How Robust is your Financial Reporting?
By: Trent Barnes
When it comes to the M&A process, pre-sale preparation can significantly enhance valuation and the chances of success. Ideally, pre-sale preparation begins years before the owner intends to sell the business. When preparing for a sale, an important question to ask is: “How robust is my company’s financial reporting?” This may be a challenging question to answer, and once weaknesses are identified, implementing solutions will likely take a significant amount of time and effort. That said, improving your company’s financial reporting will pay dividends, both in the near term and when it comes time for a sale. Before we discuss how to assess a company’s financial reporting capabilities, let’s first discuss why it is important.
Financial reporting is the language of business. It gives the reader insight into how the company is currently performing and allows comparison with past operating results to improve operational decision-making. Further, accurate financial reporting is crucial when attracting new sources of capital, whether that be debt providers, new minority equity investors, or potential acquirers. In any case, capital providers will expect to see financial statements, prepared in accordance with Generally Accepted Accounting Principles (i.e., GAAP), before they make an investment decision. While most companies have financial reporting capabilities, the level of sophistication varies significantly across the board. So how do you assess a company’s financial reporting capabilities? Below are a few questions that you can ask:
- Does the company utilize a CPA to prepare and review the financial statements?
This is one of the first questions we ask our potential clients. CPAs, or Certified Public Accountants, are trained in the art of financial reporting and provide a base level of sophistication to a company’s financial statements. Although there are software applications that can assist a business owner in preparing financial statements, they are not a substitute for the personalized expertise that a CPA provides. CPAs help business owners navigate the intricacies of preparing financials statements and can assist with many, if not all, of the issues that arise when thinking through the remaining questions in this article.
CPAs typically offer three levels of financial statement service: (1) compilation, (2) financial statement review, and (3) audit.
In a compilation, a CPA prepares the financial statements using data provided by the company. The accountant does not perform additional procedures to validate the information provided. As the name suggests, the CPA is strictly compiling available financial information and producing the necessary financial statements. As such, the CPA provides no assurance whatsoever around the accuracy of the financial statements. Due to its simplicity, a compilation tends to be the first level of service that a business owner considers when beginning to work with a CPA. However, once a company is large enough that external capital providers or various stakeholders require some level of CPA assurance, business owners may consider “upgrading” the CPA services to a review.
Financial Statement Review:
In a financial statement review, an accountant performs high-level procedures over the financial statements, which provide limited assurance that the financial statements are free of material error. Examples of possible procedures include trend analysis to identify unusual changes and inquiry with management to understand accounting policies & procedures.
As opposed to a compilation and a financial statement review, an audit provides reasonable assurance that the financial statements are free of material errors, the highest level of assurance a CPA will provide. During an audit, a CPA performs detailed procedures over the financial statements. Examples of audit procedures include verifying balances and transactions with third parties, testing that transactions were recorded completely and accurately, verifying that a company’s accounting policies are in accordance with GAAP, and obtaining an understanding of the company’s internal controls.
When preparing for a sale, an owner should be aware that potential buyers will always prefer audited financial statements over compiled financial statements. That said, an audit may be cost prohibitive to smaller companies. In this case, a financial statement review, or even a sell-side Quality of Earnings (“QoE”) assessment, can be appropriate alternatives.
- Are the financials prepared on a Cash or Accrual basis?
Many small business owners prepare financial statements using a cash-basis of accounting. Under a cash-basis, revenues are recorded when cash is received, and expenses are recorded when cash is paid. Given the simplicity, cash-basis financials are easier to prepare than accrual-basis statements. However, accrual-basis statements provide benefits that cash-basis financials simply do not.
Under the accrual method, revenue is recognized once earned, and expenses are recognized once incurred, regardless of when cash is received or paid. For example, a company reporting under an accrual-basis would recognize the cost of inventory in the same period that the inventory was sold, even if the inventory was paid for in a prior period. As expenses are recognized along with the associated revenues, accrual-basis financial statements provide a clearer picture of profitability.
In the case of an acquisition, potential acquirers will expect accrual-basis financials. For this reason, it is important to produce accrual-basis financials when preparing for a sale. If you are currently on a cash basis, an accounting firm will be able to assist you with a cash to accrual conversion.
- How often are financial statements produced?
In a typical M&A process, potential acquirers will request monthly financial statements going back three or more years. This will be difficult for companies that do not prepare monthly financials. In some cases, a CPA can prepare monthly financial statements for historical periods, but this poses certain challenges. For one, the data required may no longer be available. Further, a company may perform year-end procedures to true-up certain general ledger accounts or record year-end accruals. Because these procedures are not performed monthly, it may be difficult or impossible for a CPA to retroactively determine the correct account balance for a given month. Instead, a business owner’s best bet is to prepare monthly financial statements well in advance of a sale.
- Are the financial statements prepared in a consistent manner?
When it comes to financial statements, consistent preparation is critical to ensure the reader can compare the operating results of the company over time. Comparison becomes difficult when accounting policies are routinely changed. For example, if a company changes its inventory costing methodology from LIFO (Last-In-First-Out) to FIFO (First-In-First-Out) in a rising price environment, it will result in an artificially higher inventory balance and higher income, purely due to the accounting change. This can mislead the readers of the financial statements, as they may mistakenly believe that income improved due to operational decisions.
This is not to say that all accounting changes are inappropriate. In fact, changing from one accounting method to another may present a more accurate view of a company’s true position. However, while a change in an accounting policy may be warranted, business owners should be aware of the importance of consistency when preparing financial statements.
- Does the company have controls around financial reporting?
Financial controls are regularly performed procedures that limit the risk of financial statements errors. There are numerous financial controls that a business can implement, but a few key controls specific to financial reporting include:
- Reconciling cash per the balance sheet to third-party bank statements
- Performing account reconciliations for key accounts (i.e., A/P, A/R, etc.)
- Enforcing “Segregation of Duties” – this means that distinct aspects of a business transaction are assigned to different individuals. For example, you would not want one person responsible for ordering an item, confirming its receipt, paying the vendor, and recording the journal entry in the general ledger as it introduces too many opportunities for the individual to commit fraud. Ideally, a different individual is responsible for each one of these tasks, though that is not always possible for a smaller business
- Comparing the actual results to budget or estimates, and researching meaningful variances
- Retaining documentation for all transactions
- A strong system of internal controls will limit errors in the financial statements and will save a company from further issues down the road.
- Does the company have an ERP system in place to accurately track and capture transaction data?
GIGO – Garbage In, Garbage Out – is a well-known term in computer science and equally applicable when it comes to financial reporting. A sophisticated financial reporting process is useless if the data that is being compiled is ultimately ‘garbage’. This is where an ERP system comes in. An ERP system helps manage the vital processes within your company – finance, procurement, billing, HR, etc. – and stores the data, along with support, in a database for future reference. This data can then be used to compile the company’s financial statements.
In the M&A process, a buyer’s advisors will perform a QoE assessment, and having transaction-level detail that support the financial statements will be crucial. Well-known ERP systems include SAP, Oracle, and NetSuite. ERP systems can be complicated and expensive, but there are inexpensive options for smaller companies. Ultimately, it is essential that companies have a system that accurately captures and retains transaction data.
Does the company track KPI’s and other important metrics that are not included in the financial statements?
KPI’s or Key Performance Indicators are the metrics that help track the operational success, or failure, of a company. The specific KPI’s will differ from company to company and across industries, but all companies should establish and track KPI’s. A few examples of KPI’s that relate to customers are:
- Average Revenue Per Customer
- Average Gross Margin Per Customer
- Customer Acquisition Cost
- Sales by Product by Customer
There are hundreds, if not thousands of KPI’s that a company could track. However, management should determine the most important KPI’s and ensure the company has a way to accurately track and report on those metrics.
From an M&A perspective, KPIs are important because an interested buyer will likely request information that is not disclosed in the financial statements. A buyer will want to understand the company’s customers, product mix, and vendors to further dive into the company’s operations. Having a robust system in place to track KPI’s will enable a company to provide relevant operational data to potential acquirers and will help support the story as to why the company is an attractive acquisition opportunity.
While improving your company’s financial reporting may be a daunting task, there are many highly skilled CPAs, as well as other advisors, that can assist you on the journey. If you are a business owner that is not ready to sell but would like to be prepared when the time comes, we at CC Capital Advisors would love to begin the conversation. It is never too early to prepare for a sale and having skilled advisors on your side will make all the difference.