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Financial Statement Red Flags

Reviewing your company’s financial statements often can catch problems early before they turn into bigger issues. Beware of these red flags.

CASH IS KING

While a shortage of cash generates concerns about overspending, slowed sales or collectability of your receivables, growing bank accounts can be problematic too.

It’s easy to think that having too much cash is a good thing. But unless you’re stockpiling funds for a major purchase, excess cash can suggest that vendors aren’t being paid, unnecessary interest is being incurred on debt or growth and investment opportunities are being missed.

MONITOR THE CURRENT SITUATION

When your current assets (e.g., cash and receivables) are less than your current liabilities (e.g., vendor payables and payroll liabilities) it may mean you may have trouble meeting your short-term obligations. This is especially important for seasonal businesses to manage when there may be parts of the year when you have more bills than sales.

MAKE A PROFIT

Shrinking profit margins deserve a closer look into your operations. Your profit margin is what’s left over after you subtract your product’s cost from your sales, and it’s used to cover your administrative expenses. Smaller profit margins may cause you to rely on short-term sources of cash, like credit cards or lines of credit, meaning you’ll pay interest.

GET INTO THE DETAILS

It’s not uncommon to have a line item on your income statement for “other expenses.” It’s an easy catch-all for costs that don’t fit nicely in established categories like wages or rent. But when your other expenses are higher than usual, dig deeper. It could be something as simple as a recording error or a one-time expense. You’ll want to confirm that nothing is out of line.

RISING INVENTORY

If your inventory is increasing, but nothing else has changed, it might mean items aren’t selling. And the longer inventory sits on the shelves there’s a higher chance that it will spoil or become obsolete. Devise a plan to get items moving again.

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Restating financial results

In the first half of 2021, there was a surge in financial restatements. The reason relates to guidance issued by the Securities and Exchange Commission, requiring special purpose acquisition companies (SPACs) to report warrants as liabilities. SPACs are shell corporations that are listed on a stock exchange with the purpose of acquiring a private company, thereby making it public without going through the traditional IPO process. Historically, SPACs that offer warrants (which allow investors buy shares at a set price in the future) have reported those instruments as equity.

In this situation, most SPAC investors understood that these restatements were related to a financial reporting technicality that applied to the sector at large, rather than problems with a particular company or transaction. But some restatements aren’t so innocuous.

Close-up on restatements

The Financial Accounting Standards Board defines a restatement as a revision of a previously issued financial statement to correct an error. Whether they’re publicly traded or privately held, businesses may reissue their financial statements for several “mundane” reasons. Like the recent situation with SPACs, managers might have misinterpreted the accounting standards, or they simply may have made minor mistakes and need to correct them.

Leading causes for restatements include:

  • Recognition errors (for example, when accounting for leases or reporting compensation expense from backdated stock options),
  • Income statement and balance sheet misclassifications (for instance, a company may need to shift cash flows between investing, financing and operating on the statement of cash flows),
  • Mistakes reporting equity transactions (such as improper accounting for business combinations and convertible securities),
  • Valuation errors related to common stock issuances,
  • Preferred stock errors, and
  • The complex rules related to acquisitions, investments, revenue recognition and tax accounting.

Reasons to restate results

Often, restatements happen when the company’s financial statements are subjected to a higher level of scrutiny. For example, restatements may occur when a private company converts from compiled financial statements to audited financial statements, decides to file for an initial public offering — or merges with a SPAC. Restatements also may be needed when the owner brings in additional internal (or external) accounting expertise, such as a new controller or audit firm.

In some cases, a financial restatement also can be a sign of incompetence, weak internal controls — or even fraud. Such restatements may signal problems that require corrective actions.

We can help

The restatement process can be time consuming and costly. Regular communication with interested parties — including lenders and investors — can help businesses overcome the negative stigma associated with restatements. Management also needs to reassure stakeholders that the company is in sound financial shape to ensure their continued support.

We can help accounting personnel understand the evolving accounting and tax rules to minimize the risk of restatement. Our staff can also help them effectively manage the restatement process and take corrective actions to minimize the risk of restatement going forward.

© 2021

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Private companies: Are you on track to meet the 2022 deadline for the updated lease standard?

Updated accounting rules for long-term leases took effect in 2019 for public companies. Now, after several deferrals by the Financial Accounting Standards Board (FASB), private companies and private not-for-profit entities must follow suit, starting in fiscal year 2022. The updated guidance requires these organizations to report — for the first time — the full magnitude of their long-term lease obligations on the balance sheet. Here are the details.

Temporary reprieves

In 2019, the FASB deferred Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), to 2021 for private entities. Then, in 2020, the FASB granted another extension to the effective date of the updated leases standard for private firms, because of disruptions to normal business operations during the COVID-19 pandemic.

Currently, the changes for private entities will apply to annual reporting periods beginning after December 15, 2021, and to interim periods within fiscal years beginning after December 15, 2022. Early adoption is also permitted.

Most private organizations have welcomed these deferrals. Implementing the requisite changes to your organization’s accounting practices and systems can be time-consuming and costly, depending on its size, as well as the nature and volume of its leasing arrangements.

Changing rules

The accounting rules that currently apply to private entities require them to record lease obligations on their balance sheets only if the arrangements are considered financing transactions. Few arrangements are recorded, because accounting rules give lessees leeway to arrange the agreements in a way that they can be treated as simple rentals for financial reporting purposes. If an obligation isn’t recorded on a balance sheet, it makes a business look like it is less leveraged than it really is.

The updated guidance calls for major changes to current accounting practices for leases with terms of a year or longer. In a nutshell, ASU 2016-02 requires lessees to recognize on their balance sheets the assets and liabilities associated with all long-term rentals of machines, equipment, vehicles and real estate. The updated guidance also requires additional disclosures about the amount, timing and uncertainty of cash flows related to leases.

Most existing arrangements that currently are reported as leases will continue to be reported as leases under the updated guidance. In addition, the new definition is expected to encompass many more types of arrangements that aren’t reported as leases under current practice. Some of these arrangements may not be readily apparent, for example, if they’re embedded in service contracts or contracts with third-party manufacturers.

Act now

You can’t afford to wait until year end to adopt the updated guidance for long-term leases. Many public companies found that the implementation process took significantly more time and effort than they initially expected. Contact us to help evaluate which of your contracts must be reported as lease obligations under the new rules.

© 2021

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Accounting for business combinations

If your company is planning to merge with or buy another business, your attention is probably on conducting due diligence and negotiating deal terms. But you also should address the post-closing financial reporting requirements for the transaction. If not, it may lead to disappointing financial results, restatements and potential lawsuits after the dust settles.

Here’s guidance on how to correctly account for M&A transactions under U.S. Generally Accepted Accounting Principles (GAAP).

Identify assets and liabilities

A seller’s GAAP balance sheet may exclude certain intangible assets and contingencies, such as internally developed brands, patents, customer lists, environmental claims and pending lawsuits. Overlooking identifiable assets and liabilities often results in inaccurate reporting of goodwill from the sale.

Private companies can elect to combine noncompete agreements and customer-related intangibles with goodwill. If this alternative is used, it specifically excludes customer-related intangibles that can be licensed or sold separately from the business.

It’s also important to determine whether the deal terms include arrangements to compensate the seller or existing employees for future services. These payments, along with payments for pre-existing arrangements, aren’t part of a business combination. In addition, acquisition-related costs, such as finder’s fees or professional fees, shouldn’t be capitalized as part of the business combination. Instead, they’re generally accounted for separately and expensed as incurred.

Determine the price

When the buyer pays the seller in cash, the purchase price (also called the “fair value of consideration transferred”) is obvious. But other types of consideration muddy the waters. Consideration exchanged may include stock, stock options, replacement awards and contingent payments.

For example, it can be challenging to assign fair value to contingent consideration, such as earnouts payable only if the acquired entity achieves predetermined financial benchmarks. Contingent consideration may be reported as a liability or equity (if the buyer will be required to pay more if it achieves the benchmark) or as an asset (if the buyer will be reimbursed for consideration already paid). Contingent consideration that’s reported as an asset or liability may need to be remeasured each period if new facts are obtained during the measurement period or for events that occur after the acquisition date.

Allocate fair value

Next, you’ll need to split up the purchase price among the assets acquired and liabilities assumed. This requires you to estimate the fair value of each item. Any leftover amount is assigned to goodwill. Essentially, goodwill is the premium the buyer is willing to pay above the fair value of the net assets acquired for expected synergies and growth opportunities related to the business combination.

In rare instances, a buyer negotiates a “bargain” purchase. Here, the fair value of the net assets exceeds the purchase price. Rather than book negative goodwill, the buyer reports a gain on the purchase.

Make accounting a forethought, not an afterthought

M&A transactions and the accompanying financial reporting requirements are uncharted territory for many buyers. Don’t wait until after a deal closes to figure out how to report it. We can help you understand the accounting rules and the fair value of the acquired assets and liabilities before closing.

© 2021

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Reporting profits interest awards

During the pandemic, cash has been tight for many small businesses, which may make it hard to attract and retain skilled workers. In lieu of providing cash bonuses or annual raises, some companies may decide to give valued employees a share of their future profits. While corporations generally issue stock options, limited liability companies (LLCs) use a relatively new form of equity compensation called “profits interests” to incentivize workers. Here’s a summary of the accounting rules that are used to account for these transactions.

Types of awards

Under U.S. Generally Accepted Accounting Principles (GAAP), profits interest awards may be classified as:

  • Share-based payments,
  • Profit-sharing,
  • Bonus arrangements, or
  • Deferred compensation.

Classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an expense on the income statement. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.

Valuation

Under GAAP, fair value is the price an entity would receive to sell an asset — or pay to transfer a liability — in a transaction that’s orderly, takes place between market participants and occurs at the acquisition date. If quoted market prices and other observable inputs aren’t available, unobservable inputs are used to estimate fair value.

One of the upsides to issuing profits interest awards is their flexibility. There’s no standard definition of a profits interest; the term “profits” can refer to whatever is agreed to by the LLC and the recipient of the award. In addition, profits interest units may be subject to various terms and conditions, such as:

  • Vesting requirements,
  • Time limitations,
  • Specific performance thresholds, and
  • Forfeiture provisions.

An LLC may offer multiple types of profits interests, allowing it to customize awards for various purposes. The varieties of terms and conditions that can be incorporated into a profits interest requires the use of customized valuation techniques.

Need for improvement

Many private companies struggle with how to report profits interests. In recent years, the Financial Accounting Standards Board (FASB) has discussed ways to simplify the rules, including scaling back the disclosure requirements and providing a practical expedient to measure grant-date fair value of these awards. No changes have been made yet, however.

For more information

Accounting complexity has caused some private companies to shy away from profits interest arrangements. But they can be an effective tool for attracting and retaining workers under the right circumstances. Contact us for help reporting these transactions under existing GAAP or for an update on the latest developments from the FASB.

© 2021

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Analytical procedures can help make your audit more efficient

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The use of audit analytics can help during the planning and review stages of the audit. But analytics can have an even bigger impact when these procedures are used to supplement substantive testing during fieldwork.

Definition of “analytics”

Auditors use analytical procedures to evaluate financial information by assessing relationships among financial and nonfinancial data. Examples of analytical tests include:

  • Trend analysis,
  • Ratio analysis,
  • Reasonableness testing, and
  • Regression analysis.

Significant fluctuations or relationships that are materially inconsistent with other relevant information or that differ from expected values require additional investigation.

4 steps

Auditors generally follow this four-step process when performing analytical procedures:

1. Form an independent expectation. The auditor develops an expectation of an account balance or financial relationship. Expectations are based on the auditor’s understanding of the company and its industry. Examples of data used to develop expectations include prior-period information (adjusted for expected changes), management’s budgets or forecasts, and ratios published in trade journals.

2. Identify differences between expected and reported amounts. The auditor must compare his or her expectation with the amount recorded in the company’s accounting system. Then, any difference is compared to the auditor’s threshold for analytical testing. If the difference is less than the threshold, the auditor generally accepts the recorded amount without further investigation and the analytical procedure is complete. If not, the auditor moves to the next step.

3. Investigate the reason. The auditor brainstorms all possible causes and then determines the most probable cause(s) for the discrepancy. Sometimes, the analytical test or the data itself is problematic, and the auditor needs to apply additional analytical procedures with more precise data. Other times, the discrepancy has a “plausible” explanation, usually related to unusual transactions or events, or accounting or business changes.

4. Evaluate differences. The auditor evaluates the likelihood of material misstatement and then determines the nature and extent of any additional auditing procedures. Plausible explanations require corroborating audit evidence.

For differences that are due to misstatement (rather than a plausible explanation), the auditor must decide whether the misstatement is material (individually or in the aggregate). Material misstatements typically require adjustments to the amounts reported and may also necessitate additional audit procedures to determine the scope of a misstatement.

A win-win for everyone

Done right, analytical procedures can help make your audit less time-consuming, less expensive and more effective at detecting errors and omissions. Analytics also may be easier to perform remotely than traditional, manual audit testing procedures — a major upside during the COVID-19 pandemic. To avoid surprises in the coming audit season, notify us about any major changes to your operations, accounting methods or market conditions that occurred during the reporting period.

© 2021

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How to compute your company’s breakeven point

Break-even point word with green checkmark, 3D rendering

Breakeven analysis can be useful when investing in new equipment, launching a new product or analyzing the effects of a cost reduction plan. During the COVID-19 pandemic, however, many struggling companies are using it to evaluate how much longer they can afford to keep their doors open.

Fixed vs. variable costs

Breakeven can be explained in a few different ways using information from your company’s income statement. It’s the point at which total sales are equal to total expenses. More specifically, it’s where net income is equal to zero and sales are equal to variable costs plus fixed costs.

To calculate your breakeven point, you need to understand a few terms:

Fixed expenses. These are the expenses that remain relatively unchanged with changes in your business volume. Examples include rent, property taxes, salaries and insurance.

Variable/semi-fixed expenses. Your sales volume determines the ebb and flow of these expenses. If you had no sales revenue, you’d have no variable expenses and your semifixed expenses would be lower. Examples are shipping costs, materials, supplies and independent contractor fees.

Breakeven formula

The basic formula for calculating the breakeven point is:

Breakeven = fixed expenses / [1 – (variable expenses / sales)]

Breakeven can be computed on various levels. For example, you can estimate it for your company overall or by product line or division, as long as you have requisite sales and cost data broken down.

To illustrate how this formula works, let’s suppose ABC Company generates $24 million in revenue, has fixed costs of $2 million and variable costs of $21.6 million. Here’s how those numbers fit into the breakeven formula:

Annual breakeven = $2 million / [1 – ($21.6 million / $24 million)] = $20 million

Monthly breakeven = $20 million / 12 = $1,666,667

As long as expenses stay within budget, the breakeven point will be reliable. In the example, variable expenses must remain at 90% of revenue and fixed expenses must stay at $2 million. If either of these variables changes, the breakeven point will change.

Lowering your breakeven

During the COVID-19 pandemic, distressed companies may have taken measures to reduce their breakeven points. One solution is to convert as many fixed costs into variable costs as possible. Another solution involves cost cutting measures, such as carrying less inventory and furloughing workers. You also might consider refinancing debt to take advantage of today’s low interest rates and renegotiating key contracts with lessors, insurance providers and suppliers. Contact us to help you work through the calculations and find a balance between variable and fixed costs that suits your company’s current needs.

© 2021

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Footnote disclosures: The story behind the numbers

The footnotes to your company’s financial statements give investors and lenders insight into account balances, accounting practices and potential risk factors — knowledge that’s vital to making well-informed business and investment decisions. Here are four important issues that you should cover in your footnote disclosures.

1. Unreported or contingent liabilities

A company’s balance sheet might not reflect all future obligations. Detailed footnotes may reveal, for example, a potentially damaging lawsuit, an IRS inquiry or an environmental claim.

Footnotes also spell out the details of loan terms, warranties, contingent liabilities and leases. Unscrupulous managers may attempt to downplay liabilities to avoid violating loan agreements or admitting financial problems to stakeholders.

2. Related-party transactions

Companies may employ friends and relatives — or give preferential treatment to, or receive it from, related parties. It’s important that footnotes disclose all related parties with whom the company and its management team conduct business.

For example, say, a dress boutique rents retail space from the owner’s uncle at below-market rents, saving roughly $120,000 each year. If the retailer doesn’t disclose that this favorable related-party deal exists, its lenders may mistakenly believe that the business is more profitable than it really is. When the owner’s uncle unexpectedly dies — and the owner’s cousin, who inherits the real estate, raises the rent — the retailer could fall on hard times and the stakeholders could be blindsided by the undisclosed related-party risk.

3. Accounting changes

Footnotes disclose the nature and justification for a change in accounting principle, as well as how that change affects the financial statements. Valid reasons exist to change an accounting method, such as a regulatory mandate. But dishonest managers also can use accounting changes in, say, depreciation or inventory reporting methods to manipulate financial results.

4. Significant events

Disclosures may forewarn stakeholders that a company recently lost a major customer or will be subject to stricter regulatory oversight in the coming year. Footnotes disclose significant events that could materially impact future earnings or impair business value. But dishonest managers may overlook or downplay significant events to preserve the company’s credit standing.

Too much, too little or just right?

In recent years, the Financial Accounting Standards Board has been eliminating and simplifying footnote disclosures. While disclosure “overload” can be burdensome, it’s important that companies don’t cut back too much. Transparency is key to effective corporate governance.

© 2021

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Cutoffs: What counts in 2020 vs. 2021

As year end approaches, it’s a good idea for calendar-year entities to review the guidelines for recognizing revenue and expenses. There are specific rules regarding accounting cutoffs under U.S. Generally Accepted Accounting Principles (GAAP). Strict observance of these rules is generally the safest game plan.

The basics

Companies that follow GAAP must use the accrual method of accounting, not the cash method. That means revenues and expenses must be matched to the periods in which they were earned or incurred. The end of the period serves as a “cutoff” for recognizing revenue and expenses. For a calendar-year business, the cutoff is December 31.

However, some companies may be tempted to play timing games to lower taxes or boost financial results. The temptation might be especially high in 2020, as many companies struggle during the COVID-19 pandemic.

Now or later

Test your understanding of the cutoff rules with these two hypothetical situations:

  1. As of December 31, a calendar-year, accrual-basis auto dealership has verbally negotiated a deal on an SUV. But the customer hasn’t yet signed all the paperwork. Should the sale be reported in 2020 or 2021?
  2. On December 30, a calendar-year, accrual-basis retailer pays its rent bill for January. Rent is due on the first day of the month. Can the store deduct the extra month’s rent in 2020 to help lower its tax bill?

In both examples, the transactions should be reported in 2021, not 2020. In the first example, even if the customer takes the car home for the weekend, it doesn’t matter; there’s still the possibility the customer could back out of the deal. The dealership can’t report the transaction in 2020 revenue until the customer has signed the paperwork and paid for the vehicle with cash or financing.

Audit procedures

If your financial statements are audited, your CPA will enforce strict cutoff rules — and likely reverse any items that were reported inaccurately. Audit procedures may include reviewing customer contracts and returns reported near year end. Auditors also may compare expenses as a percentage of revenues from period to period to identify timing errors. And they may vouch expenses to invoices and contracts for accuracy.

It never reflects favorably — in the eyes of investor or lenders — when auditors adjust year-end financial statements for inaccurate observation of cutoffs. Don’t give cause for others to wonder about your operations.

Timing is critical

Contact us if you need help understanding the rules on when to record revenue or expenses. We can help you comply with the rules and minimize financial statement adjustments during your audit.

© 2020

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Put your company’s financial statements to work for you

1. Benchmarking

Historical financial statements can be used to evaluate the company’s current performance vs. past performance or industry norms. A comprehensive benchmarking study includes the following elements:

Size. This is usually in terms of annual revenue, total assets or market share.

Growth. This shows how much the company’s size has changed from previous periods.

Liquidity. Working capital ratios help assess how easily assets can be converted into cash and whether current assets are sufficient to cover current liabilities.

Profitability. This section evaluates whether the business is making money from operations — before considering changes in working capital accounts, investments in capital expenditures and financing activities.

Turnover. Such ratios as total asset turnover (revenue divided by total assets) or inventory turnover (cost of sales divided by inventory) show how effectively the company manages its assets.

Leverage. This refers to how the company finances its operations — through debt or equity. Each has pros and cons.

No universal benchmarks apply to all types of businesses. So, it’s important to seek data sorted by industry, size and geographic location, if possible. To understand what’s normal for businesses like yours, consider such sources as trade journals, conventions or local roundtable meetings. Your accountant can also provide access to benchmarking studies they use during audits, reviews and consulting engagements.

2. Forecasting

Historical financial statements also may serve as the starting point for forecasting, which is a critical part of strategic planning. Comprehensive business plans include forecasted balance sheets, income statements and statements of cash flows.

Many items in your forecasts will be derived from revenue. For example, variable expenses and working capital accounts are often assumed to grow in tandem with revenue. Other items, such as rent and management salaries, are fixed over the short run. These items may need to increase in steps over the long run. For example, if a company is currently at (or near) full capacity, it may eventually need to expand its factory or purchase equipment to grow.

By tracking sources and uses of cash on the forecasted statement of cash flows, management can identify when cash shortfalls might happen and plan how to make up the difference. For example, the company might need to draw on its line of credit, lay off workers, reduce inventory levels or improve its collections. In turn, these changes will flow through to the company’s forecasted balance sheet.

For more information

Let’s take your financial statements to the next level! We can help you benchmark your company’s performance and create forecasts from your year-end financial statements.

© 2020