Financial statements: It might not be the sexiest topic in the world, but they present a picture of the health of your business, and we have to pay attention to what they are telling us! Much like a doctor monitors your weight, blood pressure and other key health markers when you go in for a checkup in order to recommend steps to head off or prevent bigger problems from developing, financial statements must be tested and monitored regularly to head off financial sickness.
A good set of financials contains many indicators of financial health and can provide you with early warning signs of potential ill-health and/or larger underlying problems or areas of risk. These indicators reach far beyond just the financial and administrative procedures which contribute directly to the financial statements; they can also give you valuable feedback on many of the procedures, functions, and decision-making processes that make your business successful. Additionally, the graphic trending of these indicators can be an important tool in identifying changes in either positive or negative directions. Employing visual displays of financial data helps the user to quickly see and understand the story the data is telling.
So, what constitutes a “good” set of financials? As a Certified Public Accountant for many years, I’m going to lean on my auditing background here and get a little nerdy. There are 5 main financial statement assertions, in other words, 5 objectives that financial statements must accomplish in order to be considered materially accurate: existence/occurrence, completeness, rights and obligations, valuation, and presentation and disclosure. While these are fairly self-apparent terms, for illustration and thought-provoking purposes, I’d like to give a brief definition and a bit of commentary on each.
Existence or occurrence: Assets, liabilities and equities shown on the balance sheet actually exist, and transactions included in the income statement actually occurred.
What happens when you sell a capitalized fixed asset, say a vehicle, and it no longer “exists” as far as your company is concerned? Is the value of the vehicle properly removed from your balance sheet? And, if there was a related loan, has that also been properly removed from the liability section? This is an easy place for financial statements to go wrong.
Cleaning those types of items up often means making journal entries, and those entries are not always straightforward, especially when the asset sale involves a trade-in, etc. that may muddy the waters. Since this type of transaction is not an every-day occurrence for most businesses, the accounting staff may not know how to handle it properly, resulting in a balance sheet that displays inappropriate amounts for assets and liabilities.
Completeness: All transactions and accounts that should be presented in the financial reports are included.
This one may be the hardest to identify by merely looking at the financial statements themselves. Similar in concept to “you don’t know what you don’t know.” Sometimes there are clues within, but it often requires some additional input from managers and owners who are intimately involved in all the activities of the business. For example, maybe you’re an owner and you’re travelling on business, but you forget to bring your corporate credit card. You pay for gas, hotel, etc. with your personal card. Let’s say you’re the sole owner, so you don’t necessarily care if you are reimbursed for these expenses because you figure it’s all coming out of the same bucket anyway. But, if you don’t capture those expenses on your income statement, you’ll miss out on legitimate tax deductions, and your net profit figures will be skewed. So, what is your process to capture those expenses? This may seem like a relatively insignificant example, but I think it illustrates how easily the completeness assertion can be violated and how quickly it could add up if left unchecked.
Rights and obligations: Asset amounts represent the company’s true rights to property, and liability amounts represent actual obligations of the company.
Commonly seen indiscretions in this area result from the honest confusion of transactions amongst related parties to the company such as corporate shareholders, partners, LLC members, or parties to a parent-subsidiary or brother-sister controlled group. Examples of this type of indiscretion include (but are not limited to):
- Inflated intercompany transfer balances
- Improper loans to or from shareholders
- Stock sales transactions between individuals improperly booked to the company
- Assets titled in the owner’s name booked on the company balance sheet
- Loans taken in company name and used for personal purposes and not booked by the company
As you might imagine, misrepresentation in this category can be quite significant in terms of both dollar amount and consequence. Inaccuracy here can have major tax implications, a severe impact on ability to gain desired financing or attract potential buyers to your business, as well as potential legal and succession planning ramifications.
Valuation: The amount assigned to each asset, liability, equity, revenue and expense transaction is correct in both value and mathematical accuracy.
As with all five of the financial statement assertions, I could give any number of illustrations of the valuation standard. It’s probably the first thing that comes to mind when you talk about the accuracy of financial statements. In the copier dealer industry, here are some of the problems I often come across when evaluating a set of financials:
- Cash on the balance sheet not tying out to the cashbook reconciliations because of well-meaning journal entries that affect the G/L balance, but don’t touch the cashbook
- Old, uncollectible accounts receivable balances that have crept higher and higher in amount over time, initially due to insufficient collections practices and compounded by an absence of uncollectible accounts write-offs and/or allowance for doubtful accounts
- Inflated undeposited receipts balance commonly resulting from duplicate recording of deposits
- Inflated unapplied payments balance commonly resulting from an under-booking of accounts payable invoices
- Large and ever-growing uninvoiced purchases or uninvoiced inventory receipts balance arising from the improper use of vendor invoices instead of purchase order invoices
- Unmonitored deferred revenue balances which can easily be high or low based on over or under accrual of prepaid contracts
Presentation and disclosure: Accounting principles are properly selected and applied, and disclosures are adequate.
This is a beast of an assertion, and a full discussion of this would provide enough material for several more articles devoted to the topic. For the scope of this writing, I will leave you with a few very common, but basic oversights in presentation:
- Improper classification of general ledger accounts between assets, liabilities, equity, revenues, COGS, operating expenses and non-operating items
- Haphazard assignment of liabilities between current and non-current
- Absence of current portion of long-term debt
- Inconsistent application of accrual basis of accounting commonly seen in the lack of proper treatment of items like prepaid expenses or accrued wages
As a business owner or manager, you don’t need me to tell you how important it is to have clean and accurate financial statements. In addition to using them as an indicator of current and potential health of the company, you need to be able to rely on them for a vast array of purposes from day-to-day cash flow management, to strategic planning and goal-setting; from purchasing decisions to income tax planning and management. We at Nexera realize that knowing these needs and having the time and expertise to recognize and vet out the areas of either current dysfunction or future potential are two very different things.
If you are like many companies, and feel like your financial statements are missing the mark in any of the areas discussed above, we’d like to bring our financial team alongside your team as a resource for gaining improvements in processes and procedures which will translate into more accurate reporting and ultimately into better decision-making for a prosperous future!
We offer a wide range of financial services, which can be tailored to your specific needs, concerns and current staffing. Also, ask us about our new financial dashboard! It provides the graphic trending of your income statement data for easy visual analysis of your numbers at both the company and department level, as well as the ability to set financial targets for your business.
If you are unsure about the health of your financials, we can provide you a complete review of your e-Automate system to validate the condition of your company. You can see an example audit by clicking the button below.
Written by Bethany Sondeno, CPA – Director of Financial Operations – Nexera