In my years as a CPA and consultant I’ve worked with many small businesses that have asked for input on what they need to be doing to get more reliable financial data. Usually, it’s business owners looking for ways to be able to make important decisions faster, but lately it’s often companies new to government contracting that are trying to figure out what they need to be doing to keep clear of problems with DCAA. In either scenario, one of my first suggestions is a formal monthly close process. When I say “formal”, that doesn’t mean that it has to be cumbersome and complicated. If the business financials are relatively simple, then that close process can also be fairly simple and still be effective. But it needs to be structured, with a specific checklist in place as to the procedures that are to be performed, the order in which they are to be done, who is responsible for each task, and target deadlines for each. That recommendation then raises the next question – what do you mean by “close”?
What Is a Close?
A lot of businesses think they are closing the books each month, but what they’re really doing is reconciling the bank accounts and reviewing the Income Statement for accuracy. Unfortunately, that is just a small part of what even a simple close should entail. Many of the business owners I’ve worked with spend all their time focusing on the Income Statement – and for good reason. Ultimately, it’s revenues, profitability, margins, etc. that they are trying to drive, all of which are found on the Income Statement. However, I would argue that the Balance Sheet is more important than the Income Statement. Some might say that doesn’t make any sense – after all, I just agreed that many of the metrics for focus are on the Income Statement. However, if the Balance Sheet isn’t accurate, then neither are any of the numbers or metrics on that Income Statement. Ultimately, if everything is correctly represented on the Balance Sheet, then the Income Statement, at least at the bottom line, must be correct. It’s possible that some revenues or expenses might be shown in an incorrect Income Statement account and the Balance Sheet still be correct but moving those revenue or expense items to the correct account would not have any impact on bottom line net income. Ensuring that all assets and liabilities are reflected on the Balance Sheet with correct balances as of the end of the period is the only way to ensure that all activity is reflected on the Income Statement. As a result, my suggestion for the close process is to start with the Balance Sheet and work your way down through the accounts reconciling them individually. Bank account, credit cards, and loans are the easiest and most obvious. These are the things that most companies are getting right. The things I see most often missed are accounts such as Inventory, Prepaid Expenses, and Accrued Expenses. These are the areas that many companies are only really doing a hard reconciliation on quarterly or at year-end, if that. In doing that though, they are risking material errors that may be significantly skewing the results of the Income Statements they’re looking at on a monthly basis.
Why Monthly Make Sense
Once I provide some examples of the sorts of accruals that should be done, how to determine them, and how to document them, the next questions I get are - Is this really necessary? Do we really need to do this monthly? Well…ultimately, my answer is yes. I’ve seen plenty of companies just record accruals on an annual basis because they think it’s going to be too much trouble monthly. From a practical standpoint, the biggest problem with that approach is that the December and January numbers each year are going to look really off, so it becomes difficult to perform any sort of monthly financial analysis. With the proper procedures and templates in place, monthly accruals are often pretty straightforward and don’t have to be time consuming.
Compliance Requirements
Further, there are DCAA requirements that support the process of monthly adjustments. The SF1408 Pre-Award Survey is the checklist that DCAA follows to determine whether a prospective contractor’s accounting system is acceptable for award of a prospective contract, and it is one of the very first interactions that many contractors have with DCAA.
Per SF1408 Pre-Award Survey, item 1:
- EXCEPT AS STATED IN SECTION I NARRATIVE, IS THE ACCOUNTING SYSTEM IN ACCORD WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES APPLICABLE IN THE CIRCUMSTANCES?
While there are certainly cost / benefit and Materiality Principle considerations to be made here, the Matching Principle is one of the cornerstones of accounting and is supported by the Principle of Periodicity in Generally Accepted Accounting Principles (GAAP). It requires that businesses use the accrual basis of accounting and match business income to business expenses in a given time period. Accrual basis accounting means that expenses should be booked in the period incurred. Consistency is also a requirement of GAAP, which is technically violated if accruals are performed in some months but not others. DCAA Auditors will often ask to see wage and other accruals as evidence of GAAP accounting as part of this survey.
Per SF1408 Pre-Award Survey, item (g):
- Interim (at least monthly) determination of costs charged to a contract through routine posting of books on account.
Since contract costs are required to be determined on at least a monthly basis (including indirect costs), it makes sense to perform adjustments and reconciliations of account monthly as well to ensure that the costs charged to any given contract are accurate. When it comes time for your pre-award survey, the DCAA auditor is likely to ask for monthly GAAP financial statements as evidence of interim reporting. Clearly, this monthly process is most critical for cost-type contracts, but it is best practice across the board, regardless of whether there are any cost-type contracts in place. Having that structure already in place can go a long way toward a smooth transition when you do find yourself on the verge of starting a cost-type effort. In addition, it will provide a solid financial foundation for business management and execution both for any T&M or FFP contracts that you have in place, and the business as a whole.
How Redstone GCI can Help
Redstone GCI has a Collaborative Accounting team with extensive experience available to assist contractors with all manner of GL accounting support. We provide ongoing real-time accounting services, periodic review, establishment of close processes, client training, and more. Our team would be happy to discuss any potential issues or concerns facing your organization as it relates to these areas.
