Accounting The SAP Way
January 20, 2005
An understanding of accounting is a fundamental to understanding the framework on which an ERP system like SAP builds upon. This article presents a brief introduction to accounting, and how the basic concepts are incorporated into the SAP framework.
Historically, accouting is a language which was first utilized by Luca Pacioli (c. 1445 – c. 1517). Pacioli trained as an Italian Franciscan friar, tutored the sons of a Venetian merchant and then taught in several universities. He learned and popularized the Venetian method of bookkeeping known as accounting today.
Accounting has been defined as ‘the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are of a financial character, and interpreting the results.’(The American Institute of Certified Public Accountants) An alternative definition from The Americal Heritage Dictionary is ‘the bookkeeping methods involved in making a financial record of business transactions and in the preparation of statements concerning the assets, liabilities, and operating results of a business.’
To put it in a simpler manner, accounting records reveal the financial strengths and weaknesses of individuals or businesses. All businesses, large or small, must have a complete and accurate system of record keeping. In SAP, the FI module is a core component and backbone of the accounting system. All value flows in a company can be viewed in terms of either physical material or financial flows. The FI module handles all financial transaction processing for the organization. Why is it important to use sound accounting practices?
All organizations must show the operations of their businesses in financial terms for various reasons: when applying for credit, figuring costs, keeping within their budgets, or paying their employees. Also, businesses are responsible for furnishing this information to government agencies for taxing and other regulatory purposes. Keep in mind that more than one quarter of a million new bankruptcy cases are filed each year. Many of these cases are the result of faulty accounting practices. Who uses financial information in an organization?
Several different individuals may use financial information in an organization, depending on the size of the company. A large organization with many employees will have an accounting department that is solely involved in preparing and analyzing financial records. In addition, that same organization will have members of upper-management and a board of directors who will be highly interested in the company’s financial status. Conversely, if a business consists of one individual who is self-employed, this person will consult his or her accounting records almost daily. Accounting information is used by every unit of our economic society, including churches, clubs, school districts, non-profit organizations, and city, state, and federal governments. How will understanding basic accounting concepts benefit me?
Anyone can benefit from having a basic understanding of accounting concepts. You will be able to understand how the strength of your company is related to its productivity and the revenues these efforts generate. In addition, you will understand better the reasoning behind certain decisions made by the decision makers of your organization. -
Each phase of a traditional accounting cycle is written below, together with SAP’s treatment of this step below. There are nine individual steps that comprise the accounting cycle. Simply stated, they are:
1.Analyzing transactions
2.Recording transactions in a General Journal
3.Posting transactions from the General Journal to the General Ledger
SAP takes care of steps 2 & 3 in a single transaction journal posting. Thanks to the integrated nature of ERP systems, the general ledger is populated automatically when a G/L journal posting is made in SAP. 4.Preparing a Trial Balance
5.Preparing a worksheet with adjusting entry data
SAP eliminates the need to ensure that accounts balance before posting, as only balanced documents are allowed to be posted. Trial balances are available as part of a standard set of FI reports in SAP. 6.Preparing financial statements
SAP has a standard set of financial reports including the B/S statement, P&L statement, consolidated group A/Cs statement, trial balance etc. These can be further tailored to a company’s specific needs. 7.Journalizing and posting adjusting entries
8.Journalizing and posting closing entries
These FI transactions are handled as part of SAP’s period end closing processes. 9.Preparing a Post-Closing Trial Balance
What is an accounting period? An accounting period is also known as the length of time for which a business analyzes its financial activities, and it varies in length from business to business. Some businesses may use a one-month time accounting period, while others may use a three-month, six-month, or one-year accounting period. In SAP, use is made of fiscal year periods to control the accounting periods. Standard FI allows for twelve normal periods and 4 special periods for closing entries. What is an asset?
Everything of value owned and used in a business is considered an asset, such as cash, sales, supplies, and office equipment. For example, the computers, copier machine, and office furniture owned by a company are its assets. Assets even include any money owed to a business, known as ”Accounts Receivable.” In SAP, an asset management module takes care of the physical and financial accounting of all assets. What is a liability?
The amount of money a business owes a person or company for goods or services rendered is considered a liability. For example, when a company buys office supplies and charges them to an account with an oral or implied promise to pay, the charges are considered a liability and are often classified as ”Accounts Payable.” In addition, when a company borrows money at a bank, the loan is a liability for the business and is often classified as ”Notes Payable.” What is owner’s equity?
The part of a business that belongs to the owner is the owner’s equity. Owner’s equity can be determined by finding the difference between a company’s assets and liabilities; this difference is what a business is worth to the owner. For example, if a company’s total assets are worth $350,000, and its liabilities are worth $75,000, then the owner’s equity would be the difference between these two figures: $275,000. In a proprietorship or a company owned by one individual, the owner’s equity account will usually have the owner’s name followed by the word ”Capital,” such as, ”Terry Brown, Capital.” What is the accounting equation?
The accounting equation is the fundamental formula on which the books of accounting are based. It establishes the relationship among assets, liabilities, and owner’s equity and is expressed in the following manner: Assets = Liabilities + Owner’s Equity (often abbreviated as: A = L + OE) It is important to learn and remember this equation, since it is basic to every aspect of accounting, regardless of the size of the business. You will use the accounting equation at all times when recording business transactions. The Elements of ”T” Accounts
What is an account? An account is a form used for recording and summarizing business transactions. Basically, accounts are broken into the three categories of assets, liabilities, and owner’s equity, the same three elements of the accounting equation. These three account categories, or classes of accounts, are made up of smaller individual accounts. For example, some liability accounts are ”Accounts Payable,” ”Notes Payable,” and ”Wages Payable.” What is a transaction?
A business transaction is any business event or activity that involves monetary value. In other words, it is any activity that changes assets, liabilities, or owner’s equity. For example, when a company buys office supplies on account, they exchange the value of the office supplies for a debt or liability. Transactions can be both internal and external. For example, if a business moves an amount of money from its marketing department’s budget to another one of its department’s budgets, this event is an internal transaction. However, if the same business sells 10,000 units of its product to an outside client, this movement of resources is an external transaction. When you record business transactions, you fill in the accounting equation (A = L + OE). What is a ”T” account? A ”T” account is a simplified form used for recording the increases and decreases to accounts resulting from transactions. It gets its name from its resemblance to the letter ”T” and is used to divide an account into two sides, debits and credits. The left side is called the debit side and abbreviated ”Dr.” The right side of any “T” account is the credit side and abbreviated ”Cr.” The name of the specific account, such as ”Accounts Payable” or ”Office Supplies,” is listed at the top of the ”T” structure. In order to understand debits and credits, you must understand how they increase or decrease assets, liabilities, and owner’s equity.
How are debits and credits expressed? Debits increase assets and decrease liabilities and owners equity. This principal applies to all postings in SAP also. A debit increases the balance of a G/L account and a credit reduces the balance. For example, imagine that your business purchased $18,000 worth of new teleconferencing equipment from Enson Corporation and charged it with the promise to pay over the next six months. An asset account, such as ”Teleconferencing Equipment,” would be established to record the equipment purchased. Since you now own more equipment, you would increase the balance of this account by entering $18,000 on the left, or debit, side of the account. A liability account, ”Accounts Payable,” would be established to record the amount your company owes to Enson. Since the $18,000 represents an increase in the amount of money you owe Enson, the $18,000 would be listed on the right, or credit, side of the ”T” account for ”Accounts Payable.” For another example of a business transaction, imagine your business received $500 from Chelsea Insurance, a client who owed you the money for consultation services you provided last month. This transaction would affect your ”Sales” account and the ”Accounts Receivable” account, which are both asset accounts. Since your company is receiving money or payment on this account, you are increasing the balance of the ”Sales” account and decreasing the balance of the ”Accounts Receivable” account. Thus, you would list the $500 on the left, or debit, side of the ”T” account for ”Sales” to increase its balance as an asset. You would also list the $500 on the right, or credit, side of the ”T” account for ”Accounts Receivable” to decrease its balance as an asset. What is the Golden Rule for debits and credits? The Golden Rule is that for every debit that occurs during a transaction, there must be an offsetting credit, and vice versa. This principle as applied to double-entry bookkeeping is a method of recording transactions in which each transaction must have at least two entries–at least one debit and one credit. However, while some transactions may have just one debit and one credit, other transactions may have numerous debits and credits. No matter how many entries you make, the total dollar amount of debits must equal the total dollar amount of credits. All SAP postings must be balanced before posting is allowed. Parking or holding of incomplete documents is provided for to capture the details of the incomplete posting. For example, imagine that your business paid $4,500 to Enson Corporation for the teleconferencing equipment they provided. The debit entry would be $4,500 on the ”Accounts Payable” account, since it would be a decrease to this liability account. The offsetting credit entry would be $4,500 on the credit side of the ”Cash” account, since you would be decreasing the amount of cash available by paying the debt.
What are revenue and expenses? Revenue and expenses are two of the categories included in owner’s equity. Revenues are amounts of money that a business earns for selling services or goods to another firm or individual. The terms ”Income” and ”Fees Earned” are often used in revenue account names. For example, the revenue account names for a movie theater could include ”Ticket Revenue” (or ”Ticket Income”) and ”Concession Revenue” (or ”Concession Income”). Expenses are the costs in money of any goods or services a business buys and uses to help it earn revenues. Examples of expense account names could include ”Rent Expense,” ”Utilities Expense,” and ”Insurance Expense.” In SAP, revenues and expenses are integrated with the CO-controlling system through the use of cost elements. Simply stated, revenue increases owner’s equity and represents its credit side, and expenses decrease owner’s equity and represent its debit side. —+++ UNIVERSAL ACCOUNTING EQUATION Since the fundamental accounting equation is Assets = Liabilities + Owner’s Equity, the expanded accounting equation incorporates revenue and expenses in the following manner: Assets = Liabilities + Owner’s Equity + Revenue – Expenses How do revenue and expenses relate to profit and loss?
Revenue and expense transactions tell whether a business is making a profit (increasing in value) or incurring a loss (decreasing in value) from its operations. If the revenue total is larger than the expense total, then the is a net profit. A typical format of a profit and loss statement is:
Sales
less: cost of sales
gives: gross profit
less: selling expenses
less: administrative expenses
add: other income such as interest earned
gives: profit/(loss) before tax
less: income tax expense
gives: profit/(loss) after tax A commonly used term, EBITA refers to earning before interest, taxes and amortization. This gives the general formula of profits = revenue – expenses What other categories are included in owner’s equity?
Owner’s equity is divided into four categories: revenues, expenses, capital, and withdrawals. Capital is used to record an owner’s investments in a business. A withdrawal account, also called a ”Drawing” account, is used to record when an owner withdraws assets, such as cash or equipment, from the business for personal use. Capital increases owner’s equity, so it is recorded on the right, or credit, side of the account. Since withdrawals reduce owner’s equity, they are recorded on the left, or debit, side of an owner’s equity account. Both capital and withdrawal accounts usually include the name of the owner, such as, ”Terry Brown, Withdrawals.”
What are temporary and permanent accounts? A temporary account is an account that begins and ends an accounting period with a $0 balance. The temporary accounts in a company’s books include the owner’s equity accounts of withdrawals, revenues, and expenses. Reducing an account’s balance to $0 so it is ready to start a new period is called ”closing an account.” Revenue and expense accounts are temporary accounts, since their balances are reduced to $0, or closed, at the end of each accounting period (usually the end of the fiscal year). Accounts that are not closed or reduced to a $0 balance are permanent accounts. Assets, liabilities, and the owner’s equity capital account are permanent accounts, since their balances are carried over from one accounting period to the next. What is an example of a transaction involving a temporary account and a permanent account?
It is important that you understand the difference between transactions that involve temporary and permanent accounts. Imagine that your business purchased $60,000 worth of personal computers from Acme Corporation on account. This purchase would involve two permanent accounts: an asset and a liability. Since office equipment was purchased, this asset account will reflect the ownership of this equipment for several years. In addition, the ”Accounts Payable” account would reflect the balance owed to Acme Corporation until full payment is made to them. Thus, this transaction involves two permanent accounts with balances that would carry over on the company’s books to a new fiscal year. If you were to treat these two accounts as temporary accounts and close them at the end of the fiscal year, you would reflect that you own no office equipment and that you had paid off all debts without really having done so. When your company pays rent on the building you lease, the transaction involves a permanent account, ”Cash,” and a temporary account, ”Rent Expense.” ”Cash” will be reduced with a credit and ”Rent Expense” will be increased with a debit. ”Cash” is a permanent account that represents the balance in the company checking account. If the account were treated as a temporary account and closed at the end of the fiscal year, the company would have insufficient funds to operate. ”Rent Expense” is a temporary account that is closed at the end of each fiscal year because the rent you pay this year should not impact the financial statements for next year.
What is a fixed cost? Costs are categorized based on the level of activity within a company. Fixed costs remain the same, or ”fixed,” regardless of the amount of activity within the business. For example, the property taxes a business pays are fixed costs, since they stay the same, regardless of how many units the company produces. Fixed costs increase or decrease, but they do not fluctuate in relation to the level of activity within the business. For example, property taxes may increase due to increases in property values in an area.
What is a variable cost? Unlike fixed costs, variable costs change in relation to the level of activity within a company. Variable costs can be directly associated with the number of units produced by a business. For example, the cost of materials needed to produce units is a variable cost, since it will increase or decrease in relation to how many units the company produces. In addition, the packaging material used to package units has a variable cost, since it will fluctuate according to how many units are produced. —+++ ANALYZING AND POSTING TRANSACTIONS What is a Chart of Accounts?
A Chart of Accounts is a detailed listing of all the accounts that a business uses for recording transactions. Every account, from ”Cash” and ”Office Supplies” to ”Accounts Payable” and ”Common Stock,” is listed in a chart of accounts. The Chart of Accounts is unique for each organization. Each account has a number assigned to it, which is related to the broad class of accounts it represents. Assets start with a 1, liabilities with a 2, owner’s equity with a 3, revenue with a 4, and expenses with a 5. This numbering system helps identify the individual accounts. In SAP, a chart of accounts is divided into two logical components, the chart of account specific data and the company code specific data. Many company codes can share a common chart of accounts, but one company code can only use one chart of account. SAP provides a concept called country chart of accounts if alternate account groupings for country specific reporting is required. Additionally, consolidation of multiple company codes is possible via the consolidated chart of accounts.
What is a General Journal? The General Journal is a book of business transactions. It is the accounting record into which transactions are first recorded. The entries in the General Journal are recorded in chronological order, and each transaction has a brief description of its purpose, as well as its account number. All of the transactions listed in the General Journal are then posted into the General Ledger. In SAP, the general journal transaction posting updates the general ledger simultaneously. Details of each financial transaction are captured in a SAP posting document, which consists of a header section and at least one debit and one credit line.
What is a General Ledger? Once you have recorded transactions in the General Journal, you must post them in the General Ledger. The General Ledger is the book that contains all the accounts of the business, listed in numerical order from lowest to highest. Each account in the General Ledger lists all the activity or transactions for that accounting period. General ledger balances can be inspected at any time in SAP by calling up the appropriate report. Additionally, the general ledger allows the concept of ‘drilling-down’ to the original financial source documents by simply double-clicking on a balance figure. When you post a transaction from the General Journal to the General Ledger, it means that you have entered the transaction recorded in the General Journal in the appropriate accounts on the General Ledger. Unless you post transactions, the individual accounts will not be accurate in their balances.
How do I analyze a transaction? You must be able to analyze a transaction in order to record it in the General Journal and post it to the General Ledger. Analyzing a transaction is what you do when you determine what type of account is affected by a financial activity, and how the event translates into debits and credits. There are three questions you should ask yourself when analyzing a transaction:
1.What account or accounts will be changed?
2.To what account classification does each account belong?
3.How will each balance be changed? In SAP, the most basic data that is required to post a financial document is the document type, document date, posting date, document currency and balanced document line items-which consist of at minimun a debit and an equal credit line items. For example, imagine that your business paid $700 to Access Systems, Inc. on a bill you owed.
1.The accounts that will be changed would be your ”Cash” and ”Accounts Payable” accounts.
2.”Cash” belongs to the asset account classification, and ”Accounts Payable” belongs to the liability account classification.
3.Your ”Cash” account will be decreased, and your ”Accounts Payable” account would be decreased. Therefore, $700 would be credited to the ”Cash” account, and $700 would be debited to the ”Accounts Payable” account. In SAP, accounts payable, accounts receivable and asset control accounts are updated automatically when a financial posting is made in any of those modules.
How do I post transactions from the General Journal to the General Ledger? There are three steps you must follow when posting transactions from the General Journal into the General Ledger:
1.Start with the first debit entry. Record the entry and its date in the corresponding account in the General Ledger. Then, record all entries for that transaction. For example, you may have a $500 debit in your ”Accounts Payable” account. After recording this entry, you would then record the $500 credit entry for ”Cash.” 2.In the Post Reference column of the General Ledger, record the page number of the General Journal where the transaction was entered. This referencing provides a trail for anyone who needs to retrace the steps taken in posting transactions. This column is often labeled ”Post Ref.” 3.Enter the General Ledger account number where the entry was recorded in the Post Ref. Column of the General Journal. As in Step 2, this referencing establishes a trail that will help an individual retrace the steps taken to post transactions. In SAP, posting from the general journal to the general ledger is done in real-time when the general journal posting is saved. —+++ BALANCING FUNDAMENTALS
Why do I need to balance General Ledger accounts? At the end of an accounting period, when all of the month’s financial activities have been posted to the General Ledger, some accounts will have amounts posted to their debit side as well as their credit side. Therefore, after you have posted all of the transactions to the accounts, you must balance the General Ledger accounts. There will be a debit of credit balance for each account at the end of the accounting period. How do I balance a General Ledger?
Balancing a General Ledger requires balancing each of the accounts listed in the ledger. Follow these four steps in order to balance an account:
1.Draw a single line under the last figures in each column.
2.Write the total for each column in small pencil figures just below the line. In accounting, one line means ”more to come”; a double line means ”the end.”
3.If the two footings are equal, the account is ”in balance.”
4.If the two footings are different, write the difference on the side of the account that has the larger amount and circle the figure. If the debit side has the larger amount, this account is considered to have a debit balance. If the credit side has a larger amount, then the account has a credit balance. You may wonder why some accounts have footings that are not equal, since debits are always supposed to equal credits. Individual accounts may have different debit and credit totals because when you post a transaction from the journal, you post part of that transaction to one ledger account and part of it to another ledger account. Therefore the debits will be equal to the credit side if you add up all of the balances of all the accounts in the ledger.
What is a ”normal” balance? The balance of an account is considered ”normal” if it is on the same side of the account (debit or credit) as it is shown in the accounting equation (A = L + OE), or if the increase side of the account is larger than the decrease side. For example, since assets are normally on the debit, or left, side of the accounting equation, an account that is classified as an asset will have a ”normal” balance if it has a debit balance. Conversely, liability accounts will have a ”normal” balance if they have a credit balance, as will owner’s equity accounts. Since revenue represents the credit side of owner’s equity, revenue accounts have a ”normal” balance if they have a credit balance. Expenses represent the debit side of owner’s equity, so for expenses, a debit balance is a ”normal” balance. What is the cash basis of accounting?
When using the cash basis of accounting, you record revenues only when the money is received and record expenses only when they are paid. With the cash basis, there are occasions when revenue is earned in one period, but the transaction is not recorded until the money is received in a future period. Therefore, the cash basis does not accurately and completely reflect a business’s true profitability. What is the accrual basis of accounting?
The accrual basis of accounting presents a true and uniform picture of profitability because it records revenue when it is earned and expenses when they are incurred, not strictly when money has changed hands. In other words, accrual accounting records transactions when they occur, regardless of whether or not money has been received or expenses have been paid.
What is a Trial Balance? A Trial Balance is a report that lists all the account balances as of a certain date, usually at the end of an accounting period, such as at the end of the month. The Trial Balance serves two purposes: It makes sure that the total debits equal the total credits in the recording of transactions. Financial statements cannot be prepared unless the total debits equal the total credits on the Trial Balance. It ensures that each account has a ”normal” balance. If you find that a Trial Balance does not balance, there is a strong possibility that an error was made in recording the transaction, posting to the General Ledger, computing the account balances, copying balances to the Trial Balance, or in adding the Trial Balance columns. How do I prepare a Trial Balance?
In order to prepare a Trial Balance, you must follow these five steps:
1.Create a heading by centering the name of your company, the name of the accounting statement (Trial Balance), and the date.
2.List all the accounts found in the General Ledger, their account numbers, and their corresponding balances. List the debit balances in one column and the credit balances in a separate column.
3.Draw a single line under the last figure in each column.
4.Total the debit balances and credit balances and write these ”footings” under the line.
5.If the totals are the same, draw a double line just below them to show that the Trial Balance is complete.
What does it mean to say ”the books are in balance”?
”The books are in balance” if the debit balances and credit balances are equal on a Trial Balance. If the debits and credits are not the same, you will need to go back and determine where an error occurred during the recording of transactions. When looking for errors that might have been made during the recording of transactions, the referencing that was done when the accounts were posted to the General Ledger is quite helpful. Due to the trail that referencing provides, it will be easier for you to determine where a recording error occurred. What are the most common errors found in a Trial Balance?
There are several common errors that can prevent your Trial Balance from being ”in balance”: Incorrect addition of the amount columns in the Trial Balance
Copying and transferring the wrong account balance from the General Ledger to the Trial Balance
Transferring a debit balance from a General Ledger account to the credit amount column in the Trial Balance, or transferring a credit balance from a General Ledger account to the debit amount column in the Trial Balance
Incorrect computation of the account balance in the General Ledger account
Incorrect posting to the General Ledger from the General Journal
The general rule to follow when looking for errors in the Trial Balance is to retrace in reverse order the steps you followed to get your Trial Balance figures. Go back, one by one, and check each figure to your original figures. First check the Trial Balance figures to the General Ledger, and then check the General Ledger figures to the General Journal.
What is a transposition error? A transposition error is an error in which the numbers are transposed or reversed, such as 76 written as 67 or 36 written as 63. There is one common thing about transposition errors that will help you locate these types of errors: the difference between numbers that have been transposed or reversed is always a number that adds up to 9 or is evenly divided by 9. Therefore, transposing 76 and 67 leaves a difference of 9, which adds up to 9; the difference between 63 and 36 is 27, which adds up to 9 (2 + 7 = 9); and the difference between 725 and 275 is 450, which adds up to 9 (4 + 5 + 0 = 9). In addition, 9, 27, and 450 are all evenly divisible by 9: 9 * 1 = 9; 9 * 3 = 27; 9 * 50 = 450. Once you know this trick of recognizing a transposition, you will save a lot of time by knowing where to look for the error. —+++ FINANCIAL STATEMENTS What financial statements are created from the Trial Balance?
Completing a Trial Balance will enable you to complete two of the most important financial statements in accounting: the Income Statement and the Balance Sheet.
What is an Income Statement? An Income Statement, also known as a Statement of Operations, is a financial report that provides information regarding the profit or loss for the last accounting period. It is only concerned with revenue and expense accounts. This statement is important, since a business owner or manager must know how his or her business is doing, assuming profit is the reason a company is in business. All the information you need to complete an Income Statement is found on the Trial Balance. What is a Balance Sheet?
A Balance Sheet, also known as a Statement of Financial Position, is a financial report prepared at the end of an accounting period that gives a detailed picture of the financial condition, or position, of a business as of a specific date. It can almost be thought of as a ‘’snap-shot” in time of a business’s financial status. It shows what a company owns and owes, and how much capital it has at a particular point in time. The Balance Sheet summarizes the first three classifications listed on the Chart of Accounts: assets, liabilities, and owner’s equity. Like an Income Statement, all the information you need to complete a Balance Sheet is found on the Trial Balance.
What is a Cash Flow Statement? A Cash Flow Statement, also known as the Statement of Cash Flows, provides information about a company’s cash inflows and outflows during an accounting period. Specifically, it reports the impact of a company’s operating, investing, and financing activities on the cash flows during an accounting period. A general equation is: cash = inflows – outflows What is a Statement of Stockholder’s Equity?
The Statement of Stockholders’ Equity, also known as the Statement of Owner’s Equity, reports the changes that have occurred in the owner’s, or stockholders’, equity during an accounting period. It is prepared after the Income Statement is prepared, since the net profit or net loss must first be determined. Since retained earnings and capital stock are the two main components of owner’s equity, these are the two categories of accounts that are included in the Statement of Stockholders’ Equity. SAP provides pre-configured formats for all the commonly required financial reports. These can be supplemented with custom reports if necessary.
It is important for you to understand that your company’s accounting records are not only used for internal purposes, but also for external purposes. The following is a list of stakeholders, or people who have a ‘’stake” in your organization’s success, who use your company’s financial statements. Investors
One category of stakeholders that analyze your company’s financial statements is investors, which includes individuals and companies that purchase debt or equity instruments from your organization. Investors need to analyze your company’s financial statements to determine whether to invest or continue to invest in your company.
Another category of stakeholders is creditors, which include banks, financial institutions, and any business that can offer your company credit. Creditors need to analyze your company’s financial statements to determine if they should offer credit to your company. Suppliers
The next category of stakeholders that need to analyze your financial statements is suppliers. Suppliers are companies from which your organization purchases materials to facilitate the development of products and services. These companies may need to look at financial statements to determine whether your company should be approved for a contract.
Employees also utilize your company’s financial statements to determine future budgeting information, as well as the degree of risk involved in remaining employed with the organization. If, for example, your company’s net income decreased by 25 percent over one year, job security at the company may decrease. Financial results provide employees with an opportunity to foresee potential downsizing decisions. Your company’s top management team also analyzes its financial statements to determine weaknesses within the company and to help make future budgeting decisions. For example, if your company’s sales department failed to reach its financial goals for the year, management may decide to increase advertising or add a new product feature to boost sales.
Another category of stakeholders is customers, who analyze your company’s financial statements to determine if your company’s solvency is adequate. If it is not adequate, customers may decide to purchase their goods and services from another company, just in case your company goes out of business. Competitors
One more type of stakeholders that analyze your company’s financial statements is your competition. Competitors analyze your company’s annual report to determine where they stand in relation to your company, especially if your organization is the top in its industry.
Another category of stakeholders that analyze financial statements is economists, which include individuals and economic firms that analyze an economy national or worldwide. Economists need to analyze your company’s financial statements to create economic projections. Although one company’s financial performance may not heavily affect an economy as a whole, one industry’s financial performance will. For example, if the demand for gasoline were to decline as a result of the use of electric-powered cars, the oil industry as a whole would suffer. This decline in demand for oil might increase the demand for other sources of energy, such as electricity. Economists can predict trends in an economy by observing the financial results of companies.
The next category of stakeholders that analyze your company’s financial statements is the government. The Internal Revenue Service (IRS) analyzes your annual report to find any indication of unreported income, overstated expenses, and any major changes the company may be experiencing that would have an impact on the IRS. The Securities and Exchange Commission (SEC) examines your annual report to make sure that your company is complying with regulations that have been implemented to protect your investors. In addition, the U.S. Department of Justice and the Federal Trade Commission compare your annual report to annual reports of other companies in the same industry to see if your company is engaging in monopolistic actions. Financial accounting: the road to irrelevance Financial accounting was never perfect. A system that was born hundreds of years ago is looking as relevant to today’s business as the quill pens that were used in the first ledgers. There were always some basic problems: Financial accounting looks backwards, not forwards. This is fine for keeping score, but not for scoring goals. Accounting conventions leave enough room for interpretation that there is huge potential to mislead. Profit figures massaged year on year by exceptional items, write-offs, depreciation of goodwill, different treatment of stocks, inventory and even different ways of recognizing sales give plenty of room for manoeuvre. No wonder analysts and fund managers trash companies that miss earnings targets by a penny. If they miss even after all the expectation setting and numbers massaging, then something fairly profound must be wrong. Financial accounting is only a starting point for understanding corporate performance. Market share, sales, growth, productivity, new products are probably better forward indicators of performance than backwards-looking financial data. The 21st century is making the problems worse. The financial accounting profession is still fighting the battles of the last century. They are trying to harmonize irrelevant standards. The challenge for the profession is not standardization, it is relevance. At the heart of the problem are intangible assets. When Pacciole invented double entry bookkeeping, it was based on the presumption that the book entries represented real, tangible assets that had a clear market, cash value. This 500-year-old assumption is still at the heart of accounting. But a look at the shape of 21st-century business shows that this assumption is wrong. The assets of today’s businesses are not physical or tradable assets: Nike: the value of the business is in the brand. Production is outsourced. There is not that much in the way of physical assets beyond a lot of old posters. Heroic, but unconvincing, efforts are being made to value brands. From the accounting point of view, there is no reliable way of putting the brand on the balance sheet: is advertising an expense or a capital investment building the value of the brand? Investment banks: the assets are walking out of the door each evening. The assets are the skills of the staff. A 100 years ago, accounting did not have to worry about skills: capitalists provided the capital, managers managed and workers worked. Workers were not skilled, and were easily replaced. Dot.coms: the value of the business is not physical assets. It is based on the value of the intellectual property, the business idea of the dot.com. Pharmaceutical companies: the value of the business is in patents supported by a strong distribution network. The physical assets are largely irrelevant, except for their cash mountains. Financial accounting does not reflect the value of those assets, nor how investment in those assets should be treated. The shift from physical to intangible assets is also linked to a parallel shift from costs being largely variable to largely fixed. When Adam Smith observed the pin-makers in Gloucester, the cost of each pin was related to two main variable costs: raw materials and labour. There were virtually no overheads. The pin-makers did not have advertisers, training departments, strategy or HR functions, computer systems, telephone networks, corporate headquarters, accounting staff, or any of the other overhead that represent today’s corporate life support system. This explosion of overhead and semifixed cost is a nightmare for traditional financial accounting systems: Costs and profits are becomingly increasingly dependent on potentially arbitrary overhead allocation decisions. Financial accounting, based on departmental budgets, does not give management a rational basis on which to make allocation decisions. The balance sheet is becoming increasingly disconnected from the value of the business and the true, intangible, assets that underpin it. The profit figure is open to distortion: a good starting point for looking at an annual report is not the profit and loss but the notes to see how the figures will have been massaged. About the only figure that has much integrity left is the cash flow statement: even that can be distorted on an annual basis by timing sales and expenses smartly. Over a three- to five-year period, it is hard to have a cash flow statement that lies. But five years is history, not an actionable time frame for management or investors. Management accounting is starting to get to grips with the challenges of the 21st century. Financial accounting is stuck in the wrong century.
