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Accounting: the language of business.


AS THE BOTTOM LINE BECOMES the most important and over-simplified theme in American business, the great struggle between cost center and profit center heightens. The question that is regularly asked is, "Is corporate security really a cost center?" Managers regard the corporate security function as but another reduction to gross margin and dollars right off the bottom line.

Security costs are intuitively viewed as expenses for physical barriers, gadgets, and other technology designed to limit access and exclude intruders. In short, the corporate security cost center is a perceived world of physical protection. However, a careful analysis of a company's income statement shows that security should be viewed as a reduction in credits against gross margin rather than a mere allocation of the cost of a service department.

Accordingly, this article focuses on some introductory accounting concepts and how they can be of assistance to corporate security professionals. Since many corporate security professionals were recruited from the public administration sector, it is not surprising that their familiarity with accounting is limited.(1)

Accounting is the language of business. To succeed in any environment, one must know the language of that environment. In addition, most threats to corporate assets come not from terrorists but from those in fiduciary relationships. The concealment of these threats is due to the technical barriers that surround them, and often these technical barriers lie within the principles of accounting.

The knowledge of accounting principles may be one of the best methods for uncovering those who pose a threat to a company's assets. Security professionals must be at least as familiar with the defalcators' argot as they are with their own language.

Security professionals should also be familiar with accounting and financial concepts to enable them to be full corporate partners and not just company cops. Most members of the executive team speak the "language of business"; security professionals must as well.

Accounting can be divided into two general rubrics. Financial accounting is used primarily for external reporting such as tax, banking, and SEC and is concerned with the generally accepted accounting principles (GAAP). Management accounting, sometimes referred to as cost accounting, is the internal reporting technique on which fewer controls are required than financial accounting. The extent to which these controls are acceptable in the public sector is occasioned by the regulations applied by statutes such as the Foreign Corrupt Practices Act, the Securities and Exchange Commission, the Internal Revenue Service Code, generally accepted standards as delineated by the Financial Accounting Standards board (FASB), and other regulatory agencies.

It is helpful for loss prevention professionals to think in terms of their superior's concerns and goals. A major corporate player is the chief financial officer (CFO). No other person's decision-making processes more profoundly affect security professionals.

To understand a CFO's priorities, security professionals should think in terms of that individual's objectives and concerns. The CFO has two major tools to aid in management decisions - budget and performance reports. Budgets are quantitative expressions of a plan of action and an aid for implementation. Performance reports are measurements of activities. Also, they are comparisons of budgets to actual results. Deviations are known as variances.

THE CFO'S FUNCTION IS DIVIDED INTO two positions - the treasurer, who is responsible for obtaining investment capital and managing cash, and the controller, who is responsible for both management and financial accounting. A CFO seeks to obtain adequate financing for both the long-and short-term plan with the greatest return on investment (ROI) and the judicious use of retained earnings. Controlling expenses, planning and preparing long-term budgets, and reporting on results are all major objectives of a CFO. The CFO's primary commitment, however, is to act as a fiduciary.

A CFO seeks to maximize returns on marketable securities and other investment vehicles. He or she tries to maintain the lowest optimal inventory level and evaluate long-term investments.

Monitoring fixed assets allocations through capital budgeting control occupies much of a CFO's time. A CFO is concerned with accounts payable in that the cost of capital goes up with the age of the account payable. Short-term debt is a strategy used by the CFO when borrowing to meet current obligations and not capital projects (usually). Long-term borrowing (debt) has lower risk and lower interest rates ordinarily.

The firm's vitality is a major concern for the CFO, and monitoring the debt/equity ratio is one of the most significant tasks. Underleveraged or overleveraged firms may not be operating at maximum financial efficiency, and if the debt/equity ratio is not managed, they won't be operating at all.

Accordingly, cash flow is a major concern in almost every fiduciary relationship. That concern heightens the closer one gets to a retail environment. Security managers should note that the operating cash flow is routinely computed on a unit by unit basis and at least quarterly on a consolidated basis in many firms.

The CFO closes accounts every year. One of the important decisions to make is the disposition of retained earnings or profits not distributed to the owners of stock.

Where distributed, these earnings are called dividends, and if not distributed, they are closed from an account called retained earnings. Ordinarily, this account is called the income summary.

CFOs must deal with external auditors. The impact of these dealings is principally determined by whether a firm is public or private.

External auditors provide a CFO with a report that contains two significant parts. The scope paragraph describes what the auditors are examining and what tests were used for the evaluation.

The opinion paragraph is the certification or evaluation paragraph. Companies want an unqualified opinion that states auditors have found nothing wrong with the company's statements and they conform to accounting standards. A qualified opinion indicates something is wrong.

The last thing the CFO wants, particularly in a publicly held firm, is a qualified opinion. The auditors' opinion does not guarantee solvency and profitability. Auditors merely guarantee the report, and they regularly get sued.

A CFO does not like vagueness. When security professionals request to purchase a capital item, it is not enough to state that in their opinion there is an unquantifiable efficacy to their proposal. The CFO wants the proposal quantified in terms of some acceptable accounting mechanism. The most widely used mechanism is ROI. Other techniques involve internal rate of return and current and future value of cash flow.

How costs are distributed and apportioned is another of the CFO's concerns. He or she is interested in several general cost categories. (Obviously, some language distinctions must be made between a manufacturing and retail firm.) Some of these costs include the following:

* Variable costs are usually broken down by payroll and other terms. Essentially, variable costs are costs that change in direct proportion to changes in related total activity or volume.

* Fixed costs remain unchanged in total for a given period, despite wide changes in total volume or activities (sales).

*Purchasing costs are the amount paid for a product.

* Ordering costs are clerical expenses incurred through purchase orders, costs incurred for special processing, and various receiving costs.

* Carrying costs are costs involved to hold inventory for sale or disposition, such as storage rental and insurance. (Note: Carrying costs can also include carrying opportunity costs. For example, if I buy the inventory and store it, I could have used the money for something else. Accountants regularly make reference to opportunity cost and costs where no direct expenditures took place.)

* Stock out costs are the extra costs of having a product shipment expedited.

* Quality costs are costs involved in meeting certain, specifications or inspection requirements of certain products such as drugs and food. Usually the costs applied to a product to meet public agency regulations are accounted for as quality costs (but not always).

When a CFO looks at all these costs, two factors immediately come to mind - the contribution margin and the break-even point. These issues are more important in manufacturing than in retail.

The contribution margin is a basic figure of sales minus costs in a unit or product line. In short, what is the contribution of that item to total income? The break-even point is also an analytical tool of the CFO. A CFO wants to know what volume is needed to earn a certain profit. (See Exhibit 1.)

THE MOST SIGNIFICANT REPORTS found in any firm are the balance sheet and the income statement. The balance sheet says what is owned and what is owed. It should be a firm's principal public document. The balance sheet involves the main accounting equation - assets = liabilities + owner's equity (capital). The balance sheet is constructed through the double-entry system of bookkeeping. For example, a credit is a right-hand entry and debit is a left-hand entry. Credits and debits have nothing to do with plus or minus. However, credits and debits do affect the balance sheet.

For example, revenues increase owner's equity and are represented by credits. Expenses decrease owner's equity and are represented by debits.

However, credits and debits on the assets side of the equation have an entirely different impact. A credit reduces an asset account, whereas a debit increases it. Therefore, it is never advisable to think of the credit or debit as plus or minus since it is where they appear on the balance sheet that determines their impact on the financial position of the firm.

All transactions that involve transferring cash, assets, liabilities, loans, or accounts payable are recorded as credits or debits. The initial transaction is known as a journal entry. The balance sheet contains three separate divisions of financial transactions-assets, liabilities, and equities.

The transactions under each of these categories are usually diagramed in the form of T accounts, which show the credit and debit relationship. The most formidable substatement under the balance sheet is the income statement, which is fundamentally an equity account. (See Exhibit 2.)

The income statement is also known as the profit and loss statement (P&L). The income statements is a periodic statement of profit and loss and is housed under owner's equity on the balance sheet. The P&L uses the basic equation of net income = revenue - expenses.

The income statement can be a micro or macro picture of sales and expenses. It can be prepared on a unit-by-unit basis, plant-by-plant basis, or as a consolidated document reflecting total revenues of the firm.

Little can be said about the income statement except that issues such as gross margins and inventory loss are quite significant in a retail firm. That is not to say inventory loss does not affect a manufacturing firm, but margins are the line item on which retailers manage inventory loss. However, the P&L pictorializes revenues, cost of goods sold, margin, and administrative expense to provide an initial profit profile. (See Exhibit 3.)

Inventory management is one of the most puzzling aspects of day-to-day management accounting. It is an area in which one type of asset is converted into another type of asset such as cash being converted to products.

Many intricacies are woven within inventory management that threaten a firm's security. It is within inventory conveyances that a large number of improper activities are contained. Therefore, it behooves security professionals to understand how inventory is managed, received, and transacted, whether they are employed in a manufacturing or retail firm.

In a merchandising or retail company, inventory consists of all goods owned and held for sale. In the manufacturing firm inventory includes raw materials, goods in process or manufacture, and finished goods. Obviously there need to be methods to both count inventory and value all these forms of inventory.

There are two general inventory methods. Periodic inventory is used primarily for small products and products that to count, because of their sheer volume, would be a monstrous task. Perpetual inventory is used for high-priced products or those whose volume in inventory is manageable. Inventory valuation and the measurement of income are clearly connected - profits = total sales - cost of goods sold.

Let's discuss cost of goods sold (COGS). COGS can be said to be the beginning inventory plus the purchases minus the ending inventory - COGS = BI + P - EI. The cost of goods available for sale must be separated into cost of goods sold and cost of goods not sold. It is the cost of goods not sold that comprises the ending inventory.

There are a number of inventory valuation methods. The specific identification method is a good method for high-priced items. If units in the ending inventory can be identified as coming from a specific purpose then this method is most appropriate. COGS is found by subtracting the specific ending inventory from the cost of goods available for sale - BI- EI = COGS.

The average cost method is found by dividing the total cost of goods available for sale by the number of units available for sale.

The first in/first out (FIFO) method is based on the assumption that the first merchandise acquired is the first merchandise sold. Each sale is made out of the oldest goods in stock. The ending inventory, therefore, consists of the most recently acquired goods. This is the poorest approach since it takes the oldest costs and matches them against recent sales. It is good for the balance sheet but bad for the income statement.

The last in/first out (LIFO) method is where the most recently acquired goods are sold first and ending inventory consists of old goods acquired in earlier purchases. While this method is not logically consistent with the physical movement of goods in a business, there is a logical argument for it. Supporters argue the measurement of income should be based on current market conditions. LIFO is thought best for matching cost and revenues. LIFO is thought bad for the balance sheet but good for the income statement.

Another technique, known as next in/next out (NINO), deals with valuation as it relates to replacement cost. However, the FASB has published a statement requiring the disclosure of net income of companies using replacement costs for the valuation of inventory.

In place of some of these concepts, some firms use a concept called the Lower of Cost or Market Principle (LCM), which means exactly what it says with respect to the value of inventory.

Because of the complexities of inventory valuation, a large number of legitimate mistakes regularly occur in any accounting system. For example, because the ending inventory of one year is also the beginning inventory of the next year, an error (intentional or unintentional) in inventory valuation is a two-year mistake.

Some common inventory mistakes security professionals should be aware of include:

* booking sales before they are sales (in early booking of sales, accounts receivable are overstated and so are sales) and

* late booking of purchases (the purchases are too low and accordingly the accounts payable are too low).

NO DISCUSSION OF INVENTORY could be complete without discussing two major concepts involving the expensing of assets - amortization and depreciation.

Amortization is used for intangible assets such as patents, legal fees, leases, and goodwill. Intangible assets are those used in the operation of a business but that have no physical substance and are noncurrent. Ordinarily a firm may deduct as an expense no more than a 40-year life for such assets. Forty years is the acceptable amortization period for an intangible asset according to the FASB.

Basically, amortization is a term used to describe the writing off to expense of the cost of an intangible asset over its useful life. The accounting entry consists of a debit to the amortization expense and a credit to the intangible asset.

Depreciation allocates the cost of an asset to an expense over years of use. Depreciation is caused by physical deterioration and obsolescence. A number of methods can be used to compute depreciation. Here are four:

* Straight-line method. The cost of an asset is depreciated in an equal portion over its allocated period of use.

* Units of output method. This method is used when assets to be depreciated can be measured by their amount of output. For example, a motor vehicle can be depreciated by the number of miles driven over its useful life.

* Accelerated depreciation method. The accelerated depreciation method recognizes a large amount of depreciation expense in early years of use and reduced amounts later.

* Accelerated cost recovery system (ACRS). This method is used for depreciating expenses in five years for tax purposes. Most property is depreciated over five years and most buildings over 15 years. The tax reform act of 1986 now designates a modified ACRS, which sets time frames for depreciation of certain types of assets.

Depreciation is used for expensing a capital asset. Land, however, should not be depreciated.

Depreciation is one of the first concerns a CFO considers when the security department requests an exotic CCTV system. The CFO is concerned with the tax consequences, the ROI, cash flow, etc., not whether someone is caught stealing. The efficacy of the asset is a technocratic decision with which the CFO is less concerned.

Inventory loss concerns all firms. Its most significant impact is on retail firms since the gross margin in a retail firm is one of the more significant indicators of management performance. Accordingly, unexplained inventory loss, known as shrink, is a major concern to those in a fiduciary relationship in any firm.

Inventory shrink can be computed in a number of ways. These methods are employed in one form or another in both retail and manufacturing. Suffice it to say that these mechanisms are not transitory but are especially applied to the business environment in which that specific inventory is to be managed. It is easier to manage fixed and administrative expenses but tougher to manage the margin. It is at the margin that shrink takes its toll and the management of inventory is most significant.

Loss occurs from both external and internal threats. However, it is the paperwork that houses the greatest overall exposure.

Constant contact with outside firms and vendors provides a serious backdrop to external corporate loss. Suppose an employee is acting as the agent of a vendor? This double-agent scenario is all too common. Commercial bribery and kickbacks have become so pervasive that they have been incorporated into state statutes. Without an understanding of the fundamental principles of finance and accounting, security professionals cannot detect many of these scams.

Corporate loss attributable to terrorism and sabotage is serious. Preventing kidnapping and assault of key executives is not absolutely possible, but a well-ordered plan of reduction is. Shockingly, some major firms do not have any plan in place.

In addition, some of the top financial and Fortune 500 firms simply do not have effective programs to prevent sabotage. Product tampering, product counterfeiting, violations of Securities and Exchange Commission laws, facility sabotage, and other acts are just as damaging to the bottom line as any ineffective capital budgeting decision or reduction in revenues.

Internal fraud occurs in many ways - from performance data manipulation to fake debits to expense fraud to ghost employees on the payroll - and it cannot always be detected using generally accepted auditing standards (GAAS). It has been said that "the most difficult [types of fraud] to detect are those expressly designed to work within the framework of existing controls." (2)

Corporate fraud falls into one of several categories. Performance data manipulation is the most common type of executive crime. It involves manipulation of the corporate data by one with the authority to post it. It involves fraudulent capitalization of expenses, early booking of sales, injudicious selling of corporate assets, manipulating accruals, smoothing profits, manipulating off-line reserves, conducting questionable mergers and acquisitions, and using other techniques to deceive the firm or the public.

Kickbacks are the major concern in vendor conspiracies. They have a number of laundered and clean-sounding connotations. Some of the most popular are finders' fees, performance rewards, sales incentives, and marketing promotions.

When the relationship between vendors and staff is professional, conflict is rare. When that relationship is more than professional, however, seldom is the conflict positive.

In vendor conspiracies there is often a trail of source documents. A good forensic accountant is trained to follow that trail. The trail may lead to a phony company, a holding firm in the name of the employee, a post office box number, and a variety of other secondary relationships.

Another kind of fraudulent activity, direct theft, involves unlawful disposition of inventory, expense account frauds, etc. The motives for direct theft are the same as those for other crimes - greed, compelling social relationships, gambling, alcohol, and drugs. These motives have remained the same throughout the ages. The accountant merely discovers a new technique.

Ghost employees and fake debits are among the most common scams found in the paper trail. They occur through phony credit memos, phony benefit claims, phony employees added to the payroll, and phony expense vouchers. These scams are almost always uncovered through the paperwork. The problem is knowing what to look for. No one item alone means anything; it takes a cluster of items to suggest fraud.

Vendor/consultant relationships also can produce problems. The following are indicators of trouble:

* The stationery used for billing and letterhead is the same.

* The consultant never seems to write or distribute progress reports.

* The vendor's mission is unclear or vague.

* The vendor is being engaged outside of their field of expertise.

* There is a lack of competitive bidding.

* The vendor is a former employee.

* In-house employees process the vendor's own paperwork.

* The consultant claims to be an expert on everything.

Forensic accounting must be a component of a security professional's working environment. Security professionals need to develop a special relationship with the financial executives in their firm, including the controller, treasurer, internal auditor, and chief financial officer. The bad guys are always looking for the ones who have the dough. If security professionals know how to secure the dough their knowledge of systems will make them valuable corporate players. And their knowledge of security in accounting systems will make them indispensable.

(1) Vincent P. Cookingham, "Corporate Fraud and Organized Crime: The `Bust Out' Example," Security Management, July 1985, pp.28-31.

(2) Marvin M. Levy, "Financial Fraud: Schemes and Indicia," Journal of Accountancy, August 1985, p. 78.

Vincent P. Cookingham, CPP, is director of loss prevention and internal auditing for Big V Supermarkets Inc. in Florida, NY. He is a member of ASIS.
COPYRIGHT 1989 American Society for Industrial Security
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Author:Cookingham, Vincent P.
Publication:Security Management
Date:Nov 1, 1989
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