The second most important external user of a company’s financial statements is a bank (or other debt or equity institution). The financial institution will dictate the report needed. Copies of tax returns and company-prepared financial statements may be all that is required. On the other hand, the financial institution may require a higher level of assurance by requesting that an independent accounting firm either compiles, reviews, or audits the company’s financial statements.

In this case, the company might want to know what is required and the difference between these types of reports. Accounting policies and procedures for financial reporting would help. First of all, only Certified Public Accountants¹ (CPAs) who meet a higher peer review level and other reporting standards can issue these statements. A public accountant (PA), tax practitioner, or an accountant who is not a licensed CPA cannot issue such statements. Fully-licensed CPAs must keep their licenses current, with continuing education and documented peer review, to be able to issue opinions on these reports.

Compilation

A business owner will need to find a CPA with the necessary credentials to request a compilation, review, or audit.  The least expensive report, and one that should satisfy most banks for small and mid-sized business, is a compilation.  Essentially, the CPA reviews the financial statements prepared by the company and attaches an accountant’s report to it.  No further investigation is performed.

Interestingly, the standard compilation report issued by a CPA is nothing more than a glorified disclaimer, stating that the CPA is providing no financial statement assurance.  The AICPA defines a compilation as “a service where the accountant presents, in the form of financial statements, information that is the representation of the company’s management and owners without undertaking to express assurance on the financial statements.”

Review

A review involves essentially the same process as a compilation, except that the auditor does perform certain analytical reviews — reviewing account balances for reasonableness and questioning management about material modifications that might be made in order for the statements to be in conformity with GAAP².  In a review report, the CPA expresses a “limited assurance” — not an opinion — of the reasonableness of the financial statements and their conformity to a comprehensive basis of accounting, like GAAP, cash basis, or income tax basis reporting.

Audit

A financial audit provides the highest level of financial statement assurance.  An audit normally takes considerably more time than either a compilation or a review.  The audit work, itself, can fill several large binders of documentation for a small-to-medium-size business.

Every balance sheet account is proven, within the limits of materiality³. Direct confirmations of account balances are mailed from the CPA to banks, customers, vendors, and other debt holders to validate the balances of cash, accounts receivable, accounts payable, and other assets and liabilities.  If inventory is material, the CPA must observe the inventory counting as of the report date.  The CPA also tests the accounting procedures and internal controls, including computer controls.  All transactions are subject to audit under a statistical sampling formula.

A surprisingly large amount of time is spent in non-financial areas to determine any claims, lawsuits, contingencies, or other events that could harm the company. Incorporation and other organizational papers are reviewed; all leases, loan documents and other contracts are reviewed; and all minutes and other relevant correspondence are read.  The CPA also sends letters to all attorneys asking for full disclosure on any relevant matter.

The AICPA defines an audit as an engagement where a CPA provides an opinion about the fairness of a financial statement presentation in accordance with a comprehensive basis of accounting, such as GAAP, cash basis, or income tax basis.  This is a fairly simple statement for what can easily involve weeks of work for even a relatively well-structured small business.

It’s important to recognize the relative costs of these three types of reports.  If the cost of an audit is $12,000, a review for the same business might average $4,000, and a compilation, $3,000.  Relative to an audit, a review and compilation are considerably less expensive.  However, the difference in cost between a review and compilation is not nearly as great.  This is important to remember if faced with a requirement from a lender or investor.  If they request an audit, you might try to convince them that a review is adequate and certainly provides more assurance than a compilation.  This could save you considerable expense.

SEC – Audit

For publicly-held companies, an audit is the minimum level of assurance required.  In addition to the audit, there are other SEC reporting requirements, depending on the size of the business.  A full explanation of these SEC reports is beyond the scope of this article.

Internal Reports

Much emphasis has been given to financial statement reports — the balance sheet, income statement, and the statement of cash flows.  These three are the most important reports on the overall financial condition of the company over a given period of time.  A primary objective in developing policies and procedures over the accounting function is to improve the timeliness, accuracy and completeness of these statements.

A company’s accounting or information system can provide much more than those three statements, however.  Management should be encouraged to use the data available in the accounting system for other uses.  Financial statements are extremely useful; however, they only provide current valuation, and transactional information from the past.

A statement of cash flow, reconciling the sources and uses of cash, can be a useful starting point for extrapolating data that projects the anticipated sources and uses of cash needed into the future.  By analyzing changes in aging of accounts receivable and accounts payable, you can develop more reliable estimates and better anticipate future cash receipts and future cash payments.

The relationship between sales, inventory levels, and related costs of sales can be used to determine the anticipated needs for additional inventory related to projected sales.  Using the data captured by the accounting system every day, a projected cash flow report, updated daily, can be a powerful tool to alert management in enough time to properly react to anticipated additional working capital requirements.

With a powerful forward-looking cash management tool, like the described projected cash flow report, the projected activity levels in future months can be used to create budgets in the current and succeeding months.

With income statement projections, projected cash flow reports, and budgets, we have a truly interactive management information system.  Data collected from the past is used to project the future, fed back into the budgets, which control the present and determine the future.  This creates a continually updated management information loop.  This provides a business with the tools to act, not just react.

SUMMARY

We hope this introduction to your Bizmanualz™ Accounting Policies and Procedures manual will increase your appreciation of the importance of establishing effective accounting procedures.  Your business is a continuously flowing stream of transactions.  Like a sturdy, well-maintained net cast across a stream, effective accounting policies and procedures help trap data completely and accurately. Once collected, the real benefit is utilizing the data to provide the information needed to review the past, position the present, and chart the future.

NOTES

¹The “chartered accountant” designation is more common outside the USA.
²A number of accounting authorities, like the AICPA and the IASB, are currently working on convergence of GAAP with IFRS (international financial reporting standards).
³Information is material if its omission or misstatement could influence economic decisions made on the basis of the financial statements. Materiality depends, in part, on the size of the item or error, evaluated in light of the circumstances of its omission or misstatement.

Accrual Method

The accrual accounting method is defined as the method of keeping accounts which shows expenses incurred and income earned for a given period, although such expenses and income may not have been actually paid or received in cash.  Hence, the financial statements show revenues and expenses, even before any such revenues or expenses are paid.

The accrual method is the more acceptable and the more widely used because it correctly matches the earning process to the activity.  In other words, revenue is recorded when services or goods are rendered or shipped, regardless of when paid.

Cash Method

The cash method of accounting is familiar to most individuals since personal income tax returns are filed on the cash basis.  As the name implies, revenues and expenses are only recorded when the consideration paid actually changes hands.  This could be months after the actual event occurred.

Many small business owners prefer the cash basis due to its simplicity and ease of understanding.  At the end of any given period, the recorded net income will agree more closely to the change in the business’s cash balance.  However, when requesting financing from any bank or agency, business owners are generally asked to furnish financial statements, prepared on the accrual basis.  Clearly any “stakeholders” want to see the true effect on the financial statements of activities, as they occur, as opposed to when they are paid.

Many small businesses (under $1,000,000 in sales) may use the cash basis method for filing business tax returns, even if the business keeps its books on the accrual basis.  In a growing business, income taxes can be deferred for a year for revenues recorded from increases in accounts receivables.

Percentage of Completion Method

The percentage of completion method is a variant of the accrual method, used for businesses with long term contracts, primarily construction contractors.  Instead of valuing revenues based on services invoiced, contractors will adjust the revenue billed to agree with the estimated percentage of the total contract that has been completed to date.

Reporting Standards

Many transactions are entered routinely through the accounting system without much concern about reporting standards.  However, other transactions can be handled in different ways depending on a person’s judgment over the facts and circumstances.  For example, if a business decides to lease an expensive piece of machinery, how should it record lease payments?  Perhaps they should be simply charged to lease expense.   Do you have a lease policy procedure? Your accounting policies should clearly state how to record leases.

However, maybe the terms of the lease imply an obligation and the payments represent a pay-off of that obligation.  In that case, a portion of the payment should be applied to the debt and the other portion charged to interest expense.

The resulting financial statements would look different in those two cases.  The usefulness of financial statements would be severely limited if their presentation was based solely upon the preparer’s judgment.  Consequently, certain standards must be agreed upon and followed.

GAAP – Generally Accepted Accounting Principles

There was no commonly agreed upon standardization over accounting practices for within past accounting systems until after the great depression of 1933.  In response to the vast sums lost by investors in the stock market crash, the Securities and Exchange Commission (SEC) was established and given authority to set accounting standards for publicly held corporations.

In an effort to stave off further government regulation, the accounting profession, organized under the American Institute of Certified Public Accountants (AICPA), issued its first auditing standards in 1939.  This began its attempt at self-regulation, though the AICPA continues to work with the SEC and defers to the SEC on regulatory reporting requirements for publicly held companies.

Between then and 1959 the AICPA issued 51 authoritative pronouncements known as Accounting Research Bulletins (ARB) that formed the basis of what became known as generally accepted accounting principles (GAAP).  From 1959 to 1973 the Accounting Principles Board (APB) issued 31 additional standards.

In 1973 a new full-time independent body, separate from the AICPA was created, called the Financial Accounting Standards Board (FASB).  This board has issued over 147 Statements of Standards by the end of 2002.  These standards, along with official interpretations, Accounting Research Bulletins (ARB), previously issued pronouncements, SEC rulings, industry guides, and other exposure drafts make up the current basket of generally accepted accounting principles.

The Matching Principle

Woven through all of the GAAP pronouncements are several universal principles.  One is the concept of matching.  Accrual and percentage of completion methods represent attempts to more properly match the financial statement presentation to the actual transactions that have occurred.  Revenues are matched to services performed and product sold, and expenses are matched to activities that have incurred expenses.  This is why accrual based reporting conforms to GAAP and cash based reporting does not.  The matching principle is a keystone of generally accepted accounting practice.

Conformity

Conformity is another widely used concept in accounting.  The method of implementing percentage of completion, for example, should be the same for all companies.  Only by practicing conformity will there be comparability.  Investors, lenders and business owners, could not properly evaluate the success of a particular business as compared to the rest of its industry, if all businesses used different methods for recording transactions.  Conformity is another fundamental principle in GAAP.

Valuation

A common consensus in GAAP reporting is the agreement that financial statements are valued on an historical basis.  This is an important concept that provides for consistent conformity.  As an example, real estate is valued at its original cost, not what it might be worth on an appraised value.

Accounting board pronouncements have continued to modify this principle to make financial reports even more conservative than historical basis, by requiring a downward adjustment, if the potential selling value has fallen below the original cost.

An example is inventory, when obsolescence reduces its value below its original cost. Another example is the yearly devaluing of fixed assets through depreciation.  Each year the original cost of a building or equipment is lowered by writing off a portion of its expected life and expensing it to depreciation.  Other assets like accounts receivable are reviewed and written down to their expected realizable value by charging off any amount deemed uncollectible to bad debt expense.

The overall attempt is to present financial statements on the most conservative basis possible.  The objective is to ensure that the net worth recorded on a company’s financial statements is never more than the true value of a company, based upon the lower of historical cost or the expected realized selling price of its assets minus its liabilities.

Events in the early years of the 2000′s have shown how important this objective is.  In spite of all the GAAP pronouncements in place, “creative accounting” techniques that push the gray areas of accounting valuation issues have resulted in significant, previously undisclosed impairments to the financial statements of companies like Tyco, Enron, and WorldCom.

Inventory Valuation

Inventory valuation is a specially treated area that deserves specific mention.  Inventory is always valued at the lower or cost or market (realizable value, net of selling costs).  However, cost can be determined in three different ways.

First In – First Out (FIFO) values the cost of inventory based on the principle that the first item purchased is the first item to be sold.  Visually, this method mimics a store owner’s method of stocking shelves by putting its most recent purchases at the back of the shelf, so that the older product is sold first.  Hence, the value of the amount of inventory on hand, always represents the cost of the very latest purchases.  In a true FIFO valuation, each purchase is tracked as a separate layer with its own cost.  Sales are also tracked and taken from one or more specific layers.

A variant on the FIFO method is the Average Cost FIFO method, which eliminates the need to keep track of separate purchasing layers.  The cost of each new purchase is added to the “pool” which changes the overall cost of the “pool”.  Sales are then taken from this single “pool”, leaving a value of the inventory on hand that closely resembles, but not necessarily equals, the value of inventory on a true FIFO method.

A final method of valuation is based on Last In – First Out (LIFO).  This is the opposite of FIFO: the last items purchased are deemed to be the first items sold.  This means that the ending inventory value is comprised of the very first items purchased.  This value could be lower than the FIFO value, particularly in inflationary times.

One might ask how two opposing methods of valuation could both be allowed under GAAP, particularly, when this would seem to violate the important principle of conformity.  This is one of many good examples of the challenge to create a consensus of opinion when there are several options, which have equal justification and support.  Accounting principles are not static laws handed down from the mountaintop, hence the term, “generally accepted”.

In this case, there is current justification and support for either method.  In deference to conformity, GAAP provides that financial statements valuing inventory on LIFO are to include a footnote reference, which discloses the valuation difference between LIFO and FIFO.  This is one of many compromises that provide conformity over different methods of valuation.

Materiality

A final important concept in all of GAAP is materiality.  Surprisingly, coming from a group of professionals known for their penchant for chasing down pennies, every pronouncement contains a materiality clause that allows for non-compliance in any area, if the effect on the financial statement presentation is clearly immaterial.  In other words, if the effect is minimal or does not represent a significant change in the financial position of the account then it might be considered immaterial.

Balance sheet

Contains accounts whose value is determined at a specific point in time.

Assets – accounts with value that you own

• Cash – the amount on hand or in the bank at a specific point in time
• Accounts Receivable – how much people owe you
• Inventory – the value of business merchandise for sale
• Fixed Assets – the value of property and equipment

Liabilities – accounts with value that you owe to others

• Accounts Payable – how much you owe others for unpaid purchases
• Debt – how much you owe others for money borrowed
• Other Liabilities – services or money owed to others

Equity – accounts with paid in capital or earned from profits.

• Contributed Capital – money invested in business by ownership
• Distributions – dividends and other types of money paid out to ownership
• Capital Stock -            money invested in exchange for company ownership
• Retained Earnings – earnings retained in business from net profits

Income Statement

This statement contains accounts whose value is determined over a period of time (e.g., day, week).

Income: total sales and income recorded over a period time

Expenses: total purchases and other expenses recorded over a period of time

Basic Accounting Formula

All transactions are posted to one or more of these accounts.  As discussed earlier, every posted transaction must balance.  That is, debits must equal credits.  Furthermore, the result of every posting, if done correctly, will never put the Basic Accounting Formula out of balance.  Asset accounts will always equal the total of all liability and owner equity accounts.  If this formula is ever out of balance, the cause will always be an incorrect transaction posting where debits did not equal credits.

Assets include those accounts, which give value to the company: cash, accounts receivable, inventory, property, etc.  Liabilities are those accounts which reduce the company’s value:  accounts payable, debt, and other liabilities.  If total assets are greater than liabilities, then this net value (that is, the total of all assets minus liabilities) represents the true value of the business, otherwise known as its Equity. Hence, the Basic Accounting Formula can be expressed and equally understood in these two ways:

Assets = Liabilities + Equity

or

Equity = Assets – Liabilities

If the company’s assets are less than its liabilities, then it will necessarily show a negative equity.  This makes intuitive sense to anyone following the demise of a business in bankruptcy.  When a business owes more than it has in value, the resulting negative equity is an obvious warning sign.

The equity accounts include owner’s contributions, distributions, and retained earnings.  Retained earnings operate in a manner unique to all other accounts.  It contains the net effect of postings to all income and expense accounts.  It is truly the one account, which links the balance sheet accounts (assets, liabilities and owner’s equity) with the income and expense accounts.

Understanding the importance of retained earnings, the Basic Accounting Equation could be expanded thus:

ASSETS  =  LIABILITIES  + (Investor and owner contributions, and distributions + Retained Earnings)

OR

ASSETS  =  LIABILITIES  +  (OWNER’S EQUITY ACCOUNTS +  INCOME – EXPENSE)

———————EQUITY ———————————

When a transaction, like writing a check or paying a bill, is executed in an accounting program, the software is designed to take this transaction event and create the proper and necessary debit and credit entries to record the effects of the transaction in the appropriate journals and general ledger accounts.  Your accounting policies and procedures should help you acheive accounting control.

When you deliver goods or services and you extend a business customer credit by accepting a promise to pay later through an invoice, then in a sense you are loaning your customers cash.  What steps can you take to make sure you get your cash back?  If you use good cash management practices to protect yourself from your employees and co-workers, then shouldn’t you be taking the same precautions with those outside your business?

Your Credit Policies Are a Part of Proper Cash Management

Of course, we are talking about a proper credit policy for clearly establishing the process of determining who can receive credit (can “promise” to pay later) and how much credit they are allowed.  Since determining credit may not always be a straightforward matter, a credit manual that includes credit policies and credit procedures, as well as clear explanations of the strategy or intent behind the policy, can be very useful.  Communicating the purpose behind credit policies can be a great help to those making the credit decisions.

Clearly communicating information about the how the company wants to extend credit is one important goal of your credit manual, credit policy and procedures.  Another important goal is to create consistency in how you handle and extend your business customer credit, both internally and externally.  But most importantly, your credit policy is about risk reduction.  It should be created in advance and take into account such things as its effect on sales, the impact on the company’s cash flow, and legal liability.

A Credit Manual Communicates Credit Policy and Intent

Internally, the credit manual can be an instrument to get various departments on the same page when it comes to customer credit.  For example, the accounts receivable department and the sales department are frequently at odds regarding what the credit policy should be.  Accounts receivable wants tight credit so they can collect within the proper period and not deal with delinquent accounts.  Sales, obviously, wants to book sales and they are not prone to turning away customers.  It is management’s job to establish clear credit policies and clear credit procedures, as well as explain the reasoning, in order to minimize the inherent conflict created by varied interests of these two departments.

Although it is frequently overlooked, part of the credit process should be regular communication between the various departments involved with using the credit policy manual.  Imagine the synergy created when accounts receivable, collections, sales and marketing, and even design and production all agree and cooperate in managing business customer credit.   The sales department knows and agrees not to waste its efforts on customers who don’t pay, and those making credit decisions know and agree when exceptions need to be made.

A Clear Credit Policy Helps Extend Credit Wisely

Besides establishing consistency internally, the credit manual can also ensure consistent and fair treatment for external customers.  The ability to extend short term credit is an important business tool, and if customers feel they are being treated unfairly or without a modicum of trust or respect – it can mean lost business.  When it comes to completing credit applications, references and credit checks, a certain level of consistency is expected, and this is especially true for making credit decisions.  The name or size of the company should not be a major factor in deciding who gets credit.

For example, I recently worked with training at a large construction company, and one of their regular customers was somewhat of a celebrity businessman.  Apparently, as a matter of practice, this well-known businessman delayed payment of owed invoices until they fell into collections, and then he would attempt to negotiate to a lesser settlement amount.  Eventually, however, the construction company had to tell their customer “you’re fired.”  By the time they considered the delay, the collection efforts, and the reduced payment, they were lucky to break even.

Apparently, this person relied on people wanting to do business with him because of his celebrity status.  You can’t, however, put a customer’s well-known name or brand in the bank to cover your payroll and your own accounts payable.  Your company is better off finding lesser known customers who pay their bills.  Consistent and fair company credit policies can help make sure that happens.

Cash Controls Include Company Credit Policy

Your credit manual and credit policies and procedures are directly related to protecting your cash, and you should understand that component as you develop and update them.  But just as critical as development of the credit manual is how clearly you communicate your policies and procedures clearly to all affected parties in your organization.  Poor credit practice is tantamount to leaving you cash drawer open… maybe no one will take advantage of your carelessness, but why take that chance?