Many business owners have a false impression that financial statements are what their accounting software lists under “standard reports.” Others believe that their in-house bookkeeper can draw up perfectly acceptable financial statements on demand. Typically, these notions are dispelled when those business owners attempt to procure some significant financial leverage in the form of a loan or extended working capital for growth.
The moment a commercial lender sees that a business owner is trying to submit in-house standard bookkeeping software printouts for financial statements, and that these reports aren’t prepared by a CPA, the submission will more than likely be rejected.
In turn, the lender will ask the business owner to provide fully accrued and annotated financial statements that are compliant with Generally Accepted Accounting Principles (GAAP) and supported by schedules of work in progress, accounts receivable and payable, and a statement of cash flows.
Reasoning behind GAAP
All of this may sound like quite a bit of hassle to go through. But there’s good reasoning behind the strict stipulations of these external parties.
In the past couple of decades alone, several large organizations have collapsed because their financial statements hid the fact that no real assets existed and no real revenues were being earned. GAAP prevents this by requiring disclosures. The thorough nature of properly and objectively generated financial statements gives bankers, sureties, investors and others a solid understanding of:
- What’s being earned
- When and how earnings are being used to operate the business
- Whether earnings are being retained to grow and sustain the business or distributed to owners as compensation or return on invested capital
Financial statements also contain a notes section. These notes aren’t like footnotes in a book or a random list of assumptions. Rather, they’re disclosures required by GAAP to inform the reader:
- What type of company the business owner is running
- The precise nature of the core business
- How much revenue is generated from each customer type
- What accounting principles are followed
- How assets and liabilities are calculated
The purpose of GAAP is to create a uniform standard for financial reporting to allow investors and lenders the ability to easily evaluate companies simply by reviewing their financial statements. In addition, it helps to ensure that financial statements are not misleading and information is factual and not based on speculation. Financial statements should be prepared in accordance with GAAP unless a departure is warranted and disclosed.
Indeed, financial statements are intended to be seen by outside parties. But knowing what readers are looking for can help you — the business owner — understand whether your company’s financial performance will be judged favorably or if you’ll need to undertake additional efforts to improve that performance to gain favorable attention.
For example, most banks want to see a solid liquid cash position on the balance sheet. Yet some business owners invest their cash in fixed assets and leverage their own companies’ cash against future earnings growth. Maintaining a substantial cash reserve in a bank account, on the other hand, will put lenders more at ease and may soften their requests for extending lines of credit because the account shows them that the business owner values cash and understands its necessity.
Most banks also want to see positive cash flows. A cash flow statement prepared by a CPA clearly shows beginning cash and ending cash for each period, and what happened from the beginning of the period to the end to cause an increase (or decrease). This can be crucial in industries such as construction because revenues are so difficult to understand by financial statement readers who may be less experienced in revenue recognition models specific to this industry.
Many companies start out using simple paper invoices and relatively inexpensive bookkeeping software on their owners’ home computers. But times change and, one hopes, the business grows. If your company is looking to reach that next tier of success, GAAP-compliant financial statements will likely play a key role. Having your books kept per GAAP adds value to your business from a valuation perspective.
If you have any questions about the soundness of your financial statements, please contact Brandi DiGiorgio today.