Assessing Your Financial Infromation — October 2015

This topic involves financial reporting.

Dynamic small businesses frequently encounter the need for additional capital to fund their growth opportunities. Providers of capital, be they lenders or investors, will require detailed financial statements to help them determine how much they will lend or invest. It is up to the CFO to make sure that the information is accurate and does not show signs of manipulation that causes astute lenders and investors to be wary.

There are a myriad of ways financial data can be manipulated. Accordingly, the CFO must establish parameters to identify potential problems, devise detailed investigatory procedures, and establish a robust reconciliation process.

We classify the signs of manipulation into three groups: earnings manipulation; cash flow manipulation; and manipulation of key operating metrics. The CFO must look for signs of such manipulation and take steps to assure herself/himself that there has been no manipulation. Then, convince lenders and investors of the same.

Earnings manipulation can take several forms. One is recording revenue too soon. This can be done by recording revenue before the relevant work on a contract is completed. Another means is to record a sale before the customer’s final acceptance of a product. Such manipulation is often indicated by material increases or decreases in monthly or quarterly sales. These fluctuations require investigation by the CFO as soon as they are identified as falling outside established parameters.

Another method of earnings manipulation is boosting income with one time events or unsustainable activities. Examples include incorporating asset sales with product sales or classifying an operating expense as a non-operating expense. Such activities can be indicated by sudden jumps in revenue or income as well as sudden decreases in operating expenses. To detect problems the CFO should set parameters under which these events should be investigated. In addition, the CFO should have controls in place that flag misclassified expenses and segregate asset sale gains from ordinary revenue.

A third method of earnings manipulation involves shifting current expenses into a later period. Examples include capitalizing non operating expenses as assets and failing to record an expense for uncollectible accounts. These problems can be detected by observing lower than normal operating expense ratios and higher than expected increases in fixed assets. To avoid such situations the CFO should reconcile large expenditures to capital spending classifications and investigate discrepancies. In addition the CFO should review trends in accounts receivable aging reports.

Finally, earnings manipulation can be done by shifting future expenses to an earlier period. This can be done by improperly writing of an asset to avoid expenses in a future period. This action is indicated by fluctuating expense growth or a sudden spike in monthly or quarterly expenses. To avoid these situations the CFO should authorize all material write offs and investigate material expense fluctuations when they fall outside established parameters.

Two common forms of cash flow manipulation include: shifting financing cash flows to inflows of operating cash and shifting normal operating cash outflows to investing cash outflows. Each method makes operations appear to be better than reality would indicate. To prevent or correct these actions, the CFO should have daily or weekly reports that provide the details of all cash inflows and outflows. The reports should also indicate the accounting treatment for the cash inflows and outflows.

Shifting financing cash inflows to operating cash inflows can be done by recording bank borrowings as cash generated by product sales or fictitious receivables sales. These activities are indicated by fluctuations from historical patterns in the cash flow statements or material decreases in accounts receivable balances. The CFO must reconcile bank statement information to the cash flow statement and investigate the reason behind major declines the accounts receivable.

Another means of cash flow manipulation is shifting operating cash outflows to investing cash flow outflows. It can be done by improper capitalization of normal operating costs or recording inventory purchases as investments in fixed assets. Key indicators are abnormal variations in related accounts such as PP&E or metrics like inventory turnover. It is important that the CFO reconcile inventory balances to the cash flow statement and investigate material increase in fixed asset balances that fall outside established parameters.

Two common methods of manipulation of operating metrics include: emphasizing metrics that overstate performance; and an undue focus on balance sheet metrics to avoid showing deterioration in company performance. To reduce the risks of such occurrences, the CFO must understand which metrics lenders and investors care about; calculate the metrics with a constant methodology; and display each metric in each relevant time period in the financial package submitted to lenders and investors.

Emphasis on misleading metrics that overstate performance can include using misleading metrics as surrogates for revenue, earnings, or cash flow performance Common means of accomplishing this are focus on indicators like website hits, number of new customers, or profit per customer. The CFO must make sure that the calculations are consistent and demonstrate how the metric correlates with revenue, earnings, or cash flow. If there is a weak correlation, do not use the metric.

An undue focus on balance sheet metrics to avoid showing performance deterioration can be accomplished by highlighting accounts receivable metrics to hide revenue problem. This can be done by focusing on superior receivables turnover or growth in the number of receivables. Another way is to call attention to inventory metrics to hide profitability problems. Means of doing so include a sole focus on new product sales or superior inventory turnover performance. Again, the CFO must ensure that the calculations are consistent and demonstrate how the metric correlates with sales, earnings, or cash flow. If the correlation is weak, drop the metric.

Dynamic small businesses frequently encounter the need for more capital to fund their growth opportunities. Providers of capital, be they lenders or investors, will require detailed financial statements to help them determine how much they want to lend or invest. It is up to the CFO to make sure that the information is accurate and does not show signs of manipulation that causes astute lenders and investors to be wary.

Capitol CFO Solutions serves clients in Washington, DC, Maryland, and Virginia. Please contact us for a free consultation.