Purpose of Interdepartmental Accounts
The primary purpose of accounting and of course the bookkeeping component is to record economic activity. The secondary purpose is to act as one stage in the feedback loop process of management. This means it provides information for decision-making, i.e. make improvements in both performance and financial outcomes. Every management team is interested in evaluating department heads and pinpointing the core value centers, i.e. what really drives profitability in a company. There is an assortment of tools available. With accounting, departmental accounting a.k.a. class accounting, is one of those tools. This accounting format is highly dependent on the income statement to report financial performance. Subjective issues are identified with other tools.
One of the inherent problems with departmental accounting is addressing activities between departments. In most businesses one department may exist solely to support or service another department. As an example, in many commercial construction companies, the engineering department exists only to support the actual construction process. Since the engineering function has no outside sales, it would report losses in a departmental income statement. This is similar to how the front and back office in most businesses exist to facilitate overall operations. In these situations, how does management evaluate or even have some kind of formal analysis to validate the existence and/or performance of a department and its manager?
The answer is simple, run the department as if it were its own business. This means it charges the other departments for its service. In turn, the other departments have an expense (cost of sales) associated with this transaction. To illustrate suppose Department ‘A’ renders services to Department ‘B’. Both departments sell to outside customers. Let’s look at the relationship between the two for a period of 30 days.
So let’s walk through this report in a logical manner. First off, department ‘B’ really has its own sales of $37,500 plus the pass-through service value from department ‘A’ of $12,500. Added together it equals $50,000. Technically total sales to outside customers is $75,000 ($37,500 from each department), $25,000 is directly sold by department ‘A’ and other $12,500 via indirect sales through department ‘B’. Department ‘B’s true direct sales generated from its own accord is $37,500 and an additional $12,500 associated with the amount pass-through from department ‘A’. So both departments have sales of $37,500. Let’s restate the above sales section and summary of costs:
Notice with this restatement the internal sales is merely deducted in the revenue section and excluded in the costs section for department ‘B’. The net effect is the same for gross profit. With the former departmental report (Exhibit A) sales is actually overstated by $12,500. The true outside sales are $75,000. In addition the true costs are $57,000. Look at the costs in reality. The $12,500 in department ‘B’ merely reflects the charge from department ‘A’ where the costs of that work already exist within the department ‘A’ cost of sales. The adjusted detailed format is this:
Exhibit C is the technical end result with traditional departmental accounting without internal accounting. A manager looking at this will tell you that both departments are performing in an equally admiral way. The reality is that department ‘B’s revenue is really on $37,500 related to what it does but it is getting credit for $12,500 for sales for services rendered by department ‘A’. With the traditional report as noted in Exhibit C, it looks as if department ‘B’ generates the bread and butter for the company – see Absolute Dollars for a clearer understanding of this business principle. Management would think the department head for ‘B’ is better than the head of department ‘A’.
However, the opposite is actually true. The department head of ‘A’ is the real value generator for the company. So internal accounts are used with departmental accounting to clarify actual results.
Using Internal Accounts
The goal is to set up these accounts so that internal reports can be generated for management analysis and at the same time traditional financial reports exclude the values (as reported in the totals column).
To help the reader better understand how this is done I have to explain technology limitations first then two different methods (dual offset and traditional entry) of entering the interdepartmental values.
Accounting software ranges from simplistic to fully encompassing; costing the company anywhere from $400 to $400,000 depending on what you are buying. A positive attribute for any accounting software is the ability to create quiet or non trial balance accounts.
These accounts do not report in the final financial reports but are available for internal and management reports. Lower cost software programs customarily do not have this ability to create internal accounts. So accountants have to use traditional accounts.
This is why it is important to use a well laid out organizational structure when setting up the chart of accounts. Use a distinct section of each type of account reserved for internal accounts. It is best illustrated with the numbering system for accounts.
This particular client reserved the 700 series in each group for internal accounts. Take a look:
Chart of Accounts (Summary Format)
Section Type Group Description
1000 Assets All All assets begin with the number 1 in the four digit series
1100 Assets Current Typically the 100 series in assets is reserved for cash
1200 -1400 Assets Current Other current assets (A/R, Inventory, WIP, Prepaids)
1500 -1600 Assets Fixed Includes accumulated depreciation
1700 Assets Internal Reserved for internal accounts
1800 -1900 Assets Other Includes accumulated amortization
2000 Liabilities All All liabilities begin with the number 2 in the four digit
2100 – 2600 Liabilities Current Various accounts (A/P, Credit Cards, Accruals, etc.)
2700 Liabilities Internal Reserved for internal accounts related to liabilities
2800 – 2900 Liabilities Long-Term (Secured and Unsecured) debt instruments
3000 Equity All All equity accounts start with the number 3
3100 – 3200 Equity Stock Includes stock capital accounts, & capital paid in excess
3300 Equity Stock Treasury stock accounts
3400 Equity Retained Earnings Historical earnings are recorded here
3500 Equity Retained Earnings Draws, distributions, dividends
3600 Equity Retained Earnings Capital account issues
3700 Equity Internal Reserved for internal equity account issues
3800 Equity Open Historical adjustments related to equity
3900 Equity Current Earnings Income reported via P&L is reported here
4000 Revenue All All revenue related accounts start with the number 4
4100 – 4600 Revenue Sales Various forms of sales are organized in this series
4700 Revenue Internal Reserved for internal issues related to
4800 – 4900 Revenue Other Revenue Non sales related earnings such as interest
5000 Cost of Sales All All COS accounts start with the number 5
5100 – 5200 COS Materials/Inventory Physical product costs
5300 – 5500 COS Labor Labor, labor taxes, benefits etc.
5600 COS Subs/Commissions Outside contracted assistance
5700 COS Internal Reserved for internal accounts related to sales
5800 COS Other Items like insurance, compliance etc.
5900 COS Open Reserved for unusual items
6000 Expenses All All expense items begin with the number 6 in the series
6100 – 6600 Expenses General/Admin Management, facilities, insurance etc.
6700 Expenses Internal Reserved for internal expense accounts
6800 – 6900 Expenses Other Other forms of expenses
7000 Expenses All Other related expenses start with the number 7
7100 -7600 Expenses All Continuation of expenses
7700 Expenses Internal Reserved for expense related internal items
7800 -7900 Expenses Capital Capital based expenses (interest, deprec/amort.)
8000 – 8600 Other All Gains/Losses, extraordinary items etc.
8700 Other Internal Reserved for internal gain/loss issues
8800 – 9600 Other All Capital account items, taxes, etc.
9700 Other Internal Reserved for internal transfers related to capital-items
9800 – 9900 Other Reserved Set aside for historical retractions and changes
Notice in the above series, each set of 1000 uses the 700 series as its internal accounts related to that type of account (assets, liabilities, …), as an example, account number 7773 might be used to separate allocation of office technology between two office sites. Here the 7000 series is for expenses, the 7700 series are internal accounts and so on.
Internal reports allow the 700 series to be included in calculations whereas external reports exclude any 700 series account.
Lower end or more popular accounting packages do not allow this particular account to be quiet during reporting with external or financial reports. So it is up to the accountant to use the proper accounting method for internal accounts. Let’s turn the attention to the easier tool for internal entry – dual offset.
The dual offset method is relatively straight forward. If any value is assigned to another department, the same account number is used for both the debit and credit. The only difference is the departmental assignment. Going back to the department illustration from above (Exhibit C), ‘A’s real sales are its directly generated value of $25,000 and an indirect value of $12,500 that was sold by department ‘B’. Department ‘B’ never did the work nor incurred costs to make the sale. It doesn’t deserve the credit for the sale. If the credit is allowed to stay in ‘B’s column, management will get a misleading result of department ‘B’s profit. Here is the manual entry:
Date ID Ledger. Dept. Description DR CR
Today 12345 4710 – Int. ‘A’ Record ‘A’s sales via ‘B’ 12,500
. 12345 4710 – Int. ‘B’ Record ‘A’s sales via ‘B’ 12,500 -0- .
. $12,500 $12,500
The result for internal accounting in the reports looks like this:
Focus in on two important items. First, in the entry made the account number is 4710 Internal Sales. The only difference is the assigned department. ‘A’ is credited, which is the traditional value with sales types of accounts. ‘B’ received value which shows up in the report as a contra offset to ‘A’s credit value. The final outcome is a zero value in the total column. So this method provides distinct advantages:
The departmental report can also be used for external reporting purposes. And, there is no need to reverse the entry at the end of the accounting period; they automatically offset each other.
As with anything, there are drawbacks. For this method, they include:
1) The internal sales line is confusing to readers of financial reports. Novice readers will ask ‘Why on earth are we selling to ourselves?’ So this means there has to be a level of sophistication with readers of financial reports.
2) This method becomes convoluted if ‘B’ has not completed the sale to the outside customer by the end of the accounting period. Basically if this were true, ‘B’s column would have external sales of $37,500 with a reduction of $12,500 associated with ‘A’s recorded value netting $25,000 of sales and a loss of $13,000 ($12,500 plus $500) for the period.
This method is very effective with high turnover rates for external sales thus reducing or eliminating the impact associated with drawback number two’s effects.
To eliminate the above drawbacks, accountants use the much older traditional entry method.
This method is advocated by CPA’s and the more experienced accountants. Basically, the accountant treats each department as its own business for accounting purposes.
Using the example above, the entry would be a credit to ‘A’s internal sales account, the debit is a cost of the sales ‘B’ made. Think of ‘B’ hiring ‘A’ to provide a service. ‘A’ sends a bill to ‘B’. This means ‘B’ would record the entry like a subcontractor’s bill. Here is the entry:
Date ID Ledger Dept. Description DR CR
Today 12345 4710 – Int Sales ‘A’ ‘A’s service to ‘B’ 12,500
. 12345 5710 – Int COS ‘B’ ‘A’s service to ‘B’ 12,500 -0- .
. $12,500 $12,500
The result is exactly like Exhibit A above.
The advantages of this method include traditional sales and costs matching principle. However, the drawbacks include:
1) Overstated sales and cost of sales in the total column;
2) A requirement to reverse the entry prior to preparing final year-end or end of accounting period reports;
3) Requires more comprehensive reporting and accounting skill sets along with attention to details by the accountant.
The reversing drawback is the most complicated aspect of this method as failure to reverse all internal entries will affect the final set of financial reports.
Some guidance to the reader is appropriate here:
In general, I would encourage small businesses to use the dual offset method as this method is easier to implement and requires no reversing prior to printing financial statements. Furthermore, it is simpler to explain to management than the traditional method.
The traditional method is more appropriate for larger organizations that can afford to hire several accounting staff and pay for the level of accounting sophistication needed to implement and educate management. Furthermore, the traditional presentation format was designed to use with cost accounting and in manufacturing.
The real value of internal accounting lies within the reports.
Several times I mention the term ‘sophistication’ needed to use and implement temporary accounts and of course internal accounts. Sophistication simply means exercising reasonable thought processes to fully understand how and why accounting is performed and of course the resulting outcomes.
In the above illustration with department ‘A’ and ‘B’, management’s goal is to understand the resulting value each department provides. Remember the idea is to evaluate performance and contribution to the company. Go back to Exhibit D. Place yourself in the position of the owner; what is your initial thought?
First off, I would say that department ‘B’ is poorly managed and generates a loss for the company. Secondly, I would think based on this report that if this is normal I could eliminate department ‘B’ and increase my profit by $500 per accounting period. Think of the value saved, less headaches, reduced stress and more profit; who wouldn’t want this outcome?
The reality is starkly different.
Look carefully at the report. Eliminate department ‘B’ in this thought process. Would ‘A’ have $37,500 in sales?
Most likely it would only have $25,000 in sales. This means that overall the absolute profit will be reduced. There will be cost savings; i.e. there is gross profit in the $12,500 of sales. Assuming linear costs for both external and internal sales, the costs would decrease by 33.33% ($12,500/$37,500) to $12,667 which means sales of $25,000 with costs of $12,667 for a gross profit of $12,333.
In business, which gross margin is better A) $18,000 and have department ‘B’ and its headaches or B) $12,333 with only department ‘A’?
Remember the three primary goals of business:
1) Make a profit
2) Provide long-term security for employees
3) Provide a product/service to customers that they appreciate
All three of these goals are affected by a reactive decision to close department ‘B’. The reality is that department ‘B’ generates $5,667 of gross profit. The accounting staff could use the traditional method for cost of sales to get these results. Basically, the internal entries simply transfer only the costs associated with the internal sales as illustrated here in Exhibit E.
The only drawback to this presentation is that it doesn’t correctly state the sales generated by either department. Remember, department ‘B’ merely passes the sale or value of ‘A’ to its customer. It makes ‘A’ look like it doesn’t generate sales to the same level of ‘B’. Remember the reality is that both departments generated equal amounts of sales, $37,500.
So it would appear that internal accounting can’t provide a clear picture of all aspects of accounting (both sales and costs) when used.
The only way to resolve this it to use reasonable thinking when analyzing the information. To help you fully comprehend this, I’ll provide an example.
Kevin owns a pool company with two departments. The primary department is the retail store. It currently has over 600 regular customers. The second department builds and installs various outdoor recreational tub systems (jacuzzi, hot tubs, sauna’s etc.). The contracting department generates 80% of Kevin’s headaches and stress. As a part of the contracting department’s requirements, it purchases the bulk of its materials from the retail department. This includes liners, tubs, supplies and tools (outdoor pool implements). Basically, about 40% of retail’s sales are sourced from the construction department. Furthermore, all new customers exist because of the contracting department.
In its departmental reporting, the contracting department earns little to no gross profit on an annual basis. However, retail generates margins in excess of 60% of sales. Via internal accounting, Kevin learns about the value the contracting department actually generates for Mountain Pools. Without interdepartmental accounting, Kevin can only rely on actual results for his decision model.
Summary – Internal Accounts
Internal accounts resolve many problems traditional accounting can’t address. They primarily clarify economic activity. One of the types of internal accounting is interdepartmental transfers. This type of accounting uses either dual offset or traditional entry to provide management with better information related to performance of departments.
Accountants and management must use caution when reading and interpreting these management reports. It is the job of the accountant to assist management in interpreting the results. Accountants should use reasonable and logical thinking to provide insight to the results as internal accounting is not perfect. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.