Using clearing accounts
posted 2018.07.28 by Clark Wilkins, Simplexable

Sometimes there are transactional classes which benefit from the use of clearing accounts. This article is an effort to show two examples where this technique works well, and some scenarios where it would not work well at all. All are derived from “real-world” cases.

WHAT IS A CLEARING ACCOUNT

The term, as used here, is a current liability account which focuses on one source of costs. The account is linked to a single payee (vendor or internal user) and has costs flow in via the standard expense model, but reimbursements flow out via payments of arbitrary amount. This makes the account functionally identical to a credit card.

When we post a charge on a credit card, the core characteristics include:

  • A discrete expense ID and related information.
  • A posted transaction line increasing the credit card balance.
  • A matching transaction line increasing an expense account.
  • The funding (posting to the general ledger) occurs immediately and the expense is therefore “realized”.

    If we take the set of N expenses for a vendor and “pay” them via a (notional) check or credit card that posts to a specific liability account dedicated to this vendor alone, we can state categorically that the current value in this account is what we owe this vendor.

    Then we can make a decision to pay down an arbitrary amount on the vendor balance without having to link to specific expenses. The advantages include:

    • Expense costs post to the Income Statement immediately in both cash and accrual basis.
    • Payments are much simpler to construct as they become single line liabiity payments rather than a list of N expenses and payment amounts.
    • Most useful of all, if the expense is modified, the payment is not affected, because the two are decoupled since payments are against the balance, not the specific inputs.

    CASE 1: HIGH VOLUME SHIPPING ACCOUNT

    The business is making a large number of shipments using a preferred vendor. Invoices come in weekly with 10-30 shipments on each one.

    PROBLEM: If we are paying these invoices in the standard expense check model, the check has to be constructed with 10-30 lines, each with the proper expense code and payment amount. It's laborious.

    SOLUTION: Use of a clearing account and a notional credit card.

    • A dedicated current liability account is setup for the shipping vendor.
    • A notional credit card is set up that posts to this account.
    • All relevant expenses are modified to use this credit card — which makes them post immediately, and in full, to the dedicated account.

    When the invoice comes in, the processing is divided into two steps which do not have to happen at the same time.

    1. The invoice is paid in full which reduces the balance on the clearing account.
    2. Separately, the Accounts Payable staff checks the invoice against expenses and makes updates as needed — which posts to the clearing account as this happens.

    Steps 1 and 2 never have to happen at the same time and they self-correct.

    CASE 2: SALES COMMISSIONS ACCOUNT

    Percentage-based commissions are a special problem because the amount owed to the sales-rep will change depending on discounts claimed, external costs, restocking, warranties, and myriad other events. If you make commission payments constructed from specific sales, you create a nightmare scenario of constant revisions and/or adjustment transactions. It's far better to decouple commissions from payments.

    PROBLEM: paying directly from commissions expenses requires restating the value if the job costs change.

    SOLUTION: Use of a clearing account and a notional credit card.

    • A dedicated current liability account is setup for the sales representative.
    • A notional credit card is set up that posts to this account.
    • All relevant expenses are modified to use this credit card — which makes them post immediately, and in full, to the dedicated account. This is especially important because clawbacks are dealt with by simple adjustment of the commissions owed.

    Payments to the sales representative are simple liability checks of arbitrary amounts that post to reduce the clearing account balance. Clawbacks, etc. are not necessary here because the inputs are being adjusted at the expense level. The account is essentially self-correcting.

    AVOID INVENTORY IN MOST CASES (CASH-BASIS ACCOUNTING ONLY)

    Consider a case with a high-balance vendor, but the specific nature of the items being purchased is that the associated costs are flowing to inventory.

    In this case, use of a clearing account is not helpful. Your costs will flow to inventory immediately, instead of when you actually pay for the items (assuming your company is not using accrual-basis accounting which has many similar disadvantages). You're better off letting these costs “float” (not post) until you actually pay them.

    On the other hand, if you want your inventory values to be firm (not subject to constant revision), you might want to use a clearing account because the costs can be posted in here (without regard to a specific vendor) and paid down from here as cash and motivation dictates.

    CONCLUSIONS

    In summary, you can realize advantages in the decoupling of inputs and outputs using a clearing account exactly as you manage many other costs using credit lines. The technique does not depend on cash-basis accounting, but can derive most of the (few) advantages of accrual basis without incurring the (possibly significant) tax disadvantages.