April 26, 2010

Not too long ago I was asked to review the financial statements for a struggling company. This business had several years of fantastic performance, but the business was out of cash and needed desperately to correct its course. The financial statements depicted a strong, healthy company with plenty of liquidity to handle its obligations and demands. Yet the bank account was empty. Something was not right.

Upon further investigation, the financial statements were not correct. The issue went back for more than 18 months, meaning the company had operated for over a year with an incorrect understanding of its performance and direction. You can imagine the frustration and anger expressed when the owners of this company realized they could have avoided most, if not all, of their current issues if they had received accurate information that helped them identify their problems.

Here are 20 indicators that will let you know if you aren't getting accurate information.

1. Revenue Incorrectly Recognized

If your customer pays you up-front for a product in May, and then you deliver the product in June, you should recognize the revenue in June. Each industry has different criteria for revenue recognition, but it needs to be right so the financial statements are accurate.

2. Missing Matching Principle

If you pay $100 for an item in May and then sell it for $200 in June, you should recognize the $100 expense in June when you earn the revenue.

3. Gross Margin Variability

Any issues a business has with numbers one and two can cause the gross margin of the business to change more than a few percentage points each month. This should never be the case unless your business has undergone a significant change in its business model.

4. Period Cost Timing

Why did you pay $4,000 in rent in January and $0 in February (you didn't move, did you)? Most likely January and February rent payments were both entered in January. This is just one example of period cost timing issues.

5. Discounts Buried

If your business gives discounts, you should be able to see them on your Profit & Loss so that it can be measured. After all, it really is an investment into customers. Don't bury discounts against your revenue; illuminate them to track your return on this investment.

6. Bad Debt Neglected

Don't decrease your revenue when you write off your bad debt. You should expense it. It is a cost of doing business and it should not hurt all the work you are doing to correctly recognize revenue.

7. Divisional Profitability Hidden

Every time I have ever helped a company separate its divisional stand-alone performance, the business owner was shocked to learn which divisions were subsidizing the others. Do you have more than one department, division, or location? If so, you need to break it out.

8. Job Costing Forgotten

Looking at a profit and loss statement by itself will never give you all the information you need to know about your profitability. Use job-costing (or similar approaches for other industries) to find and improve your profit drivers.

9. Balance Sheet Reconciliations Dismissed

Every account should be reconciled every month, not just the bank accounts.

10. Accounts Receivable

Have an answer for why each and every invoice over 60 days past due has not been paid. If any of your answers are not truly legitimate, write it off and send it to collections.

11. Pre-Paid Item Indifference

You pay your general liability insurance every year in February. As a result, February is always one of your worst months because it bears the brunt of all twelve months worth of insurance. Book it as pre-paid and share the "love" through the entire year.

12. Physical Inventory Lost

It does not matter how good you are, how nice you are, or how smart you are. You still need to do a regular physical count of your inventory. If you have inventory, properly managing it will make all the difference to your cash flow.

13. Depreciation Debacle

Just because your tax CPA depreciated your capital expenditures last year does not mean that last year should carry the burden. Keep your depreciation on a straight-line or more appropriate basis and spread it out over a realistic lifetime of each of your assets.

14. Fixed Assets Expensed

There are differing opinions here, but pick a dollar amount, like $1,000, and capitalize anything that costs more than that and will have a life of more than 12 months in your business. Forcing one month or even one year to carry the weight of fixed asset purchases is not accurate — that is why we have depreciation!

15. Payroll Liabilities Overlooked

Reconcile this account to zero every month to make sure you stay on the good side of the IRS, your state, and any other agencies or companies to whom you owe money from payroll.

16. Long-Term and Short-Term Debt Confused

If you buy a new vehicle for your business and you finance it over four years, the portion due in the next 12 months needs to be a short-term liability and the remaining balance is a long-term debt.

17. Principal and Interest Jumbled

The principal and interest portion of each loan payment needs to be properly coded rather than applied to an expense account called "Loan Payment."

18. Retained Earnings Miscarried

The name of this balance sheet account is exactly what it means: The accumulation of all of the losses and profits that have not been distributed from the company. Appropriate journal entries need to be made at the end of every year to make this balance correct.

19. Owner Compensation Confused

Owners receive compensation in one of three ways. Make sure to code each one correctly.

20. Statement of Cash Flow Ignored

Most businesses don't have to worry about the accuracy of their statement of cash flows because they ignore it altogether!

Accurate financial statements are critical to building a successful business. Give heed to these indicators and you will be well on your way to accuracy.

Join the conversation ( 4 )

• Mary Adams, CMC 1 year 8 months and 22 days ago

  

  Ken-You have missed one of the biggest discrepancies in today's financials: intangibles. For a lot of good reasons, many of the investments that companies make in process, people and networks are not eligible to be capitalized on the balance sheet. That means that these investments end up being expensed along with current year operating costs. Both financial statements are thereby distorted.
  
  This intangibles information gap is already significant. Today, the balance sheet of the average company explains only 30% of its value. That means that 70% is in these knowledge intangibles.
  
  This gap can be filled by creating management reports that keep track of expensed intangibles investment (we call it intangible capital expenditure or i-capex). Although it doesn't change GAAP financials, it gives stakeholders a much clearer idea of the operating capacity of an organization (by showing cumulative investment) and its true operating costs (by backing investments out of expenses).

• W. Michael Hsu, CPA 1 year 8 months and 25 days ago

  

  Fantastic post Ken. You are absolutely right on how operating a business under the wrong financial understanding can end in an undesired and sometimes disastrous situation. I hope your client is now turning things around with you on board to shed some light.
  
  Also, thank you on the 20 points that you've illustrated, all of which are good indicators of how financial statements may be misstated. Although each of them can seem trivial by itself under certain circumstances, aggregated, they can provide some serious issues. Like I've always told my client, wrong financial information can sometimes be worst than no financial information. Again, thanks for sharing!

• Ed Wielage 1 year 9 months and 11 days ago

  

  The author makes good points. I'm an advocate of budgeting. A monthly budget and a monthly analysis of the budget vs actual would have enabled management to see many of these problems as they were occurring and take corrective action. Looking at a monthly financial statement without some frame of reference makes it easy to miss many of the items the author referred to.

• Tony Lael 1 year 9 months and 12 days ago

  

  Ken, you hit at the core of several areas we see companies in the IT services industry fall victim to more than we'd like. As you can well imagine it is not because owners and managers want to fall into these traps... they don't know what they don't know. The first step, as you mentioned about your client, was for them to see clearly what was (and was not) happening - this opened their eyes to where to make adjustments. Then, it was about tuning various areas in the way they accounted for certain items. Looking forward, it is about monitoring performance to make sure they stay on top of certain key financial relationships like cash, receivables and margins to name a few.
  
  I encourage you and your readers, whether they are in the IT services business or not, to look into the Corelytics Financial Dashboard (http://www.coreconnex.com) to uncover the financial picture of their business so they can leverage resources we have and business advisors like you to tune their business for better performance.
  
  Great article!