What makes an accounting system 'good'?

Electrical Apparatus, Feb 2005 by Wiersema, William H

Why managers can't afford to leave accounting entirely to the professionals

MANY MANAGERS FIND IT DIFFICULT TO evaluate their companies' accounting systems. After all, accounting is typically not their specialty. Instead, they leave the evaluating to the accountant they hired to do it. Sometimes they find that their trust has been misplaced, often too late to save their companies from chaos and excessive expense. Poor records can have terrible implications, including unpleasant surprises arising from correction of misstated presentations.

Managers will unquestionably benefit from being able to conduct their own evaluation. They will be better able to attain a comfort level with their financial records, as well as evaluate their accountant. They may also stave off potential disaster.

Stability of key relationships

An immediate tip-off of an inadequate financial report is when key relationships fluctuate from month to month. One key relationship is the gross profit percentage, which is equal to sales minus cost of sales, divided into sales. Another is the percentage of material to sales and that of labor to sales. Unless pricing policies, mark-ups, or volumes change significantly, one would expect stability in these relationships from month to month.

Fluctuations may signify misstatements of account balances, such as accounts receivable, inventories, or accounts payable. They may also indicate poor cut-off at period end, in which items counted as inventory are not fully reflected in accounts payable, or where items shipped and invoiced from inventory have not been appropriately recorded. These errors cost credibility when they inflate borrowing bases or financial performance.

Operating expenses may also vary month-to-month when improper accounting is used. This inconsistent variation makes the actual cash needs of a business unclear. For example, annual insurance premiums may be improperly expensed when paid, rather than amortized over the period benefited. Weekly payroll, when not accrued at month-end, may incorrectly have four week's expense in some months and five in others.

Reconciliation of accounts

Accounts presented on the financial statements must reconcile to the underlying details. A binder containing these reconciliations should be assembled at month-end. It should document all of the major balance sheet accounts. Often, a copy of the last page of an aging, for example, will be used to document the reconciliation.

Cash in bank as recorded on the books, for example, should reconcile to the bank statement, after adding deposits in transit and deducting outstanding checks from the bank statement. If the company owes money to the bank through a line of credit, similarly, the loan statement should also be explicitly reconciled to the accounting records.

Accounts receivable should reconcile between account balance and detailed aging of accounts. In systems that require simultaneous postings, this should not be an issue. If details can be edited without reflection on the general ledger, however, adjustments may be made that create an imbalance between the two. Additional control over accounts receivable comes from sending customers monthly statements of account, to assure that disputes are dealt with in a timely manner.

Inventory is subject to its own special set of issues. In some instances, perpetual records may not be maintained, or they may be considered unreliable. In these circumstances, inventory between physical counts may need to be estimated. A common way of doing this is to increase inventory balances for items purchased, and then relieve them at an historical material cost of sales percentage applied to net sales for the month.

Say, for example, that XYZ Service began the month with $350,000 in inventory, purchased $200,000, and recorded parts sales of $500,000. If the average markup is 100% for a 50% gross profit, the estimated cost of sales for the month is $250,000. This implies an ending inventory balance of $300,000, because the company had $50,000 in more goods sold than purchased.

A problem arises with these systems to the degree that estimates differ from actual counts at year-end. A company showing itself as profitable the entire year may suddenly be showing a loss. This discrepancy costs the company the confidence of banks, investors, and other creditors.

Accounts payable must also be reconciled. To ensure that liabilities appropriately reflect all items purchased, accounts payable records must be in sync with those for inventory. Procedures must provide for the proper accrual of liabilities for inventory received but not yet invoiced by vendors. An example of an appropriate procedure for accounts payable is contained in Table I.

Similarly, worksheets for accruals must be prepared each month. A major item is payroll, which should be prorated by the number of days within the accounting period. If payrolls are paid weekly and two days of the next month's payroll fell in the current month, those two days should be set up as a liability. Similarly, other accrued expenses, such as commissions, should be computed and documented.