Accountants should be aware of how they are used, designed and reconciled as an advanced skill set in accounting. This lesson explains all three forms of accounts and how they are used in business. The actual details of designing and reconciling them are explained in successive lessons following this introductory lesson. Reporting and interpretation is also explained in each of the corresponding lessons; this lesson introduces each of the three and why they are temporary accounts.
Internal accounts are used by management to either clarify certain aspects of the financial reports, track transactions between departments, or for uncertainty with information. The primary purpose is to provide tracking information to management.
To assist the reader in understanding internal accounts, illustrations are best. So let’s start with clarity of financial information.
Clarity of Information
In earlier lessons I explained how control and parent-child accounts are used to sum information into a single value. Control accounts are used with intensive volume of different customers or vendors; therefore accounts receivable and payable are traditionally control accounts. Parent-child accounts use a hierarchical structure to sum information into one value. When either a control sub-account or child account has its own structure these sub-accounts have little value to an outside reader of financial information. The real value is to management. A typical investor doesn’t care that customer Smith has three ongoing projects with the company; management cares, the outside reader such as the bank will only care how much Mr. Smith owes the company in all. Look at this illustration of a control account for work in process.
In this illustration, there are four ongoing projects for the following amounts:
Project number 160728 has three components totaling $80,896. An outside reader doesn’t need the details. However, management wants to know the respective costs for not only the primary contract but the amounts for the respective change orders. This way the customer is billed appropriately and analysis can be applied to each change order as if it were its own project; see project accounting for more clarification. The level of sub-projects is really a function of internal accounts, accounts used by management for management purposes only.
I’ve seen this level of detail in all sorts of control accounts. With payables, some companies separate a vendor’s bill into sub-accounts related to production runs or functions of a business. For example, cell phone bills can be separated by departments.
This same concept exists with parent-child accounts. Grandchildren accounts are customarily internal accounts as they tend to provide no real value to an outside reader but are extremely important for management purposes. Here is an illustration of a simple inventory account structure for a glass bottling manufacturer.
Chart of Accounts – Inventory Section
. (Internal Accounts)
Parent Account Child Account Grandchild Account
. – Sand
. – Soda
. – Lime
. – Oxides (Color)
. – Nickel
. – Cobalt
. – Selenium
. – Copper
. – Cullet (Recycled Glass)
. – Boxes
. – Bottle Cases
. – Internal Packaging
. – – Spacers
. – – Single Flats
. – – # 16’s
. – – Wrapping Paper
. – – Tape
. – – Bubble Wrap
. – – Sealant
. – Bottles
. – Brown
. – Clear
. – Blue
. – Jars
. – Plates
The internal accounts exist to assist management with inventory control and ensuring proper color and packaging. The internal accounts have little to no value to an outside reader of information. It is even most probable that the outside reader gains little value with account values at the child level of accounting; the outside reader isn’t going to care how much was spent on wrapping paper in the above illustration.
This clarification level of accounting is also found within the cost of sale accounts. For example some contractors will break materials out into sub groups like lumber, stone, fill etc.
Sometimes management isn’t interested in this level of detail but is interested in the relationship between departments.
Transfer to Departments
In Lesson 71 I introduced departmental accounting. In that lesson I explained departmental accounting as a function of the income statement. Internal accounts take departmental accounting to a whole new level of management understanding. Sometimes owners and management want to know how well one department performs in comparison to another department; temporary accounts act as a departmental manager evaluation tool. To do this, the accountant creates an internal account for each department as both a sales and cost of sales account for the respective departments. Look at this illustration to better conceptualize this purpose.
RV World sells new and used RV’s, trailers, 5th wheels and pop-ups. In addition RV World has a service department, parts department and a finance/insurance department.
The owner has four separate managers and gives them autonomous control over their respective departments.
When a used RV is received as a trade-in for a new RV contract, the sales manager sends the used model to the service department for repairs, upgrades and complete overhaul prior to putting the unit back in inventory for sale to customers. The service department charges a fee; just like it charges a regular customer for this work. In turn, the service department buys parts and cleaning agents from the parts department which in turn sells these items to the service department. So both the service and parts departments have internal sales or in business called interdepartmental transfers. These internal sales are not sales in the financial sense for external reporting purposes as ultimately they become a cost component of the used RV’s total cost which is reported when that unit is ultimately sold. Take a look at the relationship of these internal transfer transactions in this departmental management report. This report is configured around this one unit.
Departmental Performance Report (VIN # 7642)
. Inventory #7642 Service Dept. Parts Dept.
Trade-In Value $17,400
Internal Sales $4,707 *A $796 *B
Costs Parts/Service 4,707 (592) (402)
Costs Labor (1,346) (47)
Costs Supplies (204) (71)
Departmental Gross Profit – $2,565 $276
Inventory Balance $22,107
* A – Ticket # 160817
* B – Ticket # 2004793
The goal of this report is to account for the total cost of unit # 7642. The $4,707 of service as an additional cost to the used unit’s inventory cost value is no different than if the dealership sent the RV out to an independent shop and was charged $4,707 for the work (known as a sublet in dealership accounting terminology).
The same principle holds true for the service department. It had to buy parts for $796 from the parts department. The parts department has costs for these parts too.
Now for an interesting internal accounting principle, the dealership reports nothing on its income statement. Why? Because it hasn’t sold the unit yet. That unit sits on the lot still. Its cost value has increased to $22,107. The real hard dollars are as follows:
Notice I did not include the $204 cost of supplies from the service department. This is because this is the charge as one component of the parts ticket of $796 from the parts department. The original cost of these supplies to the dealership is $71 as noted above (add parts and supplies together for $796, the charge from the parts department).
The inventory balance is $22,107. Of this amount, $2,841 is deferred or internal profit. The service department has a margin of $2,565 and parts has its share as $276. The two combined equals the unrealized gross profit of $2,841 for these departments. Once the unit is sold, the departments will have realized profits.
As an accountant reading this, I’m sure you are shaking your head in disbelief. This appears as an accounting nightmare. The lesson about internal accounts will clarify this more; but for this lesson, these temporary types of accounts are used to account for transfers between departments.
The third form of an internal account relates to uncertainty.
Uncertainty (Suspense) with Economic Transactions
A very common occurrence with accounting includes economic transactions that are not clear. In small business, this is almost a daily event. In effect the accountant needs more information before finalizing the transaction. In the interim, the accountant records the transaction using suspense accounts. As indicated in Lesson 55 there is a suspense account with each type of account. The idea is to record the transaction where it most likely will prevail. The accountant then waits for more information to properly record the transaction.
So, suspense accounts are an internal account of temporary accounts.
Unlike internal accounts which are used for financial clarification, interdepartmental transfers and suspended transactions; regulator accounts are temporary accounts used to control/monitor production and comply with budgets. These types of accounts are very common with government and nonprofit accounting. In these cases, the entities must be able to answer with details of how money was spent. In private business, budgeting or compliance is done with the use of purchase orders and work orders.
The following two sections explain in more detail the similarities and differences involved with production control/monitoring accounts and budget based accounts. The overall key to regulator accounts is that they guide the operation to financial success.
Production Control/Monitoring Accounts
In large companies there is often a set of accounts used with cost accounting strictly related to production. One account may be used to monitor the output rate of the production line, another measures the flow rate for raw materials consumption and so on. Basically the accounts act as unit counters for overall production or for certain systems. The goal is to measure progress and stay on track to achieve a goal.
In small business, a similar set of accounts is used to monitor performance. The difference is that small business can’t afford a separate accounting software to conduct a second set of books. So many existing accounting software programs allow the user the ability to set up dormant or information only accounts within the chart of accounts. These silent accounts do not add or subtract with the trial balance or with financial reports. However they are printed with the financial reports in a separate set of management reports.
As an example, a public golf course keeps track of the number of rounds of golf played. The sales value reflects different dollar amounts depending on weekday, weekend, and twilight rates. Here is an illustration of the sales section for the course.
The units line is not included in the summation values; it is strictly dormant and is used to evaluate production. The golf course uses the same concept with cart rentals, lessons and with the snack bar. Traditional retail accounting software has this built-in as a function of its internal reports.
These types of accounts are common with the following financial accounts:
* Materials – volume sold or used
* Labor – hours of work based on skill
* Transportation – number of miles driven corresponding to the type of vehicle
* Utilities – consumption of the respective kinds (water, sewage, gas, electricity)
* Inventory – number of units on hand
* Sales – units sold based on UPC (Universal Product Code)
Budget Based Accounts
Another type of regulator account which is normal in medium and large business operations are purchase orders. Purchase orders indicate a commitment to a vendor to buy a certain dollar value contingent on delivery within a time frame. This is a form of budgetary control. Just like unit sales accounts, purchase orders are for information only and are not found in the financial statements.
Very similar to purchase orders are work orders, i.e. requested work volume from customers.
Both purchase orders and work orders are explained in more detail in future lessons. Both can and should be used in small business but are not recommended for microbusinesses. In addition to purchase orders and work orders there are traditional budget accounts. I explain budget accounts in more detail in future lessons.
Restrictive accounts are usually found on the balance sheet. They are used for legal and contractual compliance. They include cash accounts and offsets. Common names include escrow, reserves and sinking funds.
For those of you not aware, sinking funds are mostly temporary investments or set asides for use to purchase fixed assets or retire a fixed asset. Examples of sinking funds are used with mining companies that set aside money to restore the mine (fill in the hole, seal off tunnels/chambers, plant trees, etc.) back to a natural state.
The most common restrictive accounts are escrow accounts. Escrow accounts are cash funds held by a third-party and used (paid out) in accordance with contractual timing. Very common escrow accounts are taxes along with insurance paid with mortgage payments. A part of each mortgage payment is composed of escrow monies held by the mortgagor and released to the government or insurance company when the bill arrives. Escrow accounts are customarily located in the cash section of the current assets section of the balance sheet as illustrated here:
Sometimes reserves are contra accounts towards a particular loan or bond. Accountants often carry these in the long-term liabilities section of the balance sheet.
It is rare to even see a restrictive account on the income statement.
Summary – Temporary Accounts
To assist management in meeting financial and production goals, accountants use temporary accounts. Temporary accounts exist in three different forms.
A) Internal – Accounts used to clarify financial information, track interdepartmental transfers or as a suspense account to hold an economic transaction until more information is available.
B) Regulator – Accounts designed to control or monitor production and assist with budgets are regulator accounts. A good example is an account that tracks the number of units produced or sold. With small business it is ideal to use work orders and purchase orders as regulator accounts.
C) Restrictive – Accounts used to track information related to a contractual or legal obligation is known as a restrictive account.
Future articles go into more detail about these respective accounts and how they are used with the existing chart of accounts. Act on Knowledge.
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