A few years ago, almost all business purchase orders over $100 were arranged through approved purchase orders, with pay- ment after delivery. Small purchase orders used a petty cash fund. However, with the advent of business credit cards and online ordering, a lot of business purchases are now by credit card. This is very convenient and it saves time. However, you can’t allow a change in the way you send money to your ven- dors to open the door to poor accounting practices or poor budgetary tracking. You should be sure to allocate money from the appropriate expense line items each time you authorize a purchase. Trying to remember what a purchase was for later—
at the end of the month, the quarter, or the year—leads to inac- curate records. And if our records are not accurate this year, we’ll have difficulty planning next year.
When we track a budget, what we’re really tracking, at a detailed level, is transactions. Each transaction moves money from one account to another within our budget. At the same time, each transaction is an agreement, sometimes a legal con- tract. Here are the transactions that occur with each purchase if we use a purchase order.
1. Decision to buy.This includes allocating funds from expense line items to the purchase and preparing a pur- chase order. It may include a contract with the vendor. In
Debit
Credit Credit
Total Credit
Checking Acct.
$500
$500
Expense Category
$300
$150
$50
$500
Marketing Shipping General
Table 9-1. Splitting expenses
the accounting system, money is allocated from the bank account to accounts payable.
2. Receiving the item.This includes either picking up the item or receiving a delivery or shipment. It also includes checking to make sure that the shipment is correct and that the items are not damaged. The packing list from the shipment is marked “received.”
3. Approving payment.The packing list and invoice are brought together and checked. The account codes for the line item(s) are marked. The check can now be prepared.
4. Making payment.The check is prepared (often this is called cutting the check) and sent to the vendor. In the accounting records, money is moved from accounts payable to the appropriate expense category or categories.
If you pay by credit card, then the decision to buy also includes a transfer of funds from the expense account to the credit card account. Receiving and shipping are the same as with a purchase order. Payment is made to the credit card account rather than directly to the vendor.
Each day, you can identify the status of each purchase. If you add up all the current expenses, then you can find the status of each account for each line item. At any moment, the total amount you budgeted for the period equals the amount paid to vendors plus the amount committed by purchase decisions and the unused amount still available for future purchases. If you lose track of your purchases, then you won’t be able to do this and you won’t know how much money is still available to spend.
For example, let’s say that we have a budget of $1,000 for the year for computer software. Earlier in the year, we spent
$350. At the beginning of the month, we ordered one item for
$100, and it has not arrived yet. We also went to a store and purchased an item for $75 on a credit card. The credit card bill has not yet arrived, but we have the receipt and we’ve approved the purchase.
The status of the computer software expense account is shown in Table 9-2. As you can see, the funds available for pur-
Budgeting for Managers 140
chases for the remainder of the year equal the allocated funds less what has already been spent or committed.
When we commit to making an expense, we call that accru- ingthe expense; and tracking expenses when commitments are made is accrual accounting, as mentioned in Chapter 2. If we track expenses only when we actually pay the money, that’s cash accounting.
Businesses are much better off using accrual accounting.
Otherwise, managers may overspend their budgets before they know they’ve committed to spend the money, especially when several people are allowed to charge expenses to the account.
Each year, the accounting department prepares the figures for taxes and reports to the IRS based on either accrual account- ing or cash accounting.
But, whether the company reports to the IRS on a cash or accrual basis, you should track your depart- ment’s income and expenses on an accrual basis.
Budgeted Spent
$350
Committed Available
$100
$1,000
Note Allocated for year Spent in prior period
Hardware on order (Inv. # 124356)
$75 Software purchase
(credit card 7890)
$475 Budgeted
Less Spent + Committed Table 9-2. Expense account status
Cash basis Accounting system in which financial transactions are tracked when money is actually spent or received.
Accrual basis Accounting system in which financial transactions are tracked when commitments are made. Income is tracked when a client is billed and expenses are tracked when a purchase order is approved or a charge card is used.
That means that you track your commitments to spend money, rather than only payments you make, and your con- tracts to earn money, rather than only payments you receive.
When you sign a contract indicating that you’ll do work and earn money, you accrue the income. When you complete the work and bill the client, you set up the money in accounts receivable. When the client pays and you deposit the check, you credit the income account with income received and credit your bank account with the money you deposit.
For example, suppose a consulting firm estimated that it would do work for three clients this month for a total of
$300,000. One of the clients wanted one week of work at the beginning of the month for $80,000. That work is done and the client has been sent an invoice. A second client has signed a contract for two weeks of work at $150,000. The work is in progress and the client is not yet billed. The firm is negotiating with a third client, but there’s no signed contract yet, so the firm can’t count that in the committed part of estimated income. Table 9-3 illustrates the estimated income and accrued accounts receivable for consulting work for the month.