In my final years in college I had more classes in traditional accounting, including the two broad categories of accounting: financial and management accounting. After that I graduated and went to work for Price Waterhouse in Salt Lake City as a staff accountant in the auditing department. I worked there for 2 ½ years and gained an appreciation for why things are the way they are.
Financial accounting is concerned with external reporting, or releasing financial information outside the organization. The annual statement for a company is produced by financial accounting. These financial statements are built upon financial reporting standards. The free-market economy is built upon the premise that financial results in different companies can be compared because objective standards were used to measure the results.
Financial accounting standards in the US started to be codified in 1930 in response to the US stock market crash. As they became codified, they were called GAAP, Generally Accepted Accounting Principles. Because of this long development process, they are very advanced, perhaps the most comprehensive and advanced reporting standards that exist. Initial standards were developed locally in many countries, but with globalization new standards have been developed and are taking hold. The latest set of standards is called IFRS, International Financial Reporting Standards. Standardization continues.
Accounting standards are meant to increase consistency, reliability, relevance, and comparability.1 The process of creating and selling an airplane is much different from making and selling potato chips, and making the financial results comparable is challenging. Suppose an airplane manufacturer could only recognize revenue (record on the income statement) when they actually shipped a plane. They would have huge losses for many years to be followed by a period with huge revenues. Comparing their financial results to a potato chip manufacturer could only be done with income statements that cover a decade or so when the airplane manufacturer’s financial results leveled out. Measuring the financial results of an airline manufacturer against a consulting services company means even more differences. But the standards form agreement about what those differences are, and how to compare the results of the two organizations.
Although they aren’t expressed this way too often, effectively, the standards are a set of definitions of business events we are all familiar with: Sale, shipment, withdrawal, payment, etc. They help define when these events occur, and what basis should be used to measure them. For example, if one system recorded the salary expense business event when one receives an offer for employment, and another system when paid, obviously the financial reports will not be consistent. Effectively, people know what a sale means because the accounting standards define it.
I left some of Eric’s classes feeling the accounting model could be thrown out. However, I came to understand that these definitions must be applied consistently in the business systems. For example, some systems which “sell” materials to another part of the business just treat the other division as if it were a separate company. The system doesn’t care if it is a real customer or not. The source system applies “system GAAP” which is whatever the programmer understood. The financial system might be responsible to identify these internal customers and eliminate these “sales” from showing up on the income statement. So although over the course of all the systems within a company the financial reporting standards might be applied, at any one point in the process, they might not be met.
Although the standards can’t be thrown out, they also shouldn’t be mistaken for dictating how the financial systems should work. At times people believe they do, and they confuse the process for the results. The importance of these standards, and the authority and responsibility of the accountants to “sign-off” or certify their accuracy (with the all-important caveat of “in all material respects”) means at times those who have come to understand technology little have an inordinate say in how it must be applied.
Management accounting is concerned with internal reporting, or producing information for use inside the organization. Historically it was concerned with determining cost of products. For example, the accountants would add up the costs for a factory for some period of time, divide that by the number of units produced to arrive at a cost per unit. This process isn’t as straightforward as the example seems. How much of the cost of building the factory should be included in the cost of each unit? The cost of the first item manufactured is very high. So accountants develop assumptions about how long the factory will be used to determine how much should be allocated to each product.
If the company only has one factory and makes one type of product, then perhaps the life of the factory is the only assumption that has to be developed. This is unlikely for most companies, and thus the process of allocating costs can become very complex. For example, how much of the lowly accountant’s salary for developing these estimates should be allocated to each product produced in different factories? And how much of the payroll clerk’s cost for paying the accountant should be charged? The list of estimates and assumptions can get very, very long.
Rick Roth, my future partner in business, told me one time that as he was teaching these courses in college before joining the accounting firm of Price Waterhouse, he realized that the financial reporting and management reporting systems were simply parallel systems that recorded the same events from the source systems through two supply chains to produce similar types of outputs, just with different attributes.
During an internship I had as an internal auditor, and then at Price Waterhouse, I learned that audits gather two types of evidence to support the accuracy of financial statements. First is evidence that internal controls are properly functioning. Internal controls are business processes such as authorizing invoices prior to payment, and depositing cash the day of receipt. I gained practical experience in this type of evidence. I sampled records from various subsystems processes, A/R, A/P, etc., and saw that proper authorization had been performed, data was entered correctly into systems, and that those transactions were properly posted. I also learned the basics of audit documentation (and I learned that I was not very good at audit documentation). In my experience, I have not found a case where the event based concepts damaged internal controls. In fact, additional attributes may be recorded on each business event which increases internal controls. Also, each business event can be seen within the context of all reports, increasing visibility and auditability.
The second type of evidence auditors gather is that the numbers are actually correct. These tests are called substantive tests. A substantive test would be to have the bank confirm that the amount of cash on deposit actually matches the cash on the balance sheet. Auditing begins with the balance sheet because balances as of a point in time can be confirmed and counted. Financial reporting begins with the balance sheet. After establishing that the balance sheet at both ends of the income statement is correct, auditing then looks to explain changes in balances, thus moving to the income statement and explaining activity over time. Audit work papers have a section to explain each significant balance on the balance sheet, and a much smaller set that examines the changes in those balances.
Event based concepts can actually enhance the types of substantive evidence auditors can gather. The ability to see what transactions at a more detailed level created which balances increases confidence that the balances are correct. It may provide more direct evidence for the income statement. As I have watched auditors interact and test event based financial systems, they have endorsed them without reservations.2
Auditing is a kind of “quality control” function for reporting. This quality control process is what brings people back to the financial systems over and over and over again. For all its complexity, it is by and large reliable. If it provided greater information to more people, better decisions would likely be made because it is reconciled and controlled.
After a few years, I had gained an appreciation for how things really are, and how they differed from how they could theoretically be. But, I also learned that I wasn’t cut out to be an auditor. It wasn’t standards, and comparability, and reliability that I was interested in. I did my most admired work by automating auditing working papers when the process was mostly manual—a self-serving achievement because my handwriting was still so bad. I also had some success assisting one organization understand the relationships between the reports produced by their new computer systems. It whetted my appetite to understand large computer systems, and the reports and information they produced.
I came to the conclusion that I should change careers. I was coached by a kind manager and an understanding partner to look for something that fired my interest. The audit partner said to keep him informed as I looked for a new job. After walking out of his office, I returned to my office and called Eric Denna for advice about what I should do next.
Next: Chapter 11. Consulting
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Parent Topic: Part 3. The Partner