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August 17, 2005
Volume 2, No. 17
In this issue...
Private Equity Funds: One Way to Crash-
Proof Your Company
-Private Equity
If you decide to retire in the next several years from the
Funds: One Way to
business you built and desire to earn the payback you
Crash-Proof Your
deserve, in addition to ensuring the enterprise still thrives
Company
after your departure, consider private equity funds. The
number of private equity funds functioning as investors has
-Enterprise increased the past several years due to stock market MACPA Home
Resource Planning volatility, and with it has provided an influx of needed capital
for the business owner. They also provide benefits that E-News
reward key employees; offer opportunities for acquisition
-Proposed Changes Leaders' Edge
growth without the constraints of debt; and provide job
Addressing
security for senior management who decide to stay.
Consolidations and Technology Weekly
the Noncontrolling Read More
Interests Classifieds
Words from the Wise Enterprise Resource Planning
Featured Seminar
"In the last The Enterprise Resource Planning (ERP) system remains the
The Schedule M-3
analysis, what we foundational element for most manufacturers’ IT
Workshop
are communicates environment. The ERP system is also a valuable prerequisite
far more eloquently to e-business. It is critical for the system to be functioning at
Featured
than anything we a high rate of performance before other solutions can be
Conferences
say or do." properly implemented and used, such as supply chain
management, e-Procurement, customer relationship
Employee Benefits
- Stephen Covey management and collaborative product development.
Conference
Read More
Fall Accounting
Conference 1 - Lansing
Proposed Changes Addressing Fall Accounting
Consolidations and the Noncontrolling Conference 2 - Troy
Interests
Of Interest
The Financial Accounting Standards Board, in addition to
proposing several changes related to accounting for business Fall/Winter CPE
combinations, is considering changes to the consolidation of Catalog Now Available
financial statements and the reporting of minority interest. (look for it in the mail,
Financial executives should become familiar with how to call for a copy or
report noncontrolling interests; allocate income or loss; and download it online)
reflect ownership interests after control is obtained. Further,
not all the changes focus on measuring the fair value at the Business Edge Archive
date the control is gained or lost.
Read More
The information contained in The Business Edge is for guidance only. The opinions and observations are solely
those of the authors and do not reflect the opinions or official positions of the Michigan Association of Certified Public Accountants.
Readers are encouraged to contact the authors, or their professional advisors, directly.
5480 Corporate Drive, Suite 200, Troy, MI 48098 Phone: 248.267.3700 Fax: 248.267.3737 E-mail: businessedge@michcpa.org
August 17, 2005 The Business Edge PRINT
Private Equity Funds: One Way to Crash-Proof Your Company
By Deborah Douglas
Private equity funds acting as investors can be a great way to “crash-proof” your company. They add
tremendous financial strength, and can create a wonderful win-win for private-company owners who want to
cash in, but still want to see their corporations thrive and remain healthy long after they are gone. As
possible buyers or investors, these funds are different; but they are not a fit for everyone. They can,
however, be great solutions for the owner who wants to reduce risk, but is eager to nurture his company for
the long term. Private equity funds like to leave management in place. They are hopeful that management
will have enough confidence in the future of the business to keep some of their equity in place. The rewards
they are willing to pay for such long-term strategies can be significant.
The volatility of the stock market in recent years has caused an interesting phenomenon in the merger and
acquisition arena: The number of private equity funds as would-be investors in middle market companies is
at an all-time high. The number of baby boomers with significant funds to invest is enormous, and the
volatility of the stock market for the more traditional public company investment is subject to increasing
doubt and question. The earnings of the middle-market company are today often perceived as more stable
and more likely to grow.
In the typical equity fund buyout, the fund offers to purchase
51 percent to 75 percent of the company’s outstanding equity, while putting employment contracts in place
for key people. The remaining one-quarter to one-half of the equity is held by existing owners, and is
typically held for five to seven more years. The end of this ownership period is most commonly defined by an
exciting offer from the outside: to buy 100% of the company’s equity. The founding equity holder then will
exit along with his new investor.
This kind of exchange versus the more traditional sale has several advantages —
Long-term equity holders have a chance to cash in on part of their ownership and still retain a piece of
the upside for the future.
Key employees are likely to be well rewarded, and may even be granted an equity stake in the ongoing
entity.
Growth can be accomplished, even through acquisitions, without personal guarantees of debt. The
typical outside equity firm is financially backed and is impressively banked enabling it to borrow for
growth.
For the owner who really hopes and intends to keep working or who has a group of top-level
management that wants to stay, there is a measure of job security. Outside equity holders do not want
to do it alone. They are often afraid to lose the management team, and are loath to change things
dramatically.
If you have an ownership group dead set on moving to the tropics next year, this is probably not the way to
go. Alternatively, if you face a longer timeline and are looking for a reduction of risk by using the talents of
board–level members for managing growth, this may be a tremendous way for you to achieve your
objectives.
About the Author
Deborah L. Douglas is managing director of the Douglas Group,
a St. Louis-based private investment banking firm specializing in the sale of middle market companies
throughout the United States. Deborah can be reached at ddouglas@douglasgroup.net.
Enterprise Resource Planning
By Douglas Hockenbrocht
The Enterprise Resource Planning (ERP) system remains the foundational element for most manufacturers’ IT
environments. The ERP system is also a valuable foundation for e-business. It is critical for the system to
function at a high rate of performance before other solutions can be properly implemented and used, such as
supply chain management, e-Procurement, customer relationship management and collaborative product
development.
The ERP model
An effective manufacturing planning and control system manages the entire resources within a business
enterprise. This system can be explained by the following ERP model.
Source: Buker, Inc.
An organization must first operate effectively and at a high rate of internal performance before it can
consider implementing an
e-business strategy. Inefficient and poorly implemented manufacturing planning and execution within an
organization will be compounded exponentially by expanding into e-business.
The ERP system must become the supporting foundation. What results is increased visibility beyond the
enterprise’s four walls; improved synchronization of customer expectations with business performance; and
reliable and accurate data sharing with customers and suppliers. It also requires the support of transaction
processing with customers and suppliers, and the support of an agile, responsive and predictable production
facility.
A successful ERP system implementation facilitates business and operations planning, product and demand
planning and material requirements planning through continuous feedback and integration. It becomes the
primary vehicle to communicate a customer’s needs and what the enterprise must do to satisfy those needs.
The ERP system provides the capability to monitor supplier performance, facilitates resource tracking and
capacity planning, and supports process efficiency and continuous improvement. Finally, it establishes a
single source of data. What results is improved data accuracy for customer, supplier and employee purposes;
and a secure environment for the generation of bill of materials, routing and inventory control records.
ERP is critical for managing the resources within a manufacturing enterprise that promotes business
excellence. The goal of ERP is always the same: to establish continuous improvement practices for the
benefit of overall operating performance within the organization.
Software Does Not Always Equal Success
Although business operations are not typically supported by an ERP system, the remainder of the traditional
ERP model can usually be supported by application software. However, effective ERP is not achieved by
simply selecting and implementing new software. In fact, numerous organizations have invested significant
dollars in purchasing and implementing new ERP systems, but have not achieved any significant
improvement in their operating performance. It is well documented that only 25 percent of the benefits of
ERP are derived from the new application software solution. The software is only a tool. Management must
combine the enterprise’s vision, operating disciplines and procedures with the software to achieve the full
benefits of ERP.
Organizations that strictly focus on the software normally produce minimal improvements in data accuracy,
including inventory records, bills of material and routings. Often, there is a continued reliance on stand-alone
“off-line” systems because users do not “trust” the new system; this leads to redundant and ineffective
business processes. Users may not fully understand the impact their interaction with the system has on the
overall enterprise, which often results in no substantial improvements to operating effectiveness.
Example #1
Organization A completed the implementation of a new ERP system on time and under budget. However,
several months after the “go live” date they were still experiencing poor inventory record accuracy. During
the system implementation, Organization A spent a significant amount of time making inventory balances
and bills of materials 100 percent accurate. Finally, an extensive cycle count program had been
implemented to ensure inventory record accuracy. How could the inventory record accuracy have
deteriorated so quickly?
After a detailed analysis, Organization A identified bill of material accuracy as the root cause of the problem,
together with the organization’s need to backflush raw material. While the organization had entered very
accurate data into the new system, it had not addressed the issue of implementing effective engineering
change notice procedures to ensure that bill of material accuracy would be maintained.
Example #2
Organization B implemented its ERP system approximately three months late. Throughout the
implementation, Organization B had reviewed several key business processes and decided to re-engineer
them based on the capabilities of the new application software. However, it was unwilling to change its
receiving process. In the old system, there was no capability to support online receiving. All purchase orders
were sent to the purchasing department for processing. This process caused problems because the —
Receiving Department was not accountable for the accuracy of receipt compared to the original
purchase order; it just assumed that the actual quantity received was equal to the purchase order
quantity.
Time lag of interoffice mail resulted in the purchase order arriving two to three days after the receipt
of the material. Furthermore, in most cases, the material had already been consumed in the
manufacturing process. This made tracking down any discrepancies very difficult.
Inventory record accuracy was questionable since the Purchasing Department had to perform daily
manual cycle counts of quantities of key materials on hand.
Purchase order price variances were not identified until the invoice was processed.
The need to duplicate an ineffective business process had a significant impact on Organization B.
Measure Operating Performance Rather Than Financial Performance
Measuring the effectiveness of the ERP model can best be done by reviewing an organization’s performance
measurement initiative. Measuring operating performance rather than financial performance is critical for
improving overall performance. Why? By the time the income statement and balance sheet are produced, it
is too late to take corrective action. Furthermore, measuring inventory accuracy in terms of dollars should
not be used as a key performance measurement. Items that have a positive financial variance tend to offset
those that have a negative variance. By effectively measuring operating performance throughout the entire
organization, you can, on a daily or weekly basis, compare results against a plan and take action before an
operational issue significantly affects the financial statements. To measure operating performance, set target
performance levels for all aspects of the organization and measure actual performance to the plan (see
table.)
ERP Element Sample Performance Measurement
Business Planning – market,
Return on investment
product, and financial plans
Demand / Product Planning –
Orders received compared to planned sales
sales planning
Operations Planning – product
rates and resources required to Actual production compared to planned production
meet the demand plan
Master Production Scheduling –
Actual production compared to master schedule
capture forecast, customer orders
Material Planning – schedule
material availability to support the On time released orders compared to total orders
master production schedule
Bill of Material – definition of
Number of accurate bills compared to total number of bills
product structure
Routings – definition of
Number of accurate routers compared to total number of routers
manufacturing process
Inventory control – track
Number of parts correct compared to number of parts counted
inventory balance by part
Supply Partners and Logistics –
Materials received on time compared to material due date
execute the purchasing plan
High Velocity Manufacturing –
Materials completed on time compared to material due date
shop floor execution
Source: Buker, Inc.
Success = 99+ percent
What, then, are the targets for effective ERP? Actually, the performance measurement targets continue to
change. For organizations operating within the ERP model that have no current plans to implement e-
business, common performance levels should aim to operate at a level of at least 95 percent of target
metrics in all areas of the ERP model. In order to be ready for e-business, however, several performance
metrics, such as order promise dates, supplier on-time delivery, bill-of-material accuracy, inventory record
accuracy and internal schedule attainment must be at the 99+ percent level of performance.
Many organizations, unfortunately, are not operating at 95 percent performance, let alone the 99+ percent
level required for
e-business. How can an organization move toward operating at the required minimal performance levels?
There are numerous activities an enterprise can perform:
Educate the enterprise on ERP concepts. In this context, education is different from training. Education
focuses on what ERP is about, how it applies to the business, and how changes in current business
practices will be required to achieve higher levels of operating performance. Training pertains to the
use of the software.
Implement a performance measurement program that focuses on operating — not financial —
performance. The performance measurements should focus on rates of improvements in order to drive
the habit of continuous improvement.
Review existing business processes. A key characteristic of organizations that operate at very effective
levels of performance is that those operating levels are predictable. Business processes have been
reviewed and lean principles applied to eliminate significant amounts of activities that add no value.
Evaluate current technology. Determine whether the existing ERP software — as well as other existing
software applications — is positioned to support the strategy of the organization. In addition, the
network infrastructure’s scalability and security levels should be assessed to verify that it can support
external users, stakeholders and future growth.
The Bottom Line
ERP is the first and most important step toward building a sound IT environment, for both internal and
external users. The ERP system must be functioning at a high rate of performance before other solutions,
such as supply chain management, can be properly implemented.
About the Author
Douglas Hockenbrocht is a manager in Plante & Moran’s Technology Consulting & Solutions Practice in
Southfield, Mich., where he specializes in technology-enabled process improvement for manufacturers and
distributors. Doug can be contacted at Doug.Hockenbrocht@plantemoran.com.
Proposed Changes Addressing Consolidations and the Noncontrolling
Interests
By Arlette C. Wilson, Ph.D., CPA
The Financial Accounting Standards Board (FASB) decided to address the financial accounting and reporting
for a business combination in two phases. The first phase was completed in June 2001 with the issuance of
SFAS #141 which eliminated use of the pooling-of-interests method and required all business combinations
to be accounted for by the purchase method.
The FASB has now concluded its deliberations for phase two and is proposing several changes related to the
accounting for business combinations, as well as to the consolidation of financial statements and reporting of
the noncontrolling interests; otherwise referred to as minority interest. Proposed changes to the application
of the purchase method were discussed in the May 25th issue of The Business Edge. This article discusses
those changes affecting consolidation procedures and the reporting of noncontrolling interests.
Reporting of Noncontrolling Interests
Noncontrolling interests currently may be reported as liabilities, equity or mezzanine items between liabilities
and equity. FASB is proposing that noncontrolling interests be reported as equity separately from parent
equity. This change would likely increase consolidated equity and affect the debt-to-equity ratio.
Allocation of Income or Loss
Net income or loss, including other comprehensive income, would be allocated to controlling and
noncontrolling interests based on relative ownership percentage. Currently, any allocated loss in excess of
the noncontrolling interest is allocated to the controlling interest. In other words, the noncontrolling interest
would never be reported as a negative amount. But FASB proposed that all losses attributable to the
noncontrolling interest be allocated regardless of the existing equity balance.
Example #1
Assume that Wilson Company owns 80 percent of Childers Company’s outstanding stock. As of January 1,
2006, the noncontrolling interest equity is $15,000. For 2006, Childers Company reported a $100,000 loss
and distributed no dividends. Current requirements would report a noncontrolling interest of $0 with the
additional $5,000 loss ($20,000 - $15,000) reducing parent equity. Proposed requirements would report the
noncontrolling interest as $5,000 negative equity.
Changes in Ownership Interests After Control Obtained
Current requirements would report a gain or loss in consolidated income for the difference between the cost
of the shares bought or sold and the carrying value of the percent ownership acquired or sold. Proposed
changes would account for this buying and selling stock as capital transactions as long as the sale did not
result in loss of control.
Example #2
To illustrate, assume Wilson Company owns 60 percent of Childers Company’s outstanding stock. On
January 1, 2006, the carrying value of the investment was $1,200,000, while the noncontrolling interest is
$800,000. On that date, Wilson Company sells 5 percent of the subsidiary’s stock for $140,000. The
carrying value of the interest sold is $100,000 (1/12 of the percent ownership interest). Wilson Company
received $40,000 more than carrying value of the investment. The proposed requirement would report this
$40,000 as an increase in paid-in capital rather than reporting it as a gain.
Loss of Control of Subsidiary
Currently, the sale of part or all of an investment results in a gain or loss for the difference between the
selling price and the investment carrying value. The FASB is proposing that if the sale results in loss of
control, a gain or loss would be recognized not only on the part of the investment sold, but also on the part
of the investment retained. That is, any retained investment would be marked to fair value at sale date, with
the corresponding unrealized gain or loss recognized in consolidated income.
Example #3
To illustrate, assume Wilson Company owns 60 percent of Childers Company’s outstanding stock. On
December 31, 2006, the carrying value of the investment is $1,800,000. On that date, Wilson Company
sells half of the investment for $1,200,000. Current requirements would only report a gain of $300,000
($1,200,000 selling price - $900,000 carrying value), while the proposed method would report a gain of
$600,000. The retained 30 percent ownership interest would be increased to a fair value of $1,200,000 from
its original carrying value of $900,000 on the date Wilson Company loses control of the subsidiary.
Note that all the proposed changes discussed in this article focus on measuring the fair value at the date
control is obtained or lost; and therefore, changes in ownership interest subsequent to date of control would
be considered capital transactions. Proposed changes would also require noncontrolling interests be
considered as equity, and therefore, allocated its share of losses as well as gains.
About the Author
Arlette C. Wilson, Ph.D., CPA, is the Taylor Professor of Accounting at the College of Business at Auburn
University in Alabama. Arlette can be reached at awilson@business.auburn.edu.
The information contained in The Business Edge is for guidance only. The opinions and observations are solely
those of the authors and do not reflect the opinions or official positions of the Michigan Association of Certified Public Accountants.
Readers are encouraged to contact the authors, or their professional advisors, directly.
5480 Corporate Drive, Suite 200, Troy, MI 48098 Phone: 248.267.3700 Fax: 248.267.3737 E-mail: businessedge@michcpa.org
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