Matters Column

Logically, a statement is only as good as its sources

June 17, 2016
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Sometimes a stupid joke can start you thinking.

A woman sees her neighbor looking around on the street. She asks him if he has lost something. He replies that he has lost his keys. She asks where he lost them and he says in the house. She asks him why, if he lost them in the house, is he looking in the street? He replies: “Because the light is better.”

What an idiot, right? Why would you look in a place you did not lose something just because the light was better? Because logic is not always applied to problems.

When I first started in accounting, the term subsidiary ledgers was used to designate the sources of entries for the general ledger.

The balances in the general ledger are the numbers that are used to do your financial statements.

You may believe all you need to know is the balance sheet and profit and loss (P&L) numbers, but you need to know and understand the source data that verifies the accuracy of the end product.

Back during the savings and loan crisis in the 1980s, it was recognized that you could show essentially accurate financial statements showing good results while teetering on the edge of bankruptcy.

Since that period, a cash flow or source and applications of funds statement is required along with the P&L and balance sheet. The cash flow statement tells the reader where the company’s cash comes from and where it goes. It tends to give a better understanding of the company’s true health by exhibiting how much of the company’s profit is tied up in accounts receivable and inventory.

The company may show a small profit or loss due to large depreciation and amortization expense while maintaining good cash flow. The company may show a good profit due to bloated receivable and inventory.

To truly understand your situation without looking in dark places like accounts receivable and inventory records is not really possible.

Here’s an example from back in the late 1960s. I was new to the world of public accounting both from the accounting side and the hierarchy side. I was working at a client whose owner asked me to dinner. We went to a really good restaurant. Part of the ensuing problem was my answering in the negative as to whether I had ever had a Manhattan. I liked ’em.

Over dinner, the man questioned how he could show a large profit and yet never have any cash. The Manhattans seemed to drastically increase my knowledge. I explained to him that his profit was tied up in inventory, and his used car inventory needed to be managed better. I also pointed out that interest was high, so the longer the vehicles stayed in inventory the less profit he made. Pretty good for a slightly inebriated staff accountant with limited experience.

The next morning the managing partner wanted to see me, and I could tell by the tone of his voice that he had an issue with the night before. He launched into an emotional explanation of why I was out of line. The client had called him at home in a rage about the firm’s fees and why a kid had answered a question he had been asking for years. I foolishly raised the defense that my answer was accurate.

Now comes why I was self-employed for 45 years. His answer to my defense was that you could not be sued for what you didn’t say. I felt he was in error, so I pointed out to him the Firestone family’s legal action against their CPA firm for not providing advice to the family on estate taxes. I thought he would appreciate my correcting him, but such was not the case.

There was a song about looking for love in all the wrong places, and that concept may apply to financial issues. If you’re looking for the true health of a company, you may have to do some grunt work in the dark fringes of the office. CPAs are important, but they can operate efficiently only in an atmosphere where the base data is correct.

To me, it seems that financial statements do not answer questions. They ask them. You can improve a process only if you understand how it works. If you show a profit but are tight for cash, the answer lies in an analysis of your inventory, accounts receivable, prepaid accounts, etc. If your profit margins are too small, you need to look at your pricing.

The financial statements tell you only what happened. They do not tell you why it happened. To be effective, you need to know the “what” and the “why.” You find that out by looking in dark places.

Paul Hense is the retired president of local accounting firm Hense & Associates and past chairman of the Small Business Association of Michigan.

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