The Soft Close (#160)
/In this podcast episode, we discuss the nature of the soft close and how to do it. Key points made are noted below.
Characteristics and Usage of the Soft Close
The soft close means that you close the books at the end of each reporting period, but not with all of the usual closing steps. You might even skip nearly all of the closing steps, and just go ahead and print the financial statements. Now, obviously, if you skip a bunch of closing steps, you’ll save loads of time, but the financials will also be less accurate. The question you need to ask yourself is, under what circumstances does it not matter that the financial statements are a little off? Let’s work through this.
First of all, we’ll assume that your company gets its financials audited at the end of each year, so those year-end financials will require a complete closing process. OK, that still leaves 11 months of financials for which you could use a soft close.
Next, a publicly held company gets its financials reviewed at the end of each quarter. So for these companies, you still could use a soft close for eight months out of the year. Well, that’s not bad. You could save a bunch of time on your closing process two-thirds of the time. And that’s the worst case.
Now, how much time can we save with a soft close? There’s no hard and fast number. Instead, think of this as a continuum, where you could have no closing steps whatsoever, but a high risk of inaccuracy at one end, and at the other end, you have lots of closing steps and a low risk of inaccuracy.
You need to decide how much risk you want to have in the financials. This isn’t a qualitative judgment, where you just make a wild guess as to how many closing steps you can avoid. Instead, take a look at the size of the adjusting entries that you’ve made as part of the closing process for the past couple of years. Chances are, only a couple of them are really large. Everything else is so puny that you could either skip them entirely, or just copy the same entry for multiple months.
Soft Close Techniques
Let’s go through some examples, so you can see how this works. First, how about depreciation. It changes a little from month to month, but not much.
What you could do is load a standard depreciation entry into the accounting software, and set it to run automatically for the next six months. At the middle of the year, it’ll probably be off a bit, so check the underlying depreciation calculations, and set a revised entry to run through to the end of the year. Then adjust the year-to-date figure to actuals, so the full-year results will be accurate.
Here’s another example. The allowance for bad debts. You could go through all sorts of analysis to guesstimate what the allowance should be on a month-to-month basis, but let’s face it. This is a reserve account. That means you can never get it exactly right. So don’t try – or at least, don’t try every month. Instead, record a reasonable bad debt expense each month, to load up the reserve account, and then let it run for a while.
However, this doesn’t work if you have a small number of large invoices outstanding, because if even one of those is a bad debt, your allowance could be way off. So it depends on the circumstances. If there’re lots of small invoices, adjusting the allowance at long intervals is probably fine.
Here’s another possibility. What about the wage accrual? If the company has mostly salaried employees, who cares about the accrual? It’s just not for that much money. On the other hand, if practically everyone is paid on an hourly basis, you could seriously screw up the financials by not including the accrual. It just depends on the circumstances.
Let’s keep going. What about commission accruals? A lot of controllers go through this incredibly painful process of calculating the exact commission owed to every salesperson before they close the books. Why bother? If the overall commission percentage doesn’t change much, then just accrue the overall percentage of sales as commission expense, and get on with life.
And here’s a favorite for controllers – what about overhead allocations? In most companies, the amount produced in each month doesn’t vary much, and the overhead cost pool doesn’t vary much. So why allocate overhead at all? You could skip what is sometimes an amazingly convoluted exercise, and just wait until the auditors show up at year end, and then do it once.
And here’s one you may struggle with. What about account reconciliations?
Any reasonably cautious controller wants to know what’s in every single balance sheet account, because it’s possible that some of those balances should be charged to expense. Well, you don’t have to reconcile all of them. Instead, look through the accounts, and decide which ones are so small that even if they’re completely wrong, will correcting them really impact the financials all that much? Chances are, you’ll only have a couple of accounts left that really require a reconciliation. The others can all be checked at much longer intervals.
Now, I’ve just pointed out that you can drop or at least scale back a bunch of closing activities that some controllers would consider religiously important. I only consider one closing activity to be absolutely mandatory. And that activity is to print a preliminary version of the financials, and scan it for anomalies. There’re bound to be a few, and those will require an investigation – though only if they’re large enough. A small variance isn’t going to bother anyone, so don’t worry about it. Chances are, the small stuff will probably self-correct in the next month’s financial statements.
Now, all of this may sound like an awfully laid-back way to deal with what is, realistically, the most important product of the accounting department. True enough. But it can also save a bunch of staff time. You need to make the decision to adopt a soft close or not. And if you do, then keep in mind that you still need to conduct a full and very detailed close – just at longer intervals. By doing so, any minor problems can be found and corrected before they become so large that they’re causing major errors in the financials.
So in short, the soft close can be a major labor saver – but you need to figure out for yourself just how much of a soft close you can tolerate. It might be the elimination of just a few closing steps, or you could strip away most of the closing process, in exchange for a bit more variability in the results that you report. It’s you call.