Performing a Variance Analysis for Greater Accounting Accuracy

One Simple Technique for Greater Accounting Accuracy
by Anthony Nassar

It’s a few days past the end of January and you’re ready to close your books and produce your financial statements. Your finger is itching to push that one button on your keyboard and have your accounting software generate the usual monthly reports.

But WAIT! How do you know that the numerous accounting transactions in your system for the month of January have been recorded properly? And that the resulting financial statements will be meaningful and reliable?

To ensure proper bookkeeping, there's a number of steps your accountant must follow every month as part of a standard closing procedure. These steps include, among other things, the reconciliation of various accounts such as cash, accounts payable, accounts receivable, accrued expenses, etc. In addition to these closing steps, I like my clients to perform one extra procedure – a sort of sanity check - to gain additional confidence in the data before closing the books for the period.

The extra procedure I'm referring to is a variance analysis, which identifies percentage increases or decreases from period to period exceeding a certain threshold. Once these changes are identified, they should either be justified, or point to errors that must be corrected. To illustrate this approach while keeping it simple, I’m providing an example using a short income statement that does not include all the accounts you'd typically expect to see in an income statement.

Step 1

Export the income statement for the month subject to the closing procedure (in this case January 2005) and the prior month into a spreadsheet.

Step 2

Set 2 thresholds for the analysis. The first threshold (Threshold A) establishes the dollar level in the prior month above which a significant change should draw your attention. This is akin to a materiality level, which has been set in this example to $1,000. The second threshold (Threshold B) establishes the percentage change that should trigger a review. In this example, we’ll be using 10%, which is in line with the historical monthly growth of the company.

Step 3

Create percentage change formulas for each line item and use conditional formatting to color those cells with A) a prior month amount greater than Threshold A ($1,000) and a percentage change greater than Threshold B (10%), or B) a prior month amount greater than Threshold A ($1,000) and a percentage change less than (minus) Threshold B (-10%) in order to catch swings in either direction. I like to reverse the colors for the expense side as favorable directions for revenues are unfavorable for expenses.

Step 4

Review the results and produce comments for colored variances.

Here is what we find from the example:

License revenues increased by 25% because of an additional customer.
Service revenues decreased by 45% because of the completion of a non-recurring service contract in December.
Salaries, Payroll taxes and Employee benefits increased by 18%, 18% and 33% respectively as a result of the addition of 1 new employee in January.
Consulting expenses dropped by 100% in January. After investigation, it appears that a monthly accrual for consulting services in January was not recorded. An accrual entry should be made before the final financial statements are produced.
Small equipment increased by over 300%. After investigation, it was found that $8,300 in computer equipment assets acquired in January were expensed as small equipment. The corresponding entries need to be reclassified as fixed assets. And depreciation needs to be adjusted accordingly.

Note how changes in rent and travel expenses were not flagged because the dollar amounts in the prior month were below Threshold A ($1,000).

A second table illustrating the corrected income statement is shown below :

It's a good idea to perform the same analysis using the income statement for the same month in the prior year (January 2004) as well as an income statement showing the average figures for the past 12 months. These two views can provide additional insights isolating seasonal effects and extraordinary movements that can cause the numbers of a specific month to be outliers. The thresholds A and B, however, should be adjusted to reflect the changed time frame.

Finally, the same analysis should be applied to compare actuals to budget on a monthly basis. And performing this type of analysis on the balance sheet could reveal some interesting findings too. So good luck with your financial statements review. And have fun with it – if I dare say so.

This article was first published in the March 2005 issue of our e-zine, Propel Your Venture.

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