The Finance Function

1 Introduction

This chapter covers:

• The roles the finance function plays in organisations: enabling, shaping and narrating the creation and preservation of value

• The primary activities finance professionals perform, organised by the ‘information to impact’ framework

• The components of the finance function and what each does

• Finance's relationships with other parts of the organisation, and the conflicts of interest and ethical pressures that can arise.

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2 The role of the finance function

The purpose of the finance function is to help the organisation create and preserve value. CGMA describes finance as playing three roles in this:

In fulfilling these roles the finance function is responsible for five basic activities:

• Accounting operations – recording transactions: the debits and credits.

• Analysis – for example sales and profitability analyses, the performance of different teams, cost overruns in production.

• Planning – most organisations budget: if 10,000 units are to be made in November, enough material, staff and machine capacity must be arranged.

• Decision-making – supporting decisions such as withdrawing a product, closing a factory, or setting pay rises and bonuses.

• Control – safeguarding the organisation's assets and making sure money is spent only on proper, authorised activities.

Ethics is central to all of this. The value of everything finance produces depends on it being honest and objective: biased forecasts, massaged performance figures or misleading reports destroy the trust the organisation and its stakeholders place in finance. That is why finance professionals are bound by a code of ethics (covered in Chapter 12), and why this chapter ends with the pressures and conflicts of interest that can arise.

3 From information to impact

How does the finance function actually perform these roles day to day? CGMA describes the primary activities of finance professionals using the ‘information to impact’ framework. Finance takes raw data and moves it, step by step, up a chain until it changes what the organisation actually does:

The five activities in the framework are:

• Collating data to prepare information. Data is collected from the organisation's systems and beyond, cleaned (errors and duplicates removed) and connected (linked across sources) so that it becomes usable information about the organisation.

• Providing insight by analysing information. Analysis – from variance analysis to ‘what-if?’ modelling and data analytics – turns information into insight: an understanding of what is happening and what could happen.

• Communicating insight to influence users. Insight is worthless if nobody acts on it. Finance must communicate it to the right audiences, at the right frequency, in the right format – a monthly board pack, a dashboard, a conversation with a production manager – in a way that influences decisions.

• Supporting the implementation of decisions. Finance stays involved after the decision: allocating resources to it, tracking its costs and benefits, and managing performance so that the intended impact is achieved.

• Connecting the activities to each other. The chain only works as a whole. Finance joins the steps up – and joins itself up with the rest of the organisation – so that data collected at the bottom genuinely ends up improving decisions and results at the top.

This framework also maps onto the four levels of the diamond-shaped finance function from Chapter 1: finance operations collate data into information, specialists produce insight, business partners communicate it to influence decisions, and finance leadership ensures the whole chain delivers impact.

4 The components of the finance function

To carry out its activities the finance department is classically broken down into sections:

• Financial accounting

• Management accounting

• Financial planning and analysis (FP&A)

• Project management and appraisal

• Treasury

• Internal audit

4.1 Financial accounting

This function is responsible for producing the organisation's financial statements: the statement of financial position, statement of profit or loss, statement of cash flows, notes, and the statement of changes in equity.

It is also responsible for maintaining the double entry system (and memorandum records) of the organisation:

• Nominal (general) ledger

• Cash book, and perhaps a petty cash book (both are also books of prime entry)

• Receivables ledger (details of customers who owe money)

• Payables ledger (details of suppliers to whom money is owed)

• Non-current asset register

• Sales day book (a book of prime entry in which credit sales are first recorded)

• Purchases day book (a book of prime entry in which credit purchases are first recorded).

Transactions are recorded in these books more or less as they occur, so the financial accounting system deals with recording historical transactions. The financial statements are produced from the nominal ledger, as each account ends up in either the statement of financial position or the statement of profit or loss.

In most countries businesses must produce annual financial statements. These are needed for tax purposes, but they are also published so that the shareholders (the company's owners) can see how their investment has performed – indeed, the information in the financial statements often moves the share price. To add credibility, the statements are usually audited (checked over) by independent external auditors, and they must follow detailed rules and regulations about layout and disclosure.

The financial accounting department is also closely associated with the organisation's system of internal control. Internal controls exist to prevent, detect and correct errors, and to ensure the organisation's assets are safeguarded – a duty sometimes called ‘stewardship’: directors, managers and employees look after the company's assets on behalf of the shareholders. Typical internal controls include:

• Inventory locked in store rooms and issued only on proper authorisation

• Cash banked soon after receipt

• Purchase invoices checked to confirm the goods were ordered and received

• Payments to suppliers authorised only once the company is sure proper goods have been received

• Overtime authorised by managers, not self-certified

• Credit given to customers only after credit checks.

4.2 Management accounting

Unlike published financial statements, internal management accounting reports are not governed by the same statutory external-reporting formats and standards. Management accountants can therefore tailor reports and calculations to management’s decision needs, while remaining subject to professional, legal and organisational requirements. And whereas financial accounting records what has already happened, much of management accounting looks to the future.

Typical management accounting functions are:

• Drafting budgets for profit, the statement of financial position and cash flow. Budgets are rarely for less than a year and are normally broken down month by month; longer-range budgets (say three years) help with long-range planning and funding.

• Comparing actual results with budgets and investigating the reasons for differences. The differences between budgeted and actual results are known as variances.

• Working out the cost of units produced, and controlling those costs.

• Advising on selling prices (which should normally exceed cost, and must also make sense against competitors' prices).

• Working out the effects of business decisions, such as outsourcing production, setting up an overseas operation or closing a factory.

• Calculating break-even points for products.

Management accounts (results so far, variance analyses and budgets) are usually prepared and presented to the board once a month, so that timely action can be taken if something is going wrong.

Management accountants are also often responsible for evaluating capital investments. If a new factory built now will produce income over the next ten years, special investment appraisal techniques – such as discounted cash flow – are needed to deal properly with the long timescale. Often there are insufficient funds for every worthwhile project, so the management accountant helps the board decide how best to invest.

Budget-setting deserves particular attention. Budgets can be regarded as quantified plans, and they achieve (or force) the following:

• Forecasting: drafting a budget forces you to look ahead. You won't foresee every problem, but forewarned is forearmed.

• Planning: based on the forecast, plans can be made. Is there enough production capacity to meet forecast sales? If not, create more capacity or arrange to buy in products.

• Co-ordination: a subset of planning. There is no point having production capacity of one million units if distribution can handle only 500,000.

• Communication: as the budget is broken down into smaller sections, it communicates exactly what is expected of each division, department, cost centre and person.

• Control: without a budget, how does the company know whether costs are being incurred properly?

• Authorisation: a budget figure authorises spending and delegates responsibility. If the advertising budget is $3.5m, the advertising department can get on with using that money as best it can, without seeking approval for every item.

• Motivation: a budget acts as a target and, provided it is not impossibly difficult, can motivate employees to hit it.

• Evaluation: comparing actual results with the budget provides a basis for evaluating performance – though with care: a shortfall against target is not always the fault of the people being measured.

4.3 Financial planning and analysis (FP&A)

FP&A is closely linked to the traditional management accounting functions listed above. The FP&A team analyses what is happening in the company and its markets, then plans for the future: Which products? Which markets? Make in-house or outsource? Which products, markets and customers are profitable?

4.4 Project management and appraisal

The term ‘project’ implies a discrete, once-off endeavour: renewing the IT system, building a new factory, moving production abroad.

Planning starts with estimating the costs and benefits of the project – if costs exceed benefits, why embark on it? Both sides of the equation require finance to make estimates and to test the estimates of others. Many costs are up-front and relatively easy to estimate; benefits usually arise in the future and are much harder. The timing difference between costs and benefits also means specialist investment appraisal techniques, such as net present value, must be used. This discipline applies to not-for-profit organisations too: a hospital deciding whether to buy a $1m scanner must still justify why that beats spending $1m on a new operating theatre.

Once the project begins, four things must be monitored and controlled:

• Costs: costs were estimated in the initial appraisal and must then be carefully monitored and controlled – clearly a finance job. In practice, project transactions are given a project account code so the accounting system can collect the project's costs automatically.

• Time: monitoring the schedule is mainly the project manager's job, but finance should be alert to the cost and revenue implications of delays.

• Quality: not directly a finance responsibility, but cutting quality is one way of cutting costs, and the ongoing implications may need quantifying (more product failures mean more warranty costs).

• Scope: the scope is the description of precisely what the project will deliver. Projects often go adrift because scope keeps growing (‘wouldn't it be nice if…’), adding costs that may not add benefits. Changes to scope should be permitted only after a fresh justification: finance should insist that the incremental benefits of each change exceed its incremental costs.

4.5 Treasury

A treasury department is found mainly in larger organisations. It is concerned with:

• Company finance: does the company need to raise a loan or issue more shares?

• Where to deposit temporary surpluses of funds so that they earn interest

• Where to arrange temporary borrowing, such as an overdraft

• How to reduce the risk of currency movements when importing or exporting (hedging techniques can lock in the amount to be received or paid)

• How to reduce the risk of interest rate movements on borrowing or deposits

• Taxation management – for example, one group subsidiary's losses being made available to another.

4.6 Internal audit

The Institute of Internal Auditors (IIA) defines internal audit as:

“…an independent, objective assurance and consulting activity designed to add value and improve an organisation's operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.”

Most of the work of an internal audit department is making sure that the organisation's system of internal control is operating as it should. The internal control system should prevent, detect and correct errors in the accounting system (and in other systems, such as IT and quality control). Examples of internal control procedures include:

• Ensuring that all purchases are authorised by a manager

• Ensuring that claims for overtime have been authorised by a supervisor or manager

• Reconciling suppliers' accounts in the payables ledger to suppliers' statements

• Safeguarding valuable assets (banking cash promptly, locking storage areas)

• Cancelling invoices once paid, so the same invoice cannot be paid twice

• Counting inventory regularly and reconciling it to the inventory records.

Internal auditors go round the departments and check that employees are following the laid-down procedures. They might select a sample of timesheets and confirm each was authorised by the appropriate manager, or make a surprise visit to the factory stores to count items and compare the result with the inventory records. Where the laid-down system itself proves inadequate, internal audit recommends improvements.

Ideally the internal audit department reports its findings to the audit committee: a subcommittee of the board composed of non-executive directors who are independent of the day-to-day running of the company. If internal audit reported instead to the finance director, the finance director could suppress embarrassing findings to save face; the audit committee can raise problems at the full board.

Internal audit is sometimes given special assignments, such as establishing the efficiency of a department (value for money) or investigating the extent of a discovered fraud.

5 Relationships within the organisation

The finance function does not create value on its own – it creates value by working with the rest of the organisation. Finance can be thought of as sitting at the middle of the organisation: not much goes on without some aspect of finance being involved.

Examples of the day-to-day interactions:

6 Potential conflicts of interest within the finance role

Each of finance's five basic activities – accounting operations, analysis, planning, decision-making and control – can give rise to conflicts of interest: pressure not to record or interpret information accurately, or to steer decisions the wrong way. Here are some examples:

• Accounting operations: items of expense reduce profit, whilst capital expenditure does not. An accountant could come under pressure to treat expenditure incorrectly (as capital rather than revenue expenditure) so as to boost profits.

• Analysis: pressure to conceal the reasons for underperformance in one area. For example, the treatment of fixed overheads is often arbitrary, and shifting them about can alter the apparent performance of different departments or branches.

• Planning: if the directors want to close down one part of the operations, there could be adverse knock-on effects in another. Management accountants might be pressured to conceal this effect.

• Decision-making: directors, particularly of listed companies, usually want increasing profits, or at least profits close to forecast. Short-term profits can be boosted at the expense of the long term – cutting research and development increases current profit, but in a few years there will be no new products to sell.

• Control: a fraud has been discovered. This can be embarrassing for the finance director, so there is pressure to conceal it.

Resisting these pressures takes integrity: standing up for what you believe to be right and refusing to conceal or misreport. This is why ethics is inseparable from the role of the finance function – if finance's information cannot be trusted, none of the roles described in this chapter can be performed. The ethical principles that guide finance professionals are covered in detail in Chapter 12.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.