If you work in accounting and you aren’t familiar with the term firm commitment, it’s likely because most people who use this term are certified public accountants (CPAs) working at accounting firms. The word itself isn’t all that complicated, though it can be difficult to implement and understand if you don’t have the right information on hand.
Accounting Firms commitments are associated with auditing, but they are not the same thing; knowing more about firm commitments will help you better understand how auditing works and why it matters to your business.
Defining a commitment
First, a quick definition. What is a firm commitment? A firm commitment, or forward contract, is an agreement to buy or sell an asset at a specific price at some point in the future. Unlike other agreements between parties—for example, a futures contract—there’s no going back on a firm commitment once it has been made.
This means that if there are counterparty risks involved with your firm commitments (say you have agreed to pay for steel that hasn’t been delivered yet), you need to be prepared to act accordingly once those risks materialize (perhaps by providing collateral for your order). For more about forward contracts and how they work in accounting terms, see How does trading using futures impact stockholders’ equity? from Duke University’s Fuqua School of Business.
A closer look at related party transactions
In accounting, a related party transaction occurs when one entity engages in a business deal with another entity that is somehow linked. For example, if you own a company and hire your cousin for an executive position, you have entered into a related party transaction because of your relationship to him.
However, if you bought inventory from another company, even though there may be some link between your companies (for example, both are owned by members of your extended family), it would not be considered a related party transaction because there’s no direct financial link between you. It’s important to track all related party transactions carefully to avoid conflicts of interest and reduce fraud and errors.
The balance sheet effect
To illustrate how firm commitments affect accounting, imagine you purchase a car. Your balance sheet will show an asset (the car) and a liability (the loan to buy it). This makes sense; after all, if you own a car, you owe money on it.
Now imagine selling that same car back to your friend who loaned you money when you first bought it. The balance sheet effect can be seen here: Assets decrease because of an equity transaction, but liabilities stay flat or increase, depending on how much cash is exchanged for either one of these items.
The income statement effect
This is when a company signs a long-term contract to buy goods, which shows up as an expense and reduces current net income. The good news is that it also reduces future risks, since costs are fixed for many years. The bad news is that future profits are limited, since you can’t change prices for several years down the road (unless a competitor comes along).
It’s kind of like deciding to lease an apartment instead of buying one. Renting can be less expensive, but your options are more limited. Take Apple’s new operating system as an example: It has committed to purchase $10 billion worth of Intel chips over three years at current prices—the equivalent of making quarterly payments on a house you don’t own.
Revising the accrual basis of accounting
The accrual basis of accounting records financial transactions as they occur, rather than when cash is exchanged. Most businesses in operation today use an accrual accounting system; however, there are a few who use a cash-basis method of accounting.
The main difference between these two systems is that under accrual-basis accounting, expenses and revenue must be recorded when earned. Under cash-basis accounting, only cash received or paid out is recorded. The latter method ignores all other types of payments that occur during a given period, such as checks written by customers and reimbursements to employees for business expenses like travel and entertainment.
Can commitments be changed by management?
Although there are times when management needs to flex its muscle, they cannot generally change a commitment. If they try to change it, then investors will be less likely to use stock as collateral and a loss of investor confidence would affect how firms operate their businesses.
In order for a commitment to be changed or discontinued, both parties need to come together and amend it. In short, it’s harder than one might think for managers to simply pull out of firm commitments.
A firm commitment is a commitment made by a business to complete a certain action. Businesses can make both long-term and short-term commitments, but there are many rules regarding how those commitments must be accounted for. A long-term commitment is one that is expected to last more than one year while a short-term commitment is estimated to last one year or less.
Firms use these plans as guidance when making financial decisions as they might impact their budgeted revenues or expenses. The process of making and accounting for firm commitments requires using some specific terminology and financial methods, which will be discussed later in this document.