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Operationalizing Accounting Reporting in System Dynamics Models

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Operationalizing Accounting Reporting in System Dynamics Models systems Article Operationalizing Accounting Reporting in System Dynamics Models Kawika Pierson Atkinson Graduate School of Management, Willamette University, Salem, OR 97301, USA; [email protected] Received: 14 January 2020; Accepted: 20 March 2020; Published: 24 March 2020 Abstract: System dynamics implementations of financial statements are currently limited by the lack of a simple to use, yet sufficiently detailed model that operationally replicates the accounting reporting process for the income statement, balance sheet, cash flow statement, and statement of changes in owners’ equity. While system dynamics accounting structures exist, they are inconsistently applied in the literature. In this paper, we offer a comprehensive accounting model in the hope that academics and practitioners will use its structures to better represent accounting reports in their projects. Keywords: accounting system dynamics; accounting reporting model; financial statements; accounting differential equations 1. Introduction Models of businesses and business processes are some of the earliest applications of system dynamics [1,2] and continue to be very influential today [3–6]. While these models often include structures that are intended to represent financial accounting reports, the way that the accounting reporting process is represented is usually highly simplistic. In some cases, a simplistic treatment of accounting is all that is needed for a model’s purpose, but it is also likely that the lack of a standard structure [7] for operationalizing accounting inside of system dynamics models leads some modelers to over-simplify what can be an opaque and detail-oriented area of management. The most highly operational representations of accounting reporting inside of system dynamics models are the work of John Sterman and his co-authors. As early as his thesis [8,9] Sterman’s models included simple structures for endogenously representing balance sheets and income statements [10]. While his treatment of accounting is sometimes questionable (for example, the negative debt in [11]), his Analog Devices paper with Nelson Repenning and Fred Kofman [12] was the first to recognize the importance of explicitly representing accounting reporting as a discrete process. Most system dynamics models in management accurately represent basic accounting definitions such as net income being the difference between revenue and expenses, but they almost always model the instantaneous value of these flows rather than considering the way that the process of generating accounting reports aggregates the flows over time and reports them during a single time step. The instantaneous value of the flow of revenue at the end of the year is not the same as the total revenue earned over the year, yet because it is so easy to create a flow of revenue, most system dynamics models rely on simple flows. Correct accounting reporting structures are a common thread in the work of Sterman’s coauthors and students [13–15], but it is exceedingly rare to see other modelers use them [16–18] even when their express purpose is to represent accounting reports [19,20]. Not operationalizing the accounting reporting process has the potential to cause serious problems. First, managers use accounting reports to make decisions and evaluate results. Representing the way that these reports average and lag the instantaneous values of the relevant flows is required in order Systems 2020, 8, 9; doi:10.3390/systems8010009 www.mdpi.com/journal/systems Systems 2020, 8, 9 2 of 13 to build models that replicate the decision process of managers. Second, if we want to “involve the people, one hopes to influence in the modeling process from the beginning” [21] (page 38) by building face validity, replicating the types of reports managers are used to working with is an important step. Face validity is particularly salient for applications of system dynamics in flight simulators [5,22–24]. Finally, any work that aims to match simulated outputs with quantitative data on financial results will be biased if it does not replicate the accounting reporting process that produced that data. The lack of a standard structure for replicating the income statement, balance sheet, statement of cash flows, and owners’ equity statement is limiting the implementation of operational accounting structures in system dynamics models. While Repenning and Sterman [25] provide an excellent foundation for such a model, the field needs an updated effort in this direction, both because their model has been so rarely utilized, and because there are some incremental improvements that can be made. For example, Repenning and Sterman do not extend the logic of the reporting process to the cash flow statement, and so their model’s reporting of those results relies on instantaneous values of flows. They also fail to represent straight line depreciation, opting instead to model depreciation as a first order delay. These decisions are understandable given their purpose, but these omissions will stand out as incorrect to people familiar with accounting conventions. This paper’s contribution then, is to provide an open-access, well-documented model that is both general in its ability to interface with the work of modelers unfamiliar with accounting, and operational enough to produce financial statements that look familiar to seasoned businesspeople. We build and offer a module that can be used by other modelers without any knowledge of accounting. Our model boundary uses typical variables that most system dynamics professionals will understand rather than requiring users to interface with the accounting model by breaking down individual accounting transactions (such as in Ch. 3 of [26]). We hope that this strikes an appropriate balance between usability and precision. Yes, model structures should be determined by a model’s purpose, but this decision is always a judgement call. Since representing accounting accurately is difficult, some modelers may decide that their purpose does not really require it even when there would be a benefit. A standard structure that can be easily applied and adapted will allow far wider application of operational representations of accounting, increasing the ability of modelers to properly engage key stakeholders, build face validity, and match their models to reported accounting data. 2. Important Accounting Concepts The outputs of the accounting reporting process are the financial statements, the most prominent way that managers understand and direct their firms. There are five financial statements companies include in their annual reports: The income statement, the balance sheet, the cash flow statement, the statement of changes in owners’ equity, and the other comprehensive income statement. Of these, the balance sheet, income statement, cash flow statement, and statement of changes in owners’ equity are the most salient to managers, and so we will limit our model to presenting only these four. The income statement reports the net income of the firm, which is the bottom-line measure of profit, and one of the most important outputs of the accounting process [27]. The classic income statement presentation places revenue, or the flow of value created by the company’s sales, at the top, with expenses sequentially subtracted from revenue, resulting in more restrictive income figures being calculated as you move down the statement. Typical expense categories include the cost of goods sold, operating expenses like marketing and depreciation, and interest and tax expenses. The balance sheet presents the stocks of value in the company and is organized into three sections: assets, liabilities, and equity. These three sections are related through an equation known as the balance sheet identity, which states that the assets of the company must always equal the liabilities of the company plus its owners’ equity. Some assets and liabilities on the balance sheet are called accruals [28] because they add up the difference between flows of cash, such as the collection of customer payments, and flows of value, such as the billing of customers for the shipment of goods. Systems 2020, 8, 9 3 of 13 Three categories of cash flows are reported on the cash flow statement: operating, investing, and financing. Operating cash flows arise from the company’s day to day operations, investing cash flows occur when the company invests in long-term assets or financial markets, and financing cash flows arise from the debt and equity used to raise cash for the other two types of activities. Due to the focus on value flows rather than cash flows in the first two financial statements, the operating cash flow of for-profit companies is presented using the indirect method, which carefully explains the differences between net income and net cash flow from operating activities. This reconciliation is accomplished by first subtracting out the impact of any non-cash expenses counted as a part of net income and then undoing the impact of the changes in each accrual account on the balance sheet. The owners’ equity statement reports the flows in and out of each stock of equity in the firm. While this is conceptually simple for a system dynamics audience, it can often be very detailed and complex in practice. We do not implement many of the more detailed potential equity arrangements here, but they will follow the general form of the equity stocks that we have implemented. We omitted one financial statement, the other comprehensive income statement, because it documents the impacts of particularly complex transactions
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