One of my favorite bloggers writing about the publishing industry is Kristine Kathryn Rusch, a former “upper-midlister” who has moved into the world of self-publishing and prefers the results. She has lots of history in the traditional publishing world, ranging from short-story mags to full-length novels, and everything in between, and probably every form of publisher alive. However, unlike the evangelical nature of some of the newly converted, Kris’ posts tend to be more practically oriented — here’s a business issue related to publishing, here’s her experiences with it, here’s how she thinks it fits into a current business model, and here’s what she thinks is the best option for her. She’s not trying to convert the masses, she’s sharing info with the masses. It’s a great balance, and she treads it well. One of her latest posts is about royalty statements, and, basically, how screwed up they are. But she also goes on to talk about two other issues that I think are great — basket accounting and the audits by DOJ of the “colluders” who are being sued for the agency model agreements they colluded upon. See excerpts below:

Over a year ago, I wrote a blog post about the fact that my e-book royalties from a couple of my traditional publishers looked wrong. Significantly wrong. After I posted that blog, dozens of writers contacted me with similar information. More disturbingly, some of these writers had evidence that their paper book royalties were also significantly wrong.

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The reason I was so excited about the Department of Justice lawsuit against the five publishers wasn’t because of the anti-trust issues (which do exist on a variety of levels in publishing, in my opinion), but because the DOJ accountants will dig, and dig, and dig into the records of these traditional publishers, particularly one company named in the suit that’s got truly egregious business practices.

Those practices will change, if only because the DOJ’s forensic accountants will request information that the current accounting systems in most publishing houses do not track. The accounting system in all five of these houses will get overhauled, and brought into the 21st century, and that will benefit writers. It will be an accidental benefit, but it will occur.

The audits alone will unearth a lot of problems. I know that some writers were skeptical that the auditors would look for problems in the royalty statements, but all that shows is a lack of understanding of how forensic accounting works. In the weeks since the DOJ suit, I’ve contacted several accountants, including two forensic accountants, and they all agree that every pebble, every grain of sand, will be inspected because the best way to hide funds in an accounting audit is to move them to a part of the accounting system not being audited.

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My agent noticed that the royalty statements from one of my publishers were basket accounted on the statement itself. Which is odd, considering there is no clause in any of the contracts I have with that company that allows for basket accounting.

For those of you who are unfamiliar with basket accounting, this is what it means: […] a contract with a basket-accounting clause allows the publisher to put all three books in the same accounting “basket” as if the books are one entity. So let’s say that book one does poorly, book two does better, and book three blows out of the water. If book three earns royalties, those royalties go toward paying off the advances on books one and two.

You can read the full entry via The Business Rusch: Royalty Statement Update 2012 | Kristine Kathryn Rusch. And sign up for her RSS feed, maybe even toss some shekels into the hat to keep her blog monetized. 🙂

So, accounting for royalties is actually pretty complex, as Kris’ post points out, particularly when it is being done with archaic systems, slow reporting, multiple vendors, multiple formats etc. A recent discussion on the MurderMustAdvertise forum was talking about how a specific small press was not doing a great job providing updated numbers quickly (as much as daily, as was desired during a promotion period). Yet the reality is that many of those data collection systems suck. Like with the GIGO acronym for computers — Garbage In, Garbarge Out. Lots of other people, as Kris points out, think it is the system playing with authors in order to screw them out of royalties. Where some people see malice, I see basic incapacity. I also think your expectations depend on where on a broad spectrum you sit:

a. Those who trad pub and who believe that there’s no other option for them;
b. Those who trad pub and who know there are other options, but don’t want them;
c. Those who go both routes;
d. Those who go indie, but might consider trad with the right deal; and,
e. Those who go indie, drink the Kool-aid, and like new religious converts, are ready to preach to anyone and everyone about their experience.

Those in the D-E realm want numbers NOW, as they get from Amazon for self-published titles. Those in the A-B group think they’re dreaming in technicolour. Dean Wesley Smith’s blog (Kris’ husband, btw) has talked too about how he would LOVE a program that would take reports from multiple systems, convert them into a single system, and let him fiddle with the data to come up with something comparable, useful. Something resembling modern business intelligence. I see that Random House just opened an Author Portal, an supposedly “innovative tool that will help with sales tracking” but I think we are still a long way away from seeing a sale in your local bookstore show up in some daily stat you can access yourself. But, as a small defense of the Large Press publisher, this is part of what you as an author gave up when you went that route. Just as if you sold through any third party — you gave up control. They’re selling your book, not you. Yes, you’re entitled to sales info; no, you’re not entitled to daily updates unless your contract included that.

In fact, calling and asking daily for something that you should know isn’t available daily has an official legal name — it’s called harassment, and it’s ground for damages under contract law as bad faith dealings.

Now, while it might sound like I’m defending the publishers with having wonky numbers, or negating Kris’ point, I’m not. Authors should get accurate royalty statements out of their publishers. Clear record of sales. Transparent accounting. Reliable calculations. All that you would come to expect from a contract. Does the system produce it currently? No.

Kris is optimistic that the audits of the big publishing firms will spur this transformation, pointing to Department of Justice forensic audits as a catalyst. Actually, while I think the monitoring that will be coming will point out a lot of the problems that she mentions in her post, I’m less optimistic of auditing as an agent of change.

My day job involves me regularly having to deal with auditors, and you can think of auditing as having four levels of audits:

a. Audit of financial statements — this is what the large accounting firms known as the Big Four do for large corporations, and it is pretty much worthless as an exercise. Think of it as a Tier 1 audit. What they do is go meet with the company’s people, ask them questions, get their answers, make sure the general policies are in line with Generally Accepted Accounting Principles (GAAP) and that the right systems are in place, do a basic probe of the systems, ask some big picture questions about risks / liabilities / assets / revenue streams, and come to the conclusion that the people doing it all know what they are doing and therefore, yes, the systems are adequately producing financial statements that accurately portray their business. Most investors don’t understand that…heck, most CEOs don’t understand that. Which is why you see these HUGE restatements of earnings where a problem was discovered five years later that the “auditors” didn’t catch and people go, “But they were audited!”. Put bluntly, these audits amount to no more than the auditors asking in five or six different ways “Are your financial statements accurate? Is there anything you haven’t told us that is material to this audit? No, okay, well then it must be good to go.” There was a great quote from one of the Big Four about two months ago where the CFO said, “Well of course we didn’t find anything wrong in that audit — they lied to us when we asked if anything was wrong.” Most people think auditors detect things like that on their own, but often they don’t. Tier 1s are done every year, relatively routine, and they don’t go farther unless there’s a problem detected.

b. Audit of control frameworks — this is a tier 2 audit. As per the Tier 1, this is where the auditors go in and say, “What are your control points for managing the financial systems?” When you see small companies with huge frauds, it’s often because the person authorized to contract for services was also the one authorized to make payments and the one authorized to record the costs. Large firms have control points to ensure that those things are approved by three different people, sometimes as simple as a signing authority form that says “John can order things, Mary can sign checks, and Jane reconciles the bank statements”. If Mike gets an invoice for a contract not signed by John, the system comes to a halt. That’s a control point, and auditors in Tier 2 will go to that control point and say, “So, how do you ensure that Jane didn’t sign an order? And what do you do if it doesn’t have John’s signature each and every time?”. Sometimes a problem in Tier 1 will prompt a Tier 2 audit — say, for example, that the balance sheet is a little imbalanced, because John’s been ordering a LOT of supplies and the inventory is larger than normal. This might flag that John is out of control, and a Tier 2 might start to look to see that all the expected controls are (still) in place and working as designed. A recent government audit in Canada was triggered by a whistleblower…and when the report was done, after discovering massive fraud by one individual, the conclusion was that proper controls weren’t in place, which is actually misleading. They DID have controls in place, they just weren’t being used. But I digress.

c. Targeted audit — this is a Tier 3 audit and is usually only initiated if there is a clear “problem” such as a process breaking down. If Mary approves just about everything, and Jane’s not been doing the reconciliation of the bank statements regularly, and John’s ordering a LOT of inventory, then cash flow might be a problem. Perhaps IT expenditures are high. So a targeted audit would do a walkthrough of the processes in place for IT expenditures, and review a significant sample of the IT expenditures. Maybe expenditures over $500K or hardware investments. It depends on the org and the situation — Nike’s investment in office computers might be scrutinized for every transaction; Google might do a 10% sample. It’s targeted, focused, specific. It does NOT look at everything unless there is a systemic problem, which would trigger Tier 4.

d. Forensic audit — this is a tier 4 audit, and sometimes auditors call it a “true” financial audit. However, in most cases, this is only done if there is a very clear case of fraud or financial irregularity. It involves a “complete” audit, in theory. This is what most people think of when they hear “audit” because they think of it like a personal audit by the IRS or Revenue Canada. In a personal audit, the auditors will look at every line, every transaction, every receipt. It’s the image that Hollywood likes to portray. But it only works for “personal audits”. Auditors cannot review every financial transaction made by a multinational company over the course of five years to make sure everything was recorded properly — there’s a very large question of materiality here. They are not going to check to see if the Middle Manager in charge of box design was authorized to have his parking reimbursed when he went to a conference in the city. First, there’s no point, and second, they are not there to repeat the work of the financial people who were there before. They’re auditors, not financial clerks. They’re checking on systems and looking for signs of problems…like criminal fraud.

What does this mean for the DOJ monitoring? Who knows is probably the best answer. The DOJ is looking at anti-trust problems, and specifically pricing collusions. Are they going to go into issues like basket accounting? Only if basket accounting looks like fraud and doesn’t reflect a proper accounting practice. People tend to think of accounting as a simple science but it’s more of an art. A financial clerk says “2+2 equals 4”; an accountant knows it depends on who’s asking the question for what year and which method of accounting for costs.

Take Kris’ example of basket accounting. It looks like clear, unadulterated fraud on the part of the publisher. That by simple accounting standards, they are mixing revenues without authorization, violating a contract, and ripping off the author. Except there is a general accounting principle of matching revenue streams to costs AND looking at holistic relationships with partners with whom you have multiple contracts. So, like Joe’s Stationery providing memo pads on standing order. If you pay part in advance, at some point you reconcile the “account”, not the individual invoices. And, using “basket accounting” or “accounts receivable” as your lens, it would appear that the author has three advances, and has only earned back part of it, so until “all three” are earned back, the account is in deficit. And beancounters could easily argue, “No more $$ until all advances are cleared.” Cuz that is what they do when they order stamps, so why wouldn’t they do that when they have vendors providing manuscripts to them? It isn’t right, it isn’t wrong — it’s whether the accountants will call it a proper application of general principles to a long-standing relationship, and a justifiable “choice of accounting methods”. Unless there is intentional application of a clearly inapplicable approach, a forensic audit will likely only say “Company X should review its choice of advance reconciliation.” Sure, the auditors will ask for info that the company doesn’t track, and the company will say, “We don’t track that.” But unless it is something that financial regs say they HAVE to do, the auditors will just note it as an out of date system that they recommend be considered for updating — they can’t say it HAS to be updated (an actionable finding, they can only recommend it — because the financial regs don’t require it either). Think of it like a personal auditor saying you shouldn’t keep notes of a financial agreement on a paper napkin — there’s no law against it, though, even if it’s stupid, so the auditors can’t compel compliance to a non-existent regulation.

And the crappy part of all of this is the DOJ has not yet said that a Tier 4 audit is what they will do…every scrap of paper, every expense, every payment of royalties. They may only do Tier 2 or 3, with regular monitoring. Tier 4 is an enormous cost.

Plus, if I was the in-house counsel, I’d be strongly resisting providing any info on royalties for two reasons. First, it is outside the scope of the alleged infraction, which is about pricing. That’s not nothing, that’s significant. Sure, it’s a “blanket warrant” but there still has to be rational connection to the purpose. It’s not a slam-dunk that this will be automatic. Second, such a blanket approach is also potentially highly likely to infringe upon proprietary info…if they gave a sweetheart deal to Turow but stuck it to Grisham, that is none of the auditors business and highly “internal”. Plus not something that publisher X can reveal without damaging its business, with no benefit to the audit or the litigation.

Kris is hopeful that the catalyst of the audit will force accounting system changes, but I’m less optimistic.

My only real optimism regarding the auditors is not that they will find out where the bodies are buried but rather than auditors tend to be very good at exposing HOW bodies could have been buried and thus telling other people (like agents, lawyers, authors associations) what the breadcrumbs might look like if some bodies are missing.

You might still have to sue them, and it might take awhile. But at least there will be some signposts in the final auditors reports, even if it won’t be a full map.

Or maybe I’m completely wrong and these auditors will be unlike every auditor I’ve ever met and they’ll rip them a new one. I guess I’m mainly doubtful that “regime change” is something that follows a rallying cry of “Send in the auditors!”.