Back to Basics - Accounting Concepts Part 1.
We live and work in a complex world. Complexity comes from the growth of societies and the systems we have put in place to manage and be able have common ways of communicating. In business it's about the numbers. Stock markets, in theory, are driven by the ability to invest and get a return from the money in the form of dividends or capital growth. The assumption is that you aren't going to get either if the business isn't performing well.
Again in theory people are making a value judgment of the future potential return. How should they make those decisions? Well they should look at the financial viability of the company. How do you do this ? You should look at their financial statements and other reported company information.
Most average investors don't analyze the reports, it's more driven by other news about the company but that is a completely different topic on consumer behavior so I won’t go down that path.
Financial statements are what the bank is going to ask for or private equity investors are going to ask for when trying to raise capital outside the stock markets. I can hear you say great and? Well working with a lot of ERP projects sometimes we forget about the basics of what it is we are doing.
ERP software is a tool for the business used for the people in the organization. The tool is supposed to help the organization collect and analyze financial and operational data. Then use that data for reporting to internal and external consumers. The external consumers would be shareholders, investors and regulators. The internal consumers are the managers.
The internal consumers will use the data to track their progress to tactical and strategic policy. The external consumers will look at the data and see if they are making the right investments decisions. The external consumers will look at the strategy and use the numbers to give them an indicator to see if the company is heading in the right direction which protects their investment of future returns potential.
Now I can hear folks saying ok your explanation includes only concepts of public and private commercial companies. What about public sector, not for profit, charities or community organizations. Well the same basics apply there as well. They just have different strategies. They need to manage the resources they have to execute on their mission. They still have people that want to see how they are performing. In the case of public sector organization it's you and me because we pay taxes and want to see those taxes spent wisely. In the case of not for profits, the people committing money to the charity want to see it's being use for good.
Ok so I've set the scene, we have a tool ERP and we have an expected outcome. How do we connect the dots. What are the basic concepts and how does this really connect with trying to implement and ERP application? Well that is what I thought I'd try to do in a series of posts, I don't know how many, so we'll just make a start.
So back to basics the financial statements:
Revenues and Expenses
Income Statement (Profit and Loss)
The income statement is a statement of the summary of revenues and expenses for a specific period. Total the revenues for the period, if they are more than the expense then we have net income (net profit). If we didn't do so well in managing or organization then total revenue would be less than expense and we'd have a net loss.
So the income statement is going to tell us in that period if we are making money. Now that period could be a month, or quarter or year which are the typical buckets organizations manage by. If we made a loss in a month is that a concern? No maybe it's seasonal business so there maybe always a pattern of losses in the low months and then profits in the high months. But if you look across the year the plan would be that we end in a profit.
Statement of Activities (Excess or Deficit)
In a public sector organization we are not so worries about making money but how we are spending it. Conceptually the same as an Income Statement in a commercial organization we want to see how much money we have coming in verses going out. The money we have is typically managed in Funds. The fund represents were the money came from or how it is ring fenced in the budgeting cycle for spending. So typically we don't talk about profit we talk about excess. If we didn't manage the money well enough then we have a deficit.
An example Income statement. In this example it's for the period end October 31st but also includes a comparison to year to date (YTD).
Assets and Liabilities
To be in business we are leveraging the tools we have to help us make money. These tools are assets. It could be a building we own, it could be a machine we have. It could be the money we have in the bank. It could be patents we have developed and own. What we need to do is measure how well we are using these assets and the assets wear out over time. When we started out business we might not have had money to get the machine we needed. So we took out a loan. Or we have products that we have purchased so that we can on sell but we still owe the supplier the supplier for the goods.
So the Balance Sheet is going to be our tool here to help us understand the picture of assets and liabilities.
Statement of Financial Position
In a public sector organization they have the same need. They have roads they need to maintain. They have water or electrical infrastructure. They have planes or equipment to distribute food aid in remote parts of the world. These are assets and like a commercial business they may seek loans or have been granted credit from suppliers. Typically it is called a Statement of financial position.
Similar to the income statement the balance sheet when produced is for a specific period. An example here across a two page listing:
Remembering the accounting equation
From the balance sheet you can see the accounting equation in action:
Assets = Liabilities + Owners Equity.
From the statement above then this company has $161,935,288 in assets. $11,905,494 in liabilities and $150,029,794 in equity.
Where does the data come from
The accounting data is generated by events. Someone in the organization purchase materials. Someone combines materials together to make a finished product. A sale is made to a customer. Product is shipped to a customer. There are multiple people in the organization that need to be able to input and register data so we can collect this for accounting purposes and eventually reporting.
For example let's look at the modules in Dynamics AX 2012 compared to the Income Statement.
- Sales we might generate and manage in the Sales and Marketing, Retail or Project Accounting modules.
- Manufacturing Expense are going to be incurred in managing production in the Production Control module.
- Selling and Advertising Expenses could come from our sales people registering travel expenses in the Travel and Expense Module.
- Personnel Expenses could be generated from the Payroll module.
- Depreciation Expense would be generated by managing our depreciation books in the Fixed Assets module
If we look at the Balance Sheet:
- Bank accounts will be managed in the Cash and Bank Management module.
- Accounts receivable will be managed in the Account Receivable module after recording sales in the Sales and Marketing or Retail modules.
- Physical Inventory would be managed in the Inventory and warehouse management and Product Information management modules.
- Fixed assets both intangible and tangible assets would be managed in the Fixed Assets module.
Bringing it all together
So how does this all come together that we can report our organizational data. Well that comes together in the General Ledger as documents are posted from the other modules they end up in the General Ledger and that is what we report on. The example reports were exported from Management Reporter 2012 for Microsoft Dynamics ERP.
These samples reports give one picture for an organization and typically the company would report a summary version for external consumption. But for internal usage they might want to slice the income statement or balance but internal structures based on how they are organized.
For example you have a multi-national company with operations in Canada, USA, Mexico, UK, France, Germany. Now the CEO might appoint managers to help him run the company and execute on strategy so he appoints a manager for North America (Canada, USA, Mexico) and Europe (UK, France, Germany). Now the CEO wants the whole company to be profitable but he also wants to be able to see the profitability by region North America and Europe because he wants to track the progress of each manager.
Take a different example as an extension of the above. What if there was an additional set of managers that were responsible for product lines. A product line might expand across regions because they sell the product in North America and Europe.
This leads to a number of dimensions that we need to be able to track the financial data to be able to report out:
- Legal Entities
- To be doing business in a country I would have some form of organization registered. This legal entity is registered based on the local company law and is regulated and taxed in that country.
- In this example we have an organizational concepts for how we internally manage the company.
- We want to be able to separate expenses incurred but the different departments so we can put in place cost control policies.
- Product Line
- Another example of an organizational structure. In our example Income Statement above we have sales in October of $7,678,600. How much of this is Item X vs. Item Y sales.
There are other basic measurements concepts that we need to organize to report consistently:
- Remember we said the reports were for a stated period in time. This needs to be controlled by a calendar that we can defined are reporting period buckets.
- The example reports above are in US dollars. If the organization did operate in Europe then they would likely be making sales in Pounds in the UK and Euro for the other countries.
Back to Basics
So this post is getting long so I'm going to break here and in the next post we'll talk about the concept of recording a transaction to post to the ledger and then in sub-sequent posts over lay some the other concept on top and see how we configure these in Dynamics AX 2012
(Original post at http://blogs.msdn.com/lcash)