Financial Statements


Financial Statements

Finance officers have long-established standards for reporting the numbers. The general body of knowledge for accounting standards is contained in the Generally Accepted Accounting Principles (GAAP), published and maintained by the accounting industry. Within your business, the controller (comptroller, if you are in the government) is the chief accountant. The controller interprets and applies the GAAP to the specifics of your company.

Financial information is more often than not presented on a set of "financial statements." We will discuss three of those statements that are of most use to the project manager. The statements are:

  • The expense statement: Often called the "profit and loss" or "P&L" statement, the expense statement is where project financial expenses are "recognized" by the controller and recorded each period. We will learn that not all expenses on the expense statement are cash expenses, so to keep the books on the expense statement means keeping track of more than just the checks that are written. A common refrain is: "Cash is a fact, but profit is an opinion." [1] This reflects the thought that the expense statement is subject to much interpretation of the GAAP, whereas cash is tangible and well understood without ambiguity.

  • The balance sheet: The balance sheet is a two-sided ledger that we studied in Chapter 3. It is a recording of a snapshot in time of the dollar value of all the assets, liabilities, and capital employed on the project.

  • The cash flow statement: Actual cash going into or out of the company or project is recorded on the cash flow statement. It is on the cash flow statement that we actually see "sources and uses" of cash in the project.

The neat thing about these statements is that they actually all play together, something engineers and project professionals would call system integration, but accountants would call "balance" or "reconciliation." Even though one statement may measure flow and another may measure a value at a point in time, over the life of the project an entry on any one of these statements has a corresponding response on another statement. Collectively, and with their risk-adjusted partners, net present value and economic value add, the project financial statements provide a rich source of information about the performance of projects.

The chart of accounts was discussed in the chapter on the work breakdown structure (WBS). The chart of accounts is the controller's WBS of the business. The WBS of the project is just an extension of the WBS of the business, i.e., the chart of accounts. In this chapter, we will discuss the "trial balance" as a reporting tool for financial and project managers that is closely tied to the chart of accounts and the financial statements.

The Expense Statement

The expense statement, sometimes known as the income or P&L (profit and loss) statement, is an ordered list of the revenue and expense items for the project. The item categories and ordering of the categories is by account from the chart of accounts. Typically, there are accounts listed and expense entries for labor and labor benefits, purchased materials, travel, training, facility supplies and consumables, information services for data processing, networks and computer environments, vendor charges, facility rent and utilities, freight and fuel, capital depreciation expenses, general and administrative (G&A) expenses, sales and marketing expenses, legal and contract management expenses, taxes, and perhaps others, but not deliverables. It is very unlikely that you will see a project deliverable on the controller's expense statement for the project. The expense statement is therefore a "view" of the expenses from the controller's point of view.

Table 5-1 illustrates a project P&L.

Table 5-1: P&L Statement for Project

Statement Item

$0.00

Revenue from operations (Special note: project deliverables not operational)

$0.00

Direct expenses

 
  • Fixed expenses

 
    • Rent of project facilities

$2,000.00

    • Utilities of project facilities

$250.00

    • Project management staff labor compensation

$80,000.00

    • Project management staff compensation benefits

$16,000.00

    • Network and communications chargeback

$350.00

    • Total fixed expenses

$98,600.00

  • Variable expenses

 
    • Work package labor compensation

$850,000.00

    • Work package compensation benefits

$170,000.00

    • Office supplies

$500.00

    • Work package purchased materials

$45,000.00

    • Travel and subsistence

$10,000.00

    • Training for staff

$5,000.00

    • Rental and operating leases

$3,500.00

    • Total variable expenses

$1,084,000.00

  • Total direct expenses

$1,182,600.00

Indirect expenses

 
  • Indirect allocation of direct support expenses @ 100% of labor compensation

$930,000.00

  • G&A expenses (% direct)

 
    • Independent R&D @ 2%

$23,652.00

    • General executive management @ 15%

$177,390.00

    • Legal, HR, finance, contracts, IT @ 12%

$141,912.00

  • Selling expenses @ 3%

$35,478.00

  • Total indirect expenses

$1,308,432.00

    • Indirect rate (indirect/direct)

111%

Depreciation of capital assets

 
  • Special tools and facilities for project

$30,000.00

  • Software over $25,000

$525.00

  • Capital leases for special vehicles

$1,200.00

  • Total depreciation

$31,725.00

Total operating income (expense)

($1,340,157.00)

The Expense Statement and the Work Breakdown Structure

From the discussion in Chapter 2, we know that the project expenses on the WBS are typically presented from a "deliverables point of view" since the mission of the project manager is to provide the deliverables for not more than the resources committed to the project. Therefore, at the project level, the expense statement may have to be "mapped" to the project WBS. For example, there may be an expense item for travel and subsistence on the expense statement provided by the controller. The travel and subsistence within each WBS element should roll up to the figures in the expense statement for the same things, in this case travel and subsistence. If expenses within the project WBS are coded and identified according to the expense statement, it can be a simple matter for the project administrator to extract and add together these elements to "balance" or "reconcile" the expense statement with the WBS. Figure 5-1 shows a simple case of relating the expense statement to the WBS.

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Figure 5-1: Expense Statement Mapping to the WBS.

Most large companies run their business accounting on an "accrual basis," rather than on a cash basis. The consequence of the accrual method is that expenses can be reserved or recognized before any cash changes hands. Accrual accounting thus leads us to the fact that not all expenses are actually cash; they may only be an accrual that is being "recognized" in a particular period. For example, taxes are typically accrued each month as a recognized expense on the expense statement, but they are paid each April. The cash flow will be seen on the April cash flow statement even though "expenses" have been seen each period on the expense statement. In April, the cash flow will reconcile or balance with the cumulative expense statement insofar as taxes are concerned. Similarly, benefits, like vacation, are accrued as expenses each period. Sometimes the project manager sets up an accrual for a vendor or subcontractor's expenses so that their expenses are "smoothed" into each period. Then, when the vendor invoice is paid, the cumulative expense statement and the cash flow statements will reconcile and balance. Figure 5-2 shows an example of the process described.

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Figure 5-2: Cash Flow and Expense Reconciliation.

The Balance Sheet

In Chapter 3 we discussed the connection between the balance sheet and the expense statement. Expenses are logged on the "T" charts and totals moved to the balance sheet at the next "snapshot in time." The most important aspect of the balance sheet insofar as the project manager is concerned is the "capitalized expense" that is shown on the balance sheet. Large material purchases, and in some cases labor expenses, both internal and supplier provided, as allowed by the GAAP, are often "capitalized." "Capitalized" is a verb that has been coined to capture the idea that certain cash expenses should not be recognized on the expense statement until the item that was purchased is put into use. The GAAP idea is to align use and cost of use in the same accounting period. The balance sheet is where the unrecognized expense is maintained until the time comes to "expense" it to the expense statement. The process of expensing the balance sheet is called "depreciating," and the expense is called "depreciation expense." For example, if a truck is bought for the project in June and depreciation begins in September, when the truck goes into use on the project, there is no actual cash expense in September. The cash went out of the business in June when the truck was purchased. Depreciation is one of the prominent "noncash" expenses on the expense statement. Accruals, already discussed, are the other prominent noncash expenses.

The Balance Sheet and the Work Breakdown Structure

How would the project team handle the truck example: purchase a truck for cash in June and then put the truck into service in September when depreciation begins? Obviously the work package schedule would show the purchase activity in June and the service activity beginning in September. Regarding the financial part of the transaction, a common practice is for the project manager to maintain a capital budget for the capital items, like a truck, that are to be purchased for the project and for the work package manager to maintain an expense budget. (We will discuss some of the special factors in capital budgeting in subsequent paragraphs of this chapter.) The capital budget would have the schedule and record of the cash purchase; the expense budget would begin in September for the truck and show the depreciation expense in the work package. Each period, the balance sheet would be reduced by the amount depreciated onto the expense statement. When depreciation is completed, the sum of the depreciation expenses should equal the initial cash purchase.

The Cash Flow Statement

Now we come to the cash and to the flow of cash. As described by Robert Higgins in his book, Analysis for Financial Management, [2] the cash flow statement is commonly thought of as the place to put down the sources of cash and uses of cash in the project. Viewed this way as a double entry system, the sources ought to balance the uses. Flow refers to a change over time. As such, a cash flow statement is not a statement of cash on hand, but rather the change in cash over the reporting period.

There are only two ways a company can generate cash: decrease an asset or increase a liability. Decreasing the accounts receivable asset account brings cash into the company that is recorded on the P&L as revenue; selling a building or a truck brings cash into a business. Taking cash out of a checking account brings cash into a company. This last example is often confusing. How can reducing the cash balance of a company's checking account be a source of cash for the company? Think of it this way: reducing the balance in the asset account puts cash in the hands of the company's management just as if you had cashed a check on your personal account at a bank. The cash value of the checking account is no more actual cash than the cash value of the truck.

Correspondingly, the only two uses of cash are to increase an asset or decrease a liability. Paying vendors reduces the accounts payable liability account, as does paying off a loan. Adding to the cash balance of a checking account or acquiring a capital asset, like a truck, increases assets and is a use of cash.

Table 5-2 shows an example of a cash flow statement presented as sources and uses. Another form of the cash flow statement arranges the items into three categories: cash from operations; cash from investments in property, plant, and equipment; and cash from financing activities like stock sales. Even so, the sum of the total uses must balance the sum of the total sources.

Table 5-2: Sources and Uses

Sources of Project Cash

$000

Reductions in checking cash

$38.5

Increase notes (debt) from project investor

$5

Increase current accounts payable for project purchases

$4

Increase accrued benefits on project staff

$35

TOTAL sources of CASH

$82.5

Uses of Project Cash

$000

Increase short-term notes to project supplier

$15

Increase prepaid licenses

$10

Increase capital assets for project

$20

Reductions in accrued labor for staff

$37.5

TOTAL uses of CASH

$82.5

Unfortunately, there is no single definition of cash or cash flow, but there are several in common use, some of which will be important to project managers:

  • Net cash flow is defined as "net income from the expense statement plus or minus noncash adjustments." [3]

  • Net cash flow from operations is defined as net cash flow plus or minus the changes in current liabilities and assets.

  • Free cash flow is defined as the cash available to distribute to shareholders or owners.

  • Discounted cash flow is taken to be the present value of net cash flow or net cash flow from operations.

For projects, we will be concerned with the present value of the net cash flow from operations for net present value calculations and net cash flow for economic value add calculations.

The Cash Flow Statement and the Work Breakdown Structure

The WBS is not usually reconciled directly with the cash flow statement. Ordinarily the project manager manages the capital budget, whereas the WBS reflects the expense budget. The project manager's practice may be to reconcile the capital budget with the WBS work packages for the reporting period. However, if the project WBS is on a cash-accounting basis, then the WBS provides the sources and uses of cash in the project.

The Trial Balance for Project Managers

The controller will undoubtedly provide a "trial balance" to the project manager each month. The trial balance is a report of debits and credits by account, typically summed for each account so that at report time a specific account will show a net value in the debit column or a net value in the credit column, but not in both columns at once. Recall that there is no such thing as a "negative debit" because a "negative debit" is recorded as a positive credit. The debit or the credit amount is a report of the value of the account on the report date. The trial balance follows the same protocol as the balance sheet: asset accounts are debited to increase their value and credited to decrease their value; just the opposite is done for liability and capital accounts.

Naturally, the debits and credits of the trial balance should balance. The project manager is often called on to reconcile and correct the account values shown on the trial balance. Table 5-3 illustrates an example.

Table 5-3: Trial Balance for Project

Expense Account

Equity Account

Capital Account

Debit

Credit

Prepaid expenses

  

$500,000

 

Accrued compensation

 

$250,000

Travel and subsistence

$300,000

 

Checking

$300,000

Communications

$50,000

Rent and utilities

$550,000

Paid in stock

 

$1,000,000

Long-term debt

 

$250,000

Accumulated depreciation Capital equipment

 

$200,000

$300,000

 

Total debits and credits

$1,700,000

$1,700,000

The Trial Balance and the Work Breakdown Structure

Everything on the WBS must roll up to some account on the chart of accounts. Assuming that the project administrator has a mapping of the WBS accounts to the chart of accounts, the WBS can be reconciled to the trial balance using pivot queries in a spreadsheet.

[1]Pike, Tom, Retool, Rethink, Results, Simon & Schuster, New York, 1999.

[2]Higgins, Robert C., Analysis for Financial Management, Irwin McGraw-Hill, Boston, MA, 1998, chap. 1, pp. 16–21.

[3]Higgins, Robert C., Analysis for Financial Management, Irwin McGraw-Hill, Boston, MA, 1998, chap. 1, p. 19.