o Net worth (the balance sheet)

o Operating results (the income statement)

I want to preface this discussion by saying that each of the well-known agency automation systems is capable of generating accurate financial statements. That's the good news.

The bad news is the systems also give you enough flexibility in the set-up parameters to produce what I refer to as "bad books."

That flexibility and/or inadequate accounting procedures may render inaccurate and misleading financial statements. Let's look at some specifics.

First, the balance sheet. The most common sources of inaccuracies are:

o Accounts Receivable

If you have old balances that will never be collected, your net worth is overstated. Writing off an uncollectible balance results in bad debt expense.

Think about this: If you write off a $1,000 receivable, it takes $9,000 of new premium sales to cover that write-off. Why? Because you've incurred a $900 expense (the net premium at 10 percent commission), and it takes $9,000 of premium to generate $900 of income to offset the bad debt expense. Ouch!

In an interesting twist, your accounts receivable balances and ratios may look better than they really are if you are holding clients' old credit balances.

Arguably, that's unethical (and illegal in some states)--a topic for another day.

o Direct Bill Commissions Receivable

As discussed in a previous article, if your direct bill receivable isn't carefully monitored, it can quickly result in an overstated net worth. You may be showing a receivable (an asset) for commissions that will never be collected.

o Carrier Payables

This is an area where problems lurk undetected. There are two different scenarios, each of which may be a problem.

First, in a true open-item subsidiary system, the balance may be "reconciled" but not correct because of erroneous old items.

Second, where there is not a subsidiary listing of open items, you may have no way of knowing what makes up the general ledger balance.

More often than not, an agency is carrying a receivable (in the form of a negative carrier payable) that they'll never collect. Like an uncollectible accounts receivable item, this results in overstated net worth.

In doing due diligence for acquisitions, I have seen instances where agencies have had to write off hundreds of thousands of dollars of old negative carrier payables balances--very painful.

o Unrecorded Liabilities

The main culprit here is producer payables that aren't accrued at the same time that you record the agency revenue. This is covered in detail in the next section.

Now, let's look at the income statement and the two most common errors that we see:

o Producer Commission

One of the basic precepts of accounting is the matching of income and expense. If you have commissioned producers, their commission compensation (your expense) should be recorded at the same time that you record your agency revenue. Otherwise, your income is overstated and your liabilities are understated.

In some automation systems, you can turn off this accrual altogether or have the accrual based on several collection scenarios--all of which violate this most basic principle.

If you have commissioned producers, you should fully book the expense and the liability. Otherwise, your financials are incorrect.

o Direct Bill Commission

The industry practice is to record revenues on the installment basis. That is, you book the annual commission on annual-billed policies and the installment commission (only) on installment-billed policies.

Some agencies book their agency-billed income on an installment basis and their direct-billed income on an annual basis, thus violating the accounting principle of consistency.

(Note: In the year when an agency changes from installment to annual billing of direct bill, the year's income will be grossly overstated. In those instances, there's a double hit to value in deals--a write-down of the direct bill commission receivable and a decrease to EBITDA (shorthand for Earnings Before Interest, Taxes, Depreciation and Amortization--a measure of a company's cash flow). This comes as a most unpleasant surprise to the seller.

I don't want to be the bearer of bad news, but it may be wise to ask your chief financial officer or certified public accountant to look at this list to confirm that your financials don't have a bad case of GIGO.

The impact could be a few dollars, or it could be as much as a 20 percent blow to your agency value. On a million dollars of value, that's $200,000--real money!

Let's go back to our college days to put this all in perspective, in non-accounting scenarios.

1. You loaned a friend $20 that they never paid back. At some point, you had to admit that you were going to be short that $20. (That was an uncollectible account receivable and a bad debt write-off.)

2. You had $100 in the bank but had forgotten you had to pay a $300 credit card bill the next week.

You were short $200, which may have resulted in an overdrawn bank account and bounced checks! (That $300 credit card debt was an unrecorded liability, similar to not accruing your producer commissions payable.)