In a recent episode of the Faces in FinOps podcast with Rich Hoyer, we delved into the changing dynamics of the relationship between tech and finance teams.
Historically, this relationship hasn’t always been ideal, primarily due to a significant lack of communication and understanding between the two departments. On one side, the tech department focuses on innovation and pushing the boundaries of what’s possible, often viewing financial constraints as barriers to creativity. On the other, the finance team, primarily concerned with numbers, budgets, and the bottom line, often lacks a clear understanding of the technological challenges and requirements.
This disconnect underscores the need for a collaborative relationship where engineering teams value financial systems, and finance teams understand technical challenges.
The first step in implementing FinOps is fostering mutual understanding between these teams. Finance leaders often struggle to understand cloud technologies and the complexities underlying their economics, while technical leaders may struggle to understand key finance and accounting concepts.
This blog aims to assist tech teams in achieving just that.
The first part of the “Implementing FinOps” blog series aims to bridge this gap, starting with a fundamental concept every tech leader should know: accrual accounting.
Why Do Organizations Need Financial Reporting Systems?
To begin our exploration, let’s ask a philosophical question: Why do enterprises bother with complex financial reporting at all?
Wouldn’t it be simpler to just examine the money flowing in and out of a business’s bank account over a specific period and call it a day? Why does the accounting department need to generate “balance sheets,” “cash flow statements,” and “profit and loss statements” as opposed to just photocopying the bank statements and emailing them to interested parties?
Answering this question can help technical leaders understand the particular pressures their colleagues in accounting and finance face when “closing the books” each month. Technical leaders may not realize it, but at the start of every month, three primary audiences are figuratively (and sometimes literally!) standing behind finance and accounting leaders, tapping their feet while waiting for the previous month’s financial statements:
- Investors, who want to know how the business is performing;
- Tax authorities, who are interested in their tax payments;
- The business’s management team, which requires reports to make decisions about future plans.
Each of these audiences needs to see financial results presented in a standardized format that provides a consistent comparison of results across multiple periods of time. The central focus of accounting is therefore to answer what seems like a fairly simple question: “What happened (financially) to the business during the month?” As we will see, answering that question is not as simple as it looks.
Understanding Key Accounting Concepts: Capitalization, Depreciation & Amortization
The practice of “capitalizing” financial outlays results in the single biggest difference between the money flowing in and out of an enterprise’s bank account and the financial results reported in its monthly “profit and loss” or “P&L” statement. Capitalization is therefore the central concept underpinning accrual accounting itself. We can conjure up a hypothetical case study to understand what capitalization is and why we use it.
Imagine for a moment that you have started a new software business called NewCo and have raised money from a group of investors to get your start. Your new business will make a fortune for you and your investors by creating the next great generative AI language model, “Jarvis,” which will serve as a vocalized virtual assistant and companion hosted on customers’ mobile telephones.
In order to create Jarvis, you will need a team of engineers closely collaborating in person. In your first month as a new business you lease office space and buy furniture, computers and other related office equipment for your new team. At the end of the first quarter of NewCo’s operations, your investors ask for a report on your financial results.
Looking at your bank statements, you see that in addition to staff salaries, $231,640 was spent during the quarter on computer equipment and furniture. During the same period, no money came into the enterprise, as Jarvis has yet to be written and so NewCo has nothing to sell yet. How should your investors evaluate your performance in quarter #1?
Are you failing them by “losing” over $230K, or is the story of your first quarter more nuanced than that? How would you respond when one of your more skeptical investors accuses you of performing poorly right out of the gate by quickly “losing” almost a quarter of a million dollars of investor money?
“Capitalization” is the accounting concept that comes to your rescue! The guiding principle behind whether an outlay can be “capitalized” – and therefore be reflected as an asset rather than an expense on your books – is whether the outlay has benefits to NewCo in future time periods. When you share your skeptical investor’s accusation with your accountant, she confirms that the computers and furniture meet the accounting standard for being recorded on NewCo’s books as a capital asset, not an expense.
She therefore generates financial statements for your investors that remove almost all of the $230k from the “expense” portion of your profit and loss statement. She removes almost all of it, but not all! She reminds you that the purpose of the profit and loss statement is to show investors what happened financially at NewCo in its first quarter. Since the computers and furniture have future benefit, their entire purchase price was not an expense in your first quarter – only a portion of it was.
She asks you how long you expect the computers to last, and you share with her that NewCo will have a refresh cycle of 3 years for computers and 10 years for the furniture. Since three years is equal to 12 quarters, she records “depreciation” expense of 1/12 of the value of the computers for quarter number one on the profit and loss statement and 1/40th (10 years X 4 quarters = 40 quarters) of the cost of the furniture as well. What is left of the $230K purchase price for these items after deducting the depreciation for quarter #1 is listed on NewCo’s books as an asset!
The fact that your accountant used capitalization means that she generated your first profit and loss statement on an accrual basis. The concept of accruals centers on the practice of recording at least some portion of an outlay as an expense in a different period than that in which the outlay was incurred. In the case of the computers, the $230K outlay was incurred by NewCo in quarter #1, but it will be reflected as an expense over the three years of the computers’ life and 10 years of the furniture’s life. In actual practice, there are many other accruals that businesses use to more accurately reflect their financial performance within any given period.
Understanding Depreciation/Amortization for Cloud Workloads
Here’s an example that will be immediately relatable to technical owners operating public cloud workloads: All-Upfront Reserved Instances on AWS.
Suppose as part of NewCo’s development efforts, you need to operate several EC2 instances and you purchase 3-year All Upfront RIs for a portion of your usage. Should your skeptical investor become angry again that you “spent” $80K on these RIs in one month? Of course not: the $80K has three years of future benefit.
The most common accounting treatment for this outlay is to record it as a particular type of accrual called a “prepaid expense.” Because the RIs have future benefits, they are recorded as assets on NewCo’s financial statements – assets that are gradually reduced in value on the books over the course of the three years. As RIs are intangible assets – meaning they can’t be held or touched – the term that is used to describe the expense associated with them is “amortization” instead of “depreciation.” The term “depreciation” only applies to physical assets.
In practice, any given business will have many different accruals which will seek to bridge the gap between cash flows in and out of their bank accounts and their actual financial performance in any given period. For example, when NewCo receives an invoice from a Las Vegas event center for their Re:Invent party, it is recorded as an expense in November (the month the invoice was received), but they don’t pay it immediately. Instead, the amount of the invoice is shown as an accrual liability in an account called “accounts payable.”
If this accrual practice were not followed, NewCo’s books would show that the Re:Invent expenses were incurred in December when NewCo pays the invoice rather than when they actually were incurred, which would distort NewCo’s financial results by overstating December’s expenses and understating November’s. Accrual accounting therefore helps us meet the matching principle, which advocates for matching up the revenues of a business with the expenses incurred to generate them.
Understanding the End Goals of the Financial Reports
Your colleagues in accounting and finance have a lot of work to do each period gathering data from around your organization and interpreting how it should be recorded to meet the standards for accrual accounting. That is why they can at times seem stressed and eager to get data from your technical teams as soon as possible. Remember, investors, tax authorities, and the management team are pressuring your finance and accounting colleagues each month to get the three primary financial statements they need to do their jobs: the profit & loss (P&L) statement, the balance sheet, and the statement of cash flows.
The exact nature of each of these statements and the methods used to generate them are perhaps more complex than the intended focus of this paper, but it would be helpful for technical leaders to have a high-level understanding of what each of these statements provides:
- The P&L describes a business’ financial performance during a specific time period (a month, quarter, or year).
- The Balance Sheet shows the assets owned by the business and also the amount it owes to third parties such as investors, lenders, and vendors.
Remember when NewCo’s accountant recorded the cost of the computers as a capital asset? The portion of the $230K remaining after deducting the depreciation for quarter #1 is shown on the balance sheet as an asset. During the period between receiving an invoice for the equipment and paying it, the $230K figure was shown as a liability on the balance sheet, representing the amount owed to the vendors. This is where the balance sheet gets its name: the total amounts of assets and amounts owed to third parties must be exactly equal.
The Statement of Cash Flows reconciles the difference between the monies coming in and out of the bank and the P&L. In other words, it effectively unwinds all of the accruals recorded in the period so that the reader can see what they were!
Final Thoughts
We hope this blog has provided an increased understanding of how accounting works and an appreciation of the complexities involved in generating each period’s financial statements. These complexities lie behind the pressure technical leaders may feel from accounting and finance to provide specific reports on their cloud costs each period.
If you haven’t viewed the podcast yet, here’s your chance: Faces in FinOps, Episode #12 with Rich Hoyer at FinOptik.
Explore more informational blogs at ProsperOps or book a demo to understand how our FinOps experts can help you save more on the cloud.
About the writer: Rich Hoyer is a FinOps thought leader with over 27 years of experience in IT and Finance, and he is the CEO and co-founder of FinOptik, a niche cloud financial management agency.
