Budget in Security

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217

Accounting Controls and Budgeting

Money for which no receipt has been taken is not to be included in the accounts. —Hammurabi

Managers monitor and regulate their programs in several ways. This chapter is concerned with one of the most important controls: the use of financial policies. Controlling purse strings involves numbers. This discussion is meant for readers who are not particularly numeric and who may never have taken a course in accounting. The principles involved are simple, but also are fundamental to the success of any organization. Managers of security programs need to be comfortable with basic accounting processes in order to speak the language and understand the concepts raised by financial managers. The dis- cussion thus takes into consideration simple but critical notions a manager will need to understand in dealing with financially oriented irregularities. Even more significant are formulas, ratios, and rules of thumb needed to understand and control the budget of a security department. To create a context in which controls needed for security operations can best be understood, some basic principles of corporate finance will be discussed first.

FINANCIAL CONTROLS IN THE ORGANIZATION

All organizations have financial aspects associated with their activities. Guidance is provided by people who are dedicated to the management of money. The principal senior manager in for-profit and not-for-profit organizations is the chief financial officer (CFO) or vice presi- dent of finance. This individual may also have the title of controller. The CFO’s responsibil- ities include budget analysis and forecasting, monitoring of accounts payable and receivable, salary and compensation projections and recommendations, internal auditing, investment of excess funds, and compliance with tax and regulatory issues. The CFO is also in charge of financial management, which includes raising capital, determining the mixture of debt and ordinary capital, helping to decide on investment opportunities, valuing businesses that might be acquired or sold, and recommending dividends or capital payouts to shareholders. The office of the CFO maintains accounting and financial records that are audited by an out- side auditing firm of certified public accountants (CPAs). These accounting records, usually maintained electronically, are the basis for financial reports issued to various parties includ- ing management, stockholders, and creditors (banks and other lenders).

McCrie, R. D. (2007). Security operations management. ProQuest Ebook Central <a onclick=window.open('http://ebookcentral.proquest.com','_blank') href='http://ebookcentral.proquest.com' target='_blank' style='cursor: pointer;'>http://ebookcentral.proquest.com</a> Created from apus on 2020-08-03 12:41:29.

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218 ACCOUNTING CONTROLS AND BUDGETING

The finance department is concerned with past, present, and future monetary issues. In public corporations, certain financial reports are widely available documents. For example, the finance department prepares an annual financial picture of operations of the previous 12 months. Quarterly reports are issued for publicly traded companies. Such reports are available on a more frequent basis as required by operations. These financial documents have similarities regardless of the type of organization involved, be they for-profit corporations, not-for-profit organizations, or government units. Tax filings also are required for all nongovernmental units. Two fundamental documents central to organizational control functions are the consolidated balance sheets and the consolidated operating (income) statements. In addition to these two historical reports, the modern corporation may also produce a consolidated statement of cash flow. Complex organizations that include separate divisions and/or companies will issue these financial statements on a consolidated basis combining all activities.

The Evolution of Financial Controls

Accounting techniques have been important management tools for centuries, long before the modern corporation appeared. The Code of Hammurabi (about 1780 B.C.) recognizes the significance of accounts. Organizations grew in complexity during the Renaissance, and with that growth came an increase in the number of persons who handled an organi- zation’s money. As a result, financial controls evolved to make sure that mistakes were not made and that assets were not misappropriated. By the 14th century, double-entry book- keeping was used by the merchants of Tuscany in Italy. The first treatise on this topic was written by a friar, Luca Pacioli, and published in Venice in 1494.1 Pacioli wrote in the ver- nacular of the region rather than in the Latin of the church. Consequently, the treatise became broadly useful in local commerce. This “Venetian” or “Italian method” of report- ing assets with liabilities soon was translated into English, Dutch, German, Bohemian, and Russian. Today, this method continues to be used throughout the industrialized world as the fundamental procedure for stating the financial position of an organization.

The notion of double-entry bookkeeping is that any resource of a business has two aspects: its monetary value expressed as assets, and the corresponding monetary claims on those assets (expressed as liabilities or owners’ equity) according to who has a legal claim arising from it either as a creditor or as an owner. In bookkeeping, the duality of the accounting method is expressed by recording assets in one column and liabilities and owners’ equity in another. A monetary value is assigned to all assets and liabilities in the organization. The balance sheet may be created at any time and the two columns or sides will be equal. If the liabilities exceed the assets, the owners’ equity will be a negative amount. This is generally an indication that the business is insolvent.

The following are a number of formulas that describe the relationship between assets and liabilities in an organization:

Assets = Liabilities + Owners’ Equity therefore

Liabilities = Assets − Owners’ Equity or

Owners’ Equity = Assets − Liabilities

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The modern bookkeeping techniques to record business transactions have evolved from the 1490s writings of Pacioli. These bookkeeping terms and procedures have evolved from handwritten documents to computer-prepared financial information. The terminology of the accounting process discussed by Pacioli includes:

• Journal—the book of original entry or a diary of business transactions in chronological order.

• Ledger—a book (or computer file) for each item on the financial statements.

• Debits and credits—technical terms related to the recording of transactions in the journal and ledger.

Consolidated Balance Sheets

All organizations use balance sheets to determine their periodic financial condition. (Table 8.1 is an example of a consolidated balance sheet.) Assets and liability are constantly in flux; thus, periodic statements allow comparisons to be made with earlier times. The term “consolidated” here and elsewhere implies that financial reports from separate operating units have been merged into the balance sheet, creating a master financial statement for the whole organization. If the corporation is small and operates as a single unit, the word “consolidated” is superfluous.

Balance sheets list assets at original historical cost and consequently do not neces- sarily establish the value of the organization. Assets held for long periods of time gener- ally have increased in value, while the balance will reflect the original cost. For example, land purchased in 1970 for $10,000 would have a much higher current value, possibly $100,000 or more. While balance sheets may vary in the items they include, generally the information will include the following components:

• Current assets. These assets represent cash or items that can be converted to cash, generally within a year. This is the strongest asset category because of its liquidity. Cash is the first current asset listed. Next, marketable securities at cost, if any, are listed. (In most cases, the current market value will be different from the acquisition cost; this may be cited in the balance sheet or through a note.) Accounts receivable, less a deduction (allowance) for the estimated amount of uncollectible accounts, is listed next. This category represents invoices owed by customers. Next, stated inventories of merchandise available to sell to customers or to be used in the manufacturing process are listed. While the inventories are stated at original cost, the determination of this cost could be based on recent (current) purchases or older purchases, possibly years earlier. The notes to the financial statements will indicate the method of costing employed. There could be a significant difference between current costs or older costs. Finally are prepaid expenses that represent items purchased for use in future periods (other than inventories accounted for separately) that were paid for in the current period. For example, rent of the following year paid in the current year would be considered an asset until the use of the property.

Financial Controls in the Organization 219

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220 ACCOUNTING CONTROLS AND BUDGETING

Table 8.1 Example of a Consolidated Balance Sheet

Current Year Previous Year

Current Assets Cash and Cash Equivalent _________ ________ Marketable Securities _________ ________ Accounts Receivables _________ ________ Inventories at Cost _________ ________ Other Current Assets _________ ________

Total Current Assets _________ ________ Fixed Assets Property, Plant and Equipment _________ ________

Land and Building _________ ________ Machinery and Equipment _________ ________

Less Accumulated Depreciation ( _________) (________) Net Property, Plant and Equipment _________ ________

Other Assets Payment and Deferred Charges _________ ________ Intangibles _________ ________

Total Fixed Assets _________ ________ Total Assets _________ ________ Liabilities and Shareholders’ Equity Current Liabilities Accounts Payable and Accrued Expenses _________ ________ Notes Payable _________ ________ Total Current Liabilities _________ ________ Long-term Liabilities Long-term Debt _________ ________ Other Long-term Liabilities _________ ________ Total Liabilities _________ ________ Shareholders’ Equity _________ ________ Common Stock _________ ________ Non-voting Common Stock _________ ________ Reserves for Dividends _________ ________ Retained Earnings _________ ________ Total Shareholders’ Equity _________ ________ Total Liabilities and Shareholders’ Equity _________ ________

The consolidated balance sheet is a means of determining whether the organization has a positive or negative net worth, reflected in shareholders’ equity or its lack. Comparison with the previous reporting period per- mits the observer to determine the direction of the net worth.

• Fixed assets. Most organizations will have invested in capital expendi- tures to meet their needs. Once acquired, these assets will appear as fixed assets. Capital expenditures are used for the purchase of assets that increase the utility of operations when the benefit is likely to extend more than one year and more likely over a number of years. These include buildings, machinery, systems, vehicles, and land. Such expenditures will be subject to depreciation, which is an allocation of

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the cost of an asset over its expected useful life. An estimated expected useful life of an asset is determined, and then deductions from the original purchase price are made each year to allocate the original cost.2 This allocation, called depreciation, reduces the value of the assets in the accounting records (book value). Both the value of the asset on the balance sheet and the profit recorded on the income statement are reduced by the amount of depreciation. Depreciable assets include buildings, fixtures, machinery, office equipment, furni- ture, and fixtures. Fixed assets specific to security programs include security systems, guardhouses, automobiles, golf carts, and sometimes security officer uniforms. Land is not subject to depreciation because it is not a “wasting asset.” Fixed assets are reported less accumulated depreciation. The schedule for depreciation relates to presumed life- time use of the asset.

• Payments and deferred charges, if any. An example would be advanced payment of taxes and other credits earned. These are incurred charges that had been deferred to the future. Some examples include start-up costs, moving expenses, and certain income tax charges.

• Intangibles. Assets like patents, trademarks, and goodwill are examples of these assets. These assets are listed at original cost. Consequently if a company has goodwill or a valuable patent that it has developed itself, there may be no cost listed on the balance sheet. Some acquisitions are worth more than their asset value because they are believed to have more than average expected future earnings. Goodwill is the value of a business that has been acquired that is greater than its asset value. The allocation of the cost of intangibles against profit is called “amortiza- tion,” which is a similar concept of depreciation. The rule for deter- mining the amount of intangible asset amortization and related expense (decreased profit) on the income statement each accounting period has recently changed and requires complex computations related to the impairment (reduction) to the value of the asset.

• Total assets. This figure represents the summation of current, fixed, and other assets.

• Liabilities and owners’ equity. The other side of the balance sheet equation contains two parts: liabilities, which are economic claims on the organization, and equity, which reflects ownership interests. The owners’ equity of a corporation is called shareholders’ or stock- holders’ equity, while the equity of a firm owned by a group of part- ners or one individual is called partners’ equity or proprietor’s equity, respectively. The liabilities and equity are composed of several com- ponents: • Current liabilities. These are liabilities owed by the organization

either immediately or usually within one year from the balance sheet date. Most current liabilities are due within 30–60 days. They include accounts payable to trade vendors; notes payable to lenders; accrued expenses payable to employees, vendors, or others; and income taxes payable.

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• Long-term liabilities. These include long-lived debts such as notes payable and mortgages (debts secured by property such as buildings or equipment) due more than a year in the future.

• Total liabilities. This category summarizes current and long-term liabilities.

• Owners’ equity. This section represents a claim by ownership to the net worth of the organization. This includes the value of claims from the capital contributed by the sole proprietor, partners, or stakeholders. Also in this category are accumulated profits available for payments as dividends to stockholders or withdrawals to partners or sole proprietors (an unincorporated business owned by one person).

The owners’ equity of a corporation includes two categories: paid in capital and retained earnings. Paid in capital is the amount paid into the corporation by stockholders, both common and pre- ferred. While there are many variations of preferred stock, these stockholders generally have a “preferred” guarantee on distribution of profits (dividends) and allocation of assets at the termination of the corporation. Common stock, the most “common” type of stock issued, represents the interests of owners of a corporation after the preferred stockholders have been satisfied. If a corporation has only one type of stockholder, the title common or capital stock is generally used. Normally, but not always, preferred stockholders do not have the right to vote on issues related to corporation management and financing. The “retained earnings” account is listed next in the owners’ equity section of the corporation balance sheet. This cate- gory includes accumulated profits (since inception of the business) less all payments (dividends) to stockholders. The owners’ equity of a partnership or sole proprietor includes one owner’s equity account for each owner, called a capital account. The capital account contains investments by the owner plus the owner’s share of business profits less withdrawals (usually cash) by the owner.

• Statement of operations or income statement. This important account- ing report provides a picture of income and expenses over a previously stated period of time. An example of such a report is shown in Table 8.2. The statement of operations identifies the main types of expenses and charges against earnings that the enterprise experiences.

• Net revenues. This identifies the sales recorded over the reporting period for all the goods and services provided by the organization, both for cash and accounts receivable (credit sales), minus any dis- counts taken. A series of deductions from this gross revenue are made, leaving a final profit. The following categories are deducted from the net service and sales revenues: • Cost of sales. In retail business, this includes the wholesale cost of

inventories sold to customers. For a manufacturing firm, the costs include factory operations for the period. This is adjusted for finished goods not sold (included in inventory on the balance sheet) at the beginning and end of the accounting period. Manufacturing

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costs include the cost of raw materials, labor, equipment and systems (including depreciation), and other expenses of operating a factory, as well as related expenses like transportation and storage.

• Gross profit. This profit reflects the remainder after deduction of the fundamental costs of inventories or manufacturing (sales less cost of sales). It is called “gross”—or “gross margin”—because numerous other expenses for operations are yet to be deducted from it, such as finance, administration, and taxes. The gross profit, however, can be a useful comparative tool for one year’s performance with another’s. The gross margin ratio is the percentage of sales remaining after a firm has deducted the cost of sales. The only way a gross margin ratio can be increased is by increasing selling prices, reducing the cost of sales, or both.

• Selling, general, and administrative expenses. Costs relating to sales and marketing personnel, advertising and public relations, plus all the general and administrative expenses of operating the enterprise, are recorded here. They include senior operating staff costs (headquarters-allocated expenses including depreciation of selling general and administrative assets), legal and accounting costs, subscriptions, fees, donations, and a host of expenses not previously recorded. Subcategories may also be reported.

• Other expenses, net. This category recognizes unconventional costs that the organization experienced for the reporting period. For example, if the organization had a minority ownership of a business

Financial Controls in the Organization 223

Table 8.2 Consolidated Statement of Operations

Current Year Previous Year

Net Revenues –––––––– _________ Costs of Products and Services –––––––– _________ Gross Profit –––––––– _________ Selling, General and Admin. Expenses –––––––– _________ Depreciation of Intangible Assets –––––––– _________ Other Expenses, Net –––––––– _________ Interest Expense and Finance Charge –––––––– _________

Earnings Before Income Taxes –––––––– _________ Provision for Income Taxes –––––––– _________

Earnings from Continuing Operations –––––––– _________ Gain (Loss) from Discounted Operations –––––––– _________

Earnings (Loss) from Continuing Operations –––––––– _________ Extraordinary Item –––––––– _________

Net Earnings (Loss) –––––––– _________ Earnings (Loss) per Common Share –––––––– _________

Continuing Operations –––––––– _________ Discounted Operations –––––––– _________ Extraordinary Item –––––––– _________

Net Earnings (Loss) per Share –––––––– _________

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that was not consolidated with other expenses, the amount could be indicated here.

• Interest expense and finance charge. Since interest expense relates to how a business is financed and is not related to the operations of a business, it is generally shown in a separate category near the bottom of the income statement. Organizations normally have a line of credit, that is, funds available on a short-term loan basis from a bank. This category reflects the interest expense to continuing operations. Changes from one year to another could relate to different debt levels and the variable costs of debt. Sometimes long-term and short-term debt are indicated separately. Short-term indicates debt that matures within one year of the date of the financial statement.

• Earnings before income taxes. This amount represents the earnings before deductions for federal, state, and local taxes levied against the net earnings of a business. This may be significant if the organization has unusual tax consequences that could change from one year to the next.

• Provision for income taxes. For-profit corporations pay taxes. However, these can differ from year to year if the tax rate changes.

• Earnings from continuing operations. Large organizations are dynamic, often selling or closing significant business units within a single financial reporting period. To aid comparison with ongoing operations, accountants distinguish continuing from discontinued operations for which there may be a gain or loss reported.

• Extraordinary item. This assumes that an exceptional event that is both unusual and infrequent is being recorded, and presumably not likely to recur. For example, it could be due to the loss or gain from the early redemption of long-term liabilities or a natural disaster such as an earthquake in an area where earthquakes are unusual and infre- quent. The extraordinary items, if any, are reflected less any tax bene- fits or cost related to the item.

• Net earnings (loss). This figure indicates the post-tax earnings of operations for the year. However, the consequences for shareholders of a corporation are not apparent from this amount and must be deter- mined from the earnings (loss) per share.

• Earnings (loss) per share (EPS). As an example, a company that earned $10 million after tax and had 10 million shares outstanding would realize earnings of $1 per share. A note will indicate whether the number of shares has changed from one reporting period to another, so that the consequences for the owner of a single share will be apparent. The calculation for computing EPS may be complicated by various issues including the existence of preferred stock or bonds payable that may be converted to common stock.

• Impairment charges. In recent years, SEC and general accounting policies have mandated the recording of impairment charges in some circumstances. These reflect the permanent decline in the value of a significant asset previously carried on the books of the enterprise. Therefore, recovery of the asset’s cost or book value is not realistic.

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Notes to the Consolidated Balance Sheet and Statement of Operations

All consolidated statements include a number of explanations about the organization that are relevant in the opinion of the independent accountant.

To become aware of fundamental and structural financial changes in the organiza- tion, perusal of these notes is vital (see Box 8.1). Such notes include a summary of signif- icant accounting policies. This section also describes important procedures, including any changes made from the previous year. Other notes provide specific information on invest- ment in affiliates, discontinued operations, valuation of types of financing held, leasing commitments, contingent liabilities (for example, significant possible losses or gains), retirement benefits commitments, and stock options. The notes to the consolidated finan- cial statements also provide business segment information (assuming the corporation has different lines of business), income tax information (both domestic and foreign), a review of quarterly financial information, notes on major acquisitions, and information concern- ing capital stock and earnings per share. Revenues also may be reported separately for international and domestic activities.

Financial Controls in the Organization 225

Box 8.1 In Financial Statements, Notes Tell a Story

The main financial information in a corporation’s annual report often seems skewed to emphasize the positive. But in some cases, notes in the report reveal a serious problem that eventually will affect the ability of the organization to oper- ate. Only by reading and understanding the consequences of these notes may an investor or employee be alerted to impending disaster.

An example of a company that was able to “hide” certain accounting prac- tices in its annual report concerns Crime Control, Inc. This former Indianapolis- based business was incorporated in 1977, and was composed of small alarm companies owned by its two founders. In 1978, operating revenues were $685,000, with a pro forma (estimated) profit of 14 percent. Two years later, operating rev- enues had grown to $5,800,000, with a pro forma profit of 16 percent. Business grew steadily as the firm purchased accounts from other alarm businesses. This growth, up to that point, was made possible mostly by bank financing based on the positive sales and profit trend. In 1982, Crime Control issued an initial public offer- ing, selling about 27 percent of equity, while the founding shareholders retained the remainder. The public market for Crime Control’s common stock grew, enabling the alarm business to continue aggressively on its acquisition path.

Crime Control’s alarm monitoring business soared in sales and profits com- pared to their major competitors. Why? The answer relates to Crime Control’s unorthodox accounting policies. Alarm businesses generate income in two ways: from leases or sales of alarm systems and from ongoing revenues derived from monitoring alarm signals. Both forms of income usually are reported in the year in which they occur. However, if security system leases are accounted for as sales-type

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226 ACCOUNTING CONTROLS AND BUDGETING

leases under the provisions of the Statement of Financial Accounting Standards (SFAS) No. 13, a more aggressive accounting method may be elected by the finan- cial managers. This is what Crime Control elected to do. It accounted for future anticipated years of revenues the first year the alarm contract was signed with a customer.

The company offered incentives to renew the rental rate at the expiration of the original lease with a savings of 10 percent. The company assumed that the bar- gain lease term would keep the customer for eight years. These sales-type leases were then accounted under SFAS since the eight-year lease term exceeded 75 per- cent of the estimated economic life of the equipment (10 years). Crime Control, with the approval of its accountants, Coopers & Lybrand (currently part of PriceWaterhouseCoopers), was able to report exceptional revenues and profits rel- ative to other peer companies that used conservative and conventional reporting methods.

Due to its accounting assumptions and policies and nothing else, the company grew quickly because it appeared to be so much more profitable than its peers. Rapidly increasing “revenues” were booked. But they were not received, since they would not actually be paid by customers for years into the future. To keep the accounting game going as long as possible, Crime Control vigorously sought more and more acquisitions, for which it was willing to pay unconventionally high pur- chase prices in stock or cash. Jealous competitors and astute investors could not understand how this regional alarm business was able to flourish compared with others in the industry possessing far greater experience. The answer was explained in the notes of Crime Control’s annual reports. Few people bothered to read them and understand the consequences until it was too late.

Despite strong apparent revenues and profits, the company kept running out of money because actual revenues were weak. When investors finally realized the scheme, it was too late for most. Crime Control was liquidated, and the remnants were purchased at a diminished value.

Source: Security Letter (February 1, April 1, August 1, September 4, November 15, 1984; July 1, 1985; July 1, 1986; April 15, 1987).

Statement from the Independent Auditor

All corporations are audited by independent auditors to assure stakeholders and the public that the financial statements and the process by which they have been created have been fairly stated. The auditors provide a statement attached to the annual financial statement and some other financial information issued by a firm that includes the state- ment, “In our opinion, such consolidated financial statements present fairly, in all mate- rial (large) respects, the financial position of” the corporation being audited. Recent changes in auditing techniques and reporting require that the auditor not only audit the numbers on the financial statement but also the systems and accounting controls used to

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develop the numbers. The independent auditor will insist that any critical issue relative to the corporation’s activity be fully disclosed either on the financial statements or in the notes to the financial statements as well as in other publicly available documents. In extreme cases, the auditors may include references to unusual accounting issues in their report.

The Significance of Change in Auditors

In publicly held corporations, auditors theoretically have a fiduciary responsibility, not to the corporate board who recommend them, but to the ownership of the organization, shareholders, and others with a potential legal claim on the company. Failure of the inde- pendent auditors to identify to the shareholders and the public at large any substantial irregularity or fiduciary urgency, in the case of publicly held companies, can lead to civil action against the entire audit firm.3 It is because of this fiduciary responsibility that the change in auditors for a publicly held corporation is normally a matter of public record. Shareholders vote annually on the appointment or reappointment of independent audit firms included as part of the annual proxy statement. The changing of one audit firm for another may be a normal and healthy development in which the corporation seeks fresh professionals to review their account. Indeed, the Sarbanes-Oxley Act (www.sarbanes- oxley.com) requires periodic changing of external auditors. The change can also be one that reflects unwillingness to pay the fees for the forthcoming year requested by the exist- ing audit firm; such a change thus could represent significant cost savings.

However, the replacement of one audit firm for another also may signal the fact that the outgoing independent audit firm refused to report financial statements the way man- agement wanted. The accountants may have wished to attach qualifications, or potential warnings, to their statements that would reflect unfavorably on the activities or prospects of their client. Or the independent auditors may have advised that certain impairment charges be taken. Should the audit firm refuse to back down from its proposed position, the client firm may opt to change its audit service in retaliation. However, changes in auditing firms based on disputes related to accounting policies are not usual. The audi- tor has a confidential relationship with the client and is not ethically permitted to release confidential information to third parties without the client’s permission. Yet, third par- ties such as creditors may insist on receiving information on disputes with the auditor as a requirement of continuation of granting credit, including loans. The business also will have difficulty appointing a new auditor if the previous auditor is not permitted to dis- cuss accounting issues with the new auditor. Both the Securities and Exchange Commission and stock exchanges require disclosure of reasons for a change of auditor.

The Securities and Exchange Commission (SEC)

In the 1920s and previously, institutions and individuals who invested in stocks and bonds were frequently victimized by fraudsters who manipulated the market for their own benefit. Unfounded rumors—often fanned by scheming corporation officers them- selves—might drive up the market price for stock long enough for insiders to liquidate their holdings before the market price crashed. To protect the public, the Securities Act of 1933 required issuers of securities, and their controlling persons making public offer- ings of securities in interstate commerce, to file with an agency created to receive such

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information. The SEC was established under authority of the Securities Exchange Act of 1934 (15 USC 78a-78jj). It was created partially to receive registration statements con- cerning financial and other pertinent data about the issuers and the securities being offered. In the United States, it is unlawful to sell such securities unless a registration statement has been filed with the SEC and is in effect. Registration with the SEC does not suggest approval of the registration disclosure, nor is it taken to be as accurate. Further, investors are not insured against loss of their investments in common stock by any federal or state agency. However, the securities legislation made it a criminal offense for anyone to cause the financial statements under the jurisdiction of the SEC to be false and/or misleading. Those affected by this legislation include but are not limited to management, auditors, and stockbrokers. Consequently, anyone involved in the preparation and distribution of false or misleading financial statements could be subject to fines or prison.

Registration serves to provide information upon which investors may make informed and realistic evaluations of the worth of such securities. About 10,000 public corporations are registered with the SEC, which provides a variety of timely information filed by the registered entities. Table 8.3 presents a guide to the filings of public corpora- tions. To the general manager or security practitioner, this information represents readily available, accurate, and valuable information about corporations.

228 ACCOUNTING CONTROLS AND BUDGETING

Table 8.3 Guide to Filings of Public Corporations

SEC Form # Description

8-K Report of Unscheduled Material Events 10-K A detailed annual accounting including comparison with previous years.

It may be included optionally in the annual report to shareholders; otherwise, it is available to shareholders on request and from the SEC as mentioned below.

10-K405/A Amended Annual Report 10-Q Quarterly Report 10-SB12G/A Amended Small Business Issuer Registration Statement 15-12B Certification of No Change in Definitive Materials DEF 14A Proxy Statement S-1 Initial Registration Statement. Includes Risk Factors S-3 Prospectus Filed for Secondary Offerings S-4/A Amended Business Combination Transaction Registration Statement SC 8 Employee Benefit Plan Registration Statement SC 13D Ownership Statement SC 13D/A Amended Ownership Statement SC 13G Ownership Statement SC 13G/A Amended Ownership Statement SC 14D1 Tender Offer Statement SC 14D1/A Amended Tender Offer Statement SC 14D9 Tender Offer Statement

The Securities and Exchange Commission requires issuers of securities and their controlling persons making public offerings of securities in interstate commerce to file registration and issue periodic activity statements. These provide the public with presumably accurate information on operations, including problems and opportunities. Filings may be examined at www.sec.gov.

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Manipulation of Financial Statements

Businesses have some leeway regarding the means by which some revenues and expenses may be reported. Corporate treasurers and independent outside auditors are bound by generally accepted accounting principles (GAAP), the industry’s body of widely recog- nized concepts, standards, and rules followed in recording and summarizing transactions and in preparing financial statements. Nonetheless, with the goal of managing earnings or hiding problems, many organizations use methods that may not necessarily violate the GAAP norms but result in misleading financial statements. Sometimes, these reports go unnoticed. The following are some financial actions corporations may take to manipu- late their official financial records:4

• Writing off exceptional expenses. The company decides to write off one or more failed activities, restructuring expenses, and other unusual costs. By eliminating excess expenses, future profits look better. Yet some companies have frequent restructuring write-off costs, suggesting an inability to produce a reliable stream of quality earnings.

• Smoothing quarterly profits. Some companies experience a windfall, for example, from the sale of a major asset. But instead of reporting it in the quarter when the sale was achieved, the money is stored, typi- cally in special reserves. Then when some bad news comes along, the company reports the special reserves as income to offset the loss. This is also referred to as managed earnings.

• Deferring costs. Consider a company investing in a major new prod- uct. The expenses may last for several years before income is gener- ated. Should management recognize the development expenses as they are incurred, or defer some of them until revenues start rolling in? The difference can have a substantial effect on profits.

• Reporting revenues variably. The most common way of accounting for long-term contracts is a method called “percentage of comple- tion.” Management determines how much of the contract work has been completed, and recognizes the income and expenses related to that portion, even though a major part of the payment might not be received until the contract is completed.

• Hiding inventory. Businesses can make a quarter look good by ship- ping inventory to some customers even if they do not order it. (On a smaller scale, this same irregularity is committed by salespersons seek- ing to obtain a higher bonus during a particular time period.) True, they may have to take some merchandise back later and issue credits for it, but in the meantime, the report for the quarter will be better than it otherwise would have been. Such a manipulation of reality is most common in the month prior to the end of the financial year.

• Dabbling with depreciation. The useful life of assets can be depreci- ated over a different time period. For example, capital costs entailed for a new alarm monitoring account customer are expensed by some companies in the year they occur. Other alarm companies, however, assume that the account has a lifetime of two to 13 years. The longer the

Financial Controls in the Organization 229

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write-off, the higher the reported profits may be in a given year. Corporation may correctly use one type of depreciation for their tax filings and another for the firm’s income statement.

• Combining one-time gains. A company that buys and sells assets, separate from its major business, normally reports one-time gains or losses carefully segregated from normal operating income. But some companies argue that such regular gains should be included with normal income. This can distort the perception of whether the corporation is actually prospering.

Not-for-Profit (NFP) Organizations

The preceding discussion concerned corporations that are established with the intention of making a profit. However, an important portion of the economy is composed of NFP organizations. These include charities, educational institutions, many healthcare and medical research facilities, religious organizations, and trade and research groups. Over one million such organizations are incorporated in the United States alone. These organizations have enjoyed federal tax exemptions since the passage of the first income tax law in 1894. Prior to that, such organizations were exempted from state property tax laws.

Despite such NFP status, most of the accounting and audit concerns of such organ- izations are identical to those of for-profit corporations. Similarly, the security risks to such organizations are largely equivalent.

BUDGETING FOR A SECURITY DEPARTMENT

Up to this point in the chapter, a macro view of financial activities in an organization has been presented. The next part of this discussion concerns programmatic details incorpo- rated in the cost of doing business. The total cost of operations includes numerous departmental and programmatic activities that are intended to achieve the overall goals of the organization. One of these is security. Therefore, security activities require bud- gets in order to operate. Indeed, the importance of this topic is reflected in the fact that many chief security officers find that they spend about one-quarter to one-half of their time on budget-related activities.

A budget is a statement of estimated revenues and expenses for a specified period of time. It is usually an annual plan of action, but it can also be set at monthly, quarterly or semi-annual periods. Budgets also can extend for several years in the case of multiyear projects. A budget may refer to a sum of money allocated to a particular purpose or proj- ect for a specific period of time. Budgeting is inextricably involved with good planning, as it seeks to coordinate resources and expenditures.

The purposes of budgets are to:

1. Support planned operational activities with necessary financial resources.

2. Commit money to complete planned programs and projects. 3. Control allocated money.

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4. Evaluate management effectiveness by noting how well resources are managed within previously set guidelines.

Annual budgeting is a process that extends over many months in large organiza- tions. Throughout the process, planning and collaboration are vital between the chief of security, who is preparing the budget, and subordinates, who manage budget subsets. A security director with budget responsibility also will interact with senior managers, who will provide guidelines, raise questions about plans and proposals, and perhaps present obstacles in the annual budget approval process that must be resolved. A budget manual prepared by the CFO’s office includes the budget planning calendar and distribution instructions for all schedules. For organizations operating on a calendar-year basis, the following is an example of the budget approval process:

Spring or summer: The finance department issues budget request guide- lines to various operating units within the organization.

Two weeks later: Chief or director consults with subordinates on next year’s plans.

Two months later: Security chief of director submits budget to finance department.

One month later: Budget is reviewed. Changes or explanations are requested.

One month later: Revised budget is approved. Consolidated budgets of all departments are presented to the board of directors for approval, or may be vetted by a board committee.

One month later: Budget approved, subject to minor revisions. One month later: Final revised budget approved.

The budget process requires looking into the future to identify a variety of financial needs that conceivably could be growing while others are contacting and still others are being reorganized. Budgets must have details to show how money is to be allocated and spent. They also must be flexible enough to adapt to the dynamic contingencies that could arise in security programs. Some common types of budgets include:

1. Revenue budgets. These indicate the revenues that a department might generate, if any. Security departments generally do not bring in revenues, but some do become profit centers. If security operations generate income (see discussion later in the chapter), the estimate for such income appears.

2. Expense budget. These are the projected operating expenses for the budget period. Each item on the expense portion of the budget reflects a particular monetary outlay calculated in advance. This type of budgeting, commonly called incremental budgeting, takes the expenses of the previ- ous year as a baseline and uses them as the basis of proposed increments to represent programmatic changes, inflation, and merit pay increases.

3. Capital expenditure budgets. In this category, the department identifies capital costs for systems, equipment, vehicles, furniture, and fixtures. These capital costs are amortized (depreciated) over time. In contrast, supplies—and often security guard uniforms—are “expensed,” that is, written off the year they are purchased as expense items.

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4. Variable budgets. Expenses of an organization may be classified as either “fixed” or “variable.” A fixed expense is one that is fixed or remains the same at different levels of production or sales. For example, depreciation of equipment and rent are generally fixed expenses. They will be the same during the current period no matter what the level of output or sales. A variable expense varies or changes with sales or production. Inventory costs and sales salaries are variable since they change as sales change. Variable budgets include formulas that changes certain expenses with different levels of sales or output budget must be submitted.

5. Zero-based budgets (ZBB). This concept was developed by Texas Instruments in the 1970s, and was proposed as an alternative to the incremental budget process. ZBB questions all costs by setting the new year’s budget at zero and forcing all operating managers to justify their expense requests.5 ZBB forces managers to scrutinize all costs, rather then assuming that a little bit more each year—incremental budgeting—will satisfy the needs of the organization under constantly changing circumstances. ZBB requires that the security program “sell” its security services each year to the budget approval committee, as it assumes initially that no commitment exists to spend money on any activity unless adequate reasons justify it.

The Process of Budget Creation

Budget preparation and modification have changed drastically with the availability of software spreadsheets and specialized programs useful for the process. Gone are the days when budgets were created on accountant-type paper and items would be written across broad columns reflecting various payments or disbursements over a year’s periods. These would then be totaled for each payment or disbursement category and then for the year as a whole. If the allocated budget equaled the total on the bottom right-hand corner, the process was considered a success. If not, the manager and staff had to review and revise projections to see where alterations could be made.

The same process still occurs, though procedures are greatly eased by software pro- grams that produce running totals of the budget, instantly adjusting with each change. Each significant expenditure constitutes a line in the personnel and expense portion of the budget, as shown in Table 8.4. The manager reflects the budget changes that occur during the process. For example, if employees are granted pay increases at specific times, these are taken into account in the year’s total plan by inserting the increase at the projected time.

Security program line-item budgets usually are completed on electronic spreadsheets, which allows for specific indication of fund allocations. Personnel budgets frequently are expressed as line-item expenses in that each position is considered permanent, and funds are allocated for an entire period. The spreadsheet allows numerous adjustments to occur over time. When a user changes a figure, the program immediately updates the figures in all columns. The following are factors that effect change in a line-item budget:

• Personnel costs. Table 8.4 divides security program costs into four quarters for illustrative purposes. However, most programs allocate

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Budgeting for a Security Department 233

Table 8.4 Security Illustrative Budget Line Items over Yearly Quarters

Quarters

Budget Line Item First Second Third Fourth

Personnel Costs Including Benefits Director –––––– –––––– –––––– –––––– Assistant Directors –––––– –––––– –––––– –––––– Managers –––––– –––––– –––––– –––––– Supervisors –––––– –––––– –––––– –––––– Support Staff –––––– –––––– –––––– ––––––

Expenses Other Employees (Contractual) –––––– –––––– –––––– –––––– Travel –––––– –––––– –––––– –––––– Office Supplies –––––– –––––– –––––– –––––– Uniforms and Laundry –––––– –––––– –––––– –––––– Telephone –––––– –––––– –––––– –––––– Training Expenses –––––– –––––– –––––– –––––– Educational Costs –––––– –––––– –––––– –––––– Insurance –––––– –––––– –––––– –––––– Automobile Leasing –––––– –––––– –––––– –––––– Automobile Repair and Maintenance –––––– –––––– –––––– –––––– Consultant Services –––––– –––––– –––––– –––––– Memberships –––––– –––––– –––––– –––––– Miscellaneous –––––– –––––– –––––– –––––– Total Expenses –––––– –––––– –––––– ––––––

Capital Budget Security Systems –––––– –––––– –––––– –––––– Automobile Purchases –––––– –––––– –––––– –––––– Guard Structures –––––– –––––– –––––– –––––– Two-Way Radios –––––– –––––– –––––– –––––– Office Furniture –––––– –––––– –––––– –––––– Other –––––– –––––– –––––– –––––– Total Capital Budget –––––– –––––– –––––– –––––– Corporate Overhead Charge –––––– –––––– –––––– –––––– Total Budget Request –––––– –––––– –––––– ––––––

Budget planners allocate expenses for people, supplies, and major purchases over the length of the budget period. Numerous variations are possible to suit the recording and operating policies of particular organiza- tions. The overhead charge, used in some organizations, is a charge management may impose on different departments reflecting a portion of the shared services provided by the organization to the department. A line-item budget of this sort is best loaded onto a computer program so that cost items may be changed at any time, with budgetary consequences being instantly reflected. Security services may also be included in the organizational overhead, which is charged to other departments.

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personnel expenditures according to pay periods; that is, weekly, biweekly, semimonthly, or monthly.

• Expenses. These predictable costs can be planned over an extensive period of time based on previous experience. They also represent vari- able expenditures. For example, plans for employees to attend conven- tions can be curtailed if projected costs get out of hand. Previously the “miscellaneous” category allowed managers a safety valve for adjust- ing their budget according to contingencies. Today, that category is small or is eliminated entirely in many reports.

• Capital budget. This represents spending for purchases that have a lifetime of many years.

• Budget emergencies and contingencies. As one budget is being planned, a budget for the current year is operating. Further, the imple- mentation of unexpected plans will cause budget changes that will have to be taken into consideration. Senior management expects oper- ating managers to stay within their budgets without substantial devia- tion. Senior managers also may ask departmental managers to reduce their budgets on short notice. A reason for this could be to respond to an unexpected earnings shortfall or other reversal.

Managing the budget can be a challenge to security practitioners, who sometimes deal with emergencies that create budget overruns. At such times, the manager is nonetheless expected to “find the money” within the budget. This signifies that managers need to have the capacity to meet a contingency by cutting previously planned and allo- cated expenditures. Managers with budget responsibilities constantly analyze what cuts in programs or purchases could be made if necessary. Similarly, they consider how they would expand programs if additional resources not presently contemplated were made available. At all times, it is vital for the protection manager to understand what the pro- gram’s benefits are and communicate to senior management how the security function is contributing to the ultimate goals of the operations.

THE GOALS OF THE CORPORATION: PROFITS

For-profit organizations exist in order to make a profit. If a corporation does not achieve consistent profits, it will eventually face liquidation. If a corporation does not achieve sustained and adequate profitability, the providers of capital (shareholders, bond hold- ers, lenders) will remove their money from the enterprise and use it where the return appears to be better and the prospects are safer. To achieve profit, the organization first must monitor fixed costs. These include overhead, such as space, utilities, and other normal operational costs. Such overhead costs exist whether the organization is just beginning, operating at a loss, or operating at a profitable level. In reality, overhead costs increase slightly as sales rise, but other factors—such as incremental production and ser- vice expenses—grow faster and in relation to increased production or service provided. Thus, considerable business must be generated before a break-even point is achieved; only beyond that is a profit possible. Figure 8.1 illustrates the ways in which fixed costs and variable costs relate to profit.

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Achievement of a profit within an organization surely cannot be taken for granted. Considerable effort is required to earn a profit. Once achieving a profitable level of oper- ations, the concept of the enterprise becomes attractive to others. Competition and changing market conditions invariably threaten a profitable operation. To sustain growth, corporations use money from profitable operations to fund new products or services. These might one day become profitable and offset earlier products or services that might decline in their financial return. However, some new products or ventures will not succeed, resulting in a loss of capital. The corporation must be managed so that such failures will not put the whole enterprise at risk.

New corporations and new ventures within a larger entity are not expected to make a profit initially. Developmental expenses are projected, followed by costs to produce the goods or offer the services. For example, in the pharmaceutical industry, a new patented proprietary drug may take 10 to 12 years to receive approval to enter the market. Then, only five to seven years remain in the life of the patent during which the extensive invest- ments in development can be recovered. After patent expiration, other firms can market

The Goals of the Corporation: Profits 235

FIGURE 8.1 Fixed and variable costs related to profit.

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and sell exactly the same product under their own name. Thus, the patience of investors is required for profit goals to be realized from any new product.

Security programs must operate with the same level of objectivity as any program in an organization. Every department considers itself to be critical to operations. It is helpful to envision each operating unit interlinking with the others. Any weak link threat- ens the entire structure. Chiefs and directors of security programs need to understand the biases of financial directors toward the use of money for different segments of the oper- ation. Programs are funded because they are critical, or at least desirable, to the goals of the operation. The security director needs to communicate how loss reduction programs contribute positively to the profit interests of an organization. This is possible when the manager understands the nature of the business and how an intelligently conceived pro- gram is justifiable and necessary to the organization’s success. The following sections dis- cuss concepts that are important in explaining or justifying the necessity for security spending.6

Return on Equity

Return on equity (ROE) measures the return on shareholders’ equity and gives a mea- sure of the company’s return relative to equity; that is, shareholders’ paid-in capital and retained earnings. This can be represented as follows:

Return on Investment

Financially oriented managers often put any use of capital to the test to determine what it represents to the organization. This is done using the return on investment (ROI) mea- surement, which can be represented as follows:

This performance measure is widely used by management because it accounts not only for earnings but also for the assets to achieve such earnings.

ROI is similar to ROE except that ROI includes debt. Both of these concepts are used to estimate the performance of the organization as a whole, and both are used to indicate the payback of a capital expense, such as the purchase of a security sys- tem. Assume that a security director wishes to purchase a security system. Will the cost of the capital commitment pay back the investment required to obtain it, including debt costs, in a satisfactory period? Or is the investment unlikely to be a good use of capital?

Consider a facility with a $1 million per year budget for security, fire watch, and maintenance operations administration. Assume further that a new comprehensive secu- rity system costing $1 million can reduce personnel cost by 25% of its purchase price.

Net Income ROI =

Equity + Debt

Net Income ROE =

Equity

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Therefore, the facility could save $250,000 per year. Would the introduction of an elec- tronic security—safety—fire communications system pay off sufficiently to pay for the cost of the system? An approximation of the value of such system could be calculated as follows:

This would be calculated:

Therefore, in this crude assessment, the investment would pay for itself in four years, with 25 percent being returned for each of the four years. Since the system would continue to be useful for several years longer, the loss prevention manager likely would have a fair to strong argument that the ROI is attractive to the company, and the purchase should be supported by senior management.7 Other factors, such as the necessity of bringing the facility into code or linking the system installation with a wider capital improvement proj- ect, might tip the balance to a favorable vote to provide the financing. In many cases, a more detailed evaluation of the use of money for capital expenditure will be indicated.

A more detailed ROI scenario is provided by Walter E. Palmer, who proposes that the value of a security system—such as an electronic article surveillance (EAS) system for a retail store—be determined by first estimating the incremental cash flow.8

In this example, let’s say that sales are at $10 million and are growing at an annual rate of 2 percent. The baseline shrinkage rate is set at 3 percent. The assumption is that the shrinkage reduction from the new system that would cost $75,000 and have a five-year depreciable life would be 25 percent of the baseline shrinkage rate, resulting in a savings of $75,000 the first year, as shown in Table 8.5. Because shrinkage is considered a cost, savings at retail must be calculated by the cost/retail ratio. In this example, the average cost of mer- chandise is considered to be 57 percent of the selling price, 0.57, and producing a savings at a cost of $42,750. It is assumed that the management of the system will require expenses of $10,000, which are growing at an annual rate of 2 percent, which are now deducted.

Depreciation of the value of the cost of the asset is determined as a straight-line writeoff over five years, or $15,000. Expenses and depreciation are subtracted from the net savings.

The next step is to determine savings before taxes. Assuming that the tax rate is 34 percent, the net savings would be $11,715. But depreciation is added back in since it is an accounting device and does not generate an actual cash amount, and the $75,000 first-year expenditure is deducted from cash flow.

Finally, the addition of net savings and depreciation produces cash flow. This now allows the advisability of the project to be assessed from three types of analysis: payback period, net present value (NPV), and internal rate of return (IRR).

250,000 ROI = = 0.25

1,000,000

Savings in Personnel Costs ROI =

Cost of System and Finance Charges

The Goals of the Corporation: Profits 237

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• Payback period. The formula for calculating the number of years it will take to generate enough cash to pay for the project is:

If the system costs $75,000 and was expected to return $20,000 annually, the payback period would be $75,000/$20,000 = 3.75 years. Using the cash flow example, the project cost would be completely paid for in about two years and nine months, because $75,000 is equal to the first three years’ revenues, plus $15,000. That remainder is equal to about .75 of the third year’s revenues. The payback method of analysis may rank projects with shorter payback periods higher than those with longer paybacks. The disadvantage is that the straight payback method ignores the time value of money, which is discussed in the next example.

• Net present value (NPV). This method considers future cash flows of a project. Assume the company desires a 12 percent return on its investments. Table 8.6 illustrates this calculation using the assumptions

Cost of Project = Payback

Annual Cash Flow

238 ACCOUNTING CONTROLS AND BUDGETING

Table 8.5 Cash Flow Statement to Assess a Capital Investment

Cost of Asset = $75,000 1 Yr. 2 Yrs. 3 Yrs. 4 Yrs. 5 Yrs.

Sales (+2% each year) 10,000,000 10,200,000 10,404,000 10,612,080 10,824,322 Baseline shrinkage 3% 3% 3% 3% 3% Baseline shrink $ 300,000 306,000 312,120 316,362 324,730 Shrink reduction % 25% 25% 25% 25% 25% New shrink $ 225,000 229,500 234,090 238,772 243,547 Savings (@ retail) 75,000 76,500 78,030 79,591 81,182 Cost/retail ratio 0.57 0.57 0.57 0.57 0.57 Savings (@ cost) 42,750 43,605 44,477 45,367 46,274 Less: expenses 10,000 10,200 10,404 10,612 10,824 Less: depreciation 15,000 15,000 15,000 15,000 15,000 Savings before taxes (SBT) 17,750 18,405 19,073 19,755 20,450 Tax (34%) 6,035 6,258 6,485 6,717 6,953 Net savings 11,715 12,147 12,588 13,038 13,497 Plus: depreciation 15,000 15,000 15,000 15,000 15,000 Cash flow investment 26,715 27,147 27,588 28,038 28,497 Cost of investment 75,000 Cumulative cash flow (48,285) (21,138) 6,450 34,488 62,985

This illustration shows the payback on an electronic article surveillance (EAS) system that reduces shrinkage from 3% to 2.25%. Adjusting for sales growth of 2% per year and accounting for wholesale costs, expenses, and other factors, the payback cost of the system can be evaluated. Source: W.E. Palmer (January 1998). “Return in Investment: Beyond the Conceptual.” Pinkerton Solutions.

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discussed in Table 8.5. The columns in Table 8.6 are Year, Cash Flow, Discount Factor (DF) and Present Value (PV). The Year column (total 5 years) represents the number of years the project is expected to generate cash. Cash Flow represents the amount of cash the project is expected to generate each year after taking into account expenses including taxes (Table 8.5). Discount Factor is the value today of $1.00 received in the future at a certain rate of return (12% in this case). For example, having $.8929 today is equal to receiving $1.00 in one year at a 12 percent return (0.8929 + 12% of .8929 = 1.00). Likewise, having .5675 today is equal to receiving 1.00 in five years (.5675 + 12% five times compounded = 1.00). Financial calculatora and computer spreadsheets programs (Excel, for example) are available for making these calculations. The fourth column, Present Value (PV), represents the value today (present value) of cash expected sometime in the future. Looking at years 1 through 5, Table 8.6 indicates the project will generate from $26,715 in the first year through $28,497 in the fifth year. Consequently, if $1.00 received within a year is worth .8929 at an expected rate of return of 12 percent, then $26,715 has a present value of $23,854. In the fifth year the expected cash generated by the project is $28,497. However, the value today of receiving $1.00 in five years is only .5675. Therefore, the value today (PV) of receiving $28,497 in five years is 28,497 × .5675 = $16,172. The total column of the Table 8.6 indicates the project that has an original cost of $75,000 will generate total cash of $137,985. However, the value of that cash today (PV) which will be received in the future is $99,123. The project appears to have a positive cash flow since spending $75,000 today will generate cash in the future with a value today of $99,123.

• Internal rate of return (IRR). The IRR is the cost of capital that would make the NPV for the project equal to zero. (The calculation of the IRR is complex and will not be discussed here.) If the IRR exceeds the cost of capital, the project is attractive. If the IRR is less than the cost of capital, the project is likely to be rejected.

These three methods each have their advantages. The payback method is easiest to compute. NPV and IRR require financial calculators, but these methods are more accu- rate in identifying the time value of money. Typically, managers will consider different methods in making a decision. These issues are discussed in greater detail later in the chapter.

Capital Budgeting for Security Programs

Assume that a security program determines that it requires computerized control systems for a new facility. The security director would begin by preparing a written summary detailing the benefits and costs over the life of the system. The manager also would pre- pare a capital budget that would allow the parties involved to evaluate the proposal.

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They can then decide whether this capital proposal is attractive relative to others in the internal departmental competition for use of funds. Various ways of considering the value of the budget exist.

An important factor at the time such a decision is being made is the cost of capital. How it is determined can differ, and no single accounting method is used uniformly. In addi- tion, the security chief or director likely may face competition from other managers with their own capital requests. The attractiveness of capital expenditures for new systems, therefore, in part is that such systems may reduce ongoing costs over what is currently being paid. These benefits are calculated in order to identify factors related to savings through efficiencies. The following sections discuss widely used capital budgeting methods.

Payback Method The payback method is the simplest and most widely used technique. It determines the earnings required by an investment in order to pay back the initial capital outlay. As seen in the previous example, this method is popular because it usually demonstrates a rapid repayment of capital, allowing management to reinvest the savings. However, this method does not consider the time value of money. In times of high or rising interest rates, this issue gains in importance.

Money invested earns interest, while money borrowed costs interest. Therefore, the money to be used for the capital budget has to be considered in terms of compounding and discounting. These terms are the opposite of each other. Compounding asks, “If money is invested at the current interest rate, what will it be worth in a certain number of years?” Discounting asks, “How much money should be invested at a given interest rate in order to achieve a particular amount at a defined period in the future?”

The payback method fails to consider the significance of compounding or discount- ing required for purchase of the capital asset. The longer time required for a capital investment to be paid back, the less interest senior management is likely to have in authorizing it. If the payback is less than the goal set by management, then the project has a good opportunity of being approved.

Initial Investment Rate of Return (IIRR) Method This method also overlooks the time value of money, creating a bias in favor of investments that yield a return quickly. The IIRR method considers the effects that taxes

240 ACCOUNTING CONTROLS AND BUDGETING

Table 8.6 Discount Factor (DF) for Calculating Present Value (PV)

Year Cash Flow Discount Factor (12%) Present Value

1 $26,715 0.8929 $23,854 2 27,147 0.7972 21,642 3 27,588 0.7118 19,637 4 28,038 0.6355 17,818 5 28,497 0.5675 16,172 Total $137,985 $99,123

This is another way to determine whether the system is a good buy. This calculation takes into account the “present value” of money. Cash flow is adjusted by a discount factor reflecting the cost of money. The pres- ent value of the money would decline each year. The EAS system is still an attractive project, but less attrac- tive than it was under the payback period calculation. Source: W.E. Palmer (January 1998). “Return on Investment: Beyond the Conceptual.” Pinkerton Solutions.

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and depreciation have on the investment, a consideration overlooked in most payback method computations. However, the method does not identify operating cash flows, which can be significant considerations. Senior management is more likely to approve a project if the IIRR is greater than the cost of capital to the organization.

Time-Adjusted Rate of Return (TARR) Method This method considers discounted cash flow. TARR provides the interest yield predicted by the investment over its projected useful life. It is also called the internal rate of return (IRR) method. TARR is calculated using a spreadsheet program. If future cash flows are the same for each period, the calculations are performed easily. If the cash flows are uneven, then a trial-and-error process is necessary to arrive at the net present value. If the TARR is greater than the organization’s cost of capital, senior management is more likely to approve the project.

Other Managerial Options What if the savings projected from the capital expenditure are not sufficiently attractive to senior management to approve a capital purchase? In this situation, other measures may be available to the security planner. Assume that the security chief or director advo- cates a new system but that a capital commitment is not available. One alternative would be to lease the system from the supplier or a leasing facility provided by the supplier. In this case, the system obviously would not belong to the user, but this factor might not be consequential. One advantage of this arrangement is that service of the system might remain the responsibility of the lessor. Another benefit is that the cost of the lease would be expensed each year, which could produce a tax advantage to the organization. However, if the lease is approximately the same life as the system, accounting interpreta- tions might require the entire cost of the lease at present value be put on the balance sheet as an asset.

If the leasing option is not available, the vendor might offer flexible payment options to make the purchase attractive to the customer.

Another possibility, though one less frequently available, is that the vendor will pro- vide the system free under certain conditions. The system must produce definable, certain savings. If the vendor can share in the savings, the vendor may be willing to “split the savings” with the customer, in effect providing the system without cost but actually paying for it through cost reductions. For example, an organization may desire a system to automatically turn off lighting, heat, and air conditioning if no individuals are in the area. The cost for such an energy management system including installation could be paid by the systems company. The customer then splits the energy savings with the systems company above the previous base-level costs of power.

BUDGET DOWNFALLS

Budgets are often management’s main way to gauge performance by matching actual results with budgeted results, but they can also block managers from shifting resources to take advantage of opportunities and can distort long-term planning.9 Further, budgets concentrate on spending, but may fail to identify what is really important to the customer.

Budget Downfalls 241

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Security services, like research and development, accounting, and human resources, are sometimes regarded as expense centers, not profit centers, by persons who fail to grasp the interrelatedness of organizational units. This mentality puts security at a disad- vantage if measures are not found to identify value for the whole organization and com- municate it effectively. Well-designed, relevant security measurements can be translated into value-added services that are critical to the entire operation. This can be achieved, for example, by demonstrating savings gained by the lack of costly problems that beset other organizations with inferior security programs. Lower turnover, fewer costly litiga- tions, employee and customer satisfaction, and attractive insurance premiums are other signs of value provided by high-performance security programs.

SECURITY AS A PROFIT CENTER

If organizations seek to create profits, how can proprietary security services be crafted into a profit center? In many cases, security programs have no options to create profits in the same way the principal business of the organization does. Further it would be unwise for some organizations to attempt to develop new sources of income from security programs. However, in other situations, such possibilities exist. The following are examples of such services:

• Alarm services. A technology firm was required by federal contracts to maintain an advanced proprietary security system with backup guard response. The firm was able to provide services to nearby noncompetitive corporations that were attracted by the advanced standards of the system and the certainty of nearby, experienced security officers. These corporations preferred to contract with a well- regarded neighbor than with a distant security alarm service business or to provide the service for themselves.

• Investigative services. A diversified clothing manufacturing concern and retail chain developed a team of highly proficient investigators to solve a series of complex internal loss problems. When the initial issues they were hired to resolve gradually were brought under control, they had less work to do. With the encouragement of senior management, the chief security officer then made those services available at professional fees to vendors and customers. The investigative team had industry-specific knowledge and expertise that put them at an advantage over other investigators. A profit center was created.

• Parking revenues. The security department of a healthcare facility took responsibility for the management of parking garages and lots. The program was able to keep a portion of revenues for discretionary purposes. This led to improving and expanding parking use, which produced further revenues.

FORENSIC SAFEGUARDS TO INTERNAL FRAUD

The cost of fraud and abuse in the workplace is undoubtedly high. In fact, the Report to the Nation on Occupational Fraud and Abuse estimates this loss level at 6 percent of the

242 ACCOUNTING CONTROLS AND BUDGETING

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monetary value of all goods and services.10 This totals over $400 billion annually if extrapolated into the U.S. gross national product.

Richard C. Hollinger and John P. Clark reported their seminal research on work- place deviance in 1983.11 It included surveys of 47 corporations in three communities; 9,431 employees; 247 top executives; 30 labor unions and employee organizations; and a variety of other organizations interested in business-related crime. One-third of all employees self-reported that they had taken property from the workplace. The deviance was not limited to entry-level personnel. All worker segments—including physicians in hospitals—admitted in substantial numbers to stealing at work. It should be emphasized, however, that the majority of workers in all categories did not self-report for theft. White- collar crime is a far greater financial burden on companies than robbery, larcenies, and auto theft combined. Crime that occurs by manipulating financial assets in publicly held corporations as well as not-for-profit institutions is a major issue throughout the world. Security management should regard such risks as an uppermost priority and establish controls that seek to mitigate it.

Generally Accepted Accounting Principles (GAAP)

All corporations have financial records audited by independent auditors. The purpose of this practice is to ascertain that the financial practices and records of the organization follow conventionally established accounting concepts and principles. The outside inde- pendent auditor (normally, a certified public accountant) works with the CFO and des- ignated personnel, such as controllers and internal auditors, to review financial procedures. Independent accountants maintain that the audit process is not intended to detect fraud and embezzlement, though auditors frequently do uncover serious defalca- tion. Yet the failure of regularly conducted audits to identify a pattern of financial deviance or irregularity can lead to legal action against the accounting firm in the event an unde- tected or unreported embezzlement takes place despite regular audits (see Box 8.2).

Forensic Safeguards to Internal Fraud 243

Box 8.2 Limitations to Independent Auditors

Most examples of fraud and embezzlement in operations are not encountered by independent auditors. They are discovered by accident or are brought to the atten- tion of management by insiders with specific knowledge of deviant financial prac- tices. Such insiders are often termed whistleblowers. Forensic investigators and fact-finders may then confirm the assertions of improprieties.

Audit firms maintain that it is the responsibility of management to establish financial controls. U.S. Supreme Court decisions have supported this view, and the number of lawsuits that auditors have been forced to defend has decreased in recent years. Nonetheless, numerous celebrated cases of accounting improprieties attest to the fact that auditors can be negligent. Jack Bologna and Paul Shaw present a list of some of the companies cited in these cases:

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American International American Biomaterials Corp. Cenco, Inc. Coated Sales Computer Associates Crazy Eddie Datapoint Enron Equity Funding ESM Government Securities Four Seasons Nursing Homes Gucci American, Inc. HealthSouth H.J. Heinz ImClone Mattel, Inc. McCromick Spices Miniscribe North American Acceptance OPM Leasing Penn Square Bank Pepsico PharMor Regina Vacuum Cleaners Rocky Mountain Undergarment Co. Sahlen Associates Saxon Industries Stauffer Chemical Stirling Homex J. Walter Thompson Tyco International U.S. Financial U.S. Surgical Worldcom

This list does not take into consideration “regulated” industries like banking, brokerage, and defense contracting. The causes for these accounting improprieties are numerous: pressure for performance; industry competition; quality and integrity of management; and the goal-setting process. In most cases, the quality of auditing and the ethics of those involved allowed the improprieties to continue longer than what otherwise could have been the case.

Source: J. Bologna and P. Shaw (1997). Corporate Crime Investigation. Boston, MA: Butterworth-Heinemann; C.J. Loomis (August 2, 1999). “Lies, Damned Lies, and Managed Earnings.” Fortune, p. 75. Other examples are provided by the author.

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The financial information presented in the periodic statements issued to the public is prepared according to widely respected principles of accounting to ensure that individ- uals external to the enterprise—such as shareholders, creditors, government agencies, and the general public—have accurate, relevant information. The same information is useful to management in directing the organization. In planning any future activity, manage- ment evaluates past financial statements for relevant past activities.

Fraud, Embezzlement, and Security

Within an organization, internal auditors are charged with monitoring the controls and checking systems. They attempt to ensure that fraud (the conversion or obtaining of money or other assets by false pretenses) and embezzlement (misappropriation of entrusted assets with the intention to defraud the legal owner) are detected early. The responsibilities and function of the internal auditors are different from the external auditor. While the external auditor is concerned with the overall fairness of the financial statements, the internal auditor is concerned with specific projects selected by top man- agement. However, internal auditors do have some level of independence as they may report directly to the board of directors, not the management units they are auditing. Accountants and financial investigators are involved in the specialized process of investi- gating potential or actual monetary dishonesty. This type of activity is carried out by forensic accountants, a growing field of accounting, or investigators who often have specialized training in conducting such investigations, collecting relevant facts, and preparing an action for criminal or civil prosecution.

Security directors are frequently involved with the financial functions of the organ- ization. This can include creating or consulting on the establishment of checks and con- trols within the operations, testing such controls, and investigating any monetary crime. Should a crime occur, the security director with forensic expertise will interface with financial management on aspects of the investigation. In some cases, the security director will retain and supervise forensic investigators in their fact-finding. The internal financial officer most often concerned with possible fraud or embezzlement is the chief internal auditor. By contrast, the controller is the chief accounting officer of an organization involved with financial reporting, taxation, and possibly auditing.

Separating Tasks: A Powerful Tool Against Fraud

One of the most fundamental controls created by security practitioners and internal audi- tors is to separate functions within the organization, as shown in Table 8.7. By separat- ing functions, a potential offender finds it difficult to commit fraud or embezzlement alone. Such crimes may still occur, but abettors raise the chances of success. This type of offense is called collusion and is much more difficult to control than a single rogue acting alone. However, even a single individual acting alone can cause huge losses to the organization over extended periods of time. It is for this reason that security-conscious managers seek to minimize the possibilities of such crimes occurring by separating routine functions. While this principle is particularly relevant for financial controls, it has significance in other managerial venues as well.

Forensic Safeguards to Internal Fraud 245

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A typical financial control separates check preparation from check authorization. But a third step—independent verification of the process—makes the likelihood of finan- cial fraud less possible. Security practitioners are involved in the creation of controls that make financial deviance more difficult and that review and modify such measures regu- larly to reduce risks from changing vulnerabilities.

Disastrous or near-catastrophic fraud can befall any organization without a reason- able security program. Such programs fail to have compliance measures at a high stan- dard. The financial services industry seems particularly vulnerable to such depredations. Presumably successful traders thwart the efforts of compliance officers who fail to ask the right questions. Randolph D. Brock III has cited three cases within the past genera- tion in which a single person has concealed trading losses of over $1 billion, and many more with losses in the millions.12 He argues that security practitioners have roles to play in deterring, detecting, and investigating internal theft. Three prevention principles are: Aggressively question success (it may be illusory); the most likely suspect probably did it; and suspect everyone all the time.

SUMMARY

Accounting controls and budgeting are among the most potent measures used to direct the operations of entire organizations as well as individual programs. Often, the account- ing mentality focuses on “making the numbers” rather than achieving long-term goals of the organization. Understanding the nature of such controls, nonetheless, is vital to inter- preting successfully the value of security operations for the entire organization. Measures should be identified so that security can be judged according to important organizational goals and values. In some situations, security programs can create fresh revenues for an

Table 8.7 Separating Functions to Improve Security

Function A Is Separated from º Function B

Financial examples Accounts payable Accounts receivable Payroll preparation Payroll reconciliation Records custody Use of records

General Authorizing Transaction processing Receiving Sending Purchasing Approval of purchases Ordering Verification of order Custody Accounting Vendor proposal Vendor approval Computer programming Computer operations Library management Use of library materials Employee employment offer Independent review before final offer

Separation of duties is a powerful security safeguard against internal theft and fraud and embezzlement. To prevent collusion further, management institutes a third activity: verification of the process by an independent third party.

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organization. However, such measures should not divert security management from its principal tasks for its own organization.

DISCUSSION AND REVIEW

1. How have accounting techniques changed in recent years? How do they resemble practices in Italy during the Renaissance?

2. Discuss the importance of notes to consolidated balance sheets and statements of operations.

3. How has the Securities and Exchange Commission improved reporting measures for publicly held companies? What are the weaknesses in SEC procedures?

4. What are the merits of zero-based budgeting compared with incremen- tal methods?

5. Why is a series of break-even reports unsatisfactory for a corporation in the long run?

6. Compare and contrast three ways of determining the value of a capital investment that produces reduced losses or costs for operations.

7. Cite examples of separation of controls in addition to those discussed in the text.

ENDNOTES 1 G.A. Lee (1984). “The Development of Italian Bookkeeping 1211–300.” In Christopher Nobes (Ed.), The Development of Double Entry: Selected Essays. New York & London: Garland Publishing, p. 25; F.L. Pacioli (1996). Double-Entry Book-Keeping, trans. P. Crivelli. London: Institute of Bookkeepers, p. 8. 2 Two types of calculating depreciation may be used: first, the straight-line method, by which the asset value (less estimated scrap value) is written off by equal installments over its estimated life; second, the reducing-balance method, by which depreciation for any year is a certain fixed percentage of the balance at the beginning of that year. Accounting policy maximizes the earning power of assets as much as possible by selecting the most advantageous financial policies for use. 3 Independent auditors are expected to identify accounting irregularities; most irregular- ities are discovered accidentally or are reported by whistleblowers. Still, auditors are always subject to litigation for negligence if they reasonably fail to detect and report abuses that a diligent audit might be expected to uncover. 4 G. Hector (April 24, 1989). “Cute Tricks on the Bottom Line.” Fortune, p. 193. H. Schilit, in Financial Shenanigans, provides another list of top 10 accounting tricks, which includes many of the abuses in Hector’s article, but adds some new ones: recording revenues early; capitalizing costs; changing the way inventory is valued; and swapping debt for equity. H. Schilit (1994). Financial Shenanigans. New York: McGraw-Hill. 5 A.H. Conrad (1997). Zero-based Budgeting. Monticello, IL: Council of Planning Librarians.

Endnotes 247

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6 L.E. Hargrave, Jr. (1999). Plan for Profitability! How to Write a Strategic Business Plan. Titusville, FL: Four Seasons Publishers. 7 R.L. DiLonardo (1997). “Financial Analysis of Retail Crime Prevention.” In M. Felson and R.V. Clarke (Eds.), Business and Crime Prevention. Monsey, NY: Criminal Justice Press. 8 W.E. Palmer (January 1998). “Return on Investment: Beyond the Conceptual.” Pinkerton Solutions, p. 17. 9 T.A. Stewart (June 4, 1990). “Why Budgets Are Bad for Business.” Fortune, p. 179. 10 J.T. Wells (1997). Occupational Fraud and Abuse. Austin, TX: Obsidian Publishing Co., p. 35. 11 R.C. Hollinger and J.C. Clark (1983). Theft by Employees. Lexington, MA: Lexington Books. 12 R.D. McCrie (October 2, 2001). “Clues to Catastrophic Fraud in the Financial Services Industry.” Security Letter, Part II.

ADDITIONAL REFERENCES

R.A. Brealey, S.C. Meyers and A. Franklin (2006). Principles of Corporate Finance. New York, NY: McGraw-Hill.

E.F. Ferraro and N.N. Spain (2006). Investigations in the Workplace. Boca Raton, FL: Auerbach Publications.

D.O. Friedrichs (2004). Trusted Criminals: White Collar Crime in Contemporary Society. Belmont, CA: Wadsworth.

J. Kane and A.D. Wall (2006). “The 2005 National Public Survey on White Collar Crime.” Fairmont, WV: National White Collar Crime Center.

L.M. Salinger (Ed.). (2005). Encyclopedia of White-Collar and Corporate Crime. Thousand Oaks, CA: Sage Publications.

S. Tully (April 26, 1999). “The Earnings Illusion.” Fortune, pp. 206–10.

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