The second most important external user of a company’s financial statements is a bank (or other debt or equity institution). The financial institution will dictate the report needed. Copies of tax returns and company-prepared financial statements may be all that is required. On the other hand, the financial institution may require a higher level of assurance by requesting that an independent accounting firm either compiles, reviews, or audits the company’s financial statements.

In this case, the company might want to know what is required and the difference between these types of reports. Accounting policies and procedures for financial reporting would help. First of all, only Certified Public Accountants¹ (CPAs) who meet a higher peer review level and other reporting standards can issue these statements. A public accountant (PA), tax practitioner, or an accountant who is not a licensed CPA cannot issue such statements. Fully-licensed CPAs must keep their licenses current, with continuing education and documented peer review, to be able to issue opinions on these reports.

Compilation

A business owner will need to find a CPA with the necessary credentials to request a compilation, review, or audit.  The least expensive report, and one that should satisfy most banks for small and mid-sized business, is a compilation.  Essentially, the CPA reviews the financial statements prepared by the company and attaches an accountant’s report to it.  No further investigation is performed.

Interestingly, the standard compilation report issued by a CPA is nothing more than a glorified disclaimer, stating that the CPA is providing no financial statement assurance.  The AICPA defines a compilation as “a service where the accountant presents, in the form of financial statements, information that is the representation of the company’s management and owners without undertaking to express assurance on the financial statements.”

Review

A review involves essentially the same process as a compilation, except that the auditor does perform certain analytical reviews — reviewing account balances for reasonableness and questioning management about material modifications that might be made in order for the statements to be in conformity with GAAP².  In a review report, the CPA expresses a “limited assurance” — not an opinion — of the reasonableness of the financial statements and their conformity to a comprehensive basis of accounting, like GAAP, cash basis, or income tax basis reporting.

Audit

A financial audit provides the highest level of financial statement assurance.  An audit normally takes considerably more time than either a compilation or a review.  The audit work, itself, can fill several large binders of documentation for a small-to-medium-size business.

Every balance sheet account is proven, within the limits of materiality³. Direct confirmations of account balances are mailed from the CPA to banks, customers, vendors, and other debt holders to validate the balances of cash, accounts receivable, accounts payable, and other assets and liabilities.  If inventory is material, the CPA must observe the inventory counting as of the report date.  The CPA also tests the accounting procedures and internal controls, including computer controls.  All transactions are subject to audit under a statistical sampling formula.

A surprisingly large amount of time is spent in non-financial areas to determine any claims, lawsuits, contingencies, or other events that could harm the company. Incorporation and other organizational papers are reviewed; all leases, loan documents and other contracts are reviewed; and all minutes and other relevant correspondence are read.  The CPA also sends letters to all attorneys asking for full disclosure on any relevant matter.

The AICPA defines an audit as an engagement where a CPA provides an opinion about the fairness of a financial statement presentation in accordance with a comprehensive basis of accounting, such as GAAP, cash basis, or income tax basis.  This is a fairly simple statement for what can easily involve weeks of work for even a relatively well-structured small business.

It’s important to recognize the relative costs of these three types of reports.  If the cost of an audit is $12,000, a review for the same business might average $4,000, and a compilation, $3,000.  Relative to an audit, a review and compilation are considerably less expensive.  However, the difference in cost between a review and compilation is not nearly as great.  This is important to remember if faced with a requirement from a lender or investor.  If they request an audit, you might try to convince them that a review is adequate and certainly provides more assurance than a compilation.  This could save you considerable expense.

SEC – Audit

For publicly-held companies, an audit is the minimum level of assurance required.  In addition to the audit, there are other SEC reporting requirements, depending on the size of the business.  A full explanation of these SEC reports is beyond the scope of this article.

Internal Reports

Much emphasis has been given to financial statement reports — the balance sheet, income statement, and the statement of cash flows.  These three are the most important reports on the overall financial condition of the company over a given period of time.  A primary objective in developing policies and procedures over the accounting function is to improve the timeliness, accuracy and completeness of these statements.

A company’s accounting or information system can provide much more than those three statements, however.  Management should be encouraged to use the data available in the accounting system for other uses.  Financial statements are extremely useful; however, they only provide current valuation, and transactional information from the past.

A statement of cash flow, reconciling the sources and uses of cash, can be a useful starting point for extrapolating data that projects the anticipated sources and uses of cash needed into the future.  By analyzing changes in aging of accounts receivable and accounts payable, you can develop more reliable estimates and better anticipate future cash receipts and future cash payments.

The relationship between sales, inventory levels, and related costs of sales can be used to determine the anticipated needs for additional inventory related to projected sales.  Using the data captured by the accounting system every day, a projected cash flow report, updated daily, can be a powerful tool to alert management in enough time to properly react to anticipated additional working capital requirements.

With a powerful forward-looking cash management tool, like the described projected cash flow report, the projected activity levels in future months can be used to create budgets in the current and succeeding months.

With income statement projections, projected cash flow reports, and budgets, we have a truly interactive management information system.  Data collected from the past is used to project the future, fed back into the budgets, which control the present and determine the future.  This creates a continually updated management information loop.  This provides a business with the tools to act, not just react.

SUMMARY

We hope this introduction to your Bizmanualz™ Accounting Policies and Procedures manual will increase your appreciation of the importance of establishing effective accounting procedures.  Your business is a continuously flowing stream of transactions.  Like a sturdy, well-maintained net cast across a stream, effective accounting policies and procedures help trap data completely and accurately. Once collected, the real benefit is utilizing the data to provide the information needed to review the past, position the present, and chart the future.

NOTES

¹The “chartered accountant” designation is more common outside the USA.
²A number of accounting authorities, like the AICPA and the IASB, are currently working on convergence of GAAP with IFRS (international financial reporting standards).
³Information is material if its omission or misstatement could influence economic decisions made on the basis of the financial statements. Materiality depends, in part, on the size of the item or error, evaluated in light of the circumstances of its omission or misstatement.

Three important terms are easily confused.  They are: Bookkeeping, Accounting, and Reporting. What are they, how do they interrelate, and how do they interface with accounting policies and procedures?  First, let’s define the terms.

Bookkeeping

Bookkeeping and accounting share two basic goals:

• To keep track of income and expenses, thereby improving The Company’s ability to achieve profitability
• To collect the necessary financial information about The Company’s business to file required reports and tax returns

Bookkeeping refers to the actual transactional entering and recording of data.  Examples are writing checks, processing payroll, making deposits, recording disbursements and recording receipts.

Accounting

Accounting encompasses the broader responsibilities over developing and maintaining the accounting system under which bookkeeping functions are performed and generally falls within the top ten job responsibilties of a CFO.  Accounting is concerned with the timely and accurate recording of transactions, providing useful management information, and properly reporting such information for various user needs.  Developing and maintaining an accounting system involves setting up and maintaining an appropriate chart of accounts for the particular business.

Accounting policies and procedures are then established to provide guidance and internal control for all possible financial transactions, from source documents (checks, sales orders, etc.), to journals (payroll journal, cash disbursement journal, invoice register, etc.), to the general ledger, (based on the chart of accounts), and ultimately to a variety of reports for all internal and external needs.

Bookkeeping and reporting can be thought of as the input and output of a complete accounting system.  Accounting policies and procedures ensure:

• Integrity of the input data; and
• Accuracy and validity of the output report.

Reporting

Reporting, (the output of the data generated through various bookkeeping functions), is used for both internal and external purposes.  Internal Reports are reports used within the company, by both management and other designated personnel.  Internal reporting can be further divided into non-financial and financial data.

Non-financial data

Non-financial data includes a variety of measurement and productivity data, applicable to the specific business.  These can be daily customer count, web page “hits”, production activity per employee hour, units and total weight of product shipped, or even daily weather conditions.

Financial data

Examples of financial data reports include:

• Financial statements – Profit and loss reports (income statement), balance sheets and cash flow statements
• Daily reports with critical balances, such as, sales, cash level, inventory, accounts receivable and accounts payable
• Segmented profit and loss reports (or P/L) on specific jobs, profit centers or departments
• Register reports, listing all transactions for specific areas such as, payroll, checks, receipts, invoices, etc.
• Listings of source data files such as customer, employee, vendor and inventory lists.
• Aging reports for both Customers (accounts receivable or A/R) and Vendors (accounts payables or A/P)
• Inventory reports for costing and valuation
• Exception reports – open purchase orders, back orders, inventory stock outs.

External reports generated for the use of people or organizations outside of the business.  Generally, one of the more important users is the Internal Revenue Service (IRS) and various state and local taxing authorities.  Required income tax returns can be prepared more easily from financial reports that are classified in a comparable manner.  A tax practitioner is usually retained to prepare and file these returns.  The report most commonly requested of the company is the general ledger and related financial statements.

Report data and format will vary depending on user:

• Banks, lending institutions. To observe the financial viability of a business and to determine its ability to support additional amounts and types of debt financing
• Employees. To determine the stability of the business of their employer – this may be useful in wage negotiations
• Suppliers. To assess the suitability of granting credit terms to a business
• Existing and Potential Investors. To assess the potential risk of investing in a business and to monitor the status of existing investment in a business
• Public. To gain more insight into any business, which is legally required to make certain financial information available
• Government. To fulfill the requirements of all applicable local, state and federal reporting statutes, including income, sales, insurance, property, and payroll tax returns
• Media / Press. To use available business reports in specific trade and business publications

Accounting Software Program Structure

To navigate more easily in any accounting software it is important to understand the basic organizational structure that is common to all accounting software.  In spite of all the ancillary menu options and all the different terms used by competing accounting software products, there are really only three major components of any accounting software package:  Input, Output, and Maintenance.

Input refers to all of the “bookkeeping” tasks discussed above.  This includes entering invoices, checks, bills, payments, payroll, accounts payable and adjusting entries.  Each accounting software may “disguise” this input function under different names:  “tasks” or “activities”, or it may include specific input functions separately under each cycle area, or it may simply provide icon pictures of activities to be clicked on.  Regardless of the specialized “look” of the program, the most important and most heavily used routine in any accounting software is data input.

Output refers to all of the reporting functions of the program.  Once transactional data has been entered, the only usefulness in having it entered is the ability to retrieve it in a variety of report formats.  Generally, these reporting options are found grouped together under one menu, not surprisingly labeled, “reports”!  However, with some programs, they are scattered throughout the menus as appendages to each major cycle activity.

Maintenance encompasses the accounting tasks and can be broken down into two sub-categories:  utility maintenance and data file maintenance.  Utility maintenance refers to overall utility features like backup, restore, import and export data, fiscal year close, purge, or condense and repair data.  These are all usually found on one menu and are generally placed under administrative password control to prevent unathorized use.

Data file maintenance does require data input, but the input is not transactional.  This refers to the creation and maintenance of the chart of accounts (in support of the general ledger), the customer list, vendor list, inventory list and employee list.  These are generally found in one area usually labeled “maintain” or “lists”.  In other programs they may be separated and found within each module (i.e.: customer list in the accounts receivable module or revenue cycle).

Understanding how your own accounting software works, (where its input, output and maintenance functions are), is as important as understanding the actual double entry accounting that is occurring “behind the scenes”.  As you will discover throughout the Accounting Policies and Procedures Manual, you need to know how the numbers have developed and where they came from, in order to establish effective accounting policies and procedures to insure their integrity, accuracy and completeness for financial internal control.

Accrual Method

The accrual accounting method is defined as the method of keeping accounts which shows expenses incurred and income earned for a given period, although such expenses and income may not have been actually paid or received in cash.  Hence, the financial statements show revenues and expenses, even before any such revenues or expenses are paid.

The accrual method is the more acceptable and the more widely used because it correctly matches the earning process to the activity.  In other words, revenue is recorded when services or goods are rendered or shipped, regardless of when paid.

Cash Method

The cash method of accounting is familiar to most individuals since personal income tax returns are filed on the cash basis.  As the name implies, revenues and expenses are only recorded when the consideration paid actually changes hands.  This could be months after the actual event occurred.

Many small business owners prefer the cash basis due to its simplicity and ease of understanding.  At the end of any given period, the recorded net income will agree more closely to the change in the business’s cash balance.  However, when requesting financing from any bank or agency, business owners are generally asked to furnish financial statements, prepared on the accrual basis.  Clearly any “stakeholders” want to see the true effect on the financial statements of activities, as they occur, as opposed to when they are paid.

Many small businesses (under $1,000,000 in sales) may use the cash basis method for filing business tax returns, even if the business keeps its books on the accrual basis.  In a growing business, income taxes can be deferred for a year for revenues recorded from increases in accounts receivables.

Percentage of Completion Method

The percentage of completion method is a variant of the accrual method, used for businesses with long term contracts, primarily construction contractors.  Instead of valuing revenues based on services invoiced, contractors will adjust the revenue billed to agree with the estimated percentage of the total contract that has been completed to date.

Reporting Standards

Many transactions are entered routinely through the accounting system without much concern about reporting standards.  However, other transactions can be handled in different ways depending on a person’s judgment over the facts and circumstances.  For example, if a business decides to lease an expensive piece of machinery, how should it record lease payments?  Perhaps they should be simply charged to lease expense.   Do you have a lease policy procedure? Your accounting policies should clearly state how to record leases.

However, maybe the terms of the lease imply an obligation and the payments represent a pay-off of that obligation.  In that case, a portion of the payment should be applied to the debt and the other portion charged to interest expense.

The resulting financial statements would look different in those two cases.  The usefulness of financial statements would be severely limited if their presentation was based solely upon the preparer’s judgment.  Consequently, certain standards must be agreed upon and followed.

GAAP – Generally Accepted Accounting Principles

There was no commonly agreed upon standardization over accounting practices for within past accounting systems until after the great depression of 1933.  In response to the vast sums lost by investors in the stock market crash, the Securities and Exchange Commission (SEC) was established and given authority to set accounting standards for publicly held corporations.

In an effort to stave off further government regulation, the accounting profession, organized under the American Institute of Certified Public Accountants (AICPA), issued its first auditing standards in 1939.  This began its attempt at self-regulation, though the AICPA continues to work with the SEC and defers to the SEC on regulatory reporting requirements for publicly held companies.

Between then and 1959 the AICPA issued 51 authoritative pronouncements known as Accounting Research Bulletins (ARB) that formed the basis of what became known as generally accepted accounting principles (GAAP).  From 1959 to 1973 the Accounting Principles Board (APB) issued 31 additional standards.

In 1973 a new full-time independent body, separate from the AICPA was created, called the Financial Accounting Standards Board (FASB).  This board has issued over 147 Statements of Standards by the end of 2002.  These standards, along with official interpretations, Accounting Research Bulletins (ARB), previously issued pronouncements, SEC rulings, industry guides, and other exposure drafts make up the current basket of generally accepted accounting principles.

The Matching Principle

Woven through all of the GAAP pronouncements are several universal principles.  One is the concept of matching.  Accrual and percentage of completion methods represent attempts to more properly match the financial statement presentation to the actual transactions that have occurred.  Revenues are matched to services performed and product sold, and expenses are matched to activities that have incurred expenses.  This is why accrual based reporting conforms to GAAP and cash based reporting does not.  The matching principle is a keystone of generally accepted accounting practice.

Conformity

Conformity is another widely used concept in accounting.  The method of implementing percentage of completion, for example, should be the same for all companies.  Only by practicing conformity will there be comparability.  Investors, lenders and business owners, could not properly evaluate the success of a particular business as compared to the rest of its industry, if all businesses used different methods for recording transactions.  Conformity is another fundamental principle in GAAP.

Valuation

A common consensus in GAAP reporting is the agreement that financial statements are valued on an historical basis.  This is an important concept that provides for consistent conformity.  As an example, real estate is valued at its original cost, not what it might be worth on an appraised value.

Accounting board pronouncements have continued to modify this principle to make financial reports even more conservative than historical basis, by requiring a downward adjustment, if the potential selling value has fallen below the original cost.

An example is inventory, when obsolescence reduces its value below its original cost. Another example is the yearly devaluing of fixed assets through depreciation.  Each year the original cost of a building or equipment is lowered by writing off a portion of its expected life and expensing it to depreciation.  Other assets like accounts receivable are reviewed and written down to their expected realizable value by charging off any amount deemed uncollectible to bad debt expense.

The overall attempt is to present financial statements on the most conservative basis possible.  The objective is to ensure that the net worth recorded on a company’s financial statements is never more than the true value of a company, based upon the lower of historical cost or the expected realized selling price of its assets minus its liabilities.

Events in the early years of the 2000′s have shown how important this objective is.  In spite of all the GAAP pronouncements in place, “creative accounting” techniques that push the gray areas of accounting valuation issues have resulted in significant, previously undisclosed impairments to the financial statements of companies like Tyco, Enron, and WorldCom.

Inventory Valuation

Inventory valuation is a specially treated area that deserves specific mention.  Inventory is always valued at the lower or cost or market (realizable value, net of selling costs).  However, cost can be determined in three different ways.

First In – First Out (FIFO) values the cost of inventory based on the principle that the first item purchased is the first item to be sold.  Visually, this method mimics a store owner’s method of stocking shelves by putting its most recent purchases at the back of the shelf, so that the older product is sold first.  Hence, the value of the amount of inventory on hand, always represents the cost of the very latest purchases.  In a true FIFO valuation, each purchase is tracked as a separate layer with its own cost.  Sales are also tracked and taken from one or more specific layers.

A variant on the FIFO method is the Average Cost FIFO method, which eliminates the need to keep track of separate purchasing layers.  The cost of each new purchase is added to the “pool” which changes the overall cost of the “pool”.  Sales are then taken from this single “pool”, leaving a value of the inventory on hand that closely resembles, but not necessarily equals, the value of inventory on a true FIFO method.

A final method of valuation is based on Last In – First Out (LIFO).  This is the opposite of FIFO: the last items purchased are deemed to be the first items sold.  This means that the ending inventory value is comprised of the very first items purchased.  This value could be lower than the FIFO value, particularly in inflationary times.

One might ask how two opposing methods of valuation could both be allowed under GAAP, particularly, when this would seem to violate the important principle of conformity.  This is one of many good examples of the challenge to create a consensus of opinion when there are several options, which have equal justification and support.  Accounting principles are not static laws handed down from the mountaintop, hence the term, “generally accepted”.

In this case, there is current justification and support for either method.  In deference to conformity, GAAP provides that financial statements valuing inventory on LIFO are to include a footnote reference, which discloses the valuation difference between LIFO and FIFO.  This is one of many compromises that provide conformity over different methods of valuation.

Materiality

A final important concept in all of GAAP is materiality.  Surprisingly, coming from a group of professionals known for their penchant for chasing down pennies, every pronouncement contains a materiality clause that allows for non-compliance in any area, if the effect on the financial statement presentation is clearly immaterial.  In other words, if the effect is minimal or does not represent a significant change in the financial position of the account then it might be considered immaterial.

Balance sheet

Contains accounts whose value is determined at a specific point in time.

Assets – accounts with value that you own

• Cash – the amount on hand or in the bank at a specific point in time
• Accounts Receivable – how much people owe you
• Inventory – the value of business merchandise for sale
• Fixed Assets – the value of property and equipment

Liabilities – accounts with value that you owe to others

• Accounts Payable – how much you owe others for unpaid purchases
• Debt – how much you owe others for money borrowed
• Other Liabilities – services or money owed to others

Equity – accounts with paid in capital or earned from profits.

• Contributed Capital – money invested in business by ownership
• Distributions – dividends and other types of money paid out to ownership
• Capital Stock -            money invested in exchange for company ownership
• Retained Earnings – earnings retained in business from net profits

Income Statement

This statement contains accounts whose value is determined over a period of time (e.g., day, week).

Income: total sales and income recorded over a period time

Expenses: total purchases and other expenses recorded over a period of time

Basic Accounting Formula

All transactions are posted to one or more of these accounts.  As discussed earlier, every posted transaction must balance.  That is, debits must equal credits.  Furthermore, the result of every posting, if done correctly, will never put the Basic Accounting Formula out of balance.  Asset accounts will always equal the total of all liability and owner equity accounts.  If this formula is ever out of balance, the cause will always be an incorrect transaction posting where debits did not equal credits.

Assets include those accounts, which give value to the company: cash, accounts receivable, inventory, property, etc.  Liabilities are those accounts which reduce the company’s value:  accounts payable, debt, and other liabilities.  If total assets are greater than liabilities, then this net value (that is, the total of all assets minus liabilities) represents the true value of the business, otherwise known as its Equity. Hence, the Basic Accounting Formula can be expressed and equally understood in these two ways:

Assets = Liabilities + Equity

or

Equity = Assets – Liabilities

If the company’s assets are less than its liabilities, then it will necessarily show a negative equity.  This makes intuitive sense to anyone following the demise of a business in bankruptcy.  When a business owes more than it has in value, the resulting negative equity is an obvious warning sign.

The equity accounts include owner’s contributions, distributions, and retained earnings.  Retained earnings operate in a manner unique to all other accounts.  It contains the net effect of postings to all income and expense accounts.  It is truly the one account, which links the balance sheet accounts (assets, liabilities and owner’s equity) with the income and expense accounts.

Understanding the importance of retained earnings, the Basic Accounting Equation could be expanded thus:

ASSETS  =  LIABILITIES  + (Investor and owner contributions, and distributions + Retained Earnings)

OR

ASSETS  =  LIABILITIES  +  (OWNER’S EQUITY ACCOUNTS +  INCOME – EXPENSE)

———————EQUITY ———————————

When a transaction, like writing a check or paying a bill, is executed in an accounting program, the software is designed to take this transaction event and create the proper and necessary debit and credit entries to record the effects of the transaction in the appropriate journals and general ledger accounts.  Your accounting policies and procedures should help you acheive accounting control.

Four Main Accounting Cycles

Accounting transactions in the form of sales invoices, receipts, purchase invoices, checks, and payroll entries are posted to the appropriate journals. Simultaneously — as a form of internal control — these postings are recorded in the general ledger, or “GL”. The GL accumulates all transaction activity, where it is organized by account class.

Various reports, including financial statements, can be prepared from the data collected in the GL.  Corrections or necessary adjustments can be made to the general ledger by creating adjusting journal entries, posted to the general journal.

1. Revenue Cycle

Order Entry. Invoices entered through direct entry, sales orders, or a point-of-sale (POS) system, such as a cash register, are posted to the sales journal.  These entries also accumulate on the accounts receivable ledger, organized by customer.  If the business maintains an inventory, the posting of sales also affects the inventory ledger. Finally, all sales journal activity is also posted to the GL.  A discussion of your revenue cycle should be covered in your revenue procedures.

Cash Receipts / Deposits. Receipts on sales and other bank deposits are posted to the cash receipts journal.  Sales receipt information also accumulates on the accounts receivable ledger, organized by customer.  These postings are also entered on the bank account ledger.  Finally, all cash receipts journal activity is also posted to the GL.

Accounts Receivable. Accounts Receivable is a separate journal that records both sales and cash receipt data by customer.  The data comes from the postings to the cash receipts journal and the sales invoice journal.

2. Purchase Cycle

Purchase Orders / Purchasing. Invoices entered through direct entry, or through purchase orders, are posted to the purchase journal.  These entries also accumulate on the accounts payable ledger, organized by vendor.  If the business maintains an inventory, the posting of purchases also affects the inventory ledger.  Finally, all purchase journal activity is posted to the general ledger.

Cash Disbursements / Checks. Payments on account or for expenses are posted to the cash disbursement journal.  Payment on account information also accumulates on the accounts payable ledger, organized by vendor; these postings are also entered on the bank account ledger.   Finally, all cash disbursement journal activity is posted to the general ledger.

Accounts Payable. Accounts Payable is a separate journal that records both sales and cash receipt data by vendor.  The data comes from the postings to the cash disbursement journal and the purchase journal.

3. Payroll Cycle

Payroll data by employees are entered into the payroll journal.  These postings are also entered in the cash disbursements journal and the payroll ledger.  Finally, all payroll journal activity is also posted to the GL.

4. General Journal Cycle

Corrections or adjustments to the above major transaction cycles can be made through adjusting journal entries, posted directly to the general ledger. These are also compiled in a separate journal, known as the “general journal”.

How Does “Posting” Work?

The specific postings, as outlined in the cycles above, do not necessarily take place as separate steps, especially in computerized environments.  There are only two basic posting methods in computerized accounting systems: real-time and batch posting.

In real-time posting, the source transaction (check, bill, payment, receipt, etc.) is posted to the specific journal and any related subsidiary ledger (e.g., accounts receivable, accounts payable, inventory) and is simultaneously posted to the general ledger.

In batch posting, the journals and subsidiary ledgers are posted, but entries are not yet posted to the general ledger.  Posting these journals to the general ledger is done separately.  Typically, a group of transactions (often a full day’s worth) is entered.  Later, after the journals are reviewed for accuracy, this entire day’s group, or “batch”, is posted to the general ledger.

To understand this posting process better, it would be helpful to follow specific transactions through a sample company.  First, however, we need to define various accounting terms and concepts.

Accounting Terms and Concepts

Double-Entry Accounting

We can thank the 14^th and 15^th century Italian merchants for developing the double-entry system of accounting that we still use today.  It is widely believed that Benedetto Cotrugli (aka, Benedikt Kotruljevic) was the first to document this concept of double-entry accounting (in his accounting policies and procedures, perhaps?).  In 1458, he wrote Delia Mercatura et del Mercante Perfetto (Of Trading and the Perfect Trader), which included a brief chapter describing many of the features of double-entry accounting.

In 1494, Luca Pacioli, from San Sepulcro in medieval Tuscany, published the Summa de Arithmetica‘s 36 short chapters on bookkeeping (entitled De Computis et Scripturis, or “Of Reckonings and Writings”) so the subjects of the Duke of Urbino could learn how to conduct business and provide the trader with a fast, accurate method to determine his assets and liabilities.

For many centuries before this, commercial transactions had been recorded — journalized — on paper, papyrus, or clay tablets.  However, these journals provided only totals of transaction groupings. It was the Italians who first recognized that it is impossible for a business transaction to occur without affecting at least TWO accounts. There can never be only one effect from a transaction — there has to be balance.

An Italian farmer sells wood to a shipbuilder for 400 ducats. To account for this transaction, he would record, “wood sale – 400 ducats”. His “sales” account has increased by 400 ducats. But, what else has happened?  What other account was affected? His “cash” account also increased by 400 ducats.

What if he sells his wood to the shipbuilder on credit and receives no cash? In this case, it’s his “accounts receivable” account that increases by 400 ducats.

There Are Always Two Sides – at Least – to Every Transaction

Later, when the shipbuilder pays his debt to the farmer, the farmer records an increase in his cash account and a decrease in his accounts receivable by 400 ducats each.  You can see that an integral feature of the double-entry method is that transactions must equal. At the time, this new method was heralded as an astounding discovery and was described as “a magic mirror, in which the adept sees both himself and others.”

Today, double-entry bookkeeping is used for recording a transaction in two or more different places, or ledger accounts.  This practice simplifies finding errors since the totals of both ledger accounts should agree.

Debits = Credits

Bookkeeping entries are divided into debits and credits. The debit side is typically the left side of the ledger page and credits are on the right.  The origin of the words “debit” and “credit” come from the simple concept: “who owes you” and “to whom you owe”.

Debits are transactions relating to purchases, expenses, or increases in an organization’s assets. Credits are transactions related to revenues, or an increase in the firm’s equity and liabilities. Recording a transaction requires a debit and a credit entry.  If the entries are correctly recorded, the totals on both sides of the ledger agree.

The double-entry bookkeeping method — listing debits in one column and credits in the other — requires that the debit and credit columns add up to zero. The double-entry bookkeeping method is still the basis for tracking financial affairs, almost six centuries .   The following list illustrates the effect of posting a debit or credit entry on each major account type:

These account types are the general account classifications used in all accounting systems.  They are also used to organize the general ledger, from which financial statements are developed.  Your accounting policies and procedures should take into account the main accounting cycles, accounting methods, and accounting terms to guide the operation of your accounting system.

On one hand, popular accounting programs for small and mid-sized businesses have become more widely used than ever before.  On the other hand, industry consolidation has significantly reduced the accounting program choices to a handful.  These choices are typically inexpensive, easy to implement, and come with little support to develop appropriate accounting policies and procedures to ensure that the data generated by these programs is accurate and complete.  Entry-level software like Quickbooks® and mid-level software like MAS-90 or Great Plains share this common deficiency.  “Support” documentation is long on the explanation of user features and short on accounting policy and procedural advice.

Accounting Systems – The Recent Past

Only twenty years ago, small to medium sized businesses faced daunting choices for selecting an accounting system.  There were only three choices:  Continue to use a full manual system (a comprehensive pegboard “one-write” system, employing many journals anchored to an imposing cloth bound general ledger book that rivaled the size of the largest Webster’s Dictionary); purchase or lease a computerized accounting system; or build your own automated system.

The manual systems were not trivial.  They were produced by major firms, which provided on-site implementation and training.  These systems were well documented with many accounting policies and procedures built into the regimented use of the “one-write” journals and corresponding ledgers.   Internal controls were manual at best.

An alternative decision was to purchase or lease an automated accounting system.  But this required another decision of whether to buy a “ready made” product or build your own.  To make this decision, the company would typically hire a consultant or CPA firm to perform a comprehensive “needs” analysis.  The consultant would eventually select, either a commercially built multi-module accounting program (like Solomon, our Real World), or a programmer to develop the structure from custom code (RPG was a popular language used to create custom accounting programs).

Either one of these alternatives would have to run on a leased or purchased dedicated mini-computer system, (the IBM 36 was the popular mid-size business choice for many years).  Both solutions required tremendous resources in time and money.  Even the “ready made” solutions required plenty of additional programming to fit it into the specific company’s needs.  For a half a year or more, various consultants, programmers and specialists would write code, test and rewrite code.

In either case, documentation was paramount.  Hence Accounting Policies and Procedures, as they applied to the mechanics of the accounting system were well documented as a by-product of the installation and implementation process.  The total costs in the purchase or lease of the hardware and software (ready made or custom built), and in the company’s own human resources, was staggering.

Accounting Software – The Present

Imagine the months of decision making preparation, the months of development, the reams of Accounting Policies and Procedures documentation, and the total costs that easily went from tens of thousands to hundreds of thousands of dollars.  Compare this with current practice: The company owner (or the controller or other designee) walks into a local retailer, picks up a copy of the most successfully marketed accounting software package (i.e., the one occupying prime shelf space), drives back to the office, and loads the program on any available PC.  There you have it – the decision making process, needs analysis, implementation, and installation, all for one low price…or is it?

None of these accounting programs comes with supporting accounting policy and procedure documentations.  Internal controls do not exist and require manual processes and extra paperwork.  Your accounting software does not come with support  to help in your compliance with Sarbanes Oxley.  Of course you can develop your accounting policies and procedures yourself, from scratch.  But, this take a lot of time and expertise.

Accounting Practices – The future

The future begins today, with your purchase of this Bizmanualz™ Accounting Policies, Procedures and Forms.  This manual is needed more now than ever.  Accounting systems are more accessible than ever before.  Unfortunately, they come with no instructions.  The user guide that comes with the accounting software only explains what the menu options do, it doesn’t explain which options result in sound accounting practices.

Accounting software is looking more and more like your own internet browser home page, (no surprise since each manufacturer is competing to be your primary web portal).  New Accounting Software as a Service (SaaS) applications will make this a reality.  But, in the process, the actual functions of accounting are less obvious, and as a result, less understood.

This article series will take a look behind the scenes of the “splash screen”.  Hopefully, by understanding the concepts and consistent accounting rules utilized by all accounting software programs, you will develop more confidence to rely on the information generated by the program, you will have a deeper appreciation of the importance of accounting policies and procedures for internal control, and you will be able to use it more effectively to run your company.

That’s when your boss says, “Process? Did I say ‘process’? I meant processezzz! Plural!”  And before you can blurt out, “What do you mean?”, the boss says you need to develop procedures for all accounting processes, not just the one.  Oh, and he wants them by the end of the month!

A weak “Sure, boss…” escapes from your lips as “el jefe” turns and leaves, but an instant later, you’re thinking, “No way!”  You can’t possibly get all your accounting processes documented that quickly!  Or can you?

Break Down the Documentation Process into Its Component Parts

Start by mapping out the business process you need to document.  The process map acts as an outline for your procedure writing: you have to know the steps in the process that need documenting before you start writing.  With process maps in hand — one for each business process — you’re ready to start writing procedures.  Here’s where using pre-written procedures can save you time.

How You Can Use a Pre-Written Procedure to Save Time

If you’re looking for sample accounting procedures for your accounting processes, the Bizmanualz CFO Accounting Policies-Procedures Manuals set contains many sample accounting procedures you can use as starting points.  The CFO bundle contains 239 prewritten accounting procedure templates and 373 accounting forms, organized into five functional areas, or business manuals.  The CFO set covers the ten core accounting cycles.

Once the manuals arrive, the next step is “find an example procedure – a model for the one you need to write”.  All Bizmanualz procedures are in Microsoft Word format and can be easily tailored to fit your specific business process.  Let’s say you’re writing a procedure for vendor acquisition, or the “new vendor” process.  Where would you start?

The vendor process map you wrote shows eight steps:

1. Evaluate business requirements;
2. Identify qualified vendors;
3. Interview, Inspect and test vendor;
4. Review results and approve vendor;
5. Order from vendors;
6. Log orders and delivery performance;
7. Review performance against specifications; and
8. Vendor-related corrective and preventive actions.

Accounting Manual Index

The Accounting Policies, Procedures, and Forms manual contains a Vendor Selection procedure that you can customize.  How do you find it?  In the back of the manual, you’ll find the “Index”.  Search the index for your keyword, “vendor”.  (You could also look through the table of contents in the front of the manual.)  You find the Vendor Selection procedure, containing three steps, or activities (Vendor Selection, Vendor Inspection, and Vendor Files), in the “Purchasing” section.

Your process consists of eight activities, so you expand the prewritten procedure, adding the other five steps, or otherwise modify the Bizmanualz procedure to reflect your actual situation.  Add your process map (a handy visual aid) to the front of the procedure, and you’re done!

Writing a new procedure can take between 4 and 40 hours, depending on the complexity of the process you’re documenting and whether forms are required.  The complexity of a process, as well as your level of expertise in that subject, determines the amount of research — into standards, laws or regulations, references, and the like — you need to do.  Forms also require time and effort to research and produce, assuming you don’t already have them.  The Bizmanualz Vendor Selection procedure contains six pages of forms, including a detailed vendor inspection checklist.  Many Bizmanualz procedures also include a “References” section, which can help you as you research certain topics.

Let’s say this is a 40-hour procedure to create, with forms.  If you use the Bizmanualz procedure, with minor modifications you could have the same procedure ready in less than a day, saving yourself a great deal of time (and your eyes, a lot of wear).  Using a single procedure, saving 38 hours of time off the 40 you planned on, practically pays for the entire five-manual CFO series.

And you’re going to find more than one procedure you can adapt to your business requirements.  Most companies find dozens of useful procedures, which translates to hundreds of hours of time saved, before you factor in the opportunity cost of waiting for the procedures to be completed.

So, the next time you need to write procedures fast, take a look at the complete collection of Bizmanualz business policies and procedures.  Get your procedures project done now…before the end-of-month deadline your boss gave you.

Cash Management is Vital for Internal Control

Sloppy approaches to cash management can lead to temptation. Employees handling a significant amount of cash carry the greatest opportunity for fraud or abuse. Cash handling procedures are used to minimize cash handling risks. Multiple cash counts by different people make the basis of sound cash controls.

For example, the same person who handles the money should not be the one accounting for it. Cash funds should be counted often and by at least two people. Different people should handle cash, checks and deposits from those who record them in the books.

Cash handling procedures are one area auditors examine. Poor cash management policies and lack of control over cash handling will certainly make a poor impression, and possibly even impact an auditor’s perception of your accounting practices. Good controls using cash policies and procedures that are clearly communicated and regularly audited internally indicate to external auditors that cash controls are working.

Cash Policy and Cash Procedures Set Organizational Tone

Not only do proper cash policies and useful cash procedures send a clear signal to auditors, it also creates the required operating environment for employees. Due diligence and transparency involving regular management activity (including creating and updating cash policy and procedures) sets a tone that professionalism is the standard. Mistakes that are quickly caught and corrected convey a clear message about the importance of proper cash management.

Understanding key elements of your business, setting the proper environment for employees, creating a positive impression for auditors; these are just some examples of how proper cash policies and procedures can help your business. If you don’t feel you have the proper cash management controls in place, it is never too late to start. Begin by understanding your cash processes and identify what is important and what risks you face. Address them by creating cash procedures that incorporates data collection and review as well as the typical controls such as second person reconciliation.

If your business relies on cash flow, as most do, why would you leave cash management to chance?

This obviously includes the accounting department. We know from COSO and Sarbanes Oxley compliance that accounting procedures are an important element of internal control. Organizations spend a lot of effort to produce an accounting manual containing accounting policies and procedures. So, if you are going to produce an accounting manual with accounting policies and accounting procedures, how can you make the most of the effort you put into them?

There are two important questions you should ask about your accounting procedures:

1) How well do your accounting procedures accurately capture your accounting cycles or processes?

2) How can your use your accounting procedures to benefit your organization?

A Positive Contribution from Accounting Procedures

Your accounting procedure probably describes an accounting process as a collection of process steps and associated rules. For example; a collection process might send out collection notices, make phone calls, collect money, deposit money; and then repeat.

Where in this accounting process, however, do you collect data that measures how effective the accounting process is? When are you comparing results to objectives? In a more broad view, control is more that just a set of steps and/or a list of rules. Control is awareness of how well your accounting processes are carrying out important functions. On this path the accounting processes your accounting procedures describe can really provide an important contribution to your business.

The legal, regulatory and ethical concerns surrounding accounting processes only emphasize the importance of having good accounting procedure documentation. But the difference between a controlled accounting process with measurement and review and an uncontrolled accounting collection process can be described with one word: success.

A Different Version of an Accounting Control Procedure

Controlled processes collect data as in integral part of the business process steps. Now, at regular intervals, the data can be reviewed and accounting process effectiveness evaluated. Are objectives being reached? If not, why? Are the objectives meaningful and reflect importance and risk? Now, the necessary corrections can be identified and implemented as a result of the review.

For example; a controlled accounting collection process might send out two different collection notices to test the response rate of different notices, you may also make phone calls at defined intervals to determine the response rate. Collecting data means making reflective and meaningful adjustments to the business process.

Typically, auditors accept accounting procedures that list steps and rules, with lots of inspection and verification steps, as an adequate internal control system. What value, however, does that internal control system provide for your organization? As a business owner, CFO, Controller, or accounting department manager, is an internal control system that does the bare minimum good enough?

Using Process Analysis to Develop Standard Accounting Procedures

Understanding the accounting processes is the first step in being able to document them with well-written accounting procedures. Besides noting the steps of the accounting process, consider the following:

• Who is the accounting process owner?
• How do accounting processes interact? What are the inputs, outputs, customers, suppliers?
• What are the most important facets for process and organizational success?
• What are the risks associated with the accounting process (what could go wrong and how material would it be?

You might find process maps, flowcharts, or similar tools useful during this phase. Be sure to identify accounting process objectives, key metrics and how they are recorded, as well as how frequently they should be reviewed.

Once you start reflectively analyzing your process, you may notice better approaches or waste that can be eliminated. You might, however, want to avoid introducing too much change too quickly. One strategy is to introduce the most important changes first (according to risk, return, etc…,) then introduce more process improvements over time through other improvement activities. Once you understand your process and incorporate process improvements, data collection, and review, you are ready to start writing your accounting procedures.

After planning and analyzing an accounting process, writing an accounting procedure to document it should seem easy. One tip is to focus on describing the accounting process and avoid too much mundane detail (i.e. computer instructions). Too much detail makes the accounting procedure unfriendly to users, and those details are only needed by beginners anyway. Keep that information in training materials or work instructions.

Remember, simplicity and consistency (even with other organizational procedures) is a positive attribute of an accounting procedure. It is easier to add necessary information later as needed than it is to identify and strip out useless information and needless detail.

Accounting Procedures to Benefit Your Organization

This approach to writing an accounting procedure that describes a well-defined, controlled accounting process aligns with the concept of accounting policies we presented last week. The accounting policy clearly communicates goals, and the accounting procedure communicates the accounting process in order to execute it and reach the goals. The periodic review of accounting process objectives provides feedback for the accounting policy ensuring it is still current in reflecting what is important to your organization.

To learn more about Bizmanualz Accounting Procedures go to http://www.bizmanualz.com/accounting/ and check out the Accounting Policies and Procedures Manual or sign up for the Bizmanualz Newsletter and download a free sample accounting procedure right now.

Accounting Policies Communicate Strategy

Accounting policies are an important way to communicate management’s philosophy or vision for running the organization.  It is within this framework that employees use accounting policies to guide decision making as well as establish effectiveness criteria, key performance indicators, or metrics that help determine the organization’s level of success.  Implementing accounting policies and procedures is one method of creating the internal controls needed for a successful and compliant (i.e. SOX) organization.

Accounting policies that don’t communicate management’s vision for operations, but simply state hard and fast accounting rules without explanation are less useful in communicating with employees.  Let’s take a look at a credit policy that expresses overarching goals:

The organization should provide credit in a timely manner to maximize sales and minimize risks in collections.

In other words: The organization provides fast credit to customers who will pay.  This is an example of management’s philosophy.  In order to fulfill the goal with objectives, we will need to establish effectiveness criteria based on stated goals: timely manner, maximize sales, and minimize risks.  This, however, is what a well-defined process does.  It establishes specific effectiveness criteria that can be modified to the changing conditions that all businesses and departments face.  The specific, measurable objectives have flexibility because the overarching goals of the policy remain constant.

A rule based accounting policy could be written as:

The organization provides $5,000 in credit to first time customers.

Does this leave the credit staff any latitude to make decisions to fulfill the mission?  Do you want your credit staff to follow accounting rules even when they are wasteful or detrimental to sales?  In this instance they could turn away a potentially great customer with an excellent credit rating because of this rule.

This is an example of a ballistic process focused on static credit criteria.  There is no way to judge how effective the policy and process are because people just follow the rule with no method of measurement or evaluation.

There are always exceptions to the rules, but when rule-based policies are given (instead of an overarching strategy or philosophy behind the rules), then employees are not empowered to make those decisions.  Accounting management should always be looking for ways to empower staff members to make good decisions, and a big impediment to making good decisions is the lack of information. Creating an accounting manual of clearly written accounting policies and procedures that express management philosophy is one way to communicate important information to the staff.

Accounting Policies Lead to Performance Criteria

Viewing accounting policy as way to communicate information about the overall mission or strategy of a particular function or accounting process does aid and inform organizational members.  When these overarching goals of the accounting process are translated into specific metrics or effectiveness criteria, now the puzzle is complete.  Your accounting policies should provide the guidance that helps establish criteria, but the accounting policy itself should not be the criteria.

In terms of an accounting manual for internal control, which method provides better internal controls: a set of accounting rules that may or may not be followed; or expressed guidance that fulfills organizational goals and leads to establishing criteria, which in turn clearly demonstrates how effective accounting processes are carrying out accounting policies?

Rules may be followed, and one could claim that they provide control.  But expressed rules will never play a role in improving the organization, and improvement should always be an organizational goal of any accounting manager or organizational leader.  Thinking of accounting policies as an expression of mission or strategy is a positive step in establishing clear communication with your staff and starting down the path of continual improvement.

To learn more about Bizmanualz Accounting Procedures go to http://www.bizmanualz.com/accounting/ and check out the Accounting Policies and Procedures Manual or sign up for the Bizmanualz Newsletter and download a free sample accounting procedure right now.

The Typical Accounting Manual

When exploring accounting manuals on-line you can see the table of contents and perhaps samples from accounting manuals available for purchase, and you can also see actual accounting manuals developed by public entities like universities and state/local governments. No matter where you find a sample accounting manual, they seem to have a lot in common.

Almost all of these accounting manuals are a set of accounting procedures that provide rules and guidance for various accounting functions and operations like petty cash. They typically employ what we could call the “Thou Shalt” approach. Sometimes they provide particular information like cost center account codes. At times these accounting procedures do an adequate job of describing the accounting process, and other times they read more like a list of accounting rules.

In almost every case, the accounting procedures have a ballistic approach, meaning that the accounting procedures may list the accounting steps to be carried out in the process, but rarely are any criteria established that would indicate whether the process is being carried out effectively and fulfilling organizational goals.

A Managerial Accounting Approach

Does an accounting manual that just consists of a set of accounting policies meet your needs as the accounting manager? What information do you need to establish and convey in your accounting department? If one reason you need an accounting manual is Sarbanes-Oxley compliance, then it is hard to see how a set of ballistic accounting procedures provides the internal control required by SOX Section 404. Plus, it is particularly difficult to see how a set of ballistic procedures can help management assess the effectiveness of the internal control system as required by SOX Section 302.

A different approach would be to include additional materials besides accounting procedures in the accounting manual. As an accounting manager you may want the level of consistency that “Thou Shalt” style accounting procedures provide, but that doesn’t need to be the entire content of the accounting manual.

Selecting an Accounting Manual Approach

In a recent article we talked about using risk management to create internal control systems. An accounting manual is one place you could begin to assess accounting risks by defining core accounting processes and the interaction between processes (i.e. inputs and outputs). With core processes identified, risk assessment can be applied by addressing what could go wrong, along with the likelihood and materiality of these risks.

Another approach to creating an accounting manual is to follow an ISO 9001 approach. While often associated with manufacturing and production, ISO 9001 is really an approach to creating effective management systems that can be universally applied. Using an ISO process approach, the accounting manual would include information on organization structure (your org chart), designated responsibilities of management and staff members, as well as identifying core accounting processes and their interaction. Also, following the ISO example, accounting procedures would employ the PLAN-DO-CHECK-ACT approach to processes (as opposed to the ballistic process approach of simply writing down the rules).

A Different Approach to Accounting Manuals

The Bizmanualz Accounting Policies, Procedures & Forms takes a hybrid approach that combines elements of risk management along with elements of an ISO style quality management system. The Accounting Manual section is completely separate from the included accounting procedures. The Accounting Manual includes information such as the following:

• Detailed descriptions of scope and purpose
• Typical accounting organization structures
• Establishes core accounting processes and the interaction of sub-processes (that constitute the core processes)
• A list of accounting policies
• The accounting resources required

Listing all accounting policies in one place (as well as in applicable accounting procedures) allows accounting managers, controllers and department leaders to recognize where policies align and where there are inconsistencies and conflicts between policies that require resolution.

The procedure sections in Bizmanualz Accounting Policies, Procedures & Forms are divided into the core accounting cycles (processes):

• General and Administrative cycle
• Cash cycle
• Inventory and Asset cycle
• Revenue cycle
• Purchasing cycle

Each section includes 5-10 procedures documenting in detail the sub-processes that constitute these core accounting cycles.

A set of ballistic accounting procedures may not meet your long term organizational needs for an accounting manual. There are alternatives to the ballistic approach but before you decide what goes into your accounting manual, decide why you need an accounting manual in the first place. Then deciding what goes in your accounting manual becomes much easier. Let us know your thoughts and comments about what you need or would like to see in your accounting manual.

To learn more about Bizmanualz Accounting Procedures go to http://www.bizmanualz.com/accounting/ and check out the Accounting Policies and Procedures Manual or sign up for the Bizmanualz Newsletter and download a free sample accounting procedure right now.