Martin Quinn's management and financial accounting blog

Paul Downs is a US business owner who writes on the NY Times Small Business blog. Here is a nice post in a series he wrote on “the numbers I track”.  In this post, he focuses on the importance of tracking labour costs. This quote from the post gives a good summary of Paul’s thinking:

“I’m not sure what to think about my labor costs. I have two conflicting theories running through my head. The first: pay people what they deserve. The second: pay people just enough so that they don’t leave. In reality I’m somewhere in between the two. Payroll is our biggest single expense, and it’s easy to let it get out of control and suck up all of the profit in the company”

I’m sure many small businesses experience this same sentiment. Read the full post for more.

I read an article from the Guardian  website last January, where a Bank of England official was suggesting that banks need to have separate accounting standards from other types of business. Some of the concerns mentioned were around the notion of fair value. This an extremely complex area, but I’ll try to summarise it here.

The basic idea of fair value is that certain types of assets and liabilities should be measured in the financial statements at a value which reflects what they could be sold for or settled for. In the main, the types of assets/liabilities concerned are referred to as financial instruments – e.g. debt, equities. There are two complex accounting standards which deal with how such instruments are measured according to fair value. IFRS 9  defines the what happens to the difference arising on fair value adjustment. Without going into too much detail, the fair value adjustment goes through the income statement/profit & loss account.  As mentioned in the Guardian article, this is normally fine when markets are causing the value of the assets to increase, but it perhaps less popular when markets are falling. And, of course there is the problem of ascertaining what exactly is “fair value”. IFRS13 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. It also describes a hierarchy of how to measure fair value and outlines detailed disclosures which must be made in the financial statements. Of course, all this presupposes there is a reasonable way to ascertain fair value based on a market price or equivalent market price. And, as we know from recent years, there have been plenty of media reports about the complex nature of some financial instruments. I’m sure the debate on whether or not fair value is right for the banking sector will continue.

In recent years, we have heard so much about the (financial) markets, their reactions, lack of confidence and so on. I often feel like asking who or what exactly is “the markets” and will they ever just leave us alone. The economist Adam Smith used the analogy of the invisible hand, a self correction mechanism the markets may have. More recently Chandler alone of the visible hand – the firm – which could be influenced and changes perhaps easier than something like an invisible market hand.

I’m no economist, but I do find this stuff interesting. Especially nowadays when you think if the amount of information a firm could have – social data for example. I read an article in a Forbes blog last year some time, which suggested the prevalence and increasing availability of social data might be the invisible hand that could change markets, or at least help us to understand the markets. Seems like an interesting thought – click here to read the post.

I read an interesting article in the November 2011 issue of Financial Management, CIMA’s monthly journal. The topic was peer-to-peer finance, which was something I had only heard a little about.  Given the combination currently of low deposit interest rates and high lending rates for small business, peer networks have formed and are seemingly growing fast. The basic idea is relatively simple: some business have cash surpluses and others need finance – but not at 19% (which was a rate quoted to one business mentioned in the article). Those with spare cash can group together and lend to those that need it. The risk may be lower for the provider of finance as only a small amount can be contributed, and for the borrower the rate is lower (8.9% in the case of the business the bank wanted 19% from). Two peer-to-peer lending networks are mentioned in the article – Thincats and Funding Circle. In effect such networks are like mini-money markets. They do, of course, undetake some credit checks and crediting rating, but for small business this seems to be a very sensible way to bring borrowers and lenders together.

In business, a partnership refers to the coming together of two or more persons to conduct a business. Normally, there is a maximum number of partners with exceptions made in cases like accounting practices and legal practices. A partnership is usually formed to take advantage of the combining of skills and resources. The objective is normally to make a profit, and this profit is shared out in some agreed way among partners. Losses too are borne by the partners.

As essential element in the formation of a partnership is the Partnership Agreement. This is a legal agreement (which ideally should be written) which contains items such as the following:

• the capital to be contributed by each partner
• how profits are to be divided
• any interest to be paid on capital contributions
• any interest to be paid by the partners on monies withdrawn
• salaries to be paid to partners
• arrangements for admission of new partners
• arrangements to dissolve the partnership, and procedures on the retirement/death of a partner.

In  the absence of  a partnership agreement,  in the UK and Ireland, the Partnership Act 1890 applies (see here).

In terms of preparing financial statements,  there are some differences. First, any adjustments to profit are made in a profit and loss appropriation account – which is in effect an addendum to the income statement/profit and loss a/c.  For example, any interest due to or to be paid by partners, salaries etc are made here. The resulting adjusted profit is then shared among the partners as agreed. In the statement of financial position (balance sheet), each partner will have their own separate capital account. Some partnerships used a combination of capital and current accounts. The former shows only the fixed capital contributions, the latter shows  profits, drawings, interest, salaries etc. This approach is probably better as the any negative balances on the current account will signify that perhaps a partner is taking out more from the business than they should.

John Teeling founded Cooley Distillery in 1987. In January this year, he signed off on a deal to sell the business to global spirits firm Beam (see here)  US firm to buy Cooley Distillery – The Irish Times – Fri, Dec 16, 2011. On January 14th 2012, Dr Teeling gave a very useful radio interview on his life is business. Have a listen to the podcast here (January 14th, 2012). There are a few things of interest. For example he tells the story of why Irish whiskey sales declined from 60% to 2% of the world market in the past. And how in 1960, he was one a few people in Ireland you could do Discounted Cash Flows – something we take for granted nowadays.

I’m a bit lazy today, sorry, so I’m directing you to a nice post on setting prices in small online business:  Top 5   pricing tips for small business

In recent years hard economic times have hit Ireland and other developed economies. According to an article in the Guardian over a year ago now, the number of businesses failing in Ireland was 5 times that in 2010 – a huge chunk of these being construction firms. I hope have some sympathy for many of the hard-working business people who perhaps have seen a lot of their money lost. But, there is a  part of me (probably the accountant) who is not at all surprised at so many Irish businesses failing.  Why? Am I getting more cranky (Yes, of course I am)? Well, let me give me a few of many examples I have encountered over the last few years which seem to show poor decision making.  But before I do,  I should say that many Irish businesses who started during the “boom” years were already doomed to failure due to a pretty high cost structure e.g. rent.

The first example dates back about 2-3 years now. In the area where I live, we collect an amount of money each year to help maintain the common greens in the area. The landscaping business doing the work was charging about €7000 per annum and a new landscaper offered to do the work for €4500.  Both were sole traders with similar costs (as best I could guess at least).  The original landscaper said he could not do the work for that price and would not even reduce his current price, so the business was lost. Now I don’t know what either landscaper was thinking, but it fairly obvious that the original landscaper was living in the boom years in my opinion. He could have reduced his price by some amount, say €1500. This would mean his net contribution would fall by €1500, but instead he lost €7500 – a bad decision.

The second example relates to a really nice bakery I visited recently in a more affluent part of Dublin. Yes, the price is of course going to be affected by the area, but having paid €4.60 (ok my wife bought it) for a loaf of sour-dough bread I thought this is not a sustainable business. Even people in affluent areas cut back on spending in lean times. The point here is that I thought the price was more reflective of a time four or five years ago.

The third example relates to an employee within a business. The employee left as €900 per week income was not “enough” for him. The job involved manual labour and some skills, but nothing that could not be replaced readily. The right decision was made by the business owner, which was adiós amigo.  The employees decision was rather silly though, as the immediate income from social benefits would be way lower.

These three examples to some extent portray how high prices may have become engrained in the minds of business people following many years of the Celtic Tiger.  I like to study how practices have become accepted/taken-for-granted, or institutionalised.  When practices become institutionalised, there are hard to change. So I wonder are businesses in Ireland failing because some business owners cannot make the change in their minds to reduce costs or prices? In other words, they are finding it hard to break the institutionalised practices associated with past more affluent times. I know there are many other factors, but based on my experience, at least some business failures in Ireland result from a failure to change mindset.

I don’t normally do stuff on leadership or general management, but I couldn’t resist this.

Five Leadership Lessons From James T. Kirk – Forbes.

When I teach about carbon accounting, the first thing I do is get students to look at their own CO2 footprint. This typically means going to a website and putting in some information on your lifestyle. I read an article from the Economist a while back which outlined the differences in CO2 emissions based on age. The study was based on US data on nine types of consumption—including electricity use, driving cars, buying clothes and food. The amount of money spent on each was used to estimate a CO2 footprint by age. According to the article the 60-64 age group produces the most CO2, and this group in going to get larger in number over the coming years. You can click on the link to read the full article and see a nice graphical depiction of CO2 footprint by age

Back in the late 1980′s and early 1990′s when I was young enough to be frequenting pubs/clubs around Dublin city centre, one of the biggest problems was getting a taxi home. At that time, the number of taxi’s was regulated, with (if my memory serves me right) about 1,200 taxis for a city of about a million people.  The effect of this was a market for taxi licences. Many taxi drivers depended on this for their pensions, with a licence yielding IR£ 60,000- 80,000 (about €75-100,000).  Now, Dublin has a de-regulated taxi system and has more taxi’s than New York (see here for a taxi-eye view). The price structure is also heavily regulated, and a common price structure  applies to all fares throughout Ireland.  And, of course, a taxi licence is nowadays worth very little.

Why and I writing about taxis you might ask? Well, while on holiday near Leipzig (Germany) over the Christmas period, I read an article in a local paper (Doeblener Allgemeine Zeitung, Dec 27, p.7) about how a taxi firm is dealing with rising costs. The taxi sector in Leipzig is de-regulated too as far as I know, and competition is strong.  The article interviewed a manager from a local taxi firm, 4884.  Rising fuel prices seem to be a major problem for the firm – and indeed for Dublin taxis too.  However, as I read on I realised that Dublin and Leipzig taxi firms/owners, while having a lot in common (over/high supply, rising costs, relatively declining static/declining market), the Leipzig firm 4884 seemed to adapt well to become attract and keep customers. For example, in June 2011, 4884 launched an app to order taxis (using GPS). They also (according to the Dec. article) regularly train and annually update their drivers on things like customer service skills – it is  even written into the drivers’ contracts.  In Dublin too, there is at least one taxi app I am aware of (Irish Taxi), but I am not sure it is as advanced in terms of GPS. London too has a GPS service available for ordering a taxi.

So what’s the management accounting point? Well, if we compare the market for taxis now to compared to the past (in most countries, but certainly Ireland), there is a far greater supply (volume). The cost structure is typically beyond the control of all taxis. Most costs are fixed – radio rental, advertising, taxi licence fee, insurance – with fuel being the main variable cost. With more taxis in supply, a static market, fixed prices and little ability to control costs, then the ability to earn a profit is likely to be more difficult now. So what can be done by taxi owners/firms to sustain profit.  Most have joined forces to create firms/co-ops, which can share some costs (e.g. central booking). Other options are to increase customer retention through things like apps and improved customer service.  At the end of the day, with so many costs beyond their control, taxi drivers/firms can only but be adaptive to stay in business. If they are not, they can (and do) go out of business.

Here is a useful article and example on variance analysis from CPA Ireland’s e-zine. It explains most aspects of including flexed budgets and cost/efficiency variances.

Following on from my last post on what is a business model, here I recount two articles I had saved from last year on how climate change can force businesses to change – and in some cases even change the business model.

The first article comes from Time (Sep 04, 2011). It recounts how Spanish winemaker Torres are increasingly moving their crops to higher, cooler areas of Spain.  Due to global warming, the hotter climate means sweeter fruit and earlier ripening. At the same time, the early ripening of the fruit is offset by the fact that the seeds and skin (which give flavour) are not ripe. Thus, as a possible solution, vines are being planted at a higher, cooler altitude in an effort to offset the warming experienced in traditional regions.

The second related article  comes from The Economist (Sep 10, 2011, online). In this articles, you can read how English wine is being produced in increased volumes and better quality – with locally grown grapes.  Again, it is climate change – bringing warmer climes to Southern England – meaning that more traditional grape varieties can be grown in England as opposed to the typically acidic German varieties. The result has been a product of increasing quality, and a tendency to produce higher margin sparkling wines – something that was not so easily done before. Thus, the business model of English vineyards may have changed from one where imported “grape juice” was added to make local wine, to one where high quality, high-margin product is the norm.

Photo (techlabs.com)

Accounting is often criticised, and one of the common criticisms is that too much focus on money in a business causes a short-term focus which may not be good for a business. I would agree to an extend, probably because I am more into management accounting and have seen businesses take bold decisions which eventually paid off. Of course, financial accounting (the external reporting of results basically) is less helpful (or “completely useless” as one business owner told me a few weeks ago) in situations where decisions need to be made. And sometimes, these decisions involve a lot of brave and bold creativity and innovation which accountants seen to have a reputation of pouring cold water on.

I read two articles recently which made me think about  accountants and creativity/innovation. The first one was a few months back on Forbes. The piece by Eric Savitz mentioned how creative type toys (like Lego) can be crucial to later creativity. Here’s a quote from him:

Lego, loosely translated, means “to put together” in Latin. But “to put together” doesn’t fully encompass the value – and purpose – of those buckets of colorful bricks. Legos are about putting together, then taking apart, then reassembling in new ways. That’s why I got so upset recently when a friend told me that she and her daughter had built a pirate ship out of Legos, arranged the pieces until they were just right, and then glued the whole thing together. That, I exclaimed, is not the point.

Legos unleashed my creativity when I was growing up. They drew out the part of me that had to know what things looked like from the inside out, how they worked, how they might work better. The hours I spent with them — sprawled on the floor, building and rebuilding, puzzling and visualizing — became my first lessons in engineering. There was magic in those little bricks.  There still is.

Reading this I wondered how what Savitz be as an accountant.  I think he would have a good chance of being creative, but not in a bad way. I think, like the Lego, he might be throwing away the rule book and creating accounting information which might meet the needs of the organisation he was working. This of course is what good management accountants should do, but do they all? I don’t know, perhaps its partially our fault (i.e. educators) and we need to encourage lateral (but always ethical and proper) thinking about accounting.

The second article I read was in this weeks Time, “What would Steve do?”.  Steve Jobs was an obviously brilliant innovator – and eventually made Apple one of the richest firms in the world. In the article the author (Rana Foroohar) makes a strong claim, but she is probably fairly correct. She states ” Jobs stands out as an exceptional leader not so much because of his in-your-face style, but because American business has become dominated by bean-counters focusing on hyper-efficiency rather than by innovators focused on real growth”. I suppose this is a classic case of too much focus on short-term financial goals over longer-term business development and growth. I don’t have a quick-fix solution for such a problem, but certainly an open mind by accountants towards innovators would help.

Often, when I teach about types and classifications of cost in my management accounting classes, I use the term business model. For example, I might say “whether a cost is fixed or variable, can depend on the particular business model”. But, I am assuming the term business model is well understood. Perhaps it is not, and even when I asked myself what the term means,  I had to do a bit of thinking. So here’s a simplified explanation.

An article in the Harvard Business Review from 2002 describes a business model as “the story which explains how an enterprise works”. This is a deceptively simple definition, but it does capture exactly what a business model is. If I were to ask you what are the essential elements of a story such a Cinderella or The Frog Prince, you would probably says things like characters, what the characters do, when the characters do things, and of course the (moss likely) happy outcome. Using the story analogy, a business needs to ask itself, what is that we do, who are our customers, how much does what we do cost, and will we make money (the happy outcome!). In other words, “what’s our story”  in an economic sense (Read the full HBR article for more detail and examples).

Nowadays, business models have become a bit blurred though. For example, there are so many web-based “businesses” out there who, to be honest, do not immediately show a story which makes economic sense. For example, we now know how Google and Facebook can make money on a business model which changed the advertising world.  But, what about for example Twitter or off-shoots like paper.li. I love the latter, as I can bundle all the twitter users I follow into a daily newspaper, but how can this make money. I am guessing they will introduce advertising, but has this business model already been over-cooked?

I hope this helps you understand what a business model is. To conclude, I suppose the story of what it is a business does has to be infused with accounting concepts. For example, there is not point being the world’s best at something, but costing a fortune to do it.