FINANCIAL MANAGEMENT SERIES. Building Better Financial Management Support. Functions, systems and activities for producing financial information

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1 FINANCIAL MANAGEMENT SERIES Building Better Financial Management Support Functions, systems and activities for producing financial information 1

2 Better Practice The Australian National Audit Office produces better practice guides and handbooks as part of its information services to audit clients. A better practice series has been established to deal with key aspects of the control structures of entities an integral part of good corporate governance. This guide forms part of that series. It addresses the supporting functions, systems and processes required to deliver relevant, timely and useful financial information to managers.p ISBN Commonwealth of Australia 2

3 Auditor-General s Foreword The Commonwealth Public Sector is in the midst of a period of unprecedented change. Financial management reforms have been central to this change and include; the adoption of accrual accounting and accrual budgeting, a shift to funding and reporting based on outputs and outcomes, and an increased emphasis on outsourcing as a means of program delivery. To assist in meeting the Government s expectations, as enunciated through these reforms, organisations require sound financial management practices and supporting systems. The timely capture, processing and presentation of financial information in a form which is tailored to user requirements are essential to effective planning, monitoring and decision making. Financial information is a key element in successful organisational performance and is also vital to achieving legal and regulatory compliance, most significantly in the area of financial reporting. Indeed, financial information can be designed and used to meet a variety of demands, both internal and external to the organisation. Our research has shown that a key factor in the success of new financial management processes is the ability of organisations to shift the focus of its finance function away from transaction processing and reporting to a role which is fully integrated into the strategic and daily business activities of the organisation. This new finance function would also have greater capacity for data analysis, interpretation, flexible reporting to support decision making and facilitate more accountable management in an environment of devolved authority. Typically the type of information required by an organisation includes budgetary and forecast information, information on its cost of operations and cost structure, information on resource utilisation and operational performance and information on its financial position at any point in time. The two Better Practice Guides that comprise this series have been designed to assist organisations to develop a sound financial management capability. The first of these Building a Better Financial Management Framework - outlines some of the critical considerations involved in using financial information which are essential to the establishment of a valuable financial management framework. The second - Building Better Financial Management Support - explains some of the mechanics required to deliver this financial information efficiently and effectively. P.J. Barrett Auditor-General 3

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5 CONTENTS Building Better Financial Management Support Overview of the Guides Part one The finance function 1.1 Introduction 1.2 Transforming the finance function 1.3 Interpretation and analysis of data Part two The financial information system 2.1 Introduction 2.2 Evaluating financial systems 2.3 Establishing data structures Part three Costing systems 3.1 Introduction 3.2 Cost components 3.3 Techniques for allocating costs 3.4 Costing methods Part four Closing the books 4.1 Introduction 4.2 Guiding principles 4.3 Key Processes Appendices Process Improvement Tools Glossary of terms Bibliography 5

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7 Overview of the Guides This is a companion to the ANAO guide Building a Better Financial Management Framework. The latter guide deals with the conceptual framework for defining financial information needs, presenting financial information, and using financial information to support decision-making. Organisations must establish the capability to support their financial management reform efforts. To this end, this guide deals with some of the critical functions, systems and processes needed to deliver financial information efficiently and effectively to users. Specifically it examines the current trends in the evolution of the finance function the key provider of financial information; the financial and costing systems required to capture and accumulate financial information; and the close the books process, which generates the financial information. This guide, dealing as it does with support processes and activities traditionally undertaken by the finance area of an organisation, is directed primarily at the chief finance officer and the staff who undertake finance functions. It is also intended to provide useful background for line managers seeking to understand the broader impact of financial management reforms in the above areas and who are likely to affect the timing and the nature of the financial information they receive. 7

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9 Part one The finance function 1.1 Introduction 1.2 Transforming the finance function The finance area Migration of the finance function Effecting change 1.3 Interpretation and analysis of data Adding value to information Proactive support 9

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11 1.1 Introduction The finance function is the primary provider of financial information. If this function is to add-value it needs to take a greater role in decision support by providing users of financial information with analysis and insights based on a thorough understanding of the business. The finance function encompasses more than the finance area. It includes all activities and processes undertaken which relate to transaction processing, financial reporting, control and decision-making. This will typically involve staff from both the central finance area and from operational areas. The finance function has been a transformed in many better practice organisations over recent years. This transformation has been partly in response to the cost pressures to which all business processes have been subject. It has also been in response to a growing demand from the users of financial information for more value-added information to use in their decision-making. This part of the guide examines the changing role and structure of the finance function. It considers both the changing service mix and skill requirements needed in the transformation process to ensure the finance function remains relevant and cost-effective. It also considers the means by which the finance function can achieve more effective analysis and interpretation of information. 11

12 1.2 Transforming the finance function The finance function is changing in the public sector. The introduction of accrual budgeting and accounting, requiring implementation of new financial systems, has been a major impetus for change. Organisations should seize the opportunity these changes provide to fundamentally re-examine the role and activities of this key function. In recent years finance functions in better practice organisations have undergone significant change with the following key characteristics: transformation of the role of the finance area away from transaction processing to analysis and decision support. This has been accompanied by a clear shift in resources applied to each activity in terms of quantum and skill levels. progressive migration of analysis and decision support away from the central finance area to business units, maximising the provider s understanding of the business. The finance area The diagram opposite highlights the shift in emphasis within the finance area. First there is a clear trend in better practice organisations to smaller finance areas. This has resulted primarily from greater efficiency in transaction processing by adopting integrated accounting systems and automating processes; and through outsourcing of processes. Benchmarking of the transaction processing activities undertaken by the finance function typically indicates this is where most cost savings can be achieved. The diagram also highlights the need for a change in the skill mix within the finance area, as users of financial information require more sophisticated analysis and decision-support. Resources previously used to process transactions are freed to take on more challenging roles. However, this requires a greater level of qualified finance professionals with appropriate tertiary and professional qualifications. 12

13 Transforming the role of the finance area As f inancial control is devolved to line areas and transaction processing and reporting processes become more eff icient, the overall resources applied to the f inance function are able to reduce. At the same time there is a greater investment in qualified staff to provide analysis needed to support strategic and operational decision making. 13

14 Our objective should be to have operating people think of their units in financial terms and to have financial people think of what s happening in finance in operational terms attributed to James Osterhoft of Digital Migration of the finance function It is not just within the finance area that change is occurring. In order to become actively involved in the analysis and interpretation of information by users, providers of financial information need to become an integral part of the management team of the organisation or the business unit that they support. In better practice organisations finance staff spend time with line mangers to see things from the other side of the fence. There is an increasing trend toward embedding qualified, skilled finance staff in operating/service delivery units rather than in a central finance area. These staff take on a business partnering role, providing financial analysis, working with line managers to solve operational problems. This contrasts with the trend toward recentralisation of transaction processing through the use of shared services centres or out-sourcing (refer to box on page 15). Migration of the finance function The traditional f inance area is changing. Decision support staff are moving into operational areas and transaction processing is being centralised, but not in head off ice. 14

15 Consistent with the proposed changes to the finance area which are outlined above, beyond bean counting 1 recommended the Chief Financial Officer (CFO): have suitable experience and qualifications; provide independent professional advice that improves the quality of information, or its context, for decision makers within the organisation; and be part of their agency s senior management team, reporting directly to the Chief Executive Officer (CEO). Re-centralising transaction processing: shared services centres The trend to devolution of authority of the past decade has generally been accompanied by decentralisation of processes. These included business support processes such as those undertaken within the finance function. Inevitably this led to duplication and also increased the risk of inconsistency through a lack of standardisation. In response, many better practice organisations have established shared services centres as an alternative to out-sourcing accounting processes. In shared services a group of business units create a separate entity within the organisation. Common services including accounting, finance, payroll, collections are assigned to this entity and the entity is perceived and managed as an outside vendor. The concept of shared services centres is simple: bring together functions that are frequently duplicated across business units or locations, and provide these services at a lower cost through achieving economies of scale and removal of duplication. Shared services centres are not re-centralised corporate support functions. They operate as freestanding, autonomous businesses, usually at an independent location, away from headquarters, sometimes in a green field location. They generally involve actual or notional charging for services and are therefore subject to internal and external market forces. More information on shared services can be found on the shared services forum at 1 beyond bean counting Effective Financial Management in the APS & Beyond, a publication of the Commonwealth Management Advisory Board, December

16 Effecting change Transforming the finance function involves major cultural, organisational and process change. The figure below illustrates the areas that need to be addressed in this transformation. People in the new finance function, staff will need different skills; they will need to be more analytical and problem-solving rather than being transaction oriented. Organisation in a business partnering role finance staff work in operating/ service delivery units. However, there is still a need for a central finance policy-making and coordination role. Processes in most organisations transaction processing takes approximately 40% of the finance function time. Unless processes are significantly redesigned real transformation cannot take place. Measures to ensure that new processes are efficient, appropriate performance measures must be in place. Systems are a key enabler for more efficient processes, but their structure and functionality are also critical. Controls the focus must move from corporate cop or organisational purse keeper to risk manager and effective internal control manager. 16

17 The process of transforming the role of the finance function is not a shortterm exercise and would normally take a number of years to complete. In the first instance some form of business process re-engineering will need to take place. This should include benchmarking to determine the gap between current practice and better practice. The Arthur Andersen Global Best Practices database contains a number of quantitative benchmarks relevant to the finance function. Some of the key metrics from that database are summarised in the following table. Metric Best Common Total finance cost as % of revenue 0.42% 1.17% Total finance headcount as % of total employees 1.98% 3.75% % of Accounting degree qualified staff in finance area - 30% The ANAO produces better practice guides dealing with the re-engineering of accounting processes, including Accounts Receivable, Payment of Accounts, Asset Management. These are available on our web site at 17

18 1.3 Interpretation and analysis of data As users of financial information become more sophisticated in their understanding of their financial management responsibilities, accountabilities and financial information needs, the new finance function must respond by providing useful analysis and interpretation of data. The transformation of the role of the finance function will release resources from transaction processing and provide scope for increased analysis and interpretation of data before it is delivered to the users. The providers of financial information should seek to embrace the following approaches as part of this expanded role: adding value to information; and being proactive Adding value to information Providers analysis should improve the quality of information available to users, helping them make better-informed decisions. Providers should be interpreting and analysing financial information as it becomes available and advising users on the financial consequences or impact of various courses of action. If appropriate key performance indicators (KPIs) are in place, providers should add value by presenting KPIs in an appropriate format and, in the case of financial KPIs, explaining the possible reasons for movements or providing benchmark comparisons. For instance, if an organisation has a large debtor base, a good KPI may be average debtor days (outstanding debtors divided by period revenue). This could be reported as a trend over time (in graphical format), compared with another division or State or benchmarked with the private sector. Another example is for providers to analyse support costs and advise users which costs are causing the support cost ratio to move in an unfavourable direction. Further examples of ratios and their interpretation are shown in the following table. 18

19 Ratio Calculation Use/interpretation Employee entitlements Employee benefits payable If trending up, may provide number of employees information for next certified agreement negotiation Total employee costs Employee costs Could suggest opportunity to total expenses expand user pays services or outsource/contract out some non-core services Depreciation impact Depreciation expense Reflects the use of productive net cash from operations assets in delivering services Days sales in debtors Net debtors Trend shows credit control average daily sales success and will be important for improved cash flow, in a devolved banking environment External debtors External debtors As debtors can be readily current assets turned into cash, this ratio is another cash flow indicator External income ratio External income May reflect degree of user-pays total income services Indirect to total costs Total indirect costs Indicates overhead or support total costs cost impact. Should be trending down Corporate costs Corporate support/ Focuses on impact of management costs corporate/national support total costs costs. Again, should be trending down Proactive support Providers should actively pursue and provide analysis. To do this, they need to understand the factors that will have an impact on the financial performance of the organisation (or the business unit which they support) so that the relevant analysis is well informed. This requires a strategic viewpoint and an excellent understanding and knowledge of the activities of the organisation or business unit. Providers may also take the initiative in alerting users to items of financial information which require management action as they come to hand, rather than waiting for the periodic reporting cycle to deliver this information. 19

20 Case study Proactive involvement of finance staff Group A provides consulting services on a fee-for-service basis. The majority of its work is project-based and must be won through tendering for contracts. The Group has weekly management meetings, and each fortnight these meetings are presented with financial information. At the weekly meetings the Group s managers review time, cost and quality of projects and consider resource needs (staff versus contractors) for ongoing and future projects. Finance staff attend the fortnightly meetings to present and interpret the financial information. In this forum they are able to highlight important financial information and provide additional information as required. Managers are also able to identify additional information needs and receive immediate financial information and advice. The attendance of finance staff at fortnightly meetings ensures all managers financial information needs are identified on a timely basis. It also ensures that financial information provided to managers is relevant to their needs, as the managers are able to provide immediate advice that information is no longer critical or relevant under current operating conditions. For example, managers requested that fortnightly reports be produced at summary level for key line items (that is, financial information the managers considered to be key financial indicators). The summary data is presented with a supporting graph. More detailed financial information is requested by, and provided to, managers when they or finance staff detect a problem, such as a significant deviation from budget. The more detailed information is used by managers to identify the cause of the problem and to decide how to address it. 20

21 Part two The financial information system 2.1 Introduction 2.2 Evaluating financial systems Conducting a gap analysis Financial system attributes 2.3 Establishing data structures The chart of accounts The general ledger 21

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23 2.1 Introduction Information systems need to capture and structure data to make it relevant to users needs. This means they must be able to integrate strategic, financial and operational information in a way which supports all management processes, with the ultimate objective of creating transparency across the organisation, and ensuring continuity of information from strategy through to execution. A structured approach to consideration of the information systems that are required by an organisation commences with a review of existing systems. This review should establish whether the existing systems can provide the information required by users. Even where existing systems can provide the information needed by users today, they may not necessarily do so efficiently, or may not be able to respond to future demands. To complete the analysis of existing systems organisations need to consider whether they possess the following core attributes: flexibility multi-dimensionality multi-user access user friendliness speed of response openness robustness and scalability. Having analysed existing systems and determined their suitability, or otherwise, as a platform for providing financial information, organisations need to address the way that financial data is structured and accumulated. This requires consideration both of the chart of accounts and the configuration of the general ledger. 23

24 2.2 Evaluating financial systems The current generation of financial management information systems (FMIS) reflects the need for flexibility to accommodate users changing financial information requirements, as well as changes in the processes used to collect and access financial data. Evaluation of current (or replacement) systems requires a structured approach focusing on information gaps and systems attributes. Conducting a gap analysis Organisations with legacy FMISs should put in place processes that: evaluate the ability of those systems to capture the required data; identify the data gaps; and develop plans to cost-effectively improve data collection over the short and longer terms. The following template may be used by organisations to categorise the nature of information gaps and to determine the appropriate response to bridging these gaps. Financial information flows Systems capability Meets managers need Nature of gap Cannot deliver Systems gap Does not deliver Capable of delivering No Implementation gap Configured to deliver Knowledge gap Delivers Configured to deliver Yes No gap Configured to deliver No Surplus information The nature of each gap is as follows: systems gap the system is not capable of delivering the required information implementation gap the system is capable of delivering the required information, but has not been configured to do so knowledge gap the system is capable of delivering the required information and has been configured to do so, but users are not aware of how to gain access to that information surplus information information is being delivered to users which they do not need 24

25 Core attributes of a financial information system Even where systems gaps do not exist, current systems may not possess the characteristics to ensure that systems gaps will not arise in the future. To guard against this outcome, organisations should evaluate existing (and proposed) systems against the following core attributes. Flexibility organisational structures and processes will change over time; it must be possible to adapt the organisation s systems to reflect resulting changes in information requirements. Multi-dimensionality the organisation s systems must allow performance to be broken down into its components, and scenarios to be compared by drilling down through alternative but reconciling hierarchies, for example by organisational unit, output or location, over time. Multi-user access the organisation s systems must be a common source of information, allowing users across the organisation to make decisions on a consistent basis. User friendliness while providing sophisticated functionality for advanced users, the organisation s systems must also be easy for non-financial and non- IT-literate decision-makers to use. In addition, they must be easy to configure and manage. Speed of response the organisation s systems should be dynamic and highly automated to support real-time decision-making and ensure that changing business conditions trigger appropriate, timely responses. Openness however complete the organisation s systems, they are unlikely to provide all of the required functionality; they must therefore allow for integration of third party applications and for future developments. Robustness and scalability the organisation s systems must be able to integrate large volumes of data from diverse sources. They must also be able to handle simultaneous queries from a large number of users dispersed across the organisation. 25

26 2.3 Establishing data structures It is important to establish data structures from a strategic perspective to ensure that the data meets users financial information needs fully and efficiently. In particular the process must allow data from different dimensions and levels within the organisation to be collected, reconciled and consolidated, to enable alternative views of performance to be produced. Two key determinants of the data structure for an organisation are its chart of accounts and the set up of its general ledger. To maximise the leverage from their systems, better practice organisations generally implement: a simple, universal chart of accounts that applies to all organisational units; and a single general ledger. For this implementation to be effective there must be a clear understanding about operational details such as: the level of disaggregation required (should the data be in the form of individual transactions or aggregated?); the attributes of the data (does the data need to be provided in one view or many views?); the measurement basis (cash or accrual?); and Many systems currently available have the capacity to collect and utilise non-financial data in their general ledger modules. The chart of accounts structure may also need to accommodate this requirement. the relationship with non-financial data (what non-financial data is required, where might it be derived from, and how might it be integrated with the financial data?). The chart of accounts The chart of accounts is the framework for categorising assets, liabilities, revenues and expenses. Many organisations have multiple charts of accounts used by different business units and/or locations. Creating a common chart of accounts establishes a foundation for consistency in terminology and serves to eliminate redundant accounts. The number of accounts and cost centres within the general ledger are significant cost drivers in general ledger processing. They also contribute to 26

27 complexity, thereby increasing the risk of misclassification and the need for corrective journal entries. There is no right number of accounts or cost centres the principle is to minimise the number to the extent necessary for management and external reporting purposes. This can be partly achieved by reviewing the level of activity in each account over time. An integrated accounting system also permits the use of relatively high level accounts in the general ledger, with more detailed accounts in the subsidiary ledgers. The general ledger Large, decentralised organisations, particularly those with legacy accounting systems, tend to operate multiple general ledgers. Each may have their own charts of accounts and business rules. They may also require some form of consolidation, which is rarely fully automated, to produce entity-wide financial reports. Given the current sophistication of accounting software and telecommunications, it is possible to develop a single general ledger, in effect a single set of books, for all business units. Capturing all transactions and balances, from subsidiary ledgers and directly, into a single ledger permits central control over data integrity and speeds up end of period reporting. In addition to a centralised general ledger, most better performing organisations require data entry at source, preferably, on-line and in real time. They hold operational staff accountable for the accuracy and integrity of the data in the general ledger. There is a philosophy of getting it right the first time, with errors returned to the originator of the data for correction. An integrated accounting system also lies at the core of the financial management information system in most, better practice organisations. These systems provide separate modules of software for the functions of accounting such as general ledger, accounts payable, accounts receivable, payroll, budgeting and financial reporting in a coordinated manner. The data entered into one module are used in others, thereby eliminating duplicate data entry and reducing errors. Over 90% of organisations in the Arthur Andersen Global Best Practices database have fewer than 10,000 accounts of these, almost half have fewer than 1,000 accounts in their general ledgers. In many cases integration eliminates the need for time consuming reconciliations, required when subsidiary ledgers and memorandum accounts are maintained as separate systems. 27

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29 Part three Costing systems 3.1 Introduction 3.2 Cost components 3.3 Techniques for allocating costs Allocating direct costs Allocating indirect costs 3.4 Costing methods Activity based costing Job costing Process costing Selecting a costing method 29

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31 3.1 Introduction Cost is a measure of the value of resources consumed in acquiring or delivering a product or service. Understanding costs and the ability to control the cost of operations is an integral part of good financial management. There are a number of levels at which costs can be captured ranging from high level, whole of government reporting to more detailed costing of an activity or process. Budget funded organisations are now required to cost their outputs. This requires determination of the total cost of the outputs produced and the unit cost per output. The subject of a costing exercise, whether it is a branch, a location, an activity, a process or a unit of output, is commonly referred to as a cost object. In the most common application of costing, an organisation identifies the sum total of all costs that relate to the object being measured. This is referred to as full cost. To arrive at the full cost of an object an organisation will determine all relevant costs and classify these into one of two categories those which can be readily identified with and specifically assigned to a single cost object ( direct costs ); and those which cannot ( indirect costs ). The latter are attributed across a number of objects. The decision to classify costs as direct or indirect is a pragmatic one, based on whether it is economically feasible to relate a cost to an object. Once it has been determined what costs are relevant to an object and how they are categorised a decision must be taken on the most appropriate method for capturing, accumulating and assigning costs. The three most relevant methods are process, job and activity-based costing. Each method has its advantages and disadvantages. The choice of method requires a clear understanding of the requirements for, and intended use of, the cost information generated. The second part of this section deals with these issues in detail. Firstly, however, it is necessary to amplify the cost concepts referred to above and, in particular, to address the accumulation and allocation of costs to objects. 31

32 3.2 Cost components Once an organisation has decided what it wants to cost (the cost object), the next decision to be made is what costs to capture. This depends on the objective of the decision at hand. For most decisions an organisation will be interested in full costs. In a typical public sector organisation the full cost of an object will include: labour costs, including salary costs and associated on costs; administrative and operational costs including travel, rent, repairs and maintenance, cleaning and utility charges; capital costs, including depreciation and capital use charges; and general management and support costs. These costs need to be accumulated in the accounting system and allocated to cost objects. The most accurate results are achieved when as many costs as possible are allocated to a cost object based on a direct relationship. Where there is no direct relationship, or the cost of establishing this relationship would be prohibitive, costs will need to be pooled and allocated across a range of cost objects. Whether costs are allocated directly or indirectly to an object is not necessarily a product of the nature of the expenditure. Nevertheless, the following table includes some common examples of direct and indirect costs within the classifications of labour, materials and other expenses. Category Materials Labour Other Direct Paper in a printing office Professional staff in a legal practice Specialised equipment Food in a cafeteria Counter staff Travel to investigate a claim Indirect Office stationery Chief Finance Officer Cleaning IT consumables Internal auditor Utilities Rent 32

33 Labour, administrative, capital and other costs incurred by operational areas are the most common source of costs that can be allocated directly to cost objects. Costs incurred in business support processes, such as in the Human Resources area, are the most common source of costs that need to be allocated across a range of cost objects. Business support processes have no direct association with an organisation s outputs and no contact with the final customer. Their customers are the operational areas and their outputs are the services they provide to the operational areas. It is therefore inappropriate to attempt to allocate the costs incurred in business support processes directly to outputs. They are allocated through the use of cost drivers, discussed in the next section. The following diagram illustrates the general approach to allocating direct and indirect costs. A common failing is to attempt to allocate the costs of business support processes directly to an organisation s outputs. 33

34 3.3 Techniques for allocating costs A balance needs to be sought regarding the allocation of costs. Being too specific is resource intensive; being too general results in inaccuracies, generally causing a great deal of internal dissension, and will not promote the proper management of costs. Allocating direct costs By definition, direct costs can be economically allocated to cost objects. The preferred method to achieve this is by using cost centres established within the organisation s financial management information system. In this way costs can be captured as they are recorded for other accounting purposes. An alternative to cost centre coding is the use of metering techniques. These approaches allocate direct costs to objects based on resources used. Metering can be achieved either through direct measurement of actual resource usage, or by estimating resource usage. The use of cost centres and metering techniques all have their advantages (in terms of relative accuracy) and disadvantages (in terms of relative costs). These are summarised in the following table. Technique Relative cost Relative accuracy Cost centre: Reasonably cheap but depends on Very accurate because of clear costs allocated as they the sophistication of the chart of relationship between costs incurred are captured. accounts and capability of the FMIS. and goods/services provided. Metering direct: Expensive and time consuming. Very accurate because tracks actual costs allocated on the basis Requires investment in time resource usage over time. of resources used for recording system or other example, staff time, CPU metering system to measure time, number of copies. resources used. Metering estimated: Less expensive than direct Potentially less accurate due to costs allocated on basis of metering. fluctuations and variations in usage established pattern of use over time. either over time or at a period in time. 34

35 Allocating indirect costs Indirect costs, such as those associated with business support processes, are allocated across a number of cost objects. The allocation is based on a relationship established for the indirect expenditure that is common to the cost objects. A common approach is for organisations to determine what drives the indirect expenditure. They identify events, transactions or other occurrences that cause an activity to be performed and expenditure to be incurred. These cost drivers form the basis for allocating indirect costs. Common examples are operational staff numbers, which can be related to payroll processing costs; the number of computers used, which can be related to IT support costs; and the proportion of floor space occupied by operational staff, which can be related to property costs. It is preferable, as in the above examples, that cost drivers are based on a cause and effect relationship. However, more arbitrary cost drivers may be appropriate given the nature and materiality of indirect expenditure being allocated. The range of possible cost drivers is large. Which drivers are used depends on how indirect costs have been segregated. Generally the greater degree of separation of indirect costs into separate cost pools the closer the relationship between the indirect cost and the allocation basis. As the following table shows, separation of Information Technology costs into a number of discrete cost pools and further dissection into activities within each pool provides a greater range of cost drivers. The extent to which indirect costs can be pooled depends critically on the sophistication of an organisation s accounting and costing systems, including the extent to which the capture of data on the cost drivers can be automated. A further important consideration is the materiality of the indirect expenditure compared to the full costs of the cost objects. The cost of establishing the allocation basis must be weighed against the benefit, in terms of the accuracy of the full cost of the objects being costed. This in turn depends on the use to which the full cost information is to be put. Generally, where the information is provided only for internal management purposes, and/or does not impact on key performance indicators, a lower level of precision is acceptable. The choice of allocation techniques should consider materiality of the costs being allocated, the cost of the method, the precision of the output desired and the level of information useful to management. 35

36 Examples of cost drivers Support process Cost drivers Information Technology No. of users No. of transactions The cost drivers available increase as cost pools and activities are ref ined. Support process Cost pools Cost drivers Information Technology IT operations & No. of users communications No. of transactions No. of devices Volume of Application support No. of users per application Application Time spent on development development User training No. of people trained Support process Cost pools Activities Cost drivers Information Technology IT operations & Management of local/ No. of users communications wide area network No. of transactions No. of devices Internet facilities No. of files Size of files Communications No. of hardware installations Volume of Size of in storage Application support Providing financial No. of users application support Time spent on operational support Providing human resource No. of users application support Time spent on operational support Application New system Time spent in development development development Lines of code Enhancing/maintaining Time spent existing systems Lines of code User training Training users No. of courses No. of people trained Providing help desk No. of users support Time spent on inquiries 36

37 3.4 Costing methods Determining the method used to collect the cost of an object requires careful analysis of the nature of the organisation s operations in particular, a clear understanding of the requirements for, and intended use of, the cost information. Different industries or organisations employ different forms of costing depending on their circumstances and the nature of their operations. There are five common forms of costing methods: Activity based costing Job costing Process costing Standard costing Batch costing The table on the following page describes each method and gives examples of their application. This guide does not promote one costing method over another. The decision rests firmly with management. However, it is suggested the nature of Government activities lend themselves to either Job or Process costing. Activity Based Costing can be used either as a method in its own right or to enhance the accuracy of information obtained from Job or Process costing. Accordingly, each of these three methods is explored in greater depth in the following pages. At the end of this section points for general consideration are listed to evaluate costing system functionality, together with a decision tree to aid in selecting from the alternatives. 37

38 Costing Method Description Costing A pplication Methods commonly used in the public sector Activity Based Costing The attribution of resource consumption universally applicable by activities and the allocation of activity directly applicable to the costing costs to cost objects via cost drivers. requirements of service and government entities. Job costing A form of specific order costing in which printing costs are allocated to individual jobs. research/teaching professional services, for example audit services, investigations, consultancies Process costing Costs are initially charged to a sequence chemical production of continuous, repetitive operations or power supply processes and then averaged over the units produced in the period. Methods NOT commonly used in the public sector Standard Costing Uses predetermined standard rates for useful for internal management the consumption of inputs (expressed as purposes, in particular performance a cost per unit of output). Costs are measurement, enables analysis of allocated to cost objects using these variances caused by changes in costs of standard rates multiplied by the standard inputs and/or volume of activity inputs allowed for actual volume of activity achieved. Batch costing A form of specific order costing in which assembly lines (or equivalent) costs are allocated to batches of products. canteens invoice processing What is ABC? Activity based costing Activity Based Costing (ABC) has recently gained wide acceptance in the service sector and has become the preferred method of costing throughout a wide range of commercial and government organisations. The case studies on pages 41 and 42 provide examples of its application. The basic principle of ABC is that the performance of activities within an organisation gives rise to the incurrence of cost and that cost objects consume activities. Accordingly costs are traced firstly to activities and then activity costs are traced to cost objects. While ABC was primarily developed to address the need for a more effective mechanism to deal with the allocation of overhead costs, it should not be assumed this is its only application, for example, ABC can facilitate more accurate output costing. 38

39 Activities are the tasks performed within an organisation that together result in the delivery of its outputs. The number of activities identified depends on the reasons ABC is being implemented and the degree of accepted risk regarding the distortion of costs. Another consideration is that opportunities for process improvement and the application of meaningful performance measures may be missed if the activity definition is not sufficiently detailed. What are Activities The following example illustrates the dangers of not identifying activities at an appropriate level of detail. The XYZ agency has a Finance Unit of seven people of which two are solely devoted to the Accounts Payable function. The total cost of this function including employment costs, IT support, facilities and management costs is $500,000 per annum. This function has been allocated 100% to an activity described as Processing Accounts Payable Invoices and the driver chosen to allocate the costs of this activity to the consuming organisation units is the number of invoices generated by each operating unit. There are three operating units and the allocation of the costs of the identified activity to these operating units is $250,000, $200,000 and $50,000 respectively. The manager of department A is unhappy with this result and asks that a more detailed methodology is applied. Upon investigation it is apparent that the activities undertaken within Accounts Payable fall into two distinct categories, the processing of overseas suppliers invoices and the processing of domestic suppliers invoices. An analysis of the Payables clerks time is undertaken and two distinct activities are created Processing Overseas Invoices and Processing Domestic Invoices. Because of the complexity of the payment routines the export invoices are three times as expensive to process as the domestic. In addition the bulk of export invoices are generated by operating department C. After incorporating the additional activity and driver information, the respective charges to Units A, B and C are $150,000, $185,000 and $165,000. Staff time is a major cost in most public sector organisations and a key element of ABC is the methodology to trace these costs to specific activities. Ideally the process must be robust and as accurate as possible. Determination of the technique used depends on such factors as the resources (costs and staff time) available, desired frequency of revision, purpose of the ABC implementation and desired level of accuracy. Common techniques for allocating staff time include interviews, workshops, sampling and time recording. Tracing costs to activities In some cases, certain operational staff may be able to assign their time directly to an output, generally however, staff will not able to assign their time to a specific output. In these cases, their time should be traced to activities, 39

40 and the cost of each activity allocated amongst the relevant cost objects using an appropriate activity driver. Some common examples of cost drivers are shown in the following table. Activity Raising Purchase Orders Processing Suppliers Invoices Answering Phone Enquiries Processing Grant Applications Correcting Input Processing Payroll Cost driver No. of Purchase Requisitions Received No. of Invoices Received No. of Phone Calls No. of Grant Applications Received No. of Input Errors Made No. of Pays Processed Advantages of ABC ABC provides the following advantages: output costs are supported by a schedule of costed activities instead of a conventional expenditure classification analysis; opportunities to examine work processes; identifies non value-adding activities that can be eliminated without effecting the quality or utility of the service delivered; basis of a performance measurement system and a direct link between strategic goals and operational realities; enables cost profiles to be managed; accurate costing data to operational management; and costs that are transparent, understandable and actionable. Disadvantages of ABC The disadvantages of ABC include: activity definition may become too detailed and organisations may build a model that is too complex and difficult to maintain; under estimating the task of collecting activity driver data; specialist software tools are required to provide quality implementations; the model fails to keep pace with organisational change; and implementation is considered a financial management fad and insufficient commitment from operational managers is given. 40

41 Case Study: Activity Based Costing As part of the its commitment to contestability and performance, the Department of Health and Aged Care has undertaken a series of market based and performance improvement initiatives, including Activity Based Costing (ABC), within the Corporate Service Division. The project involves review of existing costing methodologies, pilot studies in selected areas and the establishment of costing processes to support an accrual based output/outcome framework. The major steps in the processes included: definition of outputs and level of costing information required; information gathering (General Ledger analysis, Time Recording and Storyboarding); development of cost model; analysis and reporting of results; and transition planning and skills transfer. The project has provided the Division with: recognition of the need for full cost information for strategic cost management and performance measurement in a contestable environment; an Activity Dictionary based on outputs received by customers and not on functional areas; full cost information linked to outputs/services for budget negotiation and pricing; ABC functionality in an enhanced Corporate Information System; and attribution of corporate overheads to Departmental Outcomes and Output Groups. The Department has learnt a number of lessons along the way, most significantly: be clear about what information is required and for what purpose; keep the costing process simple and the Activity Dictionary manageable; be disciplined but flexible (for example - storyboarding by a supportive and focused group environment can be used instead of time recording to collect data on work flow and time/effort attribution); ABC is more than an ad hoc costing solution, use it as a management tool as it engages staff upfront and provides them with information that is relevant and meaningful; Incorporate ABC and Activity Based Management in relevant training programs such as corporate planning and leadership development; accrual accounting and budgeting; and adopt a corporate approach (for example - develop, in consultation with staff, clear and relevant policies and procedures for approval by senior management and integrate ABC into the organisation s corporate planning and management processes). 41

42 Case Study: Activity Based Costing The Therapeutic Goods Administration (TGA) carries out a range of assessment and monitoring activities to ensure therapeutic goods available in Australia are of an acceptable standard. Through a range of fees and charges, TGA recovers the full operating costs of its activities, which include control of the supply of therapeutic goods through pre-market assessments, licensing of manufacturers and post-market monitoring. These fees are negotiated with industry representatives by the TGA Industry Consultative Committee. In 1997 TGA decided to review its fees and charges structure, with the aim of accurately identifying the cost of services provided to each industry sector, no fees could be set to recover the appropriate revenue from each sector. To facilitate the calculation of more detailed cost information, it was decided to extend an Activity Based Costing (ABC) project, which had previously been piloted in a discrete area, to the entire organisation. Staff were asked to record how they spend their time against a set of predefined activities for a set period usually 6 to 8 weeks. Initially this was performed using spreadsheets but a commercial time recording system is now being used. The ABC model, developed using a commercial package, takes resource data from the general ledger and activity costs, as determined by the time recording surveys, are traced to the outputs at a section level. The resources of overhead functions, such as legal, finance and the executive are attributed on a variety of bases. Where possible using the time spent on activities related to an output, otherwise in proportion to direct staff effort as identified in the model or staff numbers. The attribution of general overheads is based on costs per area occupied and information systems costs are based on staff numbers. TGA found the resulting cost data to be robust and defensible. Fees and charges for 1998/99 were set to recover costs identified by the exercise, which is repeated periodically to ensure revenue collection and fees and charges remain appropriate. The experience gained from this exercise has provided TGA with the following lessons: clearly define why you are doing a costly exercise and what you want it to cost; involve affected staff in the development of the activity dictionary and outputs; make the activity dictionary clear and specific to ensure people interpret activities consistently; and recognise that time/activity recording is new to many staff and make it as simple as possible. 42

43 Job costing Job costing is most commonly used by organisations operating in a project or task oriented environment. Job (or project) costing is an approach to costing outputs that are: discrete; have individual characteristics; and are designed to satisfy the requirements of a particular customer. Employment costs are charged via time sheets and direct materials and expenses are directly allocated to the job. A work-in-progress (WIP) account is maintained in the general ledger to control jobs currently under way. At the completion of the job, the actual costs charged are transferred from the job account, and WIP, and charged to period costs. What is job costing The basic steps in establishing a job costing system are as follows: assignment of corporate service costs to operating units; establishment of cost centres for each organisational unit for the accumulation of employment costs and other expenditures; calculation of hourly rates for each grade of employee who charge time to jobs. The calculation of this rate will include direct salaries and on-costs, cost centre overheads and the assigned corporate overheads divided by the budgeted number of direct or chargeable hours; establishment of a job time recording and cost accumulation system; establishment of an employee time utilisation and tracking system which integrates with the costing system; and establishment of accounting routines to record actual cost centre expenditures and cost recovered via chargeable hours. Establishing a job costing system Advantages of job costing are: a clear link is established between the accounting framework and operational realities; reporting is available by organisational unit and by job; and time recording can encompass records of time spent on different activities within the job life cycle. Advantages of job costing 43

44 Disadvantages of job costing Disadvantages of job costing include: heavily dependent on accurate cost collection and a large volume of transaction processing; expensive data collection methods may be required to reduce the incidence of costs recovered through the application of overhead recovery rates (eg. telephone calls, photocopying, word processing, computer usage); and specialist job costing software is normally required. What is process costing Process Costing Process costing is applicable to instances where the individual unit of output cannot be identified and costs cannot therefore be traced directly to these outputs. Process costing was developed to satisfy the requirements of industries that process raw materials in bulk and the production flow is made up of a number of continuous processes where output from one process becomes the input to the next process in the production flow. This production flow can be found in oil refining, water treatment and a wide range of chemical plants. In the service and government sectors the same production flow is present in an office environment even if the only tangible evidence of this is paper documents. An example of this would be found in processing a benefit claim. It is not feasible to cost each individual claim, however, costs can be traced to each of the processes that the claim undergoes and an average unit process cost calculated by dividing the total process cost by the number of units produced. The unit costs of a particular output become the input costs to the next process, this continues until the final organisational output is delivered. Process costing is applicable to large transaction based organisations where uniform processes are applied to each unit of output. Establishing a process costing system The basic steps in establishing a process costing system are: establishing accounts for the collection of process costs. These may not be necessarily the same as organisational units and methods may have to be established to trace employment and indirect costs to a process cost pool; corporate services costs have to be assigned to the user organisational units and then to processes; costs have to be established for each process account; 44

45 quantities have to be collected for each unit of process production; care has to be exercised when one process can provide input to more than one subsequent process. Costs will have to be assigned on the basis of output quantities; and individual processes have to be linked to the organisations outputs. Process costing suits transaction-driven organisations, its advantages are: it can be accommodated without the need for specialist software; costing information produced is readily identifiable with operational realities; and lends itself to the integration of standard costs. Advantages of process costing Disadvantages of process costing include: it is dependent on there being a close match between expenditure incurred and output achieved. Large holdings and fluctuations in work in progress will distort the reported unit costs; on their own, calculated process costs do not provide management with an indication as to why costs are at the reported level; and it is dependent on the presence of a production flow and would not be suitable in all circumstances, for example, in an advisory or policy support environment. Disadvantages of process costing 45

46 Selecting a costing method As indicated previously, a key determinant of the most appropriate method of costing depends on the nature of operations. The following decision tree illustrates these considerations Are outputs or services tailored to individual customers? Yes Job or Project costing may be appropriate (the unit of cost is each job or project) however... No Is the workflow in the production process continuous, such that the identity of individual units is lost? Yes Process costing may be appropriate (a process should be the unit of cost) however... No Is the workflow in the production process organised into discreet batches? Yes Batch costing may be appropriate (each batch is the unit of cost) however... No Is each input into the production process able to be identified and its expected or standard cost established? Yes Standard costing may be appropriate (the unit of cost is each input) however... Better Practice is to use Activity Based Costing instead of, or in conjunction with these methods, to strengthen the accuracy of the calculated costs and enhance the information for management. 46

47 Part four Closing the books 4.1 Introduction 4.2 Guiding principles Plan for improvement Apply materiality rigorously Shift the workload Be consistent 4.3 Key Processes Preparation Reconciliations Creditors and accruals Adjusting journals Running the trial balance Generating reports 47

48 48

49 4.1 Introduction Communicating relevant and reliable performance information across an organisation, to those who need it, when they need it, is fundamental to good corporate governance. The financial information extracted from an organisation s accounting systems is an important component of the suite of performance information provided to managers and to the governing body. It is also used in the production of an organisation s annual financial statements an external, regulatory imperative closely aligned with the stewardship component of good corporate governance. The quality (or usefulness) of this financial information, both for internal and external use, is determined by its relevance, reliability, comparability and timeliness. This section of the guide examines the process undertaken by an organisation to generate periodic financial information commonly referred to as closing the books 1 or period end processing. In doing so it deals mainly with how to achieve timely reporting of financial information. It also considers the reliability of financial information, largely from the perspective of the interrelationship between timeliness and accuracy. By eliminating unnecessary tasks and streamlining necessary tasks, organisations are able to reduce the time taken to close the books, and consequently, are able to produce financial information quickly. Reducing cycle time is not the only benefit of an efficient and effective close. Equally significant, it frees up scarce (and costly) professional resources in the finance area and allows them to concentrate on value-added activities such as improving the content of financial reports; and interpreting and analysing the information contained within the reports. It is also likely to reduce the overall level of resources applied to this process and so lower the total cost of the finance function. 1 Much of the content of this part, is based on, or taken from, Closing the Books in Arthur Andersen s Global Best Practices Knowledgebase. The ANAO thanks Arthur Andersen for their permission to reproduce this information The better practice principles and practices described in the guide provide data which organisations can use to benchmark their own performance to determine the scope for cost reduction and improvement in the timeliness of dissemination of financial reports. BENEFITS Through re-engineering, world best practice organisations have reduced the total cycle time to two days for the entire close process, including report production. It is now common practice to produce financial reports within five days after the period end. 49

50 4.2 Guiding principles Analysis of the approaches adopted in the close the books process by better practice organisations, reveals a set of common principles that underpin their success. This part of the guide examines four underlying principles in operation in better practice organisations: plan for improvement; apply materiality rigorously; shift the workload; and be consistent. Organisations wishing to redesign their own processes should be guided by these principles, seeking to apply them where relevant. Plan for improvement Achieving best practice requires forethought. Planning for internal management reporting and for the annual financial statements is a key to an efficient and effective close. An important element of planning is to learn from the past. Apply materiality rigorously The approach taken to closing the books is critically affected by decisions relating to the degree of accuracy required in financial information. This in turn will be determined by the users of the information and the use to which the information is put. The key to answering this question lies in the concept of materiality. Shift the workload The timing of work required for the period end close needs to be considered. It is often the case that tasks are scheduled at the end of the accounting period without consideration of when they could be undertaken. Consideration of materiality and the timing of tasks are inextricably linked. Be consistent The extent to which an organisation uses the same financial information, in the same format, for management reporting and external reporting is worthy of consideration. This will determine the extent to which the processes undertaken at the end of each accounting period can be consistent with those undertaken for producing external financial statements. Consistency implies simplification, leading to lower costs, and fosters greater accuracy. Each of these principles is discussed in more detail in the following sections. 50

51 PRINCIPLE: PLAN FOR IMPROVEMENT A timely and efficient close the books process requires clear statements of milestones and deadlines to be communicated to all relevant staff. The largely sequential nature of many of the tasks undertaken in the close means that a missed deadline can significantly delay the entire process and jeopardise the timeliness of report production. Deadlines and targets imply planning in turn implying those responsible for the process have analysed the work steps required, identified the staff involved and determined a reasonable cycle time (elapsed time) for each activity. Having a plan is only one step toward achieving better practice. The concept of continuous improvement requires actual performance be tracked against plan. Performance tracking can be a powerful tool for ensuring compliance, especially where individual or group accountability is assigned to each activity and staff are held accountable for their performance. To complete the process improvement cycle a comparison of actual performance against plan should include an analysis of what went right and what went wrong, in order to learn from the past. This analysis will be an important input to planning the next cycle. Over time there should be an expectation that the close the books process will incrementally improve and that cycle times will be reduced. Process improvement cycle 51

52 Achieving greater accuracy, or greater precision in the case of an accounting estimate, will generally demand greater use of resources, higher costs and a longer elapsed time. A trade-off is required between accuracy and cost. That is the basis for the concept of materiality. Where financial reports are not produced for external purposes, organisations can institute a soft close (see box). PRINCIPLE: APPLY MATERIALITY RIGOROUSLY Materiality is a concept applied to financial information which relates the need for accuracy of information to the users of the information and the use to which it is put. It is defined by reference to its impact on the decision-making process. In these terms, financial information is defined as material if the knowledge of that information affects the decisions of the user of the information. In practical terms, materiality is generally applied to reported financial balances and the potential effect of errors in those balances. An error in a financial balance is material if, had the balance been correct, the user of the financial information would have made a different decision. When examining the close the books process materiality is considered at two levels which balances are significant to decision-makers, and the extent to which an organisation attempts to ensure these balances are free from error. The key question to be answered is what is the financial information used for? This question can be posed in terms of the entire financial reports or the component balances in those reports. It can even be applied to a dissection of the component balance into its constituent cash and accrual parts. For example, financial information is usually produced at the end of each accounting period solely for use within an organisation, primarily by the governing body, senior and line management. This financial information is usually only part of a suite of management information and is often expressed in a series of key financial performance indicators. Close analysis of the composition of the key performance indicators will highlight which financial balances are considered most important to managers. It is these balances only in which an organisation should invest its time to ensure they are free from material error. In accordance with Australian Accounting Standards AAS 5 and AASB 1031, materiality must also be applied to external reports, produced for regulatory compliance. In these reports it is likely there will be more balances of interest (material) to the users and that greater precision will be required. The key is to ask not just why do we do what we do? but to ask why do we do it when we do it? Source: Arthur Anderson Global Best Practices Knowledgespace PRINCIPLE: SHIFT THE WORKLOAD Traditionally the close of the books process commences on the day after the last day of the accounting period. It does not follow however, simply because all of the tasks required to be undertaken relate to this one process, that their timing must coincide. There is scope to smooth workloads by moving tasks, where it makes sense to do so, away from peak workload periods. The prime candidate for a targeted shift of workload is into the previous, logical sub-period immediately before the close. For a monthly close this would be the week prior to period end. 52

53 For a quarterly close, the month prior to period end, and for an annual close, the quarter prior to the year end. The benefits of shifting workload derive from elimination of peaks in activity which allow finance staff to operate in a less frenetic, more ordered manner. This should permit more elapsed time to perform critical tasks well, thereby reducing the occurrence of error and improving overall effectiveness. The extent to which an organisation can spread the workload is important to achieving timely reporting. If your organisation presently waits until the end of the relevant accounting period to commence work on the close and preparation of financial reports it is timely to ask why! The ultimate better practice approach to shifting workload in relation to the annual financial statements is to undertake a hard close before the financial year end. For most of the Commonwealth this would mean a hard close at the end of May. Consider a hard close at the end of May for the annual financial statements Discussion: Soft and Hard Closes A hard close is generally associated with the traditional close the books process for the production of financial reports for outside regulators. It typically involves performing reconciliations; examination of next period transactions for undetected accruals or transactions processed into the wrong period (cut-off); verification of physical balances through stock counts; and analysis of current period transactions and balances to detect errors arising from mis-classification or mis-posting. It may also include obtaining independent appraisals and estimates for balances not able to be determined by other means eg. valuation of inventories and noncurrent assets, and actuarial assessments of liabilities. This may be contrasted with a soft close in which the extent of verification and computation of individual balances is restricted. A soft close envisions closing the books with just enough precision to deliver the key financial performance indicators to management. In a soft close certain balances may not be subject to any verification or adjustment. For example reconciliations may not be undertaken, or may be replaced with variance analysis. Certain accruals may not be computed, or accruals may be computed other than at period end, or they may be estimated. Cut-off for transactions processing may be brought forward, prior to period end, and those transactions processed into the next accounting period. Better practice organisations undertake a hard close only where there is an external, regulatory requirement to produce financial statements. For most Commonwealth organisations this will be the annual financial statements. 53

54 To maximise the effectiveness of this approach the external auditor should be requested to audit these financial statements. Carrying out this hard close expedites the finalisation and audit clearance of the financial statements at year end. Issues which can slow down the audit clearance process such as those relating to the adequacy of disclosures, the appropriateness of valuations, the determination of contingencies, and the calculation of provisions, will have been resolved prior to the preparation of the full year s financial statements. Being able to undertake the same routine each period, whether it is a close for internal or external reporting, fosters consistency in performance through greater familiarity of both finance staff and line managers with close the books procedures. It also permits timely identification of emerging accounting and auditing issues, which will expedite the production and audit of the annual financial statements. PRINCIPLE: BE CONSISTENT The traditional format of financial reports produced for accounting purposes, the profit and loss statement and balance sheet (or their equivalents), will generally not provide line management with financial information in the format it needs for monitoring and controlling operations. A consequence of this is that the content and format of internal management reports can diverge significantly over time from the traditional financial reports. An unintended consequence of this may be that the processes undertaken to produce the different reports required may also significantly diverge over time. In the worst case line management may establish their own reporting routines in their areas and ignore the reports produced by the finance area at the period end close. This can lead to duplication of effort, for example through extensive re-keying of data into non-corporate systems, and may lead to material inaccuracies in the management reports used to make day to day operational decisions. Best practice organisations seek to standardise the form and content of their management reports, which then vary principally only in the level of detail contained therein the level of detail depending on the needs of the recipient. This eliminates duplication and avoids potential for material inaccuracies. It means that all line managers and the governing body are looking at information derived from the same source! Finally, it maximises the value obtained from the resources applied by finance staff to the production of the period end financial reports. The extent to which internal management reports have a similar format and content to financial reports produced for external reporting, will influence the degree of similarity and consistency able to be achieved in processing at the end of each period close and at year end. 54

55 4.3 Key Processes Redesigning the close the books process requires analysis of each of the major activities undertaken throughout the close. Application of the preceding principles to the redesign of activities will provide a logical, consistent framework for identifying non value-added steps that can be eliminated. This section of the guide examines the major activities undertaken for the close and, through the application of the foregoing principles, provides better practice insights to achieve a more streamlined and efficient close. An over-riding consideration as to the extent to which the practices discussed in this section may be adopted, is the issue of whether the organisation is undertaking a hard or soft close. For example, the use of estimates and shifting of workload away from the period end are more appropriate to balances on which a soft close is appropriate. This matter was discussed in the previous section. The activities discussed in this part are: preparation reconciliations creditors and accruals adjusting journals running the trial balance producing reports KEY PROCESS: PREPARING FOR THE CLOSE All of the organisations studied for this Guide, that have achieved significant reductions in cycle times and in cost process, instituted pre-close procedures to ensure a smooth close. The key elements of these procedures involved: establishing benchmark targets for key performance indicators on time, cost and quality; and holding coordination meetings involving key stakeholders prior to period end close. Establishing Benchmarks Better practice organisations set time, cost and quality targets for the close process and tracked actual performance. It is appropriate to set a few, key measures for which data can be obtained cost-effectively and which are understandable. For the close the books process the following measures are considered appropriate and should be tracked in each cycle: time elapsed days from end of the accounting period to production and distribution of financial reports. Establish target dates for completion of key steps within the process (eg. accruals, trial balance, adjustments, final reports). Best practices The following benchmarks are taken from the Arthur Andersen Global Best Practices Knowledgespace. Time Best Common 2 days 5-7 days 55

56 Errors Best 0.03% Common 3-7% errors number of journals raised to correct errors (expressed as a percentage of total journals). It would also be appropriate to analyse the root cause of the errors why, how and who to eliminate the source of the errors. automation number of automated journal entries as a proportion of total journals. While the latter two measures are proxies for cost, it is also appropriate to track the actual cost of the close the books process as a proportion of the total cost of the finance function. This would normally be carried out annually, preferably as part of an overall benchmarking exercise for the finance function. Annual statements The production of the annual financial statements should also be planned. External audit is a key player in this process and would normally be invited to the coordination meeting for these statements. In addition to the review of the prior year s process and forecasting of the next year s results, the following matters should be addressed: significant changes in accounting policies; changes to accounting standards or disclosure requirements; timetable for audit opinion. Coordination meetings A common feature of many of the organisations studied for this guide was the scheduling of regular meetings prior to the period end close. These meetings, typically organised by the finance area, but involving key operational staff involved in the process, canvassed the following: review of prior close comparison of actual performance against targets, discussion of problems that arose and actions required to prevent recurrence. Revision of benchmark targets if required. forecast for next close - discussion of known or anticipated exceptional transactions (such as large capital acquisitions) that will have a significant impact on results and position for period. This is particularly important for transactions expected to occur close to the period end or those that are not contemplated within existing budgets and forecasts. Some organisations produce a projected operating result and balance sheet and use this to compare to the actual results for reasonableness. 56

57 KEY PROCESS: RECONCILIATIONS Performing reconciliations is a key process which typically consumes a large proportion of resources and which can take a long elapsed time to investigate and reconcile differences. In better practice organisations the adoption of integrated financial systems reduces the need for reconciliations by having single data entry update the general ledger and subsidiary records. Where reconciliations are still required consideration should be given to which reconciliations could be performed other than at period end. For example, reconciling cash at bank is usually undertaken at month end because this coincides with the timing of statements issued by financial institutions. Renegotiating the timing of issue of statements, or obtaining direct electronic access to current balances, allows an organisation to shift this task to any convenient cycle with a period end date of its own choice. Alternatively, an organisation may decide to reconcile major accounts on a daily or weekly basis, which will make the period end reconciliation much simpler and less time consuming. In relation to problem accounts where reconciliation has been historically difficult an organisation may conduct a one-off full, detailed reconciliation outside the period end peak to resolve all outstanding reconciling items. An alternative to reconciliation is to first conduct a variance analysis note the difference between two balances and then determine whether the difference is worth time and effort to resolve. This requires clear guidance on what can be tolerated as an acceptable variation and would generally be used as part of a soft close. Tips Reconcile key accounts or difficult accounts more frequently, even daily Complete reconciliations away from the end of the period by negotiating new schedules for statements Replace reconciliations with variance analyses using tolerances based on materiality guidelines Integrated accounting systems will reduce the need for reconciliations 57

58 Tips Focus on material balances Compute accruals ahead of time Estimate accruals where possible and automate processing Consider early cut-off KEY PROCESS: CREDITORS AND ACCRUALS Most organisations will have a small number of balances that comprise a significant proportion of total accrued liabilities. For example, in most policy departments the most significant accrual will generally relate to payroll and employee provisions. A first step to the redesign of this process is to determine which items affected by creditors and accruals are material to either the operating result or financial position. Resources should be devoted to getting these balances right. Workload can be shifted, even for material accruals, where these can be estimated ahead of time with a fair degree of accuracy as to what they will be at the period end. The salaries accrual is a good example of a calculation that can be performed using current payroll data and expected employee numbers. A similar approach can be adopted for depreciation calculations that could be run close to, but before, the peak close period with little impact on accuracy. This is particularly the case where there are historically low levels of activity around the period end. There is also scope to leave out certain transactions close to the period end and process these into the next accounting period. This approach is particularly common for accounts payable. Better practice organisations also rely on estimates to approximate certain accruals (such as utilities) and other allocations rather than calculating actual figures. This approach also lends itself to the automation of accruals as standing journal entries. An estimate of the accrual can be automatically generated and posted each period saving resources and speeding up processing. This technique is particularly appropriate for a soft close. 58

59 KEY PROCESS: ADJUSTING JOURNALS Many organisations process a large number of journals at period end for a variety of reasons including posting accruals, allocating costs and reclassifying income and expenditure. These journals have two common features: they are recurring and are manually compiled and processed. Better practice organisations seek to automate the computation and processing of these journals to improve the efficiency of processing and to minimise the chance of human error. Better practice organisations also examine the journals from the perspective of their materiality. Journals that reclassify income and expenditure, or those which correct errors, which are not material to the key performance indicators can be processed during the next accounting period, helping to flatten workload. Particular attention should be paid to journals raised to correct errors. This is a non-value-added activity as it results from a breakdown earlier in transaction processing. By analysing the types and frequency of errors organisations can find and eliminate their root cause, saving significant resources in the close. It is recommended organisations track errors as a key performance indicator of the efficiency of the close the books process. Tips Automate recurring. manual entries Only process reclassifications and allocations at period end that are significant to the business Track and analyse errors to eliminate root causes 59

60 Tip run a first cut of the trial balance to identify unexpected results KEY PROCESS: RUNNING THE TRIAL BALANCE It is common practice for organisations to run a first cut of the trial balance immediately after period end processing has been completed. Better practice organisations that have smoothed their workload; shifted tasks away from period end; and automated processes; are able to run the trial balance overnight on the day of the period end; or on the following day. Achieving these time frames allows for higher quality management review of results, prior to the full close. The first cut review, carried out by operational and cost managers in line areas, is used to identify unexpected results. Expected results are based both on the projected results established at the coordination meeting prior to the close, and on the knowledge of line management of actual conditions at period end. Looking for data that differs significantly from plan, budget or recent estimates in the first cut gives business units the time to explain the result, or if it is an error, to correct the data prior to the final run of the trial balance. Operational managers should sign off on the results for their area of control, prior to the final run of the trial balance. The finance area will also carry out a quality assurance review of overall results, once the individual sign-offs have been received and the results consolidated. 60

61 KEY PROCESS: GENERATING REPORTS Better practice organisations exploit technology to generate and deliver periodic financial reports. It is now common practice to download data from the trial balance into protected electronic spreadsheets, and in conjunction with word processing and graphics packages, to generate the necessary reports. Although serving a purpose, there are potential problems with this approach. The more complex the spreadsheet the greater chance of error, particularly when formats or reporting structures change. The increasing flexibility and functionality of integrated reporting modules provides an opportunity to streamline the reporting process further and to minimise the potential for error. Such modules deliver an executive information system which eliminates the need to generate large volumes of paper-based reports. Electronic distribution of reports, or preferably provision of access to the executive information system, will ensure that managers only receive the information they need and use. Tip use an executive information system to ensure all managers share the same data An EIS distributes reports electronically and provides a user-friendly interface to help managers to drill down to the level of detail required. For example, clicking NSW on the map of Australia will display a map of NSW showing urban centres for which reports are available. Clicking on Sydney will display the report relating to Sydney results for the current month. An EIS also provides analytical tools to examine relationships between data such as trends

62 Case study: Close the Books Best Practice The following case study outlines the approach adopted by a world class organisation in achieving significant reductions in cycle time and processing costs. Background The organisation is an Australian subsidiary of a multi-national group. It has 6,000 employees, around $2.5 billion in revenues and $3 billion in assets. It has a fully integrated financial management information system and many processes, including cost allocation and variance analysis, are automated. Performance This organisation produces full accrual statements each month, two working days after period end, and monthly performance and operations reports on the third working day. Quarterly and annual financial statements, including commentary and analysis, are cleared by the external auditors within seven working days after the period end. Materiality Monthly management reports are based on a soft close. Errors under $500,000 are corrected in the off peak during the subsequent accounting period. An overall error tolerance of 2 per cent applies to monthly reports. The focus is on getting employee costs and raw material inventory 100 per cent right as they are the most significant balances impacting on operating results. Planning The finance section holds planning meetings prior to each close to identify any matters that may delay the reporting process; to resolve outstanding issues and to discuss expected major accruals and adjustments. External audit visits are planned for the second day of each month as well as prior to each quarter end. Processes All data entry is real time, at source. Operational staff perform keying. Automatic validation checks are built into the systems and operational staff are held responsible for data accuracy. Journals are raised in line areas and processed centrally. Standing entries are used for utilities such as electricity. Annual financial statements The year-end reporting process is similar to the monthly reporting process, with the following differences: third quarter accounts are reviewed in greater detail; issues identified and clarified; a hard close is undertaken one month before year end. A full set of accounts, including notes and summaries, is produced for external audit review and verification; year end results and financial position are forecasted in the last month of financial year; on the third working day after year end external audit provide verbal clearance of financial statements. 62

63 Appendices Process improvement tools 1. Quantitative benchmarks 2. Diagnostic Questionnaires Finance function: client satisfaction survey Close the books: better practice diagnostic Glossary of terms Bibliography 63

64 64

65 1. Quantitative Benchmarks The following table lists some of the key quantitative benchmarks organisations may wish to track over time to monitor the performance of their financial management support processes. World class and common practice benchmarks have been provided (where available) for organisations to use initially to diagnose their existing processes to determine whether they require redesign. These benchmarks have been obtained from the Arthur Andersen Global Best Practices database. Metric Measure Your Your Common World result target Practice Class Finance function Cost of function Total finance cost/total expenditure x % 0.42% Head count Total finance staff/total employees x % 1.98% Qualifications Degree qualified staff/total finance staff x % - Profile Finance staff/total employees x % 1.98% Role Time on transaction processing/total staff time x % <10% Financial systems Integration Integrated modules/total accounting modules x % Scale: consolidation Number of general ledgers used - 1 Scale complexity Number of accounts in general ledger <10,000 <1,000 Automation Number of generated journals/total journals x >90% Closing the books Cost Cost of close process/cost of finance function x % 2.71% Efficiency Number of hard closes in excess of requirements 8 0 Cycle time Elapsed working days from period end to report 5-7 days 2 days Accuracy Number of journals to correct error/total journals x % 0.03% 65

66 2. Diagnostic questionnaires The following questionnaires should be used to undertake a qualitative diagnosis of financial management support processes to document how things are done, or how well they are done, compared to recommended better practice. The first questionnaire is in the form of a model client satisfaction survey for the finance area. It can be used, in the first instance, by the finance area itself, to self-assess its approach. The results of this self-assessment should then be compared with results from a sample of operational managers. A useful measure to be obtained from this survey is the gap between performance and importance. A gap analysis will highlight areas of greatest concern to the users of finance services. The second questionnaire is a diagnostic for the close the books process. Both questionnaires are designed to complement the metrics obtained on the previous page. The results from both exercises should be combined to form an overall assessment of the support processes. 66

67 Finance function: client satisfaction survey Section 1 Current services and outputs 1.1 Financial services received Please rate importance and satisfaction of services received. Service Importance Performance Rating Low Mod High Vital Poor Adequate Good Excellent Transaction processing Control of financial resources Production and distribution of reports Decision-support advice and assistance Comments: 1.2 Financial reports received Please rate the importance to you, and your assessment of performance, in relation to the financial management reports you receive. Quality Importance Performance Rating Low Mod High Vital Poor Adequate Good Excellent Timeliness of reports Reliability of information in reports Summary page highlighting key results Concise length of detailed report pages Clear layout and design of reports Use of graphs, charts and diagrams Value-added analysis and commentary Comments: 67

68 Finance function: client satisfaction survey cont d Section 2 Financial systems and processes 2.1 User assessment of financial processes My role involves/is affected by the following financial processes (please tick) Accounts payable and expenses Customer sales and accounting General ledger and statutory accounting Materials, finished goods, inventory and cost accounting Investment appraisal including Acquisitions Management of finance function Treasury Other (name) Payroll and pensions Fixed assets and capital control Strategic and business planning Budgeting and forecasting Performance reporting and control analysis Corporate finance Legal Other (name) Please grade, by circling your assessment, the following statements based on your experience of those processes you have ticked (above): The financial processes are efficient Poor Adequate Good Excellent Unqualified The financial processes meet my/my department s needs Poor Adequate Good Excellent Unqualified Each process is owned by a champion whose objective is to ensure the process is efficient, cost effective and meets customer s needs Poor Adequate Good Excellent Unqualified Comments 68

69 Finance function: client satisfaction survey cont d Section 2 Financial systems and processes cont d 2.2 User assessment of financial management information system Please rate the importance to you, and performance, of the following qualities of the financial management information system (insert name of system). Quality Importance Performance Rating Low Mod High Vital Poor Adequate Good Excellent On-line user access Speed of response Robustness and availability Ease of use Complete, accurate and valid data Simplicity of chart of accounts structure Ad-hoc reporting facility/extraction of data Comments: 69

70 Close the books: better practice diagnostic Please rate the performance of your organisation in relation to the following better practice principles. Better Practice Principle 1 Planning the close Better Practice Performance Action Required Rating Poor Adequate Good Excellent Analysis of work steps, staff required and reasonable cycle time for each step in the process has been undertaken and documented A plan, including milestones and deadlines, has been set and clearly communicated to all staff involved in the process Operating results and financial position are forecast and significant prospective transactions are identified. Past performance has been analysed, including tracking whether milestones and deadlines were met Better Practice Principle 2 Applying materiality Better Practice Performance Action Required Rating Poor Adequate Good Excellent Materiality assessments have been undertaken which consider: - what the information is to be used for; which balances are significant; and - the extent to which these balances need to be free from error. A hard close Is undertaken only for reports that are prepared to meet regulatory requirements. 70

71 Close the books: better practice diagnostic cont d Please rate the performance of your organisation in relation to the following better practice principles. Better Practice Principle 3 Managing the workload Quality Performance Action Required Rating Poor Adequate Good Excellent Recurring journal entires are automated Reconciliations for immaterial balances are replaced with variance analysis or moved to off-peak. Estimates and standing journals are used for provisions and accruals where a soft close is undertaken. Errors are returned to responsible line areas for correction and re-input First-cut trial balance is run and reasonableness review of results is undertaken. Better Practice Principle 4 consistent reporting Quality Performance Action Required Rating Poor Adequate Good Excellent Detailed financial management report content and format is consistent with regulatory report content and format. Key financial performance indicators used are drawn from information contained in underlying detailed financial reports Consistent financial performance indicators are used across and down though organisational levels. 71

72 Glossary Absorption rate Activity Based Costing Assignment Attribution Budget Controllable Cost Cost Cost Accounting Cost Allocation Cost Behaviour Cost Drivers Cost Elements Cost Object Cross Subsidisation Direct Cost Fixed Costs by Attaching costs to products or services based on measures of activity such as volume of output An approach to costing and monitoring of activities which involves the tracing of resource consumption and costing final outputs. A method of allocation used when a direct relationship between the costs and the cost object exists or can be established A method of allocation that uses cost drivers to spread costs amongst cost objects on the basis of common or indirect relationships A budget is the financial plan of an organisation s operations and a tool to control the allocation of resources A controllable cost is a cost that can be influenced by its budget holder A measure of the value of resources consumed in acquiring or delivering services. The establishment of budgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variances, profitability or the social use of funds. The process of attaching costs to the identified cost object The variability of input costs with activity being undertaken. A number of cost behaviour patterns are possible, ranging from variable costs whose cost level varies directly with the level of activity, to fixed costs where changes in output have no effect on the cost level. Cost drivers are the event, transaction or occurrence that give rise to an activity being performed, for example staff numbers, number of PCs and proportion of floor space The constituent parts of the total cost identified by the nature of the expenditure (often classified as material labour and expenses) The cost object is the item requiring measurement. For external reporting the cost object will probably be at the organisation output level but for internal management purposes the cost object may be at a lower level (eg project or activity, unit output, region). The distortion of costs between cost objects so they do not accurately reflect the pattern of resource consumption A direct cost is expenditure that can be economically identified with and specifically assigned to a relevant cost object. Fixed cost are those costs which, within certain limits, tend to be unaffected fluctuations in the level of activity (output or turnover). 72

73 Flexible Budget Full Costs Indirect Costs Job Costing Life Cycle Costing Marginal Cost Marginal Costing Overhead Costs Process Costing Recurrent Costs Relevant Costs Responsibility Centre Standard Cost Variable Costs Variance Work-in-progress A budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes. The sum of the costs of a cost object An indirect cost is expenditure which cannot be economically identified with a cost object, and as a consequence has to be attributed across a range of cost objects A form of specific order costing in which costs are attributed to individual jobs An approach which identifies the costs at each phase of an asset s life, that is planning, acquisition, operation and disposal The incremental increase in costs as a result of an increase in activity or the volume of output Marginal or direct costing is an accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full Costs incurred for the general benefit of the whole organisation, rather then directly in support of a particular output. Common examples are Property Operating Expenses and the costs of Corporate Services A costing method where goods or services result from a continuous sequence of repetitive processes to which costs are attached and then averaged over the units of output Costs which are incurred on an ongoing basis Relevant Costs are future costs that are relevant to future decision making and do not include any costs incurred or committed in the past. A responsibility centre is a department or organisational function whose performance is the direct responsibility of a specific manager The expected or planned unit cost of the products or services produced in a period based on expected level and price of input Variable costs are costs that vary in proportion to changes in the level of activity The difference between a planned, budgeted or standard cost and the actual cost incurred An account used for the accumulation of the cost of a job or project which is incomplete 73

74 Bibliography The following references are recommended as further suggested reading and ongoing sources of reference material. Books Management Accounting Off icial Terminology, Chartered Institute of Management Accountants 1996, London United Kingdom ISBN Cost and Effect, by Robert S. Kaplan and Robin Cooper Harvard Business School Press 1998, Boston USA ISBN Activity Based Management for Service Industries, Government Entities and Non Profit Organisations, by James A. Brimson and John Antos, John Wiley and Sons Inc. 1994, New York USA ISBN X Managing for Outcomes - Output Costing Guidelines, Queensland Treasury 1998, Brisbane Australia ISBN Cost Management System Design, by R. Bear, F. Schmid and R. Mills, Chartered Institute of Management Accountants 1997, London United Kingdom. ISBN Perspectives on Cost Accounting for Governments - Exposure Draft, International Federation of Accountants 1998, New York USA Performance Measurement in Service Businesses, Chartered Institute of Management Accountants 1991, London United Kingdom ISBN Cost Accounting - A Managerial Emphasis, C.T. Horngren and G Foster Prentice-Hall International New Jersey USA ISBN Journals Management Accounting, The Chartered Institute of Management Accountants, London United Kingdom Charter, The Institute of Chartered Accountants in Australia, Sydney Australia Australian CPA, Australian Society of CPAs, Melbourne Australia Strategic Finance, Institute of Management Accountants, Montvale USA CMA Management, The Society of Certified Management Accountants of Canada, Hamilton Canada Public Finance, The Chartered Institute of Public Finance and Accountancy, London United Kingdom

75 Web Sites The Chartered Institute of Management Accountants - Institute of Management Accountants The Society of Certified Management Accountants of Canada - The Chartered Institute of Public Finance and Accountancy - International Federation of Accountants - Australian Centre for Management Accounting Development - Australian Society of CPA s - The Institute of Chartered Accountants in Australia

76 Acknowledgments 76