preparation and you’ll do the final quality control but you should have a fair amount of help on this.  In a smaller company you can expect to do a lot of this yourself, but this is a company filling and your boss and other senior management should help somewhat.  You should have prior year filings to act as the template for this year.  Even if this is your first annual report, you should have the S-1 from the IPO to be the starter for the annual report.

I came up to CFO from a Corporate Controller role, and I had previous experience at preparing the financial statement part of the annual report plus some experience in the business section in previous jobs.  So reviewing the report as CFO came naturally to me, but all CFOs should pay a lot of attention to the report.  It is easy to delegate the report down to your reporting staff and there are outside lawyers and accountants that review the report as well.  This makes it even easier to assume that all is well with the report.  However, the outside parties tend to be ignorant of the business conditions you are operating under and they will not necessarily have only your interest at heart when they word certain sections.  In particular they will be very conservative on sections like the liquidity section.  Make sure you are comfortable with the wording.

What I do when I review the annual report is sign and date the front page and then initial each page even if I make no other changes.  I handwrite edits unless they are long in which case I type up a rider.  Version control is important and I find that handwritten edits make it easier for my controller to maintain control of the master copy.  The signed report and initialed pages and handwritten comments are also good proof that the report was reviewed.  Some lawyers want all working copies to be destroyed after the annual report is filed, but I think they are good to keep in case there are questions later.

When I review all sections, I look for grammar and spacing or missing words mistakes.  Even with a lot of eyes looking at it, it is surprising what will slip through.  I try and read important sections backwards one by one as that helps isolate words and aids in proofreading.

I also review for meaning and to ensure the English is smooth and natural. Even in the USA, many people on your staff might speak English as a second language.  It is quite possible that people reading this blog speak English as a second language.  If you don’t consider yourself to be very strong, have a native speaker read the business section and see if they have any suggestions.  We circulate the business section within the different functional areas to see if they have any suggested changes.  Usually we get a good edit or two just by doing that.

The risk section is useful in two ways.  First is the ranking process.  You should have the most serious and relevant risks first in your list and they should be listed in descending order of importance.  The very act of ranking risks often leads to additional risks being identified and included.  The second value to the risk section as it gives you a list of threats that you need to ensure you have countermeasures to.  Look at the top risks that you and the management team think are the most serious and ask if you have any countermeasures in place.  If you cannot think of a credible solution to reduce or eliminate the main risks identified in your filing, then you have a critical issue that needs to be addressed by the management team.

As an individual investor, the business section can be interesting, but the descriptions tend to be somewhat top level.  You usually can find employment numbers, including by function and some geographic and segment information on their business, but I normally do not get all that much purely from the business section.  If you are brand new to the company or the industry it certainly helps.  One test that I do when looking at a new company is ask myself if I understand what they are selling and what their strategy and strengths are.  If I can’t articulate it after reading the business section then I need to test my assumption that I understand their business well enough to invest long term in them.

The risk factors are more interesting to me.  The can be boring legal boilerplate, but the order the company lists the risks and the way it is worded can provide valuable clues.  What is extra valuable are new risks added compared to the prior years and/or changes in risk order.  This is the section where management is trying to warn you about what might go wrong.  It is pretty much the only section where what might go wrong is discussed.  I find it valuable to weigh how likely the risks are and what a reasonably prepared management team can do to prevent the problems.  If the risk seems likely and there is not much that can be done about it, then I worry about investing.  I also try and think of what risks are not listed.  If I can come up with some that are reasonable and management does not address them in the risk factors, then I worry.

I find the MD&A section the least useful.  For years the SEC has tried to make it better, including insisting on more detail and better use of plain English, but almost all MD&A are a dry recitation of this year versus last year with one or two top level reasons given for the change.  The liquidity section can be interesting, and this is an area that I try and watch my outside service providers closely.  They like to make it sound conservative and more risky than it actually is.  I have worked at companies with large cash balances and virtually no conceivable liquidity risks and the auditors are still trying to change the language to something that implies that there are real risks of a crisis.  If you are working for a company that needs access to the debt market and the capital markets, then you don’t want an overly conservative section here.  Obviously you need to accurately portray your true situation, but the auditors stress test going concern assuming lots of bad things that are unlikely to happen occur, and then want to reflect those tests in the liquidity section.  Those risks belong in the risk section, not in MD&A.  The commercial paper market crashing like in 2008/2009 is a risk, not something that needs to be discussed in detail in the liquidity section, for example.

As an individual investor, I find MD&A to be dry and not that useful as well.  If I am trying to build a top level model, then sometimes I can find explanations of one time items to exclude, but normally I just skim read that area and check to see if there are any time bombs in the liquidity section.  I don’t find income statement models all that useful as an investor and tend to concentrate on the balance sheet and the cash flow statements anyways.

The last section is the financial statements and if there is any section that is the “CFO” section, this is it.  The three main areas here are the auditor’s report, the financial statement tables and the notes to the financial statements.  Sometimes Sarbanes-Oxley matters as well, but only if there are a failure.

The audit report is simple.  Either it is a standard report or there is a big issue.  If the auditors have to modify their report, then there is a problem.  If your auditors tell you that they have to modify their standard report, then you know you have a major problem.

The financial tables should be the same as and your earnings release, albeit more detailed.  They were already checked by the auditors before they were released.  It is not unknown to have something change but it is a little embarrassing.  It has never happened to me so I am not 100% sure what I would do if it did happen.  When I have seen it happen, it is either a subsequent event that accrues back to the already reported quarter or a balance sheet reclass from long term to short term.

The notes to the financial statements are where the real detail is.  You need to describe your main accounting policies and then give a fair amount of detail, including segment reporting, for the different balance sheet and income statement accounts.  The rules for segment reporting are straight forward, if management runs the business as different segments and uses internal reports that do it and the numbers are material, then you need to segment report.

I think the income tax note is the one that can cause the most issues, especially the disclosure on uncertain tax positions.  Make sure you have the right technical help here and try not to paint a target on your back with your disclosure.

As a CFO, this is just another technical section and I mainly worry about getting the accounting and disclosure right.  I do focus on the actual wording, but a lot can be found in other filings and is dictated by GAAP anyways.  As an individual investor, the notes are a goldmine of information.  All the detail that is glossed over in the earnings releases and calls is there.  If there is a “smoking gun”, the notes will have it.  Read that section very carefully.

As a closing note, I have written something 2-3 times a week for the past few months.  I had a few people message me and ask about last week.  One key skill in being a successful CFO is balance.  My youngest daughter was home from school last week and I spent it with her.  I should be on schedule again for a while at least.

A simple but career destroying problem

The number one fundamental error that causes material errors and misstatements in SEC reporting is spreadsheet errors. There are plenty of technical errors you can make and there always is the risk of management override and deliberate misstatement but the number one way is to shot yourself in the foot because you make a basic spreadsheet error.

Spreadsheets are used by all accountants, and it is impossible to operate without them. We all know that they cause problems, but we use them anyways because there is nothing better. Here are some recent examples of reporting errors (taken from the link below, I have not used the product they advertise and the cases cited are public and in other articles)

http://www.audinator.com/Horror_Stories.html

Fannie Mae makes billion dollar spreadsheet error overstating gains
Fannie Mae filed a Form 8-K/A with the SEC amending their third quarter press release to correct computational errors in that release. “There were honest mistakes made in a spreadsheet used in the implementation of a new accounting standard…which resulted in increases to unrealized gains on securities, accumulated other comprehensive income, and total shareholder equity (of $1.279 billion, $1.136 billion, and $1.136 billion, respectively)”

Share price drops by a third, CEO resigns due to spreadsheet error
UK support-services group Mouchel discovered an accounting error in one of its key spreadsheets that led to a £8.6m downgrade of its profits. The company pension-fund deficit had been wrongly valued as a result of the spreadsheet error.

Shares of RedEnvelope fall more than 25 percent due to spreadsheet error
The online retailer of specialty gifts drastically reduced its fourth-quarter outlook and said its chief financial officer will resign. “They were underestimating the cost of goods sold”, said Stanford Group analyst Rebecca Jones Kujawa. “It is likely CFO Eric Wong is being pushed out because of this error, which could demonstrate a material weakness in controls over financial reporting.” RedEnvelope spokeswoman Jordan Goldstein said the budgeting error was due to a mistake in one cell of a spreadsheet that threw off the entire cost forecast.

Kodak restates income downward by $11 million due to spreadsheet error
$11 million severance error traced to a faulty spreadsheet. Kodak spokesman Gerard Meuchner said “There were too many zeros added to the employee’s accrued severance.” Robert Brust, Kodak’s chief financial officer, called it “an internal control deficiency that constitutes a material weakness that impacted the accounting for restructurings.”

AstraZeneca forced to reiterate earnings forecast after spreadsheet error
Britain’s second largest drugmaker AstraZeneca scrambled to reaffirm earnings forecasts after an embarassing spreadsheet error left investor confidence sorely shaken. The behemoth drug manufacturer said the spreadsheet gaffe occurred during “a routine consensus collection process.”

I can also give a personal story about a spreadsheet error that certainly caused embarrassment and could have been worse. Earlier in my career, when I was Controller of a company, we were being bought by another company and we had bankers advising us. At the last minute, right before we filed our last 10Q as a public company, our lawyers decided we should disclose the banking fee we would be paying to our advisors. We had hired the bankers in the past for the same potential deal and the letter from the earlier, failed deal had been updated to a current date and signed again by our CEO without being reviewed.

The formula for payment was based on a certain definition of enterprise value and the fee jumped as each major valuation range was cleared. I built a quick spreadsheet model off of the balance sheet spreadsheet that had been checked by us and the auditors so I knew all the base numbers were right. I entered the formula for the fees, all in one cell instead of stacking the different ranges in a cell for each of them. The number that came out was in the low double digits of $ millions, and I thought it was high looking but the bank had been working a long time and had not been paid for any work yet on previous, failed deals, so I used that figure in the disclosure. My boss did take a quick look at the number, but no one checked my spreadsheet.

I had made a formula error. For the very last range, I was off one decimal place in the formula and the spreadsheet understated the amount due by 50%. The actual amount was a surprise to everyone and had the CEO actually done a calculation, he probably never would have signed the letter. It ended up being an issue for me because I stayed on and the acquiring company was concerned that the fee was being hidden on purpose. Once I showed them my error, I then ended up in the middle of a large investment bank’s M&A group fighting with their country office overseas that was being pressured over the fee. It eventually was resolved, but I didn’t get as smooth a start as I had hoped in my new role and it was a big distraction for a while.

After that narrow escape, I became much more careful about the base spreadsheets me and my team use in SEC reporting. Careful review for errors has caught several that would have ended up being material misstatements. Two common places where I have found errors is in the tax provision spreadsheet and the inter company accounts reconciliation spreadsheet. Both are updated quarterly, the number of rows often changes as items are added or subtracted and both have multiple people inputting data into them.

The first and still main formal study I know of on spreadsheet errors is by Raymond Panko of the University of Hawaii. I have provided a link this site below. The conclusion of his initial study was that spreadsheets are large and complicated and almost never follow a formal software development process designed to eliminate or reduce errors. Therefore it was not a matter of if there is an error, but how many.

His site lists the common errors he found in his study and how to find them. He also describes a standard development process designed to reduce errors and find any that are created. He also reviews the results of several studies that were done around 2004 after Sarbanes-Oxely became the new standard for companies to follow. Control over spreadsheets is a key internal control that all public companies need to address.

http://panko.shidler.hawaii.edu/SSR/

This problem is pretty well known and it is not hard to find newer articles on finding errors in spreadsheets. For example, this one: http://www.journalofaccountancy.com/issues/2015/nov/how-to-debug-excel-spreadsheets.html . Even with the recognition that there is a problem, CFOs are still losing their job because of simple spreadsheet errors leading to material reporting errors, misbid contracts, improper internal reporting and analysis and other embarrassing issues. It does not inspire Audit Committee confidence if you present to them and they find an error.

I suggest that you take a look at the Planko articles and do a little search for more articles on what can be done to reduce errors. Call a meeting with your staff and review this issue and discuss what they are doing to make sure they are getting their spreadsheets right. Hopefully they all know about the danger already and you already have a robust process. If not, get one in place ASAP. Even if you do, spot check a couple of the more complex spreadsheets they use and make sure you cannot find any errors.

An ounce of prevention now can save you from a $25M fine later after an error is found and you have to restate your results.

Responding to a comment letter from the SEC

imageThere is a particular circular logo that always worries even the most experienced CFO. It is a simple logo and it means that the SEC has looked at your filings and has some questions. If the letter is something as serious as a Wells Notice, then you need to engage with your outside counsel right away and I can’t really give advice as I am not a lawyer.

Comment letters are a lot more common. You can expect that your filings will be reviewed every 2-3 years and every special filing you make (like an S-1) will draw a comment letter every time. They are common, and the typical result is improved disclosure the next time you do a filing. A bad outcome is the need to restate which can have significant personal and valuation of the company repercussions. A disaster is a Wells Notice and a full legal investigation.

When I first started, responding to a comment letter was much more difficult and you needed to rely much more heavily on your auditors and your lawyers as they had many examples of responses from their client base and you typically had nothing except for anything you had done yourself or within your company in the past. Ever since the SEC made comment letter responses available online, you should be much more capable of answering them yourself or with a lot less help from your outside advisors.

Here is my general advice on what to do when you receive a comment letter.

As a general comment, you are dealing with very experienced accounting and legal professionals at the SEC. The team that reviews filings and comments on them tend to be very experienced accountants and lawyers who read and comment on filings for a living. Their letter is reviewed by even more experienced staff before it is sent to you. The SEC monitors trends and usually every year there are specific areas of accounting and disclosure that get extra questions for just about every filer that it applies to. Unless you do actually have a very severe issue, there pretty much is no intent to “get you”. I have found 100% of the SEC staff I have worked with over the years to be professional and courteous and generally helpful where they can be helpful. They tend to be pretty flexible where they can be.

Expect an iterative process. There was one pretty long letter that I responded to that the SEC accepted all my answers the first time, but usually is takes 2-3 rounds of replies with more questions.

The first thing you need to do is read it through at least once. You don’t need to fully understand or do any deep research at this point, but make sure that you and your Controller have read the comment letter and have a general idea of what is in it and what the main questions seem to be. You will be very quickly involving others in the process, and they will be relying on you, so make sure that you know how serious the letter appears to be. It usually is pretty easy to identify the most important questions, as the examiner normally makes them pretty clear. There might be a question or two that are trickier and if answered the wrong way will cause a spiral into more questions and a much higher chance of restating.

Now inform your boss and the audit committee. This should be done quickly, your process of reading and getting a general understanding should not take long at all and you need to treat every comment letter with a sense of urgency. It is a good idea to inform your lawyers and auditors immediately and I advise that you copy legal counsel on your communications where appropriate as it is possible that the comment letter will result in legal action against your firm or you personally. The SEC does not allow you to use them as a direct legal defense and your work on replying to a comment letter can be discoverable if not protected. If you are not sure what that means and how to protect yourself and your company, seek legal advice.

I always have a very strong sense of ownership of what we file. I have always found that my reporting is better after I get and respond to an SEC comment letter. You will be engaging and using outside help, but you own the comment letter responses just like you own the filings you did. Do not allow the outside advisors to take over the process. They are not always on your side. If something needs to be restated, or if more serious issues come up, they may also have the agenda of protecting themselves. Remember that auditors commonly get sued as well if accounting issues come up from an SEC review. That means that they are very much on your side until they are not. Chances are pretty good that it will not be an issue but do remember that they have their own priorities and that may mean protecting their business just like you are trying to protect yourself and your company.

Now that your boss and the Audit Committee are informed, you should have also formed a small team to actually answer the comment letter. You need to divide up the comments and delegate them to the people best able to answer the questions (and this may be you). Personally, I think the company should write the first draft of all the responses but you may not have the expertise. If you do not, remember it because you have a skill set hole in your company that may need to be fixed later after the comment letter process is done.

Now that the SEC has made other comment letter responses public, you should be able to find the same questions answered by other companies. There is no rule against using other responses word for word. No such thing as plagiarism or copyright when reviewing SEC submissions. If you check competitors or similar companies and they have identical questions, then you know that those questions are focus areas for the SEC this cycle. Look at the answer(s) that the SEC accepted in the past and consider if the same answers or something very close also applies to you.

I cannot emphasize this enough. Prior SEC filings are a huge resource and you should absolutely use them to guide your answers. There are no prizes for brilliance and answering every question yourself with completely original answers.

Dire warnings aside about making sure you understand the risk that outside advisors may have their own agenda, your auditors are a very good resource. If you are using a Big 4 firm, then their SEC advisory group will have people that recently worked at the SEC. They probably have other clients who have received comment letters from your examiner and have more personal read on his or her style. When it comes to very technical accounting questions, your technical partner can be a big help in drafting a response that cites the correct and most compelling parts of GAAP.

I personally like my responses to be direct and to the point. Sometimes your advisors like to toss in introductory phrases like “we respectfully submit”. I never answer like that. Many times the comment letter asks you to enhance your disclosure in the future. Unless the suggestion has some fundamental error in it (which I have never found in any comment letter I have received), the correct response is to say that in future filings you will do what is requested. List out what was requested and what you agreed to. When the SEC asks for support for your current accounting, provide it in a straightforward manner. Your examiner will have several open files and comment letters they are responsible for. The more clearly you write and the more simply you write, the easier you will make it for them.

One final resource is the examiner themselves. Sometimes their questions are not very clear. You are allowed to call them up and talk to them. Like your written answers, you need to be careful what you discuss with them, but as I said earlier, they are not out to “get you”. They are limited in what they can answer. You cannot run a response by them, all responses must be submitted in writing and they can only respond in writing. However, they can clarify what a question means. You can call them and let them know that you are on a tight deadline for a filing and that you would appreciate them working as fast as possible. Sometimes it can help to have a personal relationship when they have to make a final call on an accounting item. If you are more than just text on paper, maybe something will go your way. I know that it even helps me to respond when I have a voice to go with the words on the paper.

Before you send in your response, give it one last read through. Make sure all responses follow the standard format of repeating their question and then responding. Make sure you are sure the questions are actually responded to. Double check the wording to make sure it is direct and clear. Make sure each one has enough detail but not too much that it clouds your answer. If you see an answer that disagrees with a disclosure request, ask yourself why you are not just agreeing to the additional disclosure. Sometimes if you agree then you are actually agreeing to accounting that you do not think is right, but normally fighting over disclosure requirements is just not worth it.

There is an almost certain chance that you will receive another comment letter on your responses that focus on the questions that either were not fully answered or where the examiner disagrees with you or feels that there is insufficient support for your answer. If they disagree, then you are starting to have a problem. You need to be extremely careful with any question in the second set of comments because those are the ones that the examiner is most interested in.

Hopefully you will make it through the response process with nothing more than agreeing to improve disclosures in future filings. Don’t forget to actually improve disclosures when you agree to it. It should be part of your reporting checklist to ensure that you disclose what you agreed to and how you agreed to.

“Smoothing” your numbers

As you advance up the ladder in your Finance career, it is almost certain that you will arrive at a level of responsibility for the numbers where your judgment become key in determining outcomes. At the same time, you will be confronted with one of the two most common issues – numbers not being smooth or what looks like a temporary operations issues that can be fixed by some smart accounting.

There is no requirement to qualify for sainthood while being a CFO. You are part of the management and public image of the company, and investors and employees are relying on you properly present the historical results of the company and the expected future performance. You do not have to be the most conservative person in the country and report and book every possible downside and flagellate yourself publicly over every single misstep. Honesty is important but you also need maturity and respect for your audience. No one expects that you were perfect or that you will be perfect. Being overly optimistic is not good but being overly pessimistic is also a problem. Your investors will be expecting a fair accounting of results and possibilities so they can make choices in who to invest in. An immature management team that does not promote their company somewhat will result in an additional valuation hit because of a perception that management is not strong and does not believe in their company. Even in bad times, if you are still there with the rest of the management team, you must believe that you are part of the solution.  Therefore, mention the issues but focus on the solutions.

I can give a specific example from earlier in my career. The GAAP accounting for stock options granted to employees used to make expensing the options optional. This was an option that Silicon Valley companies did not take. Almost no companies expensed options, but Silicon Valley greatly depended on options and fought against changing the accounting. During that time, I believed that they should be expensed. In accounting discussions with other accountants, I would question the basis for not expensing them. Even with my strong belief that they should be expensed, I did not do it in the books I was responsible for. It simply was not the accepted practice and it was proper under GAAP to not expense options. There was absolutely no reason to “punish” my company compared to others just because I could get on my high horse about the proper accounting for options. Once GAAP changed, technology companies either reported non-GAAP numbers without the options expense or they provide the information so outside analysts could do the same. I provided the information just like others in the industry did because investors expected it.

This is actually an important concept to understand. US GAAP is very specific in many ways but judgment is still a key foundation on the accounting that is done. As I explained in an earlier entry on when I would do a prerelease, the SEC and FASB have both put judgment calls firmly on the shoulders of management. As the CFO, you will be making most of the calls. Other management team members including your boss will come to you with transactions they would like to get booked. You can wrap yourself in a holy mantle of GAAP and always say no, or you can listen to what they are trying to do and try and find a solution.

This brings me back to the original choice I started with. The world is random and bumpy. Investors prefer smooth results that fit an easy to understand framework. Closing the books means making a lot of accruals and valuation judgments and it is really easy to smooth everything out. Be very careful here. Sometimes GAAP really does result in smoother results. If you have a constant production base and higher demand at the end of the year and less at the beginning, you can naturally smooth out the unit cost by building inventory at the beginning of the year and thereby absorbing overhead that otherwise might be expensed and then not overdriving production at the end of the year and over absorbing overhead which results in lower unit costs. You essentially borrow the good news at the beginning of the year and repay it at the end of the year. The accounting matches actual production and you do incur a risk of falling costs at the end of the year or dropped demand meaning your working capital investment may not pay off in better over all results, but the results will be smoother.

Then there is the actual issue that sometimes business just doesn’t match arbitrary quarter end boundaries. It really should not make much difference in the valuation of your company is a deal actually closes January 1 instead of December 31, especially if it was supposed to close earlier and you and rest of the management team forecasted it in good faith to close before December 31. It shouldn’t, but it does. Even if your business does not have big contracts, there might be a snow storm or a flood at your main warehouse and you may miss a week of shipments right at at quarter end. Even in a regular quarter, you may run into a shipping bottleneck and customer orders may not make it out in time even though they were ready.

Sometimes the plant operations group misses their cost takeout targets. Could be an operational issue or maybe the market just didn’t correct quite fast enough but should be ok a few months from now. The shortfall easily can be made up via a slight change in inventory valuation.

Believe it or not, sometimes you get too much good news. A big customer moves up an order and suddenly this quarter is way exceeding goals. Currency moves in the right way and your gross margin now exceeds expectations. Of course, now the next quarter doesn’t look quite as good in comparison and you are wondering if you should burn some of the current good news to smooth out the next few quarters?

Finally, you can often see an issue coming a quarter or two in advance. Does it look like your sales team is making the quarter numbers more and more by borrowing from the next quarter? Did you start this quarter with a vacuum of sales and opportunities because most were recognized the quarter before? Did costs go up and a lot of the cheaper inventory from a prior quarter get used up? If so, expect results that are not smooth or within expectations are probably coming soon.

Like all good CFOs, you probably has a few accounting ideas or changes in the back of your mind that you have been thinking about for a while. Maybe just some tidying up of some overaccruals from prior quarters. Maybe a tweak in inventory accounting that you have been considering. Is this the time you should step in and do it?

I was given some very good advice by a boss early in my career when I had the first exposure to being able to suggest accounting changes. He told me “Never solve an operational problem by moving it onto the balance sheet. All you do is make an Operations problem a Finance problem and when it does come off the balance sheet no one will remember that you were a hero in the past.  You defer changes that might be needed and hide the problem so it might not get priority.” This came from someone that I considered to be a very good accountant who had championed a change in accounting that resulted in a better results for a decade into the future. I had also suggested an accounting charge at the start of the planning process (salvage value) that was accepted by him as a good idea to be implemented. The advice was not by someone that was not able to look for better and more accurate accounting, but from someone that had already made that mistake himself and seen others going it in the past and where he wanted to warn me of the consequences.

So now I always replay that advice in my mind when making a quarter end accounting judgment call. Is Sales now asking about bill and hold after the quarter has already ended to handle that inventory that did not make it over the finish line, or was this planned in advance and did the request come in before quarter end and is documented properly? Is cost higher than hoped for and your COO is looking for more expenses to capitalize into inventory to make the target? Did you just figure out that you beat expectations and now you are looking for extra reasons to boost up reserves that you felt were adequate last quarter or even last week?

I have not been afraid my whole career to make sure that our accounting is as advantageous as the accounting in my industry normally is. However, that good advice early in my career when I was at AlliedSignal still sticks to me. I don’t think that any CFO doesn’t know when the are pushing the accounting too hard.

Try to remember that no one really will think you are a hero today. That entry will be in the background and you will not get any credit for it. Remember that your boss and the rest of the management team will not remember why you capitalized those items a year ago, they will just be mad that you are expensing them now. Remember that your integrity is even more on display when you publish the numbers to the outside world. If you push the accounting too hard you could lose standing with your auditors, if there is an operations blow up and a miss and you get sued, it will come out in discovery later. If the rest of the management team gets cynical about the reported numbers, then they may start messing with them without you even getting involved.

Do the right thing for your company. Try and get the best accounting results where it makes sense and is part of a plan in advance. Otherwise, don’t try and fight the random world too much by double entry bookkeeping. Life is not smooth. Expectations do get exceeded or missed sometimes. Make sure that investors who do their work can at least rely on you and your numbers.

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Some books on the effects of “Number Smoothing”

Confessions of a Wall Street Analyst

The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America

The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition

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