“There are many ways to ‘cook the books’ so they show certain results. Here are some typical problems that we see showing up in the financial statements of A/E firms.”
A thought occurred to me the other day. I always tell our students in my Small Enterprise Management class at the Walton College that they cannot take any financials they see from a privately-held business at face value. Yet, I don’t know that I have ever cautioned The Zweig Letter’s readers similarly about the specific ways these numbers are distorted in A/E firms.
What I am saying is that there are almost always distortions and misrepresentations. Some of these are done willfully, and some occur out of ignorance. And some occur, believe it or not, from following GAAP (generally accepted accounting principles).
There are many ways to “cook the books” so they show certain results. Here are some typical problems that we see showing up in the financial statements of A/E firms:
- Inaccurate revenue accruals. This is the single most important number you have. Many times individual project managers and/or firm owners will understate or overstate their earnings on a project deliberately or out of ignorance on how to do it. Or they don’t even consider revenue “revenue” until it is billed to a client. This will then potentially affect every single calculation of utilization or effective multiplier or utilization (in some cases) that gets made based in part on that number. Question it!
- Inaccurate marketing costs. There are two primary ways this gets misstated. First is that companies roll all project-specific marketing costs into a job once it is won. This is the largest chunk of marketing expenditures and when you do that it looks like the company is spending less on marketing than it actually is. The other way this gets overstated is when anyone is allowed to charge time to marketing with no oversight. People do this because they have nothing billable to do and it looks better to management than “general overhead.”
- Personal expenses that show up as business expenses. There are so many of these buried in the costs. Things such as personal use for company cars, sports tickets that are used only by the owners, vacation houses, spouses of owners brought along on business trips, club memberships and dues, vacations ... even childcare for the owners’ kids. These “expenses” reduce profitability and create potential tax issues.
- “Leasing” arrangements with the owners that overcharge the company. Beyond $40 a square foot for office space in a $30 per square foot market for offices owned by certain firm principals, the other thing you may find is that all vehicles, computers, survey equipment, drilling rigs, desks, etc., are owned by a principal in a separate corporation that leases them to the A/E firm at excessive rates and reduces profitability. Don’t laugh. It’s more common than you may think.
- Family members on the payroll who don’t do anything for the company. “Mom,” “Grandpa,” and each of the kids of the owner(s) may be getting paid to do nothing in an effort to reduce taxable income and move profit dollars out of the firm. Check and see if any of this is going on.
- “Profit” lines that show profit after excessive or inadequate owner compensation, and/or show post-bonus profitability. You can make any business look profitable if the owners don’t take salaries for the jobs they do, or take ridiculously low salaries. I have seen this on more than one occasion. Conversely, and more commonly, you can make any business look less profitable than it really is by taking higher salaries than you should for a firm of that size. And as far as post-bonus profitability numbers go that include owner bonus payments – they mean absolutely nothing. That is a derived number. Management is in control of it. Showing this number to employees as if it means anything is misrepresentative of how the firm is actually performing. Probe into this.
- Assets that are either overvalued or undervalued on the balance sheet. Follow proper accounting procedures and assets are valued at cost less depreciation. When a firm has owned real estate for 10 or more years that almost always under-states the real value of it. And other assets – such as office improvements that are capitalized – or software or computers – they may be worth much LESS than what is shown on the balance sheet. Not to mention accounts receivable that may be years old and probably uncollectible yet still show up at full value. Start asking questions here.
- Liabilities that aren’t recognized on the balance sheet. Many companies don’t reflect accumulated vacation time as a liability. Jobs that have been over-billed yet still have to be completed. Deferred compensation agreements with owners that are unfunded yet may be significant liabilities in the future. I could go on. Everything must be scrutinized.
So in the future, whenever you look at the financial statements of a privately-held firm in this or any other business, you really need to look into each of these issues and more to be sure you are getting a proper picture of the business’s financial performance and condition.
Mark Zweig is Zweig Group’s chairman and founder. Contact him at firstname.lastname@example.org.