When a business relies on financial reporting for vital decision-making, it can be extremely concerning to learn that these financial reports are incorrect. Here are the three most common reasons for misleading financial reports.
Our virtual CFOs have worked with numerous small and medium sized businesses over many years. Without exception the first few months tend to always the same. When we review their financial reports at the end of each month, it’s very common to find that their financial results are inconsistent.
So we ask a range of questions about how their business is handling a number of basic accounting requirements. In most cases, we find that the inconsistent results are an outcome caused by incorrect accounting treatments.
How big an issue is this? It is a huge issue. All too often we hear business owners say “well, we invoiced that job last month so that has affected the result” or “we had three pay fortnights this month” or “our insurances all fell due in the month” or some other reason…
The reality is that larger businesses are generally all over these issues. They want to KNOW exactly how they performed during the latest period. They are constantly watching for signs of deterioration in any of their key business metrics. They want to understand what’s actually happening as early as possible, because only then can they address the problem effectively and in a timely manner.
There are many issues that contribute to such misleading monthly reporting. Here we have identified the three biggest issues that we see commonly in small and medium sized businesses to help you identify if your business is suffering from these financial reporting issues.
REASON 1: Revenue Is Incorrect
Businesses should recognise revenue when they earn it. This can be very different to when they invoice the customer. If your business takes deposits, they should be allocated to an unearned income account (balance sheet liability account). This amount should only be included in revenue when the goods or services have been provided to the customer. This however often works in the reverse fashion as well. Particularly in the case of service businesses where projects or “jobs” have been commenced but not completed, businesses may not have invoiced those customers for the work completed to date (work in progress).
REASON 2: Cost of Sales Are Incorrect
Cost of Sales need to be recognised in line with when revenues are recognised (known as the matching principle). Whether you’re a supplier of finished goods or services or a manufacturer, this problem will always be there. Inventory management is a critical requirement for accurate costs of sale measures. Work in progress valuations are also critical to achieving accurate cost of sales measures.
Another major difficulty here is achieving meaningful direct labour costs in your business. Most businesses have staff members that work both at an operations level and in an administrative or supervisory role. This also often results in incorrect cost of sales measures.
REASON 3: Remuneration Expenses Are Incorrect
Believe it or not, many small businesses are actually more labour intensive than larger business (a profitable return on investment in automating processes often requires high volumes). This means that achieving an accurate measurement of remuneration costs is even more important in small and medium sized businesses than in large businesses.
The 4/5 weekly pays or 2/3 fortnightly pays per calendar month are a major cause of inaccurate reporting. To ensure your business has accurate records of this cost it is important to ensure that you take up accruals for unpaid remuneration. Alternatively, businesses can move to a 4-4-5 accounting period approach thereby synchronising weekly pay periods with accounting periods.
Employee entitlements also need to be accounted for when they are earned. These entitlements are earned when employees are working ordinary hours (not when they are on annual leave). The costs of entitlements earned need to be taken up at the end of each reporting period. January is often a time when this shows up as a big issue as normally there are high levels of annual leave taken at this time. Conversely there are also reduced revenues or higher remuneration costs (casuals, contractors or labour hire) at this time for those businesses. This will often lead to a very misleading result for January.
The good news for small and medium sized businesses is that they can now address this in a very cost-effective manner. By bringing in your own virtual CFO, all these issues can be solved. The outcome will be that you will have reliable monthly reporting from which you can gain a reliable and accurate understanding of how each part of your business is actually performing. This will enable you to address any performance issues as they arise rather than letting things get worse before you start to fix them.
If you would like to speak with us further in regards to this important topic area please get in touch at our Contact Page!