I am happy to announce that I will be resuming the “Ask Allen” articles, initially on an intermittent basis. I want to thank you for the many compliments that I have received concerning the publications.
Although we discussed “The Language of Business,” including financial statements, in a previous column, given the recent references in the local news concerning the importance of financial statements, I thought it might be appropriate to expand the previous article’s comments.
Purpose of financial statements:
- Display what you (a company, government, church, etc.) own and owe at a given time.
- Display the methodology of measuring what you have, what you owe, etc.
- Analyze the above in order to manage most efficiently, make informed projections for the future and furnish information to interested parties outside the company.
Standards: Without universally accepted standards of measurement, financial statements would be rather chaotic in values used, distortions concerning opinions, etc. That being the case, years ago the American Society of Certified Public Accountants developed GAAP (Generally Accepted Accounting Standards) to insure clarity as to “best practices” in financial reporting.
Statements: There are two primary financial statements and one ancillary statement, all of which, along with explanatory notes and schedules, comprise a complete set of financial statements. They are, along with their purposes:
- Balance sheet. Reflects your assets (things of value that you own), your liabilities (amounts that you owe to others) and your financial net worth as of one day. The basic accounting formula is always in place: Assets equal liabilities plus capital.
- Income statement. Reflects the profit or loss of operations over a month, year or other stated period. Typically net operating profit or loss is computed by: Revenue less cost of sales (to derive “gross profit”) less operating expenses. Net operating profit (loss) then will have additions and deletions of non-operating income and non-operating expense items to derive “net profit/loss” from the total of all actions of any type that occurred during the reporting period.
- Cash flow statement. Reflects the “where got, where gone” of cash over the period of time covered by the income statement. There are usually many types of transactions that affect cash flows that are not tied directly to operations of the business (payments of principal on notes payable, amounts borrowed, injections of capital by owners or investors, depreciation expenses, “realization” of deferred income and expense items, etc.) The cash flow statement begins with net profit/loss per the income statement, displays those adjustments, and ends with a summary of beginning cash, net additions or deletions, and ending cash to reflect cash activities that occurred during the period.
- Explanatory notes and schedules. While not technically required for GAAP, notes are extremely helpful to potential lenders, investors, etc. They describe a multitude of aspects, projections, goal measurements, etc. of the company. A cover letter is helpful as an “executive summary” of the company’s overall financial position and prospects.
Quality of financial statements: Most financial statements are prepared internally by the company itself. In dealing with lenders, investors, etc., however, the size of the risk involved prudently requires that additional measures be taken to verify, as much as is feasible, the veracity of the statement package. Financial statements are reviewed and prepared by external CPA firms to display to the world that the CPA has performed an audit, with its comments attached to the audit report. Levels of outside CPA involvement in statement presentations are:
- Audited statement. This is the “gold standard.” The auditor has gone through extensive reviews, tests of inventories, receivables, payables, etc., to verify that figures and disclosures in the statement package are reasonable and adequately displayed in accordance with GAAP. Larger companies usually will have audited statements.
- CPA reviewed statement. Similar to an audited statement, but without the degree of “proving” receivables, payables, inventories, etc. Very thorough, but not quite as comprehensive (and expensive) as audited statements. Usually used by mid-sized companies.
- CPA compilation statement. The CPA firm has received the company’s internal statements, made a cursory review of the contents, and prepared the compilation directly from the information it received. Usually used by small companies and small charities, etc.
My apologies in advance to CPA professionals for misstatements, but I hope the proper intent was conveyed. CPA firms do not guarantee the veracity and accuracy of the financial statements. They, of necessity, must rely on information provided by the individuals, companies, governmental entities, etc. They can only express their opinions, based on the information they have been given and the research that they have performed.
To summarize, financial statements are an integral part of managing a business and dealing with lenders and investors. A company, specifically its officers responsible for financial reporting, owners and board members, can be at great risk if information displayed on statements to lenders, customers and investors is materially incorrect or false.
- Allen Wood Jr. is a seasoned Greenwood businessman. Send questions to him at excellententrepreneur1@gmail.com.
