Bookkeeping – Controls in Accounting (Lesson 95)

The President of the Ontario Center for Advanced Manufacturing stated that back in the early 80’s IBM Canada Ltd. ordered parts from a new supplier based out of Japan.   The order allowed an acceptable tolerance of 1.5 percent (%) defective parts.  The Japanese supplier sent the order in two separate packages.  The second package had a note included:

“We don’t know why you want 1.5 percent defective parts, but for your convenience we have packaged them separately.”

A story from Patrick Lush in The Globe Mail, Toronto, June 15, 1988.

Just as manufacturing uses controls to ensure quality of product, controls are used in accounting to generate accurate information, maintain security over assets and comply with Generally Accepted Accounting Standards. The company implements various controls to assure accurate and timely information.  These controls include:

A) Use of Accrual Accounting
B) Internal Controls:
.       – Policies and Procedures (Lesson 96)
.       – Work Orders (Lesson 97)
.       – Purchase Orders (Lesson 98)
C) Production and Analysis:
.       – Production Reports (Lesson 99)
.       – Management Reports (Lesson 100)
.       – Financial Reports (Lesson 101)

The following sections lightly explore the respective controls.  An in-depth lesson follows for each area and how the accountant plays an instrumental role in the success of each.

Accrual Accounting

There are two widely used methods of accounting.  The first and most simplistic is the cash basis of accounting.  It is merely a checkbook form of accounting whereby deposits are receipts and checks are expenses.  There is no such concept of receivables or payables even though there may be separate logs (journals) for them.

This method is appropriate for really small businesses from your lemonade stand to sole proprietorships with no employees and revenues less than $250,000 per year.  The problem with this method is the inability to match expenses against the revenue generated.  To resolve this, businesses utilize accrual accounting.

Accrual accounting is much more accurate in providing matching of receipts (revenue and customer payments on accounts) against the actual costs and expenses incurred to generate sales. The drawback to this more accurate information system is the demand for more record keeping (bookkeeping).  This includes using the double-entry system, journals, ledgers, trial balances and supporting spreadsheets as explained in most of the prior lessons.  The majority of internal controls in accounting are designed based on the concept and use of accrual accounting.

Internal Controls

The primary goal of internal controls is to safeguard assets from theft or manipulation with their value.  This is accomplished by implementing systems, creating processes and separating duties to prevent theft and fraud.  This is almost impractical in a small business but is achievable if the owner is willing to provide these forms of checks and balances.  Naturally, the best internal control is the owner himself (herself) as they will not steal from themselves.

Internal controls include:

  • Mandating the owner’s authorization for all expenses and payroll in a small business and for certain transactions in larger operations.
  • Having a policies and procedures manual.
  • Ensuring checks have supporting documentation when signed by an owner.
  • Limiting check signing to owners or a designated financial officer.
  • Requiring all bank statements go the owner and that the owner is the sole administrator of the online bank account actions.
  • Maintain physical security to physical assets and the accounting department.
  • Limit access to the master password for both the accounting system and the computer system.  The master password is solely held by an owner or a designated outside professional (CPA, Attorney, Banker or Broker).
  • Separate duties related to the respective functions such as cashiers not counting the tills at night.
  • Provide proper training and education for respective functions.

The list goes on and on and is covered in more detail in Lesson 96.

As an additional note, policies and procedures are augmented with work flow charts and use of production controls.  Examples include work orders (Lesson 99) and purchase orders (Lesson 98).

The end goal of internal controls is to provide timely and accurate reports.

Reports

When good internal controls exist, the accounting department is then able to produce accurate reports in a timely manner.   There are two primary tenants associated with accounting, timeliness and accuracy.

Timeliness – The first tenant of accounting is timeliness.  Timeliness means the art of providing information efficiently to decision makers to minimize errors or maximize opportunities.  The act of timeliness is a financial issue as the goal is to increase profitability.  The tenant of timeliness is inherent in accounting most notably attributable to the Internal Revenue Code and the multiple deadlines the IRS imposes on businesses to report information.  This deadline mindset exists with internal reports as aged information has little value.  Tardy decisions cannot take advantage of opportunities.

Accuracy – Along with timeliness, information must be accurate.  This includes number of units (provided and sold) and the associated dollar value.   Good bookkeeping procedures along with reconciliation ensures information is in the right accounts (classified correctly) for the proper accounting period.  Accuracy is closely associated with effectiveness.

Reports are composed of three fundamental groups: production, management and financing. The following three subsections touch base with each of these groups.

Production Reports

The primary set of reports used in business are production based.  These reports are typically non-relational in nature.  In effect they identify points in production or consumption of time and materials.  Most production reports disseminate information about:

  • Hours of Equipment Utility
  • Labor Hours Used
  • Volume of Materials Consumed
  • Units of Output

Reports at the next level begin the process of relationships.

Management Reports

This level of reports combine the primary set of reports to create relational information.  These types of reports are found in manufacturing, construction and complex output industries (shipbuilding, technology, automotive, etc.). The reports are designed to relate two or more variables and identify changes in either output or value when one variable is modified or changes.

In small business, these reports can be created or customized in basic accounting software (QuickBooks, Sage, Etc.).  Often they focus on sales by particular items or units of service against the revenue generated.

Some of the more sophisticated management reports are borderline financial reports because they relate financial information among divisions or departments.  Examples include job costing, class accounting and departmental balance sheets.

Financial Reports

There are five primary financial statements (reports) used in reporting accounting results.  These five statements are often summations of management reports.  The following go through each statement and explain their respective significance with controls in accounting.

Balance Sheet

The balance sheet is a report identifying the company’s assets and the sources of funds for those assets.  It is a picture of this value at a single moment in time for the company.  The accounting profession uses the term ‘snapshot’, similar to a photo, to point out that he balance sheet is ever-changing.  The most common moment in time for a balance sheet is the last moment of an accounting period (usually a year).

The balance sheet is divided into two halves, upper and lower.  The upper half contains all the assets of the business listed from most liquid (cash) to the more difficult and elusive intangible assets like goodwill and rights.  Another way to state assets is to look at assets as the uses of funds (what was bought with the funds).

The bottom half which equals the upper half in dollar value are sources of funds to purchase those assets.  These sources are divided into two groups, liabilities and equity.   Liabilities are monies owed to third-party creditors and in general have a priority claim to assets over the owner’s (equity) interest of the company.  Equity is the owner’s share of the value of assets.  Equity is composed of four major groups:

  1. Stock/Contributed Capital – The initial amounts paid by the owner’s for the company are referred to as stock or initial capital contributions.
  2. Treasury Stock – When a company buys back stock from owners, this portion of the stock is called treasury stock; it is available for future sale.
  3. Retained Earnings – Amounts earned lifetime to date at the beginning of the current accounting period (year) are called retained earnings or profits held in the company used for corporate purposes (to purchase assets).  These amounts are undisbursed profits to owners.
  4. Current Earnings – Profits (Losses) generated in the current accounting cycle are reported separately in the equity section and will match the net profit as reported on the income statement.

Income Statement (Profit and Loss Statement)

The second report in the set of financial statements is the income statement.  It is by far the most popular report requested by small business owners.  This is due to the fact the report identifies results of operations for a company, i.e. profitability.  The report has three major sections consisting of:

  1. Revenue – Sales and other sources of income
  2. Cost of Sales – Direct costs (materials and labor) of sales
  3. Expenses – All other costs associated with running the company are grouped together as expenses.  These expenditures include management payroll, facilities, insurance, office operations, utilities (including communications), marketing/advertising, taxes and other.

The result of revenue minus cost of sales and minus expenses is called profit.  Net profit is the result due to reduction of profit for capital costs (interest on debt, depreciation, amortization, reserves) and income taxes.  The net bottom line is net profit which equals current earnings on the balance sheet.

Another name commonly use for the income statement is the ‘Profit and Loss Statement’.

Cash Flows Statement

The third report used with financial statements is the cash flows statement.  It converts accrual accounting into a cash basis form of accounting.  It is actually three separate sub reports as follows:

  1. Cash Flows from Operations – This section reports the cash contribution or use of cash for normal operations, the heart or purpose of the business.  It typically reflects the relationship of the income statement with currents assets and current liabilities.
  2. Cash Flows from Investing – Fixed asset acquisition and disposal is reported in this section of cash flows.  For growing or expanding operations, this section is almost always an outflow (use of cash) of money.
  3. Cash Flows from Financing – The purchase price of fixed assets or the cash shortage in operations is funded by borrowing money (financing).  Outflows of cash in this section are typically principle payments.

By combining all three sections total change in cash is reported and must match the actual change in cash as reported from the beginning and ending balances of cash.

Changes in Retained Earnings

This report is a detailed historical list of one part of the equity section of the balance sheet.  Sometimes a company must address a historical issue which wasn’t reported at that time, so this report reflects any charges due to historical issues.  It also identifies the last two accounting cycles with details related to earnings and payments (dividends) made to owners.

Notes to Financial Statements

An underutilized and unappreciated report are notes to the financial information.  Most notes augment the values as reported in the other financial statements.  Many notes include schedules and clarification of the respective accounting procedure for that particular financial element of the other reports.

The financial statements are read in totality and not in a separated fashion.  These reports are designed to provide useful information for investment and credit decisions.  In addition, by using business ratios an owner, investor or creditor can compare financial performance of the entity to the performance of a similar company or to the business sector as a whole.  Furthermore, the financial reports sum the performance of both management and the board of directors.  These reports consolidate all the business activities into a summarized value for an easy assessment of the investment.  They are the absolute best control in accounting.

Summary

Controls in accounting vary from the minutia such as two individuals counting the till at a register at closing to the all-encompassing set of financial reports.  Controls are divided into three types including the method of accounting with accrual the best option.  The second type is internal controls which comprise policies and procedures to safeguard assets and report financial values accurately.  The third type is composed of three levels of reporting from the detailed level of production to management and ultimately the broad-based financial statements.

The financial statements summarize the business performance and the ability of management and board of directors to make good decisions.   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.

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