“We started like a small sari-sari store. Then, in just over a decade, we grew exponentially and became like a big department store.” This is an analogy shared by a proud owner of a growing real estate company.
He has reasons to be proud of that feat. His company has billions of pesos worth of projects in the pipeline. They have an inventory of thousands of partially and fully developed housing projects just waiting for the right buyers to place orders.
The organization as a whole, however, has not evolved and adapted to the growing demands of the business. A department store is still managed like a sari-sari store. While the owner is a good entrepreneur, his company has not invested in systems, tools and finance processes as well as resources to support the business.
Success is measured by sales performance, but not all sales reported to the owner are genuine sales. He didn’t realize that his business was out of control until reality hit him. As it turned out, cash collections were not enough to fund day-to-day business requirements. The company could not borrow money from banks. He could not even rely on internally prepared financial reports to make sound economic decisions.
He acknowledged that they are facing enormous financial challenges, and he wanted a sustainable long-term solution. He wanted stronger governance and internal controls in place.
In my view, his challenges are caused by the following:
a) Incentives and bonuses are based on sales volume. This is acceptable as long as stringent controls are sufficient to ensure that only genuine sales are reported. In this case, there were fundamental control breakdowns that led to possible abuses. For instance, a signed contract to sell and payment of minimal reservation fee (the amount is only equivalent to a cost of buffet lunch for two in a five-star hotel) were reported as sales and qualified for an incentive. A large volume of customers who have paid reservation fees eventually defaulted on the first amortization. Getting an incentive appears to be so easy!
b) Policies and controls are not enforced and implemented. Written policies, which appear generally sufficient to protect the company from credit losses and abuses, have been neglected. There is no finance function to exercise controllership. A fundamental lapse is that some buyers have not even submitted key requirements such as proof of income (bank statement/income tax return, certificate of employment) and proof of address.
Postdated checks required under the Contract to Sell were not secured. Some of the buyers may not even exist. The end result was a massive amount of uncollected receivables from worthless contracts.
c) Lack of accountability and ownership. After sales were reported and incentives were paid to concerned sales personnel, nobody was accountable for the collecting the contract price.
d) Inadequate finance resources to provide stewardship and controllership.
e) Manual processes and systems.
So how do you prevent the abovementioned issues? A few examples of controls that can be adopted are enumerated below:
a) Credit and collection controls. It starts with a robust credit assessment such as requiring all customers to submit a verifiable proof of income, capacity to pay (such as certificate of employment, bank accounts and income tax return) and proof of existence (valid identifications). Potential customers will then be assessed for creditworthiness. Can a customer pay the contract price without the risk of default? If there are significant doubts, he may not be the right customer.
b) Controls and programs to enforce integrity, values and accountability within the organization. These are company-level controls to promote, among others, awareness, enforcement, and monitoring of various policies within the organization. These are not tangible controls but they work in harmony with other physical controls to create a balanced and robust internal control environment. This is a common framework adopted by large entities but can be tailored to suit the needs of SMEs.
But benefits from policies and controls will only be achieved if an organization has sufficient and appropriate resources and systems. A competent and proficient finance team provides reliable and timely financial information to support decision-making. Nowadays, because of a stringent regulatory environment, relying on the old and traditional “tiwala” system to run the finance function may no longer work.
I have seen similar stories in the past. Some even involve large entities. Big businesses being managed like a small company. The consequences can be disastrous, from small economic losses to permanent closure. I have seen a very profitable company that got liquidated because of very simple but neglected compliance issues involving withholding taxes.
The good news is there are practical and sustainable solutions, but owners should be willing to make the necessary investments and organizational changes.
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Roderick M. Danao is the vice chairman and assurance managing partner of Isla Lipana& Co./PwC Philippines. Email your comments and questions to firstname.lastname@example.org. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.