The five greatest risks to financial security part II
ECLUB NEWS |
The February issue of eClub News featured explanations to two of the greatest financial risks facing private clubs today in Part one of The five greatest risks to financial security. This month, the remaining three risks are explored. To clarify, these are not the only risks. These are simply those risks that have been identified of tremendous importance based on potential repercussions and prevalence in the industry.
Five greatest risks:
- Incremental budgeting
- Not raising dues
- Believing depreciation is not a real expense
- Managing to metrics rather than with metrics
- Going cheap with your internal financial advisors
Believing depreciation is not a real expense
Believing depreciation is not a real expense is arguably one of the best examples of clubs burying their head in the proverbial sand.
Consider the annual reports filed by ClubCorp with the Securities and Exchange Commission (SEC). Depreciation and amortization are included in the determination of operating income. The reason for this is because depreciation is an operating expense.
Arguably, every other business in the world includes depreciation expense in operations. Private clubs have historically excluded it under the argument that capital inflows from initiation, joining or entrance fees covered that cost. Since many clubs would struggle to make that argument today, it is time to revisit how depreciation is portrayed in financial statements. Warren Buffett famously asked, "Does management think the tooth fairy pays for capital expenditures?
Clubs should probably try to fund depreciation from operating revenues if they are to act like most commercial enterprises. This inevitably provides more support for our previous contention that dues must increase regularly. Yes, some clubs will continue to push the capital funding problem down the road and charge a capital assessment to whoever happens to be a member of the club at the time a major capital asset needs replacement. Hopefully the members at that time will be more cognizant than today's members that they have a responsibility to maintain amenities at desirable levels. Current members may argue that they have paid for the asset once and should not have to pay again. To those members, clubs must ask what they think depreciation expense represents. It is a measure of the enjoyment they get from using the asset. Certainly clubs that have a residential real estate connection can testify that the ability of residents to sell their property at a reasonable price is directly impacted by the condition of club amenities. What often gets missed in this discussion is that almost all clubs have a residential real estate component—even those without homes behind the club gates.
It has always been a struggle to comprehend any point of basing cost estimates of future capital purchases on what was paid for the same asset any number of years earlier. The concept of inflation suggests that such an estimate would inevitably result in a shortfall when it comes time to write a check in the future. Questions continue to be posed regularly about whether private clubs should conduct reserve studies. The answer to such a question is a resounding yes. After all, how could a club president or treasurer ask for any level of capital assessment at the annual meeting with an independently researched study to support the need for the amount being requested? In no other business with major facility and equipment needs would management approach the capital or debt markets without professionally prepared documentation of the funding levels required.
A final thought on funding depreciation highlights how depreciation is calculated—over the estimated useful lives of the assets purchased. Clubs rarely, if ever, take a serious look at useful life estimates. This is evident when a major renovation takes place and the club has to write the old assets off the books. So many times the result is a significant book-loss for the club because depreciation accumulated to date is much less than the original cost of the asset. This suggests that the useful lives that the club had been using were arguably too short.
For example, imagine spending $4 million on a clubhouse renovation in 2001 and deciding to depreciate it over 40 years. Assuming the club put the asset in service at the start of its fiscal year, the depreciation expense each year would be $100,000 ($4m/40years). Now, assume the role of good stewards of the club's assets who are fortunate enough to be able to begin building a capital reserve by setting aside $100,000 a year, in effect funding the annual depreciation expense so that the club can, ignoring the impact of inflation, have the money to replace its 2001 asset when the time comes. Twenty years pass and it is time to renovate the clubhouse again to stay competitive. At that point, the club has recorded $2m ($100,000 x 20 years) of accumulated depreciation on its 2001 clubhouse renovation and tucked away $2m in its capital reserve account. When the club completes its 2021 clubhouse renovation, estimated at another $4m, it will be removing the old asset from our books at a $2m loss ($4m original cost minus $2m accumulated depreciation) and will find itself with a $2m shortfall in its capital reserve fund. Had the club taken a hard look at how long its 2001 asset was really going to last, it would have depreciated that asset over twenty years, not forty, and might have realized sooner that its depreciation funding was insufficient. Because of the inherent estimates and biases involved in setting depreciation lives, it appears obvious that while funding depreciation is good, funding a capital reserve study is better.
Managing to metrics, not with metrics
Managing to metrics, not with metrics is going to become more and more of a risk for club executives and boards. CMAA, NCA, PGA and NGF are just a few of the industry bodies that publish volumes of incredibly useful industry data. McGladrey also has almost forty years of published club financial trends extracted from our clients audited financial statements. All in all, there is more data than most club executives will ever have the time to sift through, analyze and apply to their own, unique operation. Yes, consultants like ourselves and others can help, but ultimately it is club management that will be held accountable by boards for meeting, or not, some of the yardsticks that the industry has published.
We see great wisdom for club managers and boards in this quote from Irish playwright George Bernard Shaw, "The only man I know who behaves sensibly is my tailor; he takes my measurements anew each time he sees me…The rest go on with their old measurements and expect me to fit them."
Given the volumes of data in the marketplace, boards are urged to view their club financial performance through the multiple prisms available. While most clubs fit within a relatively well defined range of financial metrics, be it departmental reliance on dues or member to employee service ratios, the details matter. Think back to the earlier discussion on strategic planning and zero-based budgeting. Presumably each club's strategic plan is unique to that club or else someone would just publish a boilerplate document that all clubs would follow in order to avoid the time and cost associated with the strategic planning process. If that is true, and each club should budget operationally for its own specific plan, then how useful can data from other clubs really be for a club measuring its own performance relative to its own strategic plan? Of course industry data is useful for defending the sometimes counter-intuitive club financial model, but club boards should not be setting goals for club management that is forcibly driven by generalized statistics. Understand the data, understand what drives it, understand the source and understand how it may, or may not, apply to a specific club's strategic plan.
Manage with the metrics, not to the metrics.
Cutting corners with the club's internal financial advisors
Cutting corners with the club's internal financial advisors at a time when members and leadership are demanding more financial accountability and knowledge than at any time in history is, at a minimum, foolish and more likely to be downright reckless. Clubs spend countless hours in board and committee meetings discussing as wide a variety of industry topics and a recurring theme in the discussions has emerged over the last eighteen months. Clubs are asking about the strength of their financial teams.
It is a difficult question to answer. As consultants, auditors and tax advisors, McGladrey professionals are not at these clubs for every meeting, formal and informal, that takes place around finances. The team does have a privileged view of the collective financial acumen when delivering its suite of services, but the truthful answer to this question begins with clubs asking how strong they want their financial teams to be.
Many clubs believe that they need to improve the quality of their financial teams. Controllers and chief financial officers should not panic as this is not a dire prediction of wholesale job changes in the industry. Rather, there is a growing appreciation that clubs need to invest continually in their people they want to improve results. This comes not only in the form of funding continued education and training for financial professionals, but also in the form of making these individuals a true part of the management team.
It continues to be shocking how many clubs do not allow or require the senior accounting executive to attend board meetings. How can clubs possibly expect these individuals to provide the level of service required when they are not granted a seat at the table? Perhaps clubs will find that their evaluations of those in this role will change, admittedly for better or worse, when they see them interact with club leadership and management in the rarified air of the club board meeting.
More worrying is that a decision is made in a board meeting that has a financial management impact that is missed among the passionate debate of board members. If the club's controller or CFO is in the room, a chance at least exists that this person will point out the impact immediately. If this person also misses the impact of the decision or elects not to voice any concern, that also provides a measure to evaluate that person's value to the club.
In corporate America, most CEOs would refuse to step into a boardroom without their chief accounting employee at their side. Clubs need to follow suit or truthfully understand why their controllers are not in the boardroom. Is it because the club needs to upgrade the position?
The marketplace is changing. The great recession has seen a number of financial executives enter the club job market for the first time, coming from varied industry backgrounds as far ranging as public accounting, real estate, healthcare and insurance. They bring with them a highly visible and often technical skill set as well as an appreciation for a range of standard business practices that were not commonplace in the club industry. Club boards and chief executives have responded enthusiastically to these new CFOs and the industry has demanded more. Niche club executive search firms had previously not seen tremendous demand, or willingness to pay, for recruitment assistance for controllers or CFOs. That has changed, as have the job descriptions for the chief accounting role at clubs. A recent advertisement at a leading club sought a controller that provided "financial leadership contributing to The Vision of the Club, and the Club's business and financial objectives. Other attributes sought were "strong and passionate financial leader with a proven track record of providing supportive, timely and accurate information; a team player who has a history of supporting and developing staff; a proven courageous thought partner; an intuitive style resulting in a trusting and nurturing perception by all; and a fundamental understanding of the Club business. Most importantly the club in question was willing to pay the market rate for the right person—the market not necessarily being the club industry market, but the market for high level financial leaders.
This discussion has been about financial risks to clubs. As is well known by readers of this newsletter, risks to private clubs are not only financial in nature and risk management is of the utmost importance. As for the risks highlighted in Parts I and II of this series, clubs that have the right financial leaders on staff to complement and support the club's chief operating officer will ultimately recognize and manage these risks as they effectively execute the club's strategic plan and ensure continuous alignment with the club's mission.