What drives the underlying quality in Fact-Based Management

Bookkeeping is boring and tedious business, right?

It is strategies, creative ideas and bold moves that brings business forward.

This is true. 

And it is also true that there is a big difference between haphazard actions and intelligent well thought through execution of a devised and accepted strategy.

Fact-Based Management is the way to take calculated risks with sustainable results, and bookkeeping is the cornerstone of making this work.

The goal

If we accept that one of the primary goals for running a business is profit, then keeping track of profit becomes a priority.

Keeping accounts in direct relation to the activities in a monthly P&L is crucial for directing a company towards maximizing performance and thereby profits. I.e. intelligently categorizing revenue and costs in relation to the activities in the month, and not just letting the chips fall as they do.

As Luca Pacioli the father of double entry bookkeeping writes it: “Without double entry, businessmen would not sleep easily at night”, Summa, Page 2.

Without double entry, businessmen would not sleep easily at night

Below several topics are presented and discussed in relation to making bookkeeping work for steering a business and for functioning as a tool for sanity-checks for Fact-Based Management.

The P&L as the true north star

If your accounts are sound and accurate - then the financial accounts can be used as a gauge for all other measures in running a business according to the principles of Fact-Based Management. 

By example; Data-mining for specific costs regarding maintenance on running a part of the machines in a factory, should when aggregated over all machinery tie in to the P&L for the maintenance costs. This becomes even more important in regards to sales, where there are always more conflicts as to what are the real numbers. Sales Exces will try to argue for counting sales when the order is confirmed rather than delivered, and maybe later on counting something from previous periods, which has been paid - and this can be exemplified through partitioning on products, segments, periods, districts etc. etc.

So in the end, when you look at any non-bookkeeping data-item, you should be able to either aggregate it and tie it in to the relevant place in the P&L, or cost it and then do the same - i.e. the P&L is the truth, which gives the sanity-check for all other measures, metrics, datapoints or what have you.

Proper bookkeeping as the true north star for gauging all data in Fact-Based Management

As an illustration of this principle, think of a situation when analyzing profitability of orders in a factory, you might gather time and materials used for each order using a data collection system. 

Then you value time according to average wages used either average wage per productive hour, or average wages corrected by a percentage of effectiveness according to the time registered on various categories. 

Valuing materials according to their costs in the ERP-systems warehouse-part should be easy, however waste and general shrinkage will never be fully accurate. 

Aggregating all orders on turnover should vary very little from what you have in your accounts using the same periodization as in the financial statements, however costs might be several percent low or high. This will show you that you have made wrong assumptions valuing the time or materials or perhaps the data collection is off. 

This will then guide you to debugging the costs, and how to adjust the correction factors applied, so that you end up with a valid evaluation on the total, and thus also a valid evaluation of the individual order.

When you have aligned your aggregated numbers with the financial statements, and this alignment does not fluctuate over time, you will have a direct link from your activities during production and also decisions taken in sales to what materializes in your P&L.

Thus you have a good tool for analyzing profitability on customers, market segments, machines, operators, processes etc. and in addition you will be able to pinpoint through commensurable analysis where you might optimize what you are doing to increase profits.

Now you are capable of discussing activities in relation to optimizing the business or to discuss results in the P&L and set an action plan for improvement, as you can tie in profits and activities.

This is just one example of how to use your bookkeeping as your true north star for decision making.

Basics of accounting and the legacy of Pacioli 

As you will probably know there are 2 major entities in the system of double entry bookkeeping. The Profit & Loss statement (P&L) and the Balance Sheet.

In the P&L sales and costs (calendarized and adjusted revenues and expenses) are registered and the difference is the profit.

In the Balance Sheet the Assets and the Liabilities of the company are recorded, and the two equals each other (including the equity).

Credit and debit are important to understand, and also easy concepts. Debit is an entry on the left hand side and credit is on the right hand side in a T-account.

The basics of double-entry bookkeeping are simple but important

Each time you book something you record the transaction twice - hence the double entry bookkeeping. One time debit and one time credit, so that you post equally on both sides.

In general you post one time in the P&L and one time in the Balance Sheet - or twice in the balance sheet between the assets and the liabilities.

This makes it easy to see the flow of income (P&L) through sales and costs and also where the income went (Balance Sheet). In addition it gives an easy way of “balancing” accounts, i.e. making sure that assets equal liabilities, and thus you have (probably) made the right entries.

The prudence concept, accruals and periodization

The prudence concept, also known as the conservatism principle, is an accounting principle that states that you should record liabilities and expenses as soon as they occur, but revenues only when they are assured or realized. I.e. you should not include something in the accounts, which is uncertain - or at least only include negative uncertainty. So you should always be sure that the recorded profit is to the low side.

To reflect the activity in the company you should use accruals and periodization (you may also use cash accounting, but this is in general not a good idea for larger businesses). Do not let big bonuses from purchase agreements fall in one month, but periodize in accordance with the use of what has been purchased in relation to what is sold. I.e. anticipate the bonus and include it in the cost price, or use the bonus from the last period and include this in the cost price going forward - in opposition to just booking the whole bonus in the month when it is paid.

It is vital that the accounts reflect the activity level and the results of those activities in any given period.

It is the same principle as keeping a stock in your assets and only post as cost in the P&L what you have actually used for the products that have been sold in the period.

Accruals are important for showing a true and fair view of the operation in the monthly reporting

In effect periodization will turn expenses into costs. I.e. an expense that covers 12 months, i.e. paying for insurance or the like, should not be booked into only the month where it is paid, but should be booked to the balance sheet and booked as costs in the months relevant - i.e. in the case of insurance, that would normally be 1/12th per month. The same principle goes for components which goes into products or the like, i.e. items put into the warehouse and used to assemble products should not be expensed in the P&L immediately, but instead be booked in to stock in the balance sheet, and then booked as costs in relation to what quantity is used. 

Normally in accounting today, a sales point of view is adopted, so that what has been used to generate the goods sold in the month is to be booked as costs, i.e. not what has been used physically during the month. There could be a stock of finished products entering into the month, which has been used to sell during the month, or a build up of finished goods to the stock during the month which has not been sold, or even a set of items being not fully finished, i.e. work in progress, WIP.

Periodization should treat all costs from this principle if possible - what has been used to generate the turnover should be booked as costs in the P&L, and not what has been expensed during the month.

Accruals are used to put the prudence concept into practice. When you expect a future cost may arise due to the goods sold in the month (or goods ever sold), then you should put aside an amount to cover that cost. I.e. you book the cost in the month (or the periods relevant, if possible) and then you keep the accrual in the balance sheet - until the cost materializes. Accruals should be released if they are no longer relevant, and a windfall gain from releasing an accrual from the balance sheet to the P&L will skew the month.

Naturally such biases should be avoided or sought eliminated. 

Keeping the P&L and the Balance Sheet in line with activities in the month is crucial for Fact-Based Management

There are two remedies for this. Each month all accruals should be assessed and decreased or increased as appropriate, this will make the impact of skewing the P&L smaller, as some accruals will be eliminated and others increased, so that the total effect will be smaller. The second remedy is to simply cancel out one accrual with another, i.e. using a certain tardiness in releasing accruals, so as to release them, when new ones are relevant. Another method along similar lines is to build up the accrual over several months. Either take a little of the bias each month, or simply take as much as the month can bear or take as much as release of other accruals allow.

Matching, debtors, creditors, bank & reconciliation

In order to control that the company pays what is owed and on time, a strict matching of open entries on creditors are necessary. I.e. in your books you should match outstanding entries with the actual payments from the bank. 

This also facilitates good control of liquidity, which is a prerequisite for running the operation.

Furthermore running a good a profitable business is not profitable in a real sense, if you do not collect the cash from your transactions - debtor losses will decrease your profitability, and as such a good and timely follow-up on this issue should be applied.

Suppliers will not supply you with the goods you need to transform through value added services, if they are not paid - and treating a supplier as a partner for succeeding in your business also means not only paying what is owed, but also paying when it is agreed. Thus matching and controlling creditors are also important.

Securing the same for debtors is evident, you need to get paid for your services, not just sending out invoices. 

The matching procedure is about the same and it is not a hard task to accomplish with the current advanced accounting tools - however the core of the matter is that you track all payments from debtors in the bank account to the open entries from the invoices sent. Doing so with automatized procedures is fine, as long as you understand the basics and what is to be achieved - if you do not understand the principle you will not be able to find the errors if something should fail.

Matching also describes the conversion of revenue and expenses to sales and costs, so that the activity in a period in time is shown through what has been sold and the associated costs, and not tied in to the cash flow of money in and out of the business.

Journals are used to facilitate the manual accounting process. These are specific purpose pads for a certain process. You could have a journal for all your cash receipt transactions, for example. When a sale occurs, you write the transaction in the journal as a single line item. At the end of a week or a month, you add up the transactions and make one journal entry in the general ledger; a credit to sales, and a debit to cash.

This will result in differences between cash posted from sales and in the bank account, if there are errors in the journal or errors at the bank.

The same goes for stock, creditors and debtors, depending on the system keeping track of these journals.

Keeping your journals in good order vs. the underlying systems are important to secure that the P&L can work as a true north star for valuing all activities in Fact-Based Management

Reconciliation is the process of comparing two sets of records - ie. journals, accounts and subsystems - to check that figures are correct and in agreement. Account reconciliation also confirms that accounts in the general ledger are consistent, accurate, and complete.

This is checking the agreement of by example the suppliers register with the account in the general ledger for a period, most frequently the financial year to date or a month. This secures that the basis for what is in the general ledger is consistent and valid. 

Even in modern digitized accounting software you will need to do this regularly for debtors, creditors, bank and to some degree VAT and stock - but in effect any account in your balance sheet needs reconciliation checks once in a while to secure that the basis for the vouchers or systems behind them are in good order.

Reconciliation is important, even if it is tedious business. First, in the modern digitized systems the bookkeeping is prone to fewer errors and the correction of these errors once found are easier to carry out. However the methods remain the same, and there will be errors in any system, also systems that automatically check for correct double entry and gives active warnings. Second fraud is a real risk, and there will normally be internal consistency in accounts, but not between accounts, or not between individual journals or the ledger. Even though fraud can happen with all things consistent, a first line of defence is reconciliation and making sure things tie in together.

Naturally you would like to erase any errors made and any fraud, just for the sake of good order. However even if there are minor errors which you may live with, these can aggregate over time. In addition when you run your company using the bookkeeping as the “truth”, then this becomes even more important, as errors can lead you down a non-profitable way, and small errors will be enhanced by your decisions about the future activities in the company.

Reconciliation gives security against a skewed North Star

The ledger, drill-down and using the P&L as a guide in managing the business

A Ledger was in the time before digitization a big book of entries into different accounts, this was accompanied by a chart of accounts, where one would summarize entries into accounts from various journals. Today you will in any accounting software simply have a chart of accounts, divided into a P&L, Assets and Liabilities. You will then be able to drill down from each account to the individual entries in to the account, and you will also be able to drill down to the document / voucher or subsystem which is the origin of the number entered and in addition the other leg of the double entry.

When using the bookkeeping as guidelines and steering tools for the business, you will measure the actual booked costs and revenue against the budget, i.e. the plan that you set ahead of the fiscal year. 

Analyzing the deviations from budget - negative as well as positive - should give you an insight into the activities in the month. Bridging the analysis to what actually was the results of those activities vs. what was planned is crucial. 

The starting point of this analysis will be a drill-down on individual accounts and maybe from there to the individual voucher.

It is crucial for this to work well, that the bookkeeping gives a descriptive text on each entry, so that it will be easy to understand what has happened later on, when you need to find out why an account is developing as it is - this can not be stressed enough, it is vital for good controlling of costs, and in addition indispensable for good control of the revenue too.

If this is done in a good way, you can understand what has happened in an account from simply getting a specification with the individual entries, just cursory browsing the list of entries. You will immediately be capable of “reading” the contents of the account. If a descriptive text is not given in the booking, this cursory reading of the entries is not possible, and you will have to look up each and every voucher. If this is just one page, ie. about 50 entries you will not be able to keep all the information in your head, and you have to write down what you discover 50 times. 

This is tasking work, and may take hours, where booking properly will facilitate the same in minutes. 

In addition the person trying to comprehend what has happened might not be the same as the one booking the cost, and the person booking the cost will need to gather intel in to the nature of the cost any way to book it correctly. So not giving a comprehensible booking entry text will double the work for every noteworthy deviation from budget.

With distributed accounting and invoice approval, where scanning with automatic preposting and decentralized decisions on accounts and texts, it it still of utmost importance to use descriptive texts and proper accounts and attributes - such as type, place and purpose. When the organization posts invoices decentralized, it is an important job for finance to check what has been done, correct if necessary and improve and educate with feedback to the organization. 

Just relying on what the decentralized organization does is very problematic, as people outside of finance and not in management positions will in general not understand the importance of correct accounting in accordance with the principles that make fact-based management possible - which is even also the case for many employees within finance positions.

Just getting the entry into the right account is difficult with distributed accounting, and getting a descriptive text included more so - getting attributes such as type, place and purpose correct is even more prone to error, but not less important. This is why the finance organization should check what is done, and also use a disproportionate amount of time educating the decentralized organisation from concrete examples - at best describe what is wrong and make the person do it over themselves. 

Monthly reporting should aggregate to the year end financial accounts submitted and audited. I.e. there should be no major corrections done in the last month of the year, i.e. correcting for all the other 12 months not being in par with GAAP or what other regulation you adhere to. This could be accruals not backed properly, accruals that should have been released, recosting of inventory forgotten, loss on debtors not accrued for, and so on and so forth.

Having no such corrections in your 12 months monthly reporting vs. your year end financial reporting is the quality stamp that you should look for; both as a financial manager and as general management. 

If you use your financial statements as a guideline for all other facts you gather in the business, then your financial accounts need to be in order, and they need to be as close to the truth as possible. 

The audited financial statement at year end submitted or filed with the proper authorities is by definition the truth, or should come as close as possible - this is the purpose of all laws governing bookkeeping and financial reporting in the western world. The law is set out to guarantee that the financial reporting gives a true and fair view of the financial performance of the company to all shareholders, as well as securing the right taxation. 

Sometimes there will be a difference in trying to show the true financial view of the activities undertaken in a certain period and the financial reporting demanded by the law, however the differences are normally small and should be copeable in a 12 months period.

Using the financial statements directly as an outset for optimization

The financial statements and the monthly reporting has more functions beyond facilitating a gauge for fact-based management. You should also be able to optimize your business directly from analysis of the reporting.

Looking at the financial statements there are several ways to start looking at areas of improvements in the activities of the business:

Sales, gross profit, indirect costs and capacity costs.

Sales is a given and should not even be necessary to pinpoint as an area of analysis. Maximising sales is crucial, as no sales means no business. However sales with a low margin can be improved through a higher net result if the sales are analyzed and prices are increased - this may lead to lower sales, but higher net result or lower if the customer decides to buy less or nothing at all. The key is to find the right mix of sales and price for each customer so as to maximise profits. The same goes for sales with a very high margin, which may also give rise to higher profits through higher sales if the price is lowered. Naturally this should be done through negotiations with the customer - however doing analysis on the customer and the contribution margin will in most cases pinpoint where there are opportunities.

Gross profit will be important in connection with sales, as noted above. In addition gross profit or contribution margin on orders, customers, segments, machines, products etc. will also be able to show if there are possibility for optimization and thus higher profits in the operation it self - either through lack of management in some areas, lack of general productivity in some employees, undue downtime on machinery due to lack of maintenance or to low investments, or too high price of materials or semi-finished-goods not negotiated properly, sequence of operations nonoptimal, minimizing waste and scrap, bottlenecks in production or many other factors. 

Indirect costs and capacity costs can be analyzed by key figures and ratio analysis benchmarking against best practice, as well as looking at subcontractor agreements and the cost-benefit in them and pricing and also looking at staff costs in relation to organization and task analysis. The incremental nature of these costs will result in too high cost if the company is in rapid growth, however even in that case the immanent structure of the costs should be optimized.

Thus the financial accounts through good bookkeeping gives a good starting point for optimizing the business, as is, to maximise profits - without developing the business, but simply getting more out of what you already have.

Having a good smooth running operation will also give more sales and business, as you will be able to lower prices and still be profitable and growing the business, and in addition deliver on time and in the quality specified.

The importance of bookkeeping in fact-based management

Through good and diligent bookkeeping a standard gauge is established on which all data in the company about the operation of the business can be measured.

Not only does the financial accounts themselves give a good starting point for optimization of the company, but it also provides a valid way of interpreting all aspects of the activities in the company from other data sources in relation to half of the aim of the company. Thus securing the Profit part in the maxim “Profit & Fun”.