For small companies, emulating the practices of “the big guys” usually has value. There is a reason why the big guys have been successful and gotten big. But they should only be emulated to a point. They have resources that the small guys don’t and that needs to be considered.
Financial statements should be treated differently in big companies vs. small. Yes, in both you are going for predictability and understanding, but in small companies, they must be simpler and easier for the management team to understand. They must also cause focus.
In big companies, you have a finance staff to understand, explain, provide variance analysis and make sure people are watching. Despite some notable exceptions (Enron & WorldCom, for example) big companies are actually pretty good at this. Internal financial analysts spend their days understanding changes and variances and can report to senior management. They watch the income statement, balance sheet, statement of cash flows and understand how these three statements relate to each other.
Small companies are different; they have neither the staff nor the depth of understanding. Accordingly, their financial statements must provide more focus on key issues. Where big companies often use the balance sheet to smooth certain income statement trends, small companies should use the income statement to shine a light on period to period variances.
In big companies, there is a reserve booked each period for bad debt. Usually this is a percentage of sales and insulates any month from a large bad debt write-off. If managed properly, this is an appropriate practice. In a small company, this same practice takes the focus off the income and onto the balance sheet (which unfortunately, receives only minimal attention). While it helps match revenue and expenses, it also tends to obscure bad debt issues which management needs to understand so that they can manage credit and customer relationships. Before deciding how to treat an issue like this in your company, consider the management team and their understanding of the issue.
Another example I saw was a company that accrued legal expenses monthly (buried deeply in the SG&A line). The result was that they actually used the accrual account to put money onto the income statement when needed. They were managing results. Not only were they fooling the Board, but they were fooling themselves. They didn’t understand their own financial statements. I stopped this immediately. While I use this practice for predictable expenses (dividing the known cost of the annual audit by 12 is a good example), doing the same thing with an unpredictable item such as legal expenses hides the true cost from the income statement and makes a cost that is already difficult to control virtually impossible to control.
The bottom line is that financial statements are a tool. The CFO or Controller has to consider management’s expertise before making decisions about the best practice of looking at monthly statements with the goal of improving that understanding over time. Of course, at year end, GAAP (Generally Accepted Accounting Principles) prevails, and monthly statements should follow GAAP as closely as possible – but with an eye toward simplicity, transparency and understanding.
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