Accounting, Financial, Taxation

What am I going to talk about through this post? It is not about calculating (measuring), nor recording transaction (debit and credit), neither about how to construct accounting/financial report in easy way. Instead, it is about: realizing how accounting is relevant to you, grasping how all economic activity requires accounting, watching an accounting department in action, shaking hands with business financial statements, and answering a question “Mama, should you let your baby grow up to be an accountant?”

Accounting is all about financial information — capturing it, recording it, configuring it, analyzing it, and reporting it to persons who use it. I won’t say much about how accountants capture, record, and configure financial information in this post. But I am going to talk a lot about how accountants communicate information in financial statements, and I explain the valuation methods accountants use — ranging from measuring profit and loss to putting values on assets and liabilities of businesses.

As you go through life, you come face to face with accounting information more than you would ever imagine. Regretfully, much of this information is not self-explanatory or intuitive, and it does not come with a user’s manual. Accounting information is presented on the assumption that you have a basic familiarity with the vocabulary of accounting and the accounting methods used to generate the information. In short, most of the accounting information you encounter is not transparent. The main reason for studying accounting is to learn its vocabulary and valuation methods, so you can make more intelligent use of the information.

People who use accounting information should know the basic rules of play and how the financial score is kept, much like spectators at a football or baseball game.

Let me point out another reason you should know accounting basics. A lot of people out there in the cold, cruel financial world may take advantage of you, not necessarily by illegal means but by withholding key information and by diverting your attention from unfavorable aspects of certain financial decisions. These unscrupulous characters treat you as a lamb waiting to be fleeced. The best defense against such tactics is to know some accounting, which can help you ask the right questions and understand the financial points that con artists don’t want you to know.

Is Accounting Just for Accountants?

One main source of accounting information is in the form of financial statements that are packaged with other information in a financial report. Accountants keep the books and record the financial activities of an entity (such as a business). From these detailed records the accountant prepares financial statements that summarize the results of the activities.

Financial statements are sent to people who have a stake in the outcomes of the activities. If you own stock in General Electric, for example, or you have money in a mutual fund, you receive regular financial reports. If you invest your hard-earned money in a private business or a real estate venture, or you save money in a credit union, you receive regular financial reports. If you are a member of a nonprofit association or organization, you’re entitled to receive regular financial reports.

In summary, one important reason for studying accounting is to make sense of the financial statements in the financial reports you get. I guarantee that Warren Buffett knows accounting and how to read financial statements.

Accounting Affects both Insiders and Outsiders

People who need to know accounting fall into two broad groups: “insiders” and “outsiders“.

Business managers are insiders; they have the authority and responsibility to run a business. They need a good understanding of accounting terms and the methods used to measure profit and put values on assets and liabilities. Accounting information is indispensable for planning and controlling the financial performance and condition of the business. Likewise, administrators of nonprofit and governmental entities need to understand the accounting terminology and measurement methods in their financial statements.

The rest are outsiders.

The Outsiders not privy to the day-to-day details of a business or organization. They have to rely on financial reports from the entity to know what’s going on. Therefore, they need to have a good grip on the financial statements included in the financial reports. For all practical purposes, financial reports are the only source of financial information we get directly from a business or other organization.

By the way, the employees of a business — even though they obviously have a stake in the success of the business — do not necessarily receive its financial reports. Only the investors in the business and its lenders are entitled to receive the financial reports. Of course, a business could provide this information to those of its employees who are not shareowners, but generally speaking most businesses do not. The financial reports of public businesses are in the public domain, so their employees can easily secure a copy. However, financial reports are not automatically mailed to all employees of a public business.

In our personal financial lives, a little accounting knowledge is a big help for understanding investing in general, how investment performance is measured, and many other important financial topics. With some basic accounting knowledge, you’ll sound much more sophisticated when speaking with your banker or broker. I can’t promise you that learning accounting will save you big bucks on your income taxes, but it can’t hurt and will definitely help you understand what your tax preparer is talking about.

Overcoming the Stereotypes of Accountants

Maybe you’ve heard the joke that an accountant with a personality is one who looks at your shoes when he is talking to you, instead his own shoes.

Like most stereotypes, there’s an element of truth in the preconceived image of accountants. Even I am not an accounting professor, I have met and known a large number of accountants. Most accountants are not as gregarious as used-car sales people (though some are). Accountants certainly are more detail-oriented than your average person. However, you don’t have to be good at mathematics to be a good accountant. Accountants use very little math (no calculus and only simple algebra). Accountants are very good at one thing: They want to see both sides of financial transactions: the give and take. Accountants know better than anyone that, as economists are fond of saying, there’s no such thing as a free lunch.

If you walked down a busy street in metropolis city (Chicago, London, Tokyo, New York, or Los Angeles), I doubt that you could pick out the accountants. I have no idea whether accountants have higher or lower divorce rates than others, whether they go to church more frequently or if they generally sleep well at night. I do think that accountants are more honest in paying their income taxes than other people, although I have no proof of this.

Relating Accounting to Your Personal Financial Life

I’m sure you know the value of learning personal finance and investing fundamentals. Well, a great deal of the information you use in making personal finance and investing decisions is accounting information. One knock I have on oversee in these areas is that they often don’t make clear that you need a basic understanding of accounting terminology and valuation methods in order to make good use of the financial information.

You have a stake in the financial performance of the business you work for, the government entities you pay taxes to, the churches and charitable organizations you donate money to, the retirement plan you participate in, the businesses you buy from, and the healthcare providers you depend on. The financial performance and viability of these entities has a direct bearing on your personal financial life and well-being.

We’re all affected by the profit performance of businesses, even though we may not be fully aware of just how their profit performance affects our jobs, investments, and taxes. For example: as an employee your job security and your next raise depend on the business making a profit. If the business suffers a loss, you may be laid off or asked to take a reduction in pay or benefits.

Business managers get paid to make profit happen. If the business fails to meet its profit objectives or suffers a loss, its managers may be replaced (or at least not get their bonuses).

Your investments in businesses, whether direct or through retirement accounts and mutual funds, suffer if the businesses don’t turn a profit. I hope the stores I trade with make profit and continue in business. The government depend on businesses making profit to collect income taxes from them.

Accounting Focuses on Transactions

Accounting focuses on transactions. A good bookkeeping system captures and records every transaction that takes place without missing a beat. Transactions are economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals. Transactions are the lifeblood of every business, the heartbeat of activity that keeps it going. Understanding accounting, to a large extent, means understanding how accountants record the financial effects of transactions. The immediate and future financial effects of some transactions can be difficult to determine.

A business carries on economic exchanges with six basic types of persons or entities:

1. Its customers, who buy the products and services that the business sells
2. Its employees, who provide services to the business and are paid wages and salaries and provided with benefits, such as: a retirement plan, medical insurance, workers’ compensation, and unemployment insurance.
3. Its suppliers and vendors, who sell a wide range of things to the business, such as legal advice, products for resale, electricity and gas, telephone service, computers, vehicles, tools and equipment, furniture, and even audits.
4. Its debt sources of capital who loan money to the business, charge interest on the amount loaned, and are due to be repaid at definite dates in the future.
5. Its equity sources of capital, the individuals and financial institutions that invest money in the business and expect the business to earn profit on the capital they invest.
6. The government, or the federal, state, and local agencies that collect income taxes, sales taxes, payroll taxes, and property taxes from the business.

Even a relatively small business generates a surprisingly large number of transactions, and all transactions have to be recorded. Certain other events that have a financial impact on the business have to be recorded as well. These are called events because they’re not based on give-and-take bargaining—unlike the something-given-for-something-received nature of economic exchanges.

Events such as the following have an economic impact on a business and are recorded:

1. A business may lose a lawsuit and be ordered to pay damages. The liability to pay the damages is recorded.
2. A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be written down, meaning that the recorded values of the assets are reduced to zero if they no longer have any value to the business. For example, products that were being held for sale to customers (until they floated down the river) must be removed from the inventory asset account.
3. A business may decide to abandon a major product line and downsize its workforce, requiring that severance compensation be paid to the laid-off employees.

At the end of the year the accountant makes a special survey to make sure that all events and developments during the year that should be recorded have been recorded, so that the financial statements and tax returns for the year are complete and correct.

The talk is getting more seriously eh? But let’s take a break for some drinks. If you love this kind discussion, you may want to check out my next topic: Range Of Accounting: What Accounting Department Mainly Responsible For?

Accounting and finance departments have always strived to improve the management of cash flows, reduce working capital and financing costs, track long-term indicators of solvency and contain transaction-processing costs. However, the centralized accounting function, due to intra- and inter-enterprise collaboration and integration, is no longer centralized in many organizations. Accounting processes are handled by different pieces of software, costs are not only internal but also spread across the supply chain and accounting information is contained not only in the general ledger but also is scattered in data, information and knowledge warehouses. These changes pose new challenges in dealing with old problems and offer new solutions for the same problems.

The financial supply chain, also referred to as financial value chain, is the new area emerging to deal with the new financial processes. This term has been around for at least a decade, though consultants and software vendors have put a new spin on it. Now, the area of financial supply chain, similar to SCM, has multiple interpretations, multiple perspectives and no single departmental owner.

Aberdeen Group defines financial value chain as follows:

A range of B2B, trade-related, intra- and inter-enterprise, financial transaction-based functions and processes” (Best practices in streamlining the financial value chain, 2002, www.aberdeen.com). Killen & Associates Inc. categorizes all the services provided by financial supply chain into three categories: “performance measurement and control, decision support and transaction processing (Optimizing the financial supply chain, 2002, www.killen.com).

 

SAP, on the other hand, includes: order-to-cash, purchase-to-pay, bank processes and relationship management, and cash management (mySAP Financials: Next generation integration, 2003, www.sap.com) as four processes in the financial supply chain management.

These definitions evidently cover all aspects of accounting and finance. Functionalities explored, from the revenue cycle to treasury functions seen in the last section, fall under the gamut of financial supply chain. Problems encountered by accounting departments in identifying costs, let alone controlling those costs, are formidable. Illustrative internal problems include disparate ERP systems, lack of consolidation and budgeting software, patchwork of add-on modules and absence of an organizational strategy. External problems may include establishing relationships with suppliers and customers, banking relationships, lack of access to real-time data and managing funds in an uncertain external environment. A number of these problems were reviewed earlier in the book. Financial supply chain management tools are available, though a concerted strategy to employ those tools for optimizing financial supply chain is missing in most organizations.

Aberdeen Group forecasts that optimization of financial supply chain can result in substantial savings. The savings forecasts for a billion-dollar company are as follows:

1. Reduction in working capital by 20% to 25%
2. Reduction in financing costs by $4 million per year
3. Proactive warnings for delayed receivables and reduction in Days Sales Outstanding (DSOs)
4. Approximately $13 million savings from transaction processing costs

According to another estimate, the cost to finance products moving through the supply chain is approximately $360 billion, or 4% GDP. If these forecasts are correct, then major corporations can achieve billions of dollars in savings by optimizing financial supply chain. But, how does a corporation optimize the financial supply chain?

Solutions offered by consultants and software vendors primarily revolve around the new tools seen so far. Suggested tools can be classified into three categories: ERP systems to integrate internal functions, Web-based tools to facilitate free flow of information with trading partners, and hybrid tools that use functionalities of ERP and the Internet.

Due to the convergence of software tools, no distinction in these categories was made in this post. However, most of the tools and software that we have seen is from the second and third category. A summary of these tools for each cycle is provided:

(a). Revenue Cycle

1. CRM
2. Online credit check
3. Web-enabled WMS for order fulfillment
4. Web-based tracking of shipments
5. Electronic invoice (bill) presentment and payment
6. Online management of receivables
7. Web-based cash collection and payment methods

(2). Expenditure Cycle

1. SRM tools
2. Procurement cards
3. Employee self-service features
4. Online management of expenses
5. Online management of assets

(3). Conversion Cycle

1. Supply chain planning tools
2. Supply chain execution tools
3. Supply chain collaboration tools
4. Supply chain coordination tools

(4). General Ledger Cycle

1. Technical and managerial requirements for virtual close
2. BI tools
3. Planning and budgeting solutions
4. Enterprise portals

(5). Treasury Functions

1. Cash and liquidity management tools
2. Debt and investment management tools
3. Risk evaluation tools

Financial supply chain management aims to reduce costs in financial management, transaction processing and financial reporting. Financial supply chain is optimized by automating, outsourcing Web enabling and rationalizing financial workflows and business processes. The tools to achieve these objectives are available. However, the cost effectiveness and efficacy of these tools is not proven. The optimal investment in information technology for financial supply chain management is a difficult question to answer, and the answers are probably unique for each organization. It seems that consultants and software vendors will thrive in this area for a while!

Success of a business depends on the business owner or the financial management. Too much reliance on the lending institution to help run the business may prove disastrous. There should, therefore, be flexibility in the agreement to let the business grow and be successful. Advice and help from the lender should not be overlooked. Lenders may have had experience with other similar businesses, and you can profit from that experience. As a borrower, you should request these considerations in the lending agreement:

1. There should be an option available to you to refinance at any time. Often the lender will qualify this provision to permit refinancing only after a certain period of time or with a prepayment penalty. You may need this provision in order to take advantage of lower prevailing interest rates should they occur.
2. A conversion agreement should allow for more favorable loan conditions once certain “growth forecasts” have been met. This provision takes into consideration the fact that as your business grows, its risks may decrease. Because interest rates should be tied to perceived risk, as you prove your viability and success, you are entitled to pay less of an interest premium; arguably, your riskiness has been reduced.
3. Agree on no prepayment penalty. Changing financial conditions may provide you with sufficient cash to prepay the loan. This may be done to realize significant tax benefits, as a requirement for the obtaining of additional financing, or to put you in a better business posture. Prepayment generally will work no hardship on the lender other than to take away the guarantee of expected future earnings. There would be nothing to stop the lender from reloaning this money to other individuals and thus recovering the future earnings from someone else. The lender’s risk is that the money cannot be reloaned at equal or better rates.
4. Request limitation on interest rates. Banks prefer to charge a variable interest rate. You should negotiate limitations or caps on rates and make this a major consideration in determining whether to enter into the financing agreement. Agree on the possibility of an increased loan based on meeting certain tests. Often, if you are successful and the business is growing within certain predictable ranges, additional debt financing may be necessary to continue the growth pattern. As such, you may want the loan agreement to provide for additional advances of debt to aid in sustaining that growth. A lender should consider itself an ongoing business partner in these agreements. As you grow, so does the income of the lender. Some loans have an absolute upper credit limit, and you may borrow up to that limit without further formal application.
5. The agreement should specify identifiable assets that are pledged as collateral.
6. Seek a loan “grace” period of 30 to 60 days for noncompliance with debt arrangements. Very often this provision requires you to notify the lender in advance that you will use the provision. There probably will be a limit on how frequently this can be done.

Lenders may be more willing to permit minimum defaults when you submit a plan showing how you will make it up after appropriate notice to the lender. The worst thing you can do is surprise your lender. In most cases, a lender would rather work out a mutually agreeable accommodation than seek legal redress.