Merging project and corporate accounting
is it impossible? Maybe
This paper addresses the necessity of taking both project and corporate accounting into consideration when project decisions are being made. To do so, project managers need to have a basic understanding of the key financial statements of a business and how each project affects these financial statements. This will facilitate better cooperation and communication between the business's financial department and the project management professional, as well as in making better project decisions. This paper provides an overview and explanation of the key financial statements, namely the balance sheet, the income statement, and the cash flow statement, as well as a brief overview of the earned value management keywords. Additionally, examples of how and where a project affects each financial statement are provided and suggestions on how to make better project decisions by taking both accounting systems into considerations are described.
The popularity of project management might be found in the fact that the profession is geared towards eliminating risks when earning the commodity money while taking the ever-increasing velocity of money into consideration. The profession primarily resides inside government-supported legal entities, also known as businesses. One requirement the government has for these legal entities is to pay taxes, which can only be done when money is earned. Therefore, earning money is a goal every business has in common and eliminating earning risks is an indispensible service.
Businesses are required to provide financial insight into the body that provides and protects the business's legal statuses (the government). Most businesses follow the Generally Accepted Accounting Principles to meet this requirement. The result is that most businesses create three main financial statements: the balance sheet, the income statement, and the cash flow statement. All three financial statements are prepared from the same accounting data— the general ledger, and each financial statement serves its own purpose. Business owners pay close attention to these three financial statements and make many business decisions based on these statements.
The project management profession, however, has its own financial system named earned value management, and currently most project managers make use of it when they make a project's financial decisions. It turns out that decisions based solely on earned value management are not necessarily decisions that are most favorable for the business's three main financial statements. Therefore, project managers need to have a basic understanding of the key financial statements and how each project affects these statements. This is necessary to enhance cooperation and communication between the business's financial department and the project management profession. Throughout this document the words financial statements and accounting systems, although not the same, are used interchangeably.
The Balance Sheet
The balance sheet is a snapshot of a company. It shows the company's financial position, or health, on a particular date (Exhibit 1). It is a convenient way to organize and summarize to see what a company owns (assets), what a company owes (liabilities), and the difference between the two (the company owners’ or shareholders’ equity). In other words, the balance sheet provides an overview of the value of the company's assets and who owns the company's assets.
Assets are displayed on the left side of the balance sheet; the owners of these assets are displayed on the right side of the balance sheet. An asset might be a building or office, and the owner may be a bank that has loaned money to the corporation, requiring collateral, or assets (in this case the building or office), in order to approve the loan.
The balance sheet is so named because the value of the assets and liabilities and shareholders’ equity are always balanced. Someone must own the assets, hence the formula: Assets = Liabilities + Shareholders’ equity. Current assets usually consist of those assets that can be converted into cash within one year rather easily. Liabilities, such as accounts payable, rent, and salaries are current liabilities. Fixed assets are more permanent items, such as buildings, major equipment, or trademarks. All other liabilities that are not due within one calendar year are classified as long-term liabilities.
Balance sheets are important to investors, lenders, and company owners because they illustrate who owns which assets. Furthermore, the balance sheet is an important tool used to generate financial ratios from which future decisions can be made, since certain financial ratios provide insight into the financial health of a company. Corporate managerial decisions are often made to positively influence the balance sheet ratios, and the project manager should be aware of the reason for these decisions.
Since the balance sheet is a snapshot of the company on a certain date, it is incapable of showing the net income or net loss a company had during a given time period; however, this information is shown in the income statement.
The Income Statement
Whereas the balance sheet can be compared to a snapshot, the income statement can be seen as a video covering a period between before and after snapshots (Exhibit 2). The income statement provides a convenient way to look at the company's financial performance over a period of time, be it a month, a quarter, or a year.
The income statement is sometimes called the profit and loss statement and lists the company's revenues (income) and direct expenses (costs of sales), and indirect expenses (overhead) as well as gross profit, pre-tax income, income taxes, and net income. The (basic) formula for determining a companies performance is Revenue – Expenses = Pre-Tax income. The last item on an income statement is the net income, the so-called bottom line.
Direct expenses are expenses incurred while creating a unique product, service, or result. Therefore, most project-related costs are considered direct expenses. Indirect expenses (or overhead expenses) are recurring expenses somewhat independent from creating a unique product, service, or result. The indirect expenses are added to the sales price of the unique product, service, or result with the help of an average formula. Indirect expenses can be non-project–related salaries, costs of insurance, bank fees, rent and utilities, property and payroll taxes, etc. Pre-tax income is income, which is revenue – expenses (see the previous formula), from which taxes are not yet deducted. Net income represents the income after taxes have been paid.
The income statement is valuable because it lists all the expenses the company is carrying. The income statement also shows how the company performed financially over a period of time, that is, if the company made a loss or a profit during the investigated time period. Furthermore, on the income statement, cash and non-cash items are listed but may not reflect the actual cash inflows and outflows that occurred during the given time period. This situation occurs when a sale is recorded in the income statement but the actual cash has not yet been collected. A cash flow statement is maintained to provide information on the cash (in hand) available.
The Cash Flow Statement
As seen previously, the income statement provides a picture of how a company performed financially over a period of time. The cash flow statement is used to keep track of actual cash in hand. It is distinct from the other two financial statements because it does not include future incoming and outgoing cash that has been recorded on credit. It is linked to the other two financial statements because it shows how changes in the other two financial statements affect cash. The purpose of the cash flow statement is to report the sources and uses of cash (and cash only) during a reporting period (Exhibit 3).
The cash flow statement is usually divided into four categories. The first category of the cash flow statement (operating activities) presents a summary of the cash flow (dollars) that comes in (the net increase) and the cash dollars that went out (the net decrease) from activities that are related to the principal line of business during a financial period. These activities can include cash receipts from sales of a unique product, service, or result and cash payments to suppliers and contractors. This first category can be consulted in order to get insight into when and how much cash is needed to pay the company's bills.
The second category of the cash flow statement (investing activities) lists the cash flow that took place for the investments (or sales) the company made in long-term (fixed) assets needed for a company's operation. Insight into the future direction of a company can be gained by examining this second category of a company's cash flow statement because it lists their investing activities.
The third category of the cash flow statement (financing activities) lists the cash flow on how the company acquired capital (where additional cash came from). This capital is also referred to as raising capital from debt and owners’ equity. It reports the issuance and repurchase of the company's own bonds and stock and the payment of dividends.
The fourth category of the cash flow statement (supplemental information) reports the exchange of significant items that did not involve cash and reports the amount of income taxes and interest paid. (The fourth category is not always listed on a cash flow statement.)
It is vital to track the available cash in a company at any given moment; this is an important task for the financial department. The cash flow statement can be used as a planning tool to help look into the future, and it can also help in making business decisions such as when to expand a business or take on a new project (line). It helps identify those periods when borrowing should be considered, and therefore, allows you to make arrangements before cash is actually needed. The cash flow statement is also a valuable tool for potential lenders or creditors who want a clear picture of a company's ability to repay.
Project Impacts on the Three Financial Statements
The project manager usually affects the same headings/categories on the financial statements during every project. These headings are the revenue (income), direct expenses (cost of sales), and indirect expenses (overhead) on the income statement, and the first category (operating activities) on the cash flow statement. Each change in one of these headings/categories affects certain corporate ratios. In part, the balance sheet is a consolidation of the income statement and the cash flow statement. In other words, when a project manager's decision impacts either the income statement or the cash flow statement, it impacts the balance sheet, and therefore, the balance sheet ratios. Accounts payable and accounts receivable listed on the balance sheet and impacted by the other two financial statements are examples of the consolidation.
Every time a project manager makes a sale or sends out an invoice, the revenue (income) heading on the income statement is affected. (The higher the sales/invoice volume, the higher the affect on this heading.) Project-related salaries and other direct project costs are direct expenses, which, if the project travels the project baseline, pay for themselves during project implementation. The value amount of the indirect expenses on the income statement, i.e., fixed salaries, office rent, utilities, insurance bills, etc., is predictable to a certain degree of accuracy, and revenue targets are set to cover at least these indirect expenses. The indirect expenses are somewhat fixed and constant. Therefore, the project manager's effect on these indirect expenses is somewhat limited. The project manager can also find the effect of the project hours spent (expressed in dollars) on the income statement. This makes sense, for employee time sheet entries are usually tied into both company and project accounting simultaneously. The lower the expenses (direct and/or indirect) and the higher the sales are the more positive the effects on the income statement are.
Project managers can assist the financial department by positively affecting the first category of the cash flow statement (operating activities), since every project has a certain cash flow: money out, money in. The shorter the time period between the two, the more positive impact a project manager provides to the cash flow. (Better yet: money in, money out.) Getting approval on a budget can often be expedited when insight to the financial department is provided in when what costs are expected to be paid back.
For further clarity, a few of the project manager's daily activities are listed below and linked back to the financial statements these project activities impact. For example, when the project manager:
- Tightens up planning and scheduling to shorten the duration between money spent and money collected, this will positively impact the cash flow statement
- Pays bills only when they are due and not sooner, cash outflow is delayed, which allows the company to use the cash longer, and since accounts payable is often the least expensive source of cash on hand, this could benefit the company. This impact is notable on the cash flow statement as well as on the balance sheet.
- Tries to establish extended terms with creditors, such as expended dating or paying the debt over a long period of time to the company's advantage, current liabilities will decrease and long-term liabilities will increase. Such terms affect financial ratios on both the cash flow statement and the balance sheet.
- Buys only what is needed when it is needed, cash outflow is delayed as long as possible and enhances a just-in-time inventory system. This impact is notable on the cash flow statement as well as on the balance sheet.
- Gets competitive bids from contractors or looks into contracting with smaller, less expensive “cottage suppliers,” will limit direct project expenses on the income statement, which is positive for the bottom line.
- Takes advantage of trade discounts, which limits cash outflow (positively affecting the cash flow statement) while building the asset inventory. (Asset inventory is listed on the balance sheet.) The advantages of this decision must be compared to the advantages of a just-in-time inventory system in order to get a more overall picture.)
- Keeps high quality standards, the project manager will eliminate certain needs for rework; therefore, less money will be spent, which has a positive effect on both the income statement and cash flow statements.
- Calculates the cost of inventory, including storage, handling, insurance, taxes, deterioration, etc., to establish a realistic estimate of cash outflow and to properly bill the client, the project manager uncovers and can invoice for these hidden costs. This action is noticeable on all three financial statements.
Earned Value Management
Earned value management (EVM) objectively measures project performance by integrating the project's scope, schedule, and resources. EVM is a project management accounting technique that is applied to projects and only functions when certain project accounting tools are used. For example, without a work breakdown structure, a schedule, a budget, the tracking of actual cost, and other accounting tools, earned value calculations cannot be completed. EVM answers the question, What have you got for the money you spent? It can be said that EVM lives inside a project accounting bubble because it does not take managerial preferences that stem from the financial statements into consideration.
Project accounting, with planned value (PV), earned value (EV), and actual cost (AC), with the cost performance index (CPI) and the schedule performance index (SPI) ratios, and with the projections of estimate to complete (ETC) and variance at completion (VAC) is, despite the labor intensive and often complicated implementation and monitoring processes, gaining popularity. It is the project manager, often combined with help from the project management office (PMO), that analyzes the project accounting data, and if significant deviation from the project baseline occurred, project corrections will be made. These corrections are based on project accounting numbers and are project specific, which, again, means that these correction decisions are made in a bubble, so to speak, and do not take the company's financial statement preferences (if any) into consideration.
Since every implemented project has an impact on the company's financial health, it is important to bridge project accounting in the PMO and company accounting in the company's financial department. This bridge is important, for every company has the goal to make money, and every project contributes to this goal either directly or indirectly and either positively or negatively. It can be argued that the company's financial statements are somewhat taken into consideration when the tools from project selection methods are applied in the early initiation stages of a project; internal rate of return, opportunity costs, payback period, net present value and present value, benefit cost ratio, and return on investments are financial tools which originally stem from company accounting preferences. While such tools might provide a priority ranking between projects considered, it remains important to continuously pay attention to the company's financial statements for the duration of the selected projects. It is important to know and understand how project management decisions affect the company's financial health, for it might lead the project manager to a different managerial decision than if the project manager would have drawn the accounting data from EVM alone. This is illustrated in the following example.
Project Decision: Taking Both EVM and Financial Statements into Consideration
A rather small, 18-month long, one-million-dollar project is currently in month 9 of the project life cycle. The PV is $500,000, AC is $450,000, and EV is $525,000, which makes the CPI 1.17 and the SPI 1.05. The current EAC is $854,700, and the current VAC is $145,300 positive. The favorable EV numbers show a project most project managers would be proud of.
What is not shown or mentioned in this financial project accounting bubble is, for example, that (1) the company as a whole is running low on cash; (2) the project's sponsor is falling behind on its payments (affecting accounts receivables); (3) the project manager always pays the project vendors on or before the vendors’ invoices’ due dates (affecting indirect expenses and accounts payable); (4) that once the project contract got signed, no one on the project team renegotiated better prices from their project vendors (no bidding-down techniques were utilized); (5) that according to the project plan the needed items for project implementation are to be bought a minimum of three months ahead of schedule, which, gathered from current project lessons learned, turns out to be two months too soon (affecting accounts payable, cash flow, and inventory); (6) during project contract negotiations, the project manager did not inquire about the possibilities for money upfront, the project manager would rather have the contract, and consequently run on a negative project cash flow, than taking the risk of being denied the contract.
This list, which is primarily focused on project cash flow, shows the additional information needed to manage a project more profitably. It is not extensive and could be quite longer. The point being that just looking at the EVM accounting numbers alone provides the project manager with a too limited accounting view on which to base sound project decisions. Also, a PMO overseeing multiple projects could anticipate different project cash flows and work together with the financial department to align project accounting to the company's accounting system by, for example, using the project cash flows as a communication tool.
Although every project can be seen as a micro company and project managers could potentially generate the three generally accepted financial statements for each project, it would be far too time-consuming, and the benefits might not outweigh the time and cost spent to do so. Nevertheless, since every project has an impact on the bottom line of the company, it is not advisable to manage a project solely based on EVM numbers, but also to continuously integrate the company's financial statements’ information during project decision-making processes. This does not necessarily mean that one has to merge the two different accounting systems; however, it does mean that both systems have to be taken into consideration while managing a project. The accounting system that should carry the highest priority in making project decisions will vary in each unique situation. The key is to use them both during the project decision-making processes throughout the project life cycle and keep in mind that project cash flow management is complimentary to company accounting, and therefore, creates a strong bridge between the two accounting systems.
© 2009 Stan Veraart, MPM, PMP
Originally published as part of proceedings PMI Global Congress 2009 – Orlando, FL