Accounting, Financial, Taxation

Closing of the accounting books refers to a process that starts with posting entries to the general ledger and results in a post-closing trial balance. The process begins with posting entries to the general ledger, preparing a trial balance, making adjusting entries, preparing an adjusted trial balance, preparing financial statements, preparing closing entries and, finally, preparing a post-closing trial balance. The prior year’s books are closed or computerized accounts are sealed and cannot be altered — sometimes referred to as hard close. The organization carries balances from the post-closing trial balance to the next year and the process begins again. The books are also closed for quarterly reporting and issuance of quarterly financial statements; this close is sometimes called soft close, since accounting records are not sealed and can be altered.

What is the significance of the closing process?

The primary issue is getting a handle on financial results. Unless the closing process is complete, a clear understanding of financial results is not possible. The financial results are matched with management forecasts, and corrective actions, if required, are undertaken. The initial push for faster closing of the books came in the 1990s, as markets criticized companies who did not have visibility into their financial statements. Cisco achieved closing of the books in less than 24 hours and became a symbol of the new economy of financial management. The intervening years saw a decline of the importance of virtual close, since formidable difficulties were encountered in this endeavor. However, now the days of pro-forma financial reporting are over, and GAPP-based reporting is valued again.

What is the status of the closing process in business, and does that pose a problem?

Surveys done in the U.S. and Europe indicate that the range to close the books spans from 4 to 75 days. Organizations in the U.S. are more efficient, with the average closing and reporting process being close to 12 days. The closing process is closely tied with the quality of information. However, the length of the closing process is not associated with the quality of information. For example, if the books are closed over a longer period, management may expect more accurate financial information. However, a longer process of closing of the books may indicate a chaotic state of accounting systems. Underlying causes can be fragmented legacy systems or sloppy financial procedures. On the other hand, the mere existence of quick close does not guarantee the quality of information, either.

Cisco, a poster company for virtual close, claimed that it possessed a godlike ability to peer into every nook and cranny of the business, which enabled proactive measures to control and steer the company. However, in the third quarter of 2001, sales declined 30%, 2 billion dollars worth of inventory was written off and approximately 8,000 people were laid off. Many analysts commented that Cisco’s financial systems contributed to the management’s inability to make correct decisions. As always, technology and Web-enabled virtual or fast close is merely a tool, and not a substitute for managerial thinking.

Virtual close is considered to be the ability to close the company’s books quickly and generate financial statements. Virtual close can also be viewed as a minimum distance between business activity and reporting of such an activity. The quickness or distance has not been defined precisely. According to various analysts, closing of the books in less than 5 days can generally be considered a virtual close; however, John Chambers, CEO of Cisco, may disagree, since he has defined virtual close as the ability to close the financial books with one hour’s notice. The time elapsed in closing of the books is often times considered a symptom of underlying problems. Many organizations have undertaken the virtual close process as a way to streamline the financial reporting process. This effort involves a number of important decisions concerning relevance and reliability of accounting information.

Closing of the books, though tidy on paper, can be a nightmare in the real world. Problems in closing of the books can be classified into four broad categories: accounting problems, technology problems, organizational problems and environmental problems. This classification is helpful in conceptualizing problems, though the classifications are not entirely independent. The provided list is illustrative, and each organization faces a unique set of problems in the closing process. Let us take a look at these problems and the methods used to overcome them.

The Primary Accounting Problem

The primary accounting problem is the lack of standard accounting procedures across the organization for data collection, recording and reporting. Data collection processes can be a mélange of automated processes, manual processes and spreadsheet-based processes. Adjustments, reclassifications and reconciliations can also be a mix of manual / spreadsheet / automated functions and can be time consuming. Organization can have more than one chart of accounts. This problem is more acute with multinational organizations, who must comply with local and head-office accounting requirements.

Closing of the books can also be used to generate managerial reports or correct immaterial errors, causing distractions from the core process. These problems generally go hand in hand with the complex charts of accounts. Detailed accounting codes need additional validation during closing, since these fields need to be verified before the books are closed, though all of them are not required for financial reporting. In many organizations, once the financial statements are prepared, they are reviewed by some sort of financial planning group. If the results are not acceptable, the statements might come back and additional processing may take place to achieve desired results. Such obvious manipulation of results adds to the closing process.

The fragmented accounting or financial systems cause a major problem in the closing process. Data from disparate systems need to be collected, which may be in the form of paper entries, spreadsheets or databases. Such data have to be validated and entered into the main accounting system. Data for consolidation purposes may also include budget data, human resource data, inventories and shipments. The collected data needs to be normalized to conform to a common set of definitions and entered into the accounting system. The consolidation of financial statements also requires currency translation, elimination of inter-company transactions, accrual adjustments and minority ownership calculations, which, if not automated, can consume a large block of time. The consolidation process is iterative and calculations may need to be repeated; all in all, such requirements are not conducive to virtual close.

Organizational problems start if top management is not committed to the process. If top management is not committed, problems such as user resistance and decentralized operations become even more acute. The closing process should also have a clear ownership for accountability. Decentralized and multinational organizations may have a variety of ERP or accounting systems in operation and can face consolidation problems.

Finally, even if the closing process is efficiently organized, it may have to undergo revisions if there is continuing merger and acquisition activity. The existing closing process also needs to be revised as the organization grows and expands, adds markets and products, restructures businesses and segments, or contracts by shedding markets and products. As such, the closing process is always a work in progress.

The initial rush to reengineer the closing process has slowed considerably. Organizations realized formidable barriers in such an effort. Now, the focus is not merely on time required to close the books, but also on the quality of financial reporting, process improvements and proper use of technical infrastructure. There have been some successes in this area, notably in the technology sector. For example, Microsoft’s financial reporting system consolidates 340 statutory companies in 4 days, handles 3,000 queries per month from 1,200 users, and has an uptime of 99.25%. The reengineering efforts led by Cisco, Motorola, Dell and Microsoft have led to development of guidelines in these areas.

Minimizing The Problem Of The Closing of The Books

The main lessons learned from the above explaination are summarized below:

(1). Standardize accounting procedures: The first step in standardizing accounting procedures is to have a common chart of accounts. This chart should be detailed enough at the unit level and should allow quick consolidation at the higher corporate level. The organization should have a standard method of collecting, presenting and measuring transaction data. Cutoff dates for subsidiary ledgers should be clearly specified, and a closing calendar should be synchronized. Other helpful activities are as follows:

1. Regularly close subsidiary ledgers and journals that feed data into the general ledger.
2. Reconciliations, whether subsidiary ledger to general ledger or inter-company transactions, should be continuous or at frequent intervals, not at the end of the quarter or the end of the year.
3. Make sure that a powerful consolidation system exists for consolidation purposes. Use Web-based applications or interfaces in consolidation, which have been found to be cost-effective. At minimum, the consolidation package should offer submission and consolidation workflow management, multicurrency management, inter-company and allocation processing, and journal entry processing.
4. Have a clear and coordinated closing schedule and make sure it is communicated clearly across the organization. Establish clear checkpoints for the closing process.
5. Simplify the chart of accounts.
6. Focus on material items such as sales, accounts receivable and inventory; and reduce judgments in the entry process.
7. Beware of problems in standardizing transactional data. The definitions of order, raw material and finished good can vary per user. Janelle Hill of META Group says — “Winning semantic agreement over transactional data is even harder than gaining semantic agreement over data for the data warehouse” (Decker et al., 2002).

(2). Integrate and automate financial systems: The organization should be standardized on a particular ERP system. Unless the ERP system is in place, the process of virtual close is next to impossible. Data should be captured at the source and entered only once. Adjustments, reclassifications and reconciliations should be standardized and automated. Manual entries should be minimized.

(3). Tie in operational systems: Operational systems should be closed before the financial systems or, at least, the results should be available to the financial system in real time. Operational data, such as shop floor data, needs to be integrated into the financial system, if possible.

(4). Use the Internet: Enable self-service features using the Web to reduce administrative overhead in accounting. Distribute reports via the Web, use XBRL to transmit reports to external stakeholders, send flash alerts to line managers using the intranet to enable exception-based management and publish key performance measures on the Web for immediate access. End users should be trained in Online Analytical Processing Tools (OLAP) or enterprise portals so that they can acquire needed information. Such education reduces administrative overhead on the Finance and IT departments.

(5) Automate workflows: Routing of entries for approval, the approval process and posting should be automated. Business rules should be developed to deal with formula based accruals, standardized month-end entries and standard transactions. Any deviation from the rules should result in an alert to the appropriate manager.

(6). Use Key Performance Measures: Key performance indicators should be standardized and distributed to line managers in real time. Such performance measures can provide alternate information to managers in the absence of full-blown financial statements.

A complete reengineering of the closing process is supposed to take approximately 5 years. Even after 5 years, the target may be elusive due to changes in business and accounting systems. The benefits of virtual close primarily accrue due to improvements in the underlying accounting systems and not only by faster closing. For example: Microsoft lists the following benefits of virtual close.

1. Batch processing of transactions is significantly decreased
2. Estimates and accruals have been reduced
3. The accounting process is aligned with accounting systems
4. Users find the system useful and use it more
5. Finance is a value-added partner and not a transaction-processing machine.

Virtual close is not pursued by many corporations, and for good reasons:

First, the cost benefit analysis may indicate that costs of virtual close outweigh benefits. Costs such as disruption of work, new workflows, new systems and standardized accounting procedures may be more than benefits due to real-time access to financial statements.

Second, the quality of accounting information may suffer due to virtual close. Many organizations have pursued virtual close at the cost of detailed verifications and controls, and the resulting financial information has followed the ancient law of information technology — garbage in, garbage out. Due to recent accounting scandals and Sarbanes Oxley, 2002 requirements, many CEOs and CFOs are not interested in accelerating the closing process if there is even the slightest doubt that the quality of information might suffer.

Finally, the added business value of such an effort may not be significant.

A common problem for the general ledger accountant is the relative degree of effort required to extract information from the general ledger. For example: if someone makes an inquiry regarding the exact nature of the expenses recorded in the “Utilities Expense” account, the accountant reviews the information listed in the general ledger, which probably shows no more than the total amount of accounts payable posted on a given day attributable to the utilities expense account, then goes to the accounts payable register to obtain information about the exact invoices that were charged to utilities, and then pulls the invoices from the filing cabinet in which they reside—all this to answer the simple request, ‘‘Give me the detail for the utilities expense account.” Given the number of steps involved, it is obvious that a number of information requests of this kind (which are especially common right after the financial statements are distributed) can completely overload the general ledger accountant.

Solution: Install (create) and Use a Drill-down Capability In The General Ledger Software!

What is “Drill-down” System?

The drill-down system allows one to position the cursor on the field on the computer screen for which the user wants to find additional information; the user then presses a button, and the next most detailed level of information appears on the screen. There may be several levels of information to be accessed in this manner, allowing a user to ‘‘drill down” through the various levels until the needed information is obtained.

Though an obvious godsend for anyone who must research detailed information through the general ledger, this is not an easy item to install in an existing computer system. In essence, the computer programming staff (or consultant, if it out-sourced) must redesign large portions of the general ledger programming code so that the field in a high-level screen is automatically linked to a screen that contains more detailed information, requiring a web of cross-indexes to a multitude of screens (which may be located in other software packages) before users have a comprehensive drill-down capability.

This is a major programming project, especially if the drill-down capability is given to a large number of data items, which means that there will be a large number of cross-indexes. This option is virtually impossible to implement if a company is using a third-party software package since any periodic update of the packaged software by the supplier will automatically wipe out all custom programming that the local programming staff has done since the last update was installed.

Good news, I have found many of accounting software have added “drill-down” capability, although some have not yet. To those who at the stage of choosing accounting software or business solution software, you may want to put “Is your product has integrated drill-down capability?” into your question list to be spotted during the meeting with the software developer.

Drill-down capability greatly increases a general ledger accountant’s overall level of efficiency, but it requires either a large amount of internal programming time or the purchase of packaged accounting software that already contains this feature.

Many companies are burdened with an immense chart of accounts. Instead of having a short list of accounts in which to store information—such as 100 or 200 accounts—many organizations have a convoluted and lengthy chart of accounts. The sheer length of such a list introduces a number of problems into the general ledger function.

Here are the reasons, why:

1. It is difficult to put numbers into the same accounts consistently time after time. Instead, they are recorded in different accounts, resulting in very poor comparability of information across time.
2. It can be very difficult to train a new general ledger accountant in the use of a very complicated chart of accounts; during the training period, it is likely that the accountant will make mistakes in recording financial information into the correct accounts, resulting in inaccurate financial statements.
3. It is also more expensive to audit a long chart of accounts since the outside auditors must spend more time reviewing more accounts.
4. Writing a new report with general ledger information is quite difficult if the information is being drawn from a veritable maze of accounts. In short, a plague of problems accompanies an excessively long chart of accounts.

Solution: Just reduce the number of active accounts in the chart of accounts by consolidating some similar function of accounts into single accounts.

Warning!

You have not adopted the above approach yet until the following practice is strictly followed:

1. Users may still continue to code expenses to the old accounts, if only out of habit.
2. When the chart is reduced, it is much more difficult to create historical reports to compare account balances to those of previous periods. For example, if five accounts are merged into one consolidated account, it is difficult to show how the balance in the new account compares to the old balances in five accounts. This is a particular problem if the accounts are merged in the middle of a company’s reporting year so that it is not even possible to compare financial results from month to month.
3. Information may be stored in an account strictly for inclusion in a report that has some special purpose; if the account is discontinued, the report can no longer be completed, which may be a source of irritation to the report recipient.

Solutions:

1. The old accounts that are being retired must be blocked from further use in the computer system. Though most computer systems now have this blocking feature, it is useful to determine its presence before proceeding further with an implementation.
2. Undertake major chart of account conversions only at the very beginning of a reporting year so that there is no intra-year reporting problem.
3. Fix the chart of accounts over a number of years by eliminating only a small number of accounts each year, which does not impact the comparability of accounts in any one year to any great degree.

In addition,  it is necessary to review all reports generated from the general ledger and determine which accounts are used to create them. If the information in these special accounts is truly indispensable, they should be left alone.

This approach is especially useful for older companies with many departments or subsidiaries, for these have frequently accumulated a large number of stray accounts over the years that should certainly be researched and eliminated. By doing so, it is much easier to maintain the general ledger.