Accounting is called the language of business and that’s not bad, because it helps you communicate with financial people and business people. In a family law case, accounting knowledge helps you (or your attorney, CPA or financial expert) ask the right questions to protect your legal rights. Formulating the question so that you get to what you actually need to know is sometimes the hardest part of analyzing financial statements. This following is not for someone who is easily overwhelmed by financials. I will be the first to tell you that it is perfectly fine to get an expert to do this for you. But if you are curious and want to be involved in analyzing financials and deciding how to find the right experts, read on.
The following are FACTORS to consider in analyzing a financial statement or the value and profitability of a company.
THE ADVERSARIAL NATURE OF BUSINESS REPORTING: The interests of husband and wife, in a divorce for example, may be at odds when analyzing the financials of a company. The same company that touts its strength and profitability as part of a loan application may be presented as being on the brink of bankruptcy in divorce. In the first case, financial health and viability are desired in order to convince the lender that they are worth a risk and can repay a loan. In the second case, the owner of a small business may simply want to minimize value in order to avoid sharing so much of its value with another payment.
You may want to hire an expert or agree on one to valuate a company. If you don’t, you are relying on the judgment of the person who put it together. If that person is the opposing party, you want to go through the statements and make sure it is fair to you. A lawyer can help you do this.
THE SIZE AND NATURE OF THE COMPANY: A public company is going to have more information, including public information, whereas a small private family business will have less. More digging is necessary, and regular audits are not going to happen, nor should they in many instances, as they are very expensive and time consuming. But a small company may have the occasional audit to get a loan because companies with an audit usually get a better rate. There may be something in the loan covenant that could hurt the terms of their debt: an incentive not to make the company “look worse.” You should review these documents.
ACCOUNTING METHODOLOGY: GAAP means “generally accepted accounting principles,” and that is the standard for what goes into financials. There has been an attempt to use IFRS “international financial reporting standards” and to merge GAAP into this international standard due to the increasingly international nature of business. Nonprofits use different terminology. They do not use terms like “equity” and “profit.” Governmental accounting has another set: one body for state and another for federal. Generally, it is a different process and is there for different purposes.
FASB — financial accounting standards board (called “FAS-bee”) — sets standards for determining the profitability of a company. It generates the accounting standards and updates and interprets things. The American Institute of CPAs (certified public accountants) will weigh in on FASB standards called ASC — accounting standards codification. These standards are not exact. They require interpretation. Estimates are required. Judgment is employed. Different accounting methods lead to different results. Three different experts could have three different results regarding one company, yet all be correct under various accounting principles.
Smaller businesses do not always comply with GAAP in their financials. It can be cumbersome and expensive for them to do so. This is not necessarily bad. What matters though is knowing what departures were made and why. Someday there may be separate standards for small private companies. Not yet though. A Special Purpose Framework (meaning not GAAP) is used to analyze.
Here are some Special Purpose Frameworks that may be used instead of GAAP:
- TAX BASIS: Often, you WILL have a tax return as part of disclosures, so that gives easier access to data. Also, judges have a tendency to make conclusions based on tax returns so you could be talking to the decision-maker in his or her language of comfort. The problems: you do NOT want to look at taxable income for the year and make a final decision about the profitability of the company. Tax analytics are for completely different purposes than GAAP and other Special Purpose Frameworks. They may have incentives and political agendas that have nothing to do with profitability. A tax year may be random and unrelated to factors outside that small window such as cash reserves and accrued debt. The IRS is NOT looking at ongoing profitability or cash flow. So this limits the purpose. You may need an accountant, lawyer or other financial expert to make this point in your case.
- MODIFIED CASH BASIS: This is extremely common. For example, most law firms use this. The concept is easy. Follow the cash in and cash out and “account” for it WHEN it happens. Records can be as simple as a set of check stubs. But there are financial tasks that are NOT reflected on a cash basis accounting. For example, we may have a $10,000 invoice that is not yet paid. We do not have cash but we have receivables. Pure cash basis accounting will not reflect this, but modified cash basis accounting will. One of the first things you will want to know is if the company is cash based or accrual based. Sometimes the answer is both, and that is fine. Receivables may be tracked and that is a modification of cash basis. As long as there is not a lot of distortion there then this may be fine. However, if there is a lot of distortion and fluctuation, then the modifications are misleading. Cash basis may need to be reviewed.
- ACCRUAL BASIS: This is recognizing revenue when it is earned and not necessarily when the cash comes in. Even good faith estimates may be included if the data is fairly certain.
- REGULATORY OR STATUTORY BASIS: This information required by a monitoring commission is useful but not necessarily the final word on the profitability of the company. This is for a different purpose than analyzing operating results and cash flows.
- CONTRACTUAL BASIS: Analytics based on a company’s contractual obligations.
- FINANCIAL REPORTING FRAMEWORK FOR SMALL AND MEDIUM-SIZED ENTITIES (SME Standards): This is new and is not widely used. One difference in the SME standard and GAAP is that these are “non-authoritative.” They have not gone through any commentary or approval process. They are out there as a practicality to allow small companies to make assessments on an affordable basis.