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Finance Professionals, Remember Your Journal Entries

  • By Karl Kern
  • Published: 8/6/2019

journal

As an accountant, I recognize the importance of journal entries. Journal entries represent the foundation of financial statements. Journal entries also represent an understanding of transactions, and transactions are the bridge between the choices people make and the wealth they try to accumulate. 

While working in private industry, one of my responsibilities was to write narratives about my employer’s financial statements. The purpose of the narratives was to describe reasons for changes in elements on the income statement and balance sheet. The narratives were used by outside auditors during their year-end engagements.

The narrative that to this day stands out for me was one written for outside auditors who were engaged with my employer for the first time. The audit manager read the narrative and raised a concern. The concern was that my narrative indicated a reason for a change in one account but the change was not seen in another account. The audit manager’s concern led me to redo my analysis. On the surface, redoing the analysis looks inefficient, however, it was one of my better learning experiences.

The advice the audit manager gave to me remains to this day: “Remember your fundamentals; remember your journal entries.”

APPLYING THE ADVICE

One of my engagements in private practice involved analysis of a company’s inventory. The focus of the analysis was the company’s raw materials, work-in-process and finished goods inventories. The focus was due to two reasons. First, the company used its inventories as collateral for a loan. Second, the company did not conduct comprehensive analyses of its inventories due to staffing.

The reasons for the focus established a framework for the engagement, which was to determine the reliability of the inventory balances reported to the company’s lender. Determining the reliability of the balances was necessary for not only the lender but also the stockholders. The primary stockholder was a private equity firm that was looking to sell its interest at a later date. The role of the private equity firm added another layer of importance to the engagement. As a result, the engagement needed expertise to not only identify but also solve problems, and the advice I received years earlier came into play.

One of the issues I addressed was the accounting for scrap. Scrap occurred in the company’s production process, which was provided to an individual who would record the transactions. The transactions were recorded in the company’s accounting software and communicated online. What made this process challenging was the volume of transactions that were recorded to inventory. The challenge was the proverbial “finding a needle in the haystack.”

The needle was to be found by remembering the journal entry for scrap: a debit to scrap and a credit to work-in-process inventory. This looks simple but what I found wasn’t. I found that debits, not credits, to work-in-process inventory were recorded for scrap. How did that happen? It happened due to a flaw in the recording process in which the module used to record scrap was programmed to increase instead of decrease work-in-process inventory.

I brought this error to a colleague’s attention and the colleague did not believe what I found. By incorporating the advice I received from the audit manager I was able to illustrate the error. The colleague reviewed my illustration and agreed with my finding. My finding led to an adjustment of work-in-process inventory and a correction to the process of recording scrap. When I look back at this engagement, I realize how important the advice given to me years earlier helped me solve a significant problem.

ESTABLISHING A FRAMEWORK

How can one establish a framework for financial analysis from this advice?  I did so by using the cash conversion cycle (CCC). The CCC determines the amount of time taken to sell inventory, receive cash and pay cash. The amount of time taken for these three tasks is measured by three items: the average age of inventory (AAI), the average collection period (ACP), and the average payment period (APP). All three items incorporate the advice I received.

The average age of inventory focuses on the relationship between cost of goods sold and inventory. The average collection period focuses on the relationship between sales and accounts receivable. The average payment period focuses on the relationship between purchases and accounts payable. All three relationships represent journal entries recorded when companies purchase inventory, sell inventory and receive payment. This representation makes it easy for people to assess the ability of companies to effectively conduct relationships with customers and suppliers.

Using the CCC is important due to its use of time. Time is a metric used in our lives every day so it can be easily understood by people not familiar with statistics created by financial analysis, most notably turnover ratios. As finance professionals we must remember that the purpose of financial analysis is to learn about how companies accumulate wealth, so the learning must be made easy. I can think of no other way to simplify this process than to use an everyday measurement—time—to help people not only learn but also progress.

Let’s see how the CCC can be applied to the following companies:

COMPANY

AAI

ACP

APP

CCC

Apple

12.44

23.73

76.75

-40.58

Dell

20.29

47.35

104.78

-37.14

HP

44.56

35.20

111.68

-31.92

 

Here’s what we can assess from this data:

  1. Apple sells its inventory faster than Dell and HP.
  2. Apple receives cash faster than Dell and HP.
  3. Apple pays cash faster than Dell and HP.

The above listed assessments provide a story. The story is Apple’s ability to stand out from its competition. This ability is demonstrated by Apple’s connection with its customers through the amount of time it takes to sell products and collect cash. The ability also is demonstrated by Apple’s connection with its suppliers through the amount of time to pay its bills. These connections serve as an explanation for Apple’s success in the marketplace.

APPLYING THE FUNDAMENTALS

Financial analysis has become more developed over time. Its development has occurred due to advancements in technology and data science. These advancements can appear overwhelming to those pursuing a career in financial analysis but it does not have to be overwhelming. Preventing financial analysis from becoming overwhelming can be accomplished by applying fundamentals. Perhaps the most important fundamental is what I learned many years ago—remember your journal entries.

Karl Kern is an accountant, lecturer and writer focused on economics and finance.

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