By Ben Wann
Financial Planning and Analysis (FP&A) is the process of thinking and learning about how companies accumulate wealth. Many disciplines can enhance this process. One discipline that has played an important part in this enhancement is accounting. Accounting is more than financial statements and tax returns, accounting is the study of transactions. Transactions are the primary element in thinking and learning about how companies accumulate wealth, so FP&A professionals should incorporate three areas of accounting in their work.
Many people see tax accounting as nothing more than filing tax returns, but tax accounting is much more. Tax accounting incorporates this task, but there are two more tasks, tax planning and tax research, which are important in FP&A. How do tax planning and tax research apply to FP&A?
The objective of tax planning is to minimize tax liabilities. Tax liabilities affect the cash disbursements that companies make. Cash disbursements are an integral part of FP&A. They are integral due to their effect on two key elements that FP&A assesses:
- Liquidity, which is the ability of companies to pay bills within one year.
- Solvency, which is the ability of companies to exist over the long-term.
So what can tax planning do to maximize a company’s liquidity and solvency?
What tax planning can do is establish a framework for FP&A. The planning framework is to think about how tax liabilities can be minimized, and the analysis framework is to learn about how tax liabilities can be minimized. Both frameworks utilize a top-down approach to FP&A. However, a bottom-up approach is necessary to achieve balance, and the bottom-up approach is tax research.
The objective of tax research is to find solutions to tax problems. Tax problems arise due to misapplications of regulations issued by the Internal Revenue Service (IRS). This affects the objective of tax planning, which is to minimize tax liabilities, by failing to take advantage of deductions allowed by the IRS or taking deductions not allowed by the IRS, which result in penalties and interest. Tax research, therefore, has its place in FP&A. Its place in financial planning is to think about how the internal revenue code can be used to minimize tax liabilities. Also, it is used to learn about how the internal revenue code is or is not being used to minimize tax liabilities.
Working with the internal revenue code through tax research is a natural act for accounting. Since accounting is the study of transactions, the internal revenue code is an excellent resource to connect choices with transactions. Choices have been affected by the internal revenue code due to the tax reform act that was passed in December 2017. The tax reform act introduced new ways of making choices. One new way of making choices was a topic of discussion with one of my friends.
One of my friend’s works at a restaurant and one of his responsibilities is purchasing equipment. Purchasing equipment has been affected by the tax reform act due to bonus depreciation. Bonus depreciation is an incentive to immediately deduct a large percentage of an asset’s purchase price. My friend asked about bonus depreciation because the restaurant needed new equipment. I provided information about the changes in bonus depreciation due to the tax reform, and he found the information useful. The usefulness of the information will be the basis for his financial planning as it relates to capital expenditures for the restaurant.
Tax accounting has a role in FP&A. Its role is to think and learn about how the internal revenue code can be used to minimize tax liabilities and in turn cash disbursements. However, we must remember that tax accounting is only one part of accounting’s importance in FP&A. Two more elements of accounting are important in FP&A.
Another element of accounting that is important in FP&A is managerial accounting. Managerial accounting is about communication that helps people inside businesses – executives, managers, supervisors, etc. – make better decisions. There are a number of topics in managerial accounting that are important in FP&A and here are three of them.
1. Cost Behavior
I have found cost behavior to be one of the more powerful topics in managerial accounting’s importance in FP&A. Cost behavior focuses on the relationship between volume and cost. Some costs will be affected when volume changes while other costs will be unaffected. Knowing which costs are affected or unaffected by changes in volume provides a foundation for a bottom-up approach to FP&A. A bottom-up approach can enhance FP&A by helping people who make decisions think and learn about how their decisions accumulate wealth.
2. Incremental Analysis
Incremental analysis is a topic that is integral to financial planning. Financial planning addresses issues like expanding or reducing operations. These issues require analysis on changes in revenues and expenses; changes are what incremental analysis is about. The key is identifying what will change versus what will not change. Knowing what will change versus what will not change is based on the following types of costs:
- Incremental costs: Costs that will be affected due to decisions like expanding operations to a new geographic location or consolidating operations by eliminating accounting centers.
- Opportunity costs: Costs that are incurred when an opportunity is foregone, e.g., the receipt of cash when existing equipment is not disposed of.
- Sunk costs: Costs that are irrelevant to decisions, e.g., the purchase price of equipment that can be disposed of when new equipment will be purchased.
Budgeting may be the most important topic in managerial accounting when it comes to its importance in FP&A. Budgeting drives the process of thinking about how to accumulate wealth, i.e., financial planning. Budgeting applies to several elements of financial statements like sales, cost of goods sold, SG&A expenses, current assets, long-term assets, current liabilities, and long-term liabilities. Budgeting expands into financial analysis through two areas:
- Variance analysis: focuses on reasons that actual events differ from expectations.
- Performance measurement: focuses on the effectiveness of decision making established in financial planning.
Managerial accounting establishes a framework for decision makers inside companies. This framework provides feedback for FP&A. This feedback is fundamental; however, accounting can go beyond the fundamental through another element of accounting.
Financial accounting is the process of identifying, recording, and communicating transactions. The purpose of this process is to help people outside the business – creditors and stockholders – assess financial health. Incorporating this process and its purpose is an integral part of FP&A. It’s integral because it applies not only to established businesses but also to startups. Its application to startups is where I found financial accounting’s importance in FP&A.
One of my most rewarding experiences is my work with an advisor to entrepreneurs who were looking to raise money for their startups. For entrepreneurs to raise money, they needed to provide financial projections to the advisor. The advisor needed the projections to answer two questions:
- What is the valuation of the startup?
- What is the startup’s funding requirements?
The advisor relied on my expertise in financial accounting to answer these questions with financial statements. Income statements, balance sheets, and statements of cash flows were the products I created to help the advisor. The financial statements served as the foundation for financial planning, but they also served as the basis for financial analysis. The financial analysis of the projections allowed me to bring concerns I had to the advisor’s attention. These concerns helped the advisor better understand valuation and funding issues.
Accounting seems to have taken a backseat in FP&A due to the advancements in data science and technology. These advancements are important in FP&A. However, we cannot ignore the importance of accounting. Tax accounting, managerial accounting, and financial accounting have been, is, and will be an important part of FP&A. I may be partial to its importance due to my education and experience; however, I know I could not be the FP&A professional I am without my work in this field. My hope is other FP&A professionals will not ignore the importance of accounting in FP&A.
This article was originally published in The Numbers Guys is republished with permission.