Demystifying the financial close – What is journal entry?

1. Overview: The importance and challenges of the financial close

Accurate financial information is the backbone of good business decision making, never more so given the high levels of economic volatility and shifting strategic priorities. So it is critical for executives to have timely access to reliable financial data. The financial close process is fundamental to that financial visibility; it ensures the accuracy and timeliness of individual company’s numbers so they can be passed over to the group for consolidation and reporting and comply with regulatory reports – either internal or external.

A well-executed 'fast close' can bring many valuable benefits to the business, from improving organizational performance to propelling accounting executives from financial historians to trusted advisors. Research into the financial close conducted by analyst Hackett Group found that top performers close their ledgers earlier in the month and complete the process in less time than their peer group, helping them free up resources to conduct analysis and provide financial and other company executives with support for fact-based decision-making.[1]

And yet the financial close has long been a source of frustration and pain for finance departments, with potentially significant ramifications for the organization as a whole.

The challenge of extracting numbers from disparate places remains a major bone of contention for senior finance professionals. Around a quarter of respondents to research into financial reporting conducted last year by FSN said they spent too much time on data collection from multiple data sources.[2] A similar proportion bemoaned the time spent cleaning and manipulating data. The analysis clearly highlighted the desire among respondents to spend more time on financial risk management and analysis and performance measurement activities.

Opportunity costs aside, a slow financial close is more than likely an indicator that your processes are cumbersome. That typically means manual and labor-intensive, relying on use of multiple spreadsheets. The bottom line is that a slow close will increase general and administrative (G&A) expense. It could also be an indication of underlying inefficiencies across other financial processes – such as billing, cashflow and accounts payable.

The last few years has seen a growing focus on the ‘last mile’ of the close – the most externally visible management processes that finance executives perform after the monthly, quarterly or annual close to prepare for financial reporting and disclosure. In contrast, the early stages of the financial close – the ‘first mile’ – which includes the capture of financial data and production of the preliminary trial balance and consolidations, have largely been neglected. And this is the case even though many of the problems that occur in the last mile are due to first mile issues. It is this first mile where there is the potential to make huge improvements in the efficiency, speed and accuracy of the entire record-to-report (R2R) process.

[1] Streamlining the Financial Close Process (Hackett Group, 2017)

[2] The Future of Financial Reporting (FSN, 2018)

2. The 4 key pillars of the financial close process

While the detailed financial close will undoubtedly mean different things to different people, in its broadest sense, it relates to the set of paths or workflows that must be completed in a timely manner to ensure the complete accuracy of financial reporting.

Typically condensed into a 10-day timeframe, the financial close happens every month, quarter and year to varying degrees of complexity. The financial close is the process of taking those individual entities, closing their books and rolling the numbers up to a group level where they can consolidate and produce group financial statements before the information is passed over to a reporting group for disclosure.

There are four main components of the close:

  • Close checklist – a checklist of all the processes that need to be executed along the R2R journey, typically varying from 300 to 1,200. They need to occur within a tight timeframe and there are lots of dependencies, working across geographies and timeframes – requiring sophisticated project management capabilities to manage that checklist.
  • Journal entry – the process of posting journals and validating them. What you enter must be approved and controlled.
  • Intercompany – intercompany trade can represent a lot of transactions and a huge amount of work for the finance team, but you need to eliminate it from the results. Reconcile and accrue into the next month. The ideal situation is where the reconciliation is zero.
  • Balance sheet reconciliation and certification – it used to be the auditor’s job to ensure the accounts are in order and identify discrepancies, but today it’s an essential part of an organization’s financial checks and balances.

For this article we will focus on journal entry – what it is, its role in the close and how you can tackle the challenges related to it.

3. What is the role of journal entry in the close?

Journal processing is one of the main activities within the period end close. However, one of the major stumbling blocks to a painless and faster financial close for many organizations is manual journal entry. It’s a process that is relatively painless when you’re dealing with a few manual journal entries, but scale that up to the numbers at play in a larger organization, which can easily run into the thousands, and the pressure that puts on the close soon becomes apparent.

Journal entry is something you do to your general ledger to adjust your final figures before you send them up for group consolidation. Accountants use journals to fine-tune the books, reconcile ledgers and produce accurate financial statements. In fact, over 50% of close related tasks are journal related and are used to keep the books in balance and financial statements compliant and accurate. Even in world class companies, journal entries can take several days because of the laborious nature of preparation and approvals.

The risks associated with journal entry are potentially huge. Think how many people could access the system and make an incorrect adjustment or erroneously or maliciously enter an incorrect number that affects your final number. It’s vital that there are clear controls around journal entry and any changes to the numbers before you report them. That’s why journal entry is commonly the first part of the financial close process that organizations want to automate.

At the same time, the already cumbersome burden of journal processing in the accounting cycle is increasing as finance professionals look beyond the general ledger for more varied sources of data and insight. Each sub-ledger or fresh source of data adds to journal complexity, much of which is paper-bound and manually intensive.

Without accurate journal entries, your general ledger will contain errors that prevent you from gaining a clear picture of your company’s financial performance. Ultimately, journal errors can result in inaccurate financial statements and reports, as general ledger balances will contain either over- or understated revenue, expenses, assets, liabilities, equity, or a combination of all of these. Skewed financial balances in the general ledger can initiate poor financial decisions that could negatively impact your company’s bottom line.

4. The key elements of journal entry

In manual accounting or bookkeeping systems, business transactions are first recorded in a journal. Journal entries that are recorded in a company's general journal – the record of business transactions, in order, according to the date events occur – will consist of the following:

  • the appropriate date
  • the account(s) and amount(s) that will be debited
  • the account(s) and amount(s) that will be credited
  • a short description or reference

The journal entries appear in a journal in date order and are then posted to the appropriate accounts in the general ledger. Computerized accounting systems will automatically record most of the business transactions into the general ledger accounts. However, even with computerized accounting systems some manual journal entries are necessary – for example adjusting entries to record depreciation or to accrue interest on a bank loan.

What’s often glossed over is the huge amount of leg work and data manipulation in particular to get organizations and their finance teams to the journal entry stage. In fact it is estimated that 70-80% of the work is in preparation of the data so you can put it into a journal entry. And this done by one of your most expensive resources – your accountants.

5. The common pitfalls and challenges of journal entry

Journal entry is an extremely labor-intensive and time-consuming part of any close process. Month-end journals in a large enterprise can easily number the thousands, often requiring the completion of unwieldy data validations, error corrections and approval routing being uploaded to an ERP system for posting.

While some journal activity is automated within ERP systems, the reliance still on manual preparation means finance teams can spend days just collating the data needed to calculate accruals, prepayments and adjustments before month-end. Far from a nebulous source of frustration, more than half of finance professionals believe they spend too much time on transaction processing of this nature, according to FSN Research’s ‘Future of Financial Reporting’ study.[3]

At the same time, a lack of visibility over controls, missing documentation, estimates based on very old assumptions, and the inability to check every line of a journal will increase the risk of error and wreak havoc with plans to complete the financial close in a timely fashion.

The most common manual journal entry mistake relates to account coding errors, especially in large journals with a high number of entry lines. Other common mistakes include incorrect capture of journal amounts, a failure to flag reversal periods, accounting period misallocation, use of incorrect foreign exchange rates or capture of ambiguous journal information.

[3] The Future of Financial Reporting (FSN, 2018)

Due to an absence of sufficient controls in ERP systems to help organizations manage that, many turn to point solution applications to post, validate and approve journals. While that goes some way to alleviating the effort required, at best those aspects of the process represent only 20-30% of the effort and these applications fail to address the complex calculations for the complex calculations required when closing journals.

Errors aside, the risks posed by malicious manipulation of journal entries is a growing cause for concern. Indeed, financial fraud is one of the biggest risks facing financial teams, according to the University of Portsmouth’s Centre for Counter Fraud Studies. The most frequent types of management fraud involve fictitious or premature revenue recognition, typically through management override of internal controls.

In large-scale frauds, such as WorldCom, management override around the journal entry process was the key contributing factor. Adjustments in subledgers are possible but require collusion with other organizational departments, which is much harder to orchestrate.

A beefing up of rules and heightened corporate awareness of the importance of strong financial controls is all but meaningless if employees are able to circumvent the control structure. A recent study by the Association of Certified Fraud Examiners (ACFE) highlighted the limitations of internal controls for fraud detection when it found that internal controls were not the first but the fourth most common way to detect fraud.

All too often, corporate complacency leaves the doors to fraud open as employees, including senior management, find creative ways to work around the supposed failsafe controls in place. For example, in journal entries, employees can post numerous smaller entries to various departmental general ledgers to circumvent approval processes, as well as to make it more difficult for auditors to detect the malfeasance.

From experience, organizations posting a large number of manual entries is often a sign of underlying problems with the financial close process because it can hide systemic problems. Therefore, it is always a good idea to look at how many manual journal entries your organization makes because this might call for a revision of standards and optimization of your accounting processes.

 

6. How can finance teams tackle the challenges of journal entry?

Remove the manual burden

Automating the creation, entry, management and approval of month-end journals eliminates the burden of this manually- and volume-intensive process to tirelessly power through repetitive tasks without errors and accelerate the close. Employees previously occupied by keeping data moving are now freed to perform higher-value tasks, such as reviewing reports and complex exceptions.

A focus on automating validation, approval, posting and archiving can result in process improvement of up to 30%, however the significant manual effort really occurs further upstream. To truly automate your journal process, you also need to integrate to ERPs and disparate systems, retrieve data, and perform calculations.

 

Validate with underlying ERP systems

Using inbuilt financial intelligence means that journal processing ‘understands’ the underlying structure of financial management and ERP systems. In practice this means data can be drawn from underlying systems and written back to the ledgers instantaneously. This allows thousands of journals to be processed at the same time. And pre-validation rules built into the automation greatly reduce the risk of rejected or incomplete items.

 

Focus on risk

Faced with thousands of journals, multiplied up by potentially hundreds of ledgers and thousands of people across the enterprise, the process of approving journals can stretch the limits of practicality. But the ability to set risk-based rules (for example, journal size or class of asset) governing what needs to be approved, enables finance teams to focus on the areas of highest risk. 

An effective system of internal control will help prevent material misstatements from appearing in a company’s financial statements, whether due to error or fraud. This is one area where automation is particularly valuable. Approval workflows can focus attention on the high-risk accounts, leaving those accounts, balances and risks that are below the risk threshold to be automatically posted.

 

Provide supporting documentation

It’s not just the creation and posting of journals that is labor-intensive. Huge amounts of time are wasted every month explaining the reasons and logic behind journal entries. Frequently this ‘know-how’ is lost or forgotten from one period to the next, leading to journal entries being slavishly copied from one month-end to another without a true understanding of the underlying logic.  
 
The ability to store supporting documentation digitally alongside relevant journals saves time, reduces effort and allows subsequent journals to be posted with full knowledge of what has gone before, cutting down on paperwork and improving the accuracy of the accounting records.

 

Build confidence and control

Once established, automation leads to robust and dependable processing that, unlike manual controls, can be relied upon to work faultlessly every time. Automation of journal processing leads to higher levels of confidence and control while cutting swathes of time out of the `first mile’ of finance.

A full audit trail that tracks the entire journal entry process from end to end allows organizations to flag up recurring bottlenecks in the journal entry process. This can help you benchmark your performance, address underlying issues and subsequently streamline the journal entry process.