As we approach the end of the calendar year, which for many is the end of the fiscal year, it becomes more critical to avoid cut-off errors which may have been tolerated earlier in the year. The year end closing process is the final opportunity to ensure that financial statements for the fiscal year are accurate. Use the strategies below to reduce cut-off errors.
Cut-off is the process of ensuring that financial transactions and events are appropriately and accurately accounted for in the correct accounting period. As an example, proper cut-off for the year ending 31 December 2018, means that accounting transactions and events related to 2019 are not recorded in the financial statements for 2018, and transactions related to 2018 are accurately included in the 2018 financial statements.
However, what appears to be a simple concept is the source of many accounting errors and misstatements, particularly in components like accounts receivable, accounts payable (AP), and inventories. Cut-off errors occur much more frequently than we imagine and tend to be material.
Cut-off errors mean that financial statements fail to embody essential characteristics or assertions which they should, including:
- Completeness – the 2018 financial statements are incomplete if 2018 transactions are erroneously reflected in the financial statements for 2019; and
- Accuracy – both the 2018 and 2019 financial statements are inaccurate if transactions are reflected in the wrong accounting period.
Avoid cut-off errors by:
- Training department heads: It is helpful if department heads understand the concept of cut-off. If they do, they will understand the importance of submitting invoices, expense claims and other documents to the accounting department in a timely manner, so that they can be entered in the correct accounting period.
- Training accounting staff: Members of the accounting team may not fully understand the challenges that improper cut-off can cause, may not know how to identify common cut-off traps, or how to implement effective mitigating strategies. Accounting managers and supervisors should ensure that their team members understand the cut-off risks relevant to their areas of responsibility. For instance, persons responsible for inventories must determine the delivery dates for goods, to ensure that items delivered to the organization after the end of the fiscal year are reflected as inventories in the subsequent year financial statements.
- Implementing proper cut-off from the initial point of data entry into the accounting system: An AP clerk entering invoices just after year end, may be tempted to enter all invoices in the subsequent fiscal year, regardless of the accounting period to which they relate. This necessitates correcting accruals to achieve proper cut-off. Instead, keep the current year AP subledger open for a reasonable period of time after the year end, and instruct the clerk to enter current year invoices in the current fiscal year, and subsequent year invoices in the next fiscal year.
Avoid these common cut-off traps:
- Credit card statements: The period covered by credit card statements may straddle the year end, such that the end of the billing period for the statements fall after the year end but include charges incurred prior to the year end. Additionally, depending on how aggressive the organization’s closing schedule is, it may not receive mailed statements in time to enter the transactions in the current fiscal year. AP departments should review credit card statements carefully and may need to parse transactions into current and subsequent year transactions if there are significant credit card expenditures. AP clerks should use online statements for coding purposes where possible, instead of waiting to receive mailed copies of the statements.
- Ordering too close to the year-end: Sometimes, department heads may place orders very close to the year end, such that the items are not delivered until after the year end. If an asset is delivered after the year end, title may not have passed to the organization and it would be incorrect to record it as an asset in the current fiscal year.
- Paying for services or goods prior to year end but consuming them after the year end: For example, a department head may pay for a team-building course before the end of the year, but the course will actually take place in the next fiscal year. The department head may believe that because they pay for the course before the year end, the cost is a current year profit and loss expense. In fact, it is a prepayment and should be reflected as such in the current year financial statements.
Cut-off errors are common and it is important that you avoid them, particularly at year end when one fiscal year will be closed and finalized for the external audit or as a precursor to starting the new fiscal year.
Read more about strategies to address cut-off issues and other challenges associated with year end and external audits, in Finance and Accounting PolicyPro (GV 1.09 – Relationship with External Auditors) and Not-for-Profit PolicyPro (NP 1.10 – External Audits).
Policies and procedures are essential to managing cut-off and other internal controls, but the work required to create and maintain them can seem daunting. Finance and Accounting PolicyPro and Not-for-Profit PolicyPro, co-published by First Reference and Chartered Professional Accountants Canada (CPA Canada) contain sample policies, procedures and other documents, plus authoritative commentary in the areas of finance and accounting and not-for-profit management, to save you time and effort in establishing and updating your internal controls and policies. Not a subscriber? Request a free 30–day trial of Finance and Accounting PolicyPro here, or Not-for-Profit PolicyPro, here.