To help ensure that the financials include all material liabilities, the firm can employ a variety of tracking and estimating procedures, including:
• Purchase orders: A firm that successfully implements a purchase order (PO) system to ensure all purchases are properly approved also creates an excellent tool to track its liabilities that remain unpaid at the end of the month. A simple compilation of outstanding POs, organized by
expense type, can provide most of the information necessary to accrue unrecorded liabilities during the close process.
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• Account review by vendor: A very useful procedure to employ during the close process is to review a spreadsheet for each account, which shows a line for each vendor and the amount of money that the firm
paid that vendor each month during the year (and the prior year if possible), with a separate column for each month and some basic statistics such as the average monthly activity for each vendor. By arraying all this data on a single page for each account, it is very easy to track anomalies, which often lead to the discovery of unrecorded liabilities.
For example, assume a firm’s monthly telecommunication expenses
were between $50,000 and $60,000, depending on usage patterns. In
the current month, the trial balance for the firm showed that it in-
curred only $25,000. Under these circumstances, the financial staff
should begin a search for unrecorded liabilities because the variance is material to the firm’s financial statements. If their financial systems were designed to deliver a report by vendor and month for each account, the analyst can search for trends in spending to see which vendor was showing an abnormally low balance for the month. In this case, the analyst might have discovered that the long distance bill, which normally runs between $30,000 and $40,000 of the total, had been booked at only $15,000. A quick investigation might reveal that the invoice was still on the IT director ’s desk because the director had been on vacation since it arrived in the mail and thus it had not yet been processed. The accounting staff can then quickly accrue an amount approximately equal to the bill (if found) or the historical average spending level (if not found) until the bill is paid, thereby ensuring that the P&L ref lects a full month’s expenses and the balance sheet includes the value of unpaid liabilities.
Even if a PO system is in place, it rarely is used to cover all expenses, particularly those that are recurring in nature such as utilities, so the method described earlier represents a parallel process that can be employed to help ensure that accurate financials are prepared.
• Special valuation estimates: Certain accounts, such as accrued vacation pay and pension expense, must be valued periodically based on specific assumptions and the resulting calculated liability. Executive management review of the assumptions underlying the calculations is important to ensure visibility as to the reasonableness of the resulting balances included in the financials. For example, in the case of accrued vacation pay in a state that mandates an employee cannot “lose it,” the liability should ref lect the total amount that would have to be paid to all employees as of the end of the accounting period if the firm were shut down on that day. Accordingly, the number should be based on the actual unused vacation balance for every employee as of that date multiplied by his or her respective salary. To do this, the firm must employ a vacation tracking system that computes the vacation days earned each period,
the number of days taken, and the resulting balance as of the end of the
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period. Further, the system must adhere to any limits as to the total number of days an employee can accrue in accordance with local law
and firm policy.
Revenue and Expense Recognition: The
Games People Play
In spite of the wide application of GAAP and diligent efforts of the firm’s auditors, many financial statements still are not presented fairly in accordance with GAAP. Often, this happens because managers who are paid based on achieving certain revenue or profit levels are motivated to deliver those results, often without a full understanding of GAAP, relying instead on their own understanding of the way it should be. Professional firm executives should be aware of the areas in which financial statements have been misstated in the past and keep alert for warnings that their statements may include anomalies that include:
• Booking revenue based on a verbal agreement: It is not unusual for sales/business development professionals to come to a verbal agreement with a client. When those agreements come at the end of a reporting
period, they may consider that agreement to be worthy of booking as
revenue since they “closed the deal” in their mind. Rarely could revenue be booked under GAAP if the agreement had not been reduced to
writing and the firm had yet to do the work.
• Booking revenue before it is earned: On contracts that span multiple accounting periods, revenue may be recognized either at the end of the project or on a rational percentage of completion method. If the firm estimates its percentage of completion in an arbitrary manner, revenues may be manipulated to suit certain managers’ desires but may not re-f lect accurately the actual amount of revenue earned.
• Double booking intercompany revenues: In some cases, different groups within a firm will work on a client project. In those cases, care must be taken to ensure that each group records only the revenue to
which it is entitled. For example, if Team A has an annual contract to provide services to a client and the client needs work from Team B
from within the firm and that work is to be paid from the annual fee paid to Team A, then Team A must be sure to reduce its normal contractual revenue by an amount agreed on with Team B so that the total revenue recognized by the firm is not overstated by the amount to be transferred to Team B. Once a firm has several hundred employees, it is very easy to misunderstand the billing arrangement and have Team B
recognize revenue to which it is entitled while Team A continues to
book its monthly fee in the same manner as it always has, thereby overstating revenues.
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• Failing to book intercompany expenses: In some firms, particularly those with multiple offices and separate accounting teams for each,
managing the intercompany chargeback process can be especially chal-
lenging. If one office invoices another office for goods or services rendered and the receiving office disagrees with the charge, it is unlikely that that office will record the expense. In the meantime, the office issuing the invoice will most likely have booked either revenue in the amount of the bill or an offset to expense in the same amount; either way, the consolidated financial statements of the firm will be overstated by the amount of the invoice until the receiving office books the expense. This exact situation resulted in a major, multinatinal advertising agency, having to restate its earnings in 2002 when it was discovered that numerous offices failed to record intercompany charges they disagreed with. The total effect of these transactions was to overstate the firms profits by more than $130 million over several years.
Monthly Close and Financial Statement Review
The monthly close is the process by which transactions booked during the month are summarized, accruals are made for items not yet booked, and financial statements are prepared for management review and analysis. This process is iterative and is intended to result in a summary of the firm’s financial performance that presents fairly its financial position as of the close date. This doesn’t necessarily mean that the numbers are precise, but rather fair, in that financial statements, by their very nature, include estimates as well as actual amounts. Accordingly, a well-managed close process includes:
• Preparation of the trial balance—first cut
• Search for unrecorded revenues
• Search for unrecorded liabilities/expenses
• Preparation of the second draft of the trial balance now ref lecting accruals for revenues and expenses
• Analysis of the second draft trial balance, which includes a comparison of all variances from budget, last forecast, and prior year
• Ratio analysis of certain key metrics including gross margin and
salary/compensation expenses as a percent of revenue
• Final adjustments resulting from those analyses and preparation of the final draft of the financial statements as well as processing of all journal entries necessary to close the books for the period
The key deliverable from this process is a comprehensive set of financial statements and graphs that provides senior management with a solid understanding of its past financial performance as well as a view of its pacing to
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achieve current and, to a certain extent, longer term financial projections.