It’s often said that facts don’t cease to exist just because you ignore them. In fact, ignoring them can be down-right dangerous.
It’s why all businesses, including rapid-growth startups and emerging companies, need a sound and effective financial reporting system. Access to accurate, reliable and timely financial and operational information is vital to their success.
Your company’s owners and management require accurate financial information to make informed decisions, leveraging opportunities and avoid pitfalls. And your investors and lenders expect it — on a regular basis.
So, what are the essential elements of an effective financial reporting system and how do you approach creating one?
If you’re like most early stage companies, your focus tends to be on things like finishing or refining your product or service, raising money and attracting customers. Developing a system for financial reporting probably isn’t near the top of the list. It may not even make the list. But it should.
Your financial reporting system provides the basis for sound decision-making and ensures the quality and timeliness of the information it generates. It can reduce the chances of various kinds of fraud.
There are three essential steps for creating an effective financial reporting system, as follows:
1. Establish internal controls.
2. Adopt an appropriate financial reporting framework, such as cash basis, income tax basis, or generally accepted accounting principals (GAAP).
3. Ask questions.
Establish Internal Controls
Internal controls are the formal policies and procedures that govern your financial reporting processes. As a startup or young company, you ignore internal controls at your own peril.
Following are a few of the many best practices for a startup’s internal controls:
Segregation of Duties – Ensure that no one person in your company handles more than one type of function in a business process. For example, the employee who is assigned to collect payments from customers, order inventory, or pay vendors, should not also be responsible for recording these transactions in the accounting system.
Approval Authority – Require that a manager or other authorized employee sign off on certain types of transactions, such as large purchase orders or cash disbursements.
Account Reconciliations – Reconcile all major balance sheet accounts on a monthly basis and designate an employee with the necessary authority and accounting experience to review the reconciliations for completeness and accuracy.
Establishing effective internal controls, such as those above, helps prevent fraudulent activity and ensure the completeness, accuracy and timeliness of financial information. All are essential for raising capital and making strategic operational decisions.
Consider creating a process map for each major transaction cycle. This exercise will help confirm your understanding of the process and assist you in identifying any weaknesses or inefficiencies.
If you don’t have the resources to maintain effective internal controls, you have an option. You can outsource some or all of your accounting processes — which has the added benefit of allowing you to focus on your core competencies.
Adopt an Appropriate Financial Reporting Framework
If you intend to raise capital or sell your business in the future, it is imperative that you maintain your accounting records in accordance with an appropriate financial reporting framework. Although cash basis and income tax basis frameworks are acceptable, GAAP (generally accepted accounting principles) is more widely used and accepted in the banking and investor communities.
Most banks and investors won’t even consider a deal unless you can provide current and historical GAAP financial statements. As such, it’s critical to adopt GAAP and establish formal accounting policies sooner rather than later. Financial records that aren’t properly maintained on a GAAP basis can require significant costs to correct in the future.
As a profession, accountants and auditors are required to maintain a degree of skepticism — an attitude that consists of asking questions, critically examining available evidence and remaining alert to conditions that may indicate errors or fraudulent activity.
You should evaluate your financial information regularly with this same mindset. Following are a few best practices:
Track budget vs. actual results. It is important to be able to explain variances and understand the correlations between account balances and the drivers behind any significant changes from prior periods. This analysis helps you make more informed operational decisions and assists in detecting any material misstatements in the financial statements.
Challenge the reasonableness of all major estimate accounts, such as allowance for doubtful accounts, allowances for discounts and sales returns, warranty reserves and inventory allowances, to name a few. Given their subjectivity, these accounts are often susceptible to material misstatement. Tracking actual activity related to key estimates and consulting with operations personnel in these areas (e.g. sales, collections, and inventory management) will help you develop more precise estimates.
If you have multiple product lines, ensure that sales and the associated cost of sales accounts are tracked by product or service line and analyzed on a monthly basis. It is also important to understand which costs roll up into cost of sales, as well as how discounts and rebates are accounted for. Improper accounting for these items can significantly impact pricing and mislead users of the financial statements.
Finally, meet with your CPA periodically, not just at year end. Discuss any accounting issues and operational plans that could materially impact your business, so they stay current and can be proactive in giving advice.
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