Preparing End of Year Financial Statements Best Practices?

The yearend financial statements are the basis of financial reporting to owners and investment analysts. In addition, they form the basis of income tax and are often the basis of bonus plans for employees and executives. Dividends are also calculated from yearend figures and budgets for upcoming years are dependent on the operating results of the current year. So there is ample reason to care about the yearend financials.

At yearend, many corporations are confronted with the annual audit. Preparing statements for audit in conformance with GAAP requires footnotes and adjustments that may not be required on a monthly basis for business measurement. Adjusting statements to GAAP is not a trivial matter and will include non operating items such as stock option valuation, income tax provision, valuation of assets that may not be performing and preparation of detailed footnotes.

The first tip is to recognize that an audit puts your firm in a new league with respect to financial reporting. Often statements (pre-audit) will be less formal and done in an accounting system with poor controls. Many transactions and journal entries will have poor or no documentation as to why the entry was made. There must be a strong recognition that the old ways will not suffice and will generate a very painful audit. The advice here is to select auditors very early in the year, listen to what they need, and obtain personnel for your accounting department that are capable to providing the quality information and accounting transactions to assure accurate statements. This may not be the folks that are there today.

The second tip is to consider the audience for your statements, which can be auditors, controlling owners and other shareholders, lending institutions, investment bankers, the Board of Directors, vendors and customers. It makes sense well before year end to consider the audience and tailor the statements to meet the needs of each constituency. While the formal audit report does not allow for too much leeway in formatting, there may be other constituencies that require specialized information, for example your bank may require year end performance against loan covenants. As early as possible during the year, good managers will set down these requirements and make sure that systems are procedures are adequate to bring forth the required reporting. Further, there may be financial targets for the business such as inventory turnover or free cash flow. Setting up systems to capture these measurements and take effective action when variance from target is revealed can make the annual statements much more rewarding.

My final observation is that the accounting and tax departments (or tax provider) need to work carefully together to minimize the firm’s overall tax bill. Every profitable business should have tax considerations in the forefront and take advantage of the tax provisions that may be advantageous at any year end. Each month, the tax department should be considering the probable tax bill from the results of operations and providing management with alternatives that can make the business more tax efficient. An example would be to acquire needed capital equipment in years when accelerated write-offs are available. The timing of contracts that may be signed at year end or recorded in the following year can also affect the tax bill. Until the final day of the year, the firm may have certain flexibility with respect to taxes. Once the year is over, many tax alternatives die with it. Careful attention needs to be paid to use of Net Operating Losses to make sure they are available as expected. Firms that are too small to have an internal tax expert on the payroll should meet with a qualified tax provider that is familiar with their industry several times during the year to learn what is new and to review how to make the business tax efficient.

Please list 3 tips that you would like to share with the Focus community on preparing end of the year financial statements. High quality contributions will be included in an upcoming report on end of the year financials.
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If I were instructing my CFO regarding what was significant to the organization in the preparation of Year-End statements, I would begin with 1) timeliness. Although Cisco may have pioneered the "perpetual close", current technology allows for something approaching it, without the need for huge expenses in software. End of year is not, in itself, significant. It only represents the end of a predetermined accounting period. End of Year is less significant than "process". 2) Secondly, I would demand transparency. How do we close any time period? What are our objectives regarding reported numbers (a tricky issue with larger companies)? By itself, it may or may not give an accurate reflection of the financial health of the entity.
Philosophically, revenues and costs should be transparent and timely. Finally, 3) I would demand accuracy. A simple request but one which is suffering as conflicting management objectives, requirements and instructions hinder the fundamental function of any close: A true financial snapshot of the state of the enterprise.

John makes some very good points and I would like to add to Timeliness, Transparency and Accuracy, by stating that the process itself should be structured that it satisfies the three points John made.

Three steps that would insure that the process itself is conducive of superior reporting are:

1) Planning - take a project management approach to constructing year end financial statements. Develop a project plan for the Financial and assign resources, time allocations and critical success points.

2) Closing Process - the processing of the year end data is the most vital piece of the reporting process so it too should be treated with the same level of detail. There should be a separate project time line for the closing piece itself that will lead up to the drafting of the financials.

3) Internal Auditing - immediately following the closing process it is vital that an internal audit of the data is performed and proper coding of data is insured. This supports the accuracy of data and also will insure that decision makers are getting the most useful insights into the business because the data is true.

The overall process of closing, auditing and reporting should be approached with the same importance that an external project is approached. The proper management of internal projects such as these are a direct reflection of the competence and ability of the business and will ultimately be displayed in the final product (YE Financials).

The 3 things I have found to be most important are:
Make sure the accounting staff has a closing schedule complete with responsibilities and due dates.
Create a check list of things I have to do for the closing process.
Start going through the books a month before and perform a "clean up" of data to be sure that your year end entries will be based on good information.

This request for three tips to share regarding best practices on preparing end of year financial statements unfortunately I believe should be addressed at the beginning of the financial year not, albeit, at the end. Actually to implement these suggestions, is likely to involve a major project whose payoff will be a substantial reduction in costs and a huge improvement in quality and efficiency of developing financial statements.

The gargantuan job of preparing end of year financial statements is due mostly to the following reasons. Most corporations failed dismally in effectively using the accounting system. An effective accounting system should by default create not only at December 31 the correct positions but at each month end during the course of the year. The paperwork flow in most corporations fails to ensure that only qualified and trained personnel are responsible for signing off and charging general ledger accounts. The majority of managers are not accountants and yet they are placed in a role that does require this functionality; and it does not work. Besides managers, there are many other accounting and other financial department personnel who are responsible for allocating and charging general ledger accounts who are not qualified or skilled sufficiently to do this accurately. Furthermore, using a Sox 404 top-down approach, only items of a material magnitude that could distort the faithful representation of a company's financials should be viewed critically and aggressively to verify accuracy. All other numerical data, immaterial amounts and voluminous, should only be given periodic review and certainly not at year end. The users of financial statements need to be assured that they can make accurate and a faithful financial decisions relying upon the published results. If my approach were adopted, not only would accuracy be greatly enhanced but any degree of inaccuracy or incorrect postings would fall into a very insignificant level of materiality. In all probability the auditors, whose lives would be greatly simplified in their review, would totally support this perspective. In terms of the bottom-line, it is highly probable that audit costs and fees would greatly decrease. As a side note, these observations and comments above will contribute greatly to a very difficult and stressful IFRS implementation!

I will now suggest three tips as requested that summarize the above commentary:

1. For each and every general ledger account, develop a process flow map that sources each and every document that contributes to the entries and then create a series of subaccounts each of which reflects the major sources. (As an interim CFO, I implemented such an approach with a company’s bank accounts and virtually eliminated problematic bank reconciliations)

2. Identify, and again perhaps using process flow mapping, each and every individual and manager that has responsibility within their function to charge and/or allocate expenses to general ledger accounts. The options existing are to either reroute the paperwork or put in place a comprehensive training program that will minimize this risk, i.e. the risk of incorrect allocations.

3. Using a Sox 404 approach, assign a qualified accountant to systematically monitor and control that each subaccount is correctly being charged that for which it was set up. Any observed errors should result in immediate remedial and corrective action. Note, this is not a year-end exercise but one that will be carried out all year round.

Often preparing the year end financial statements is treated as though it is a one time event, rather than a repeating process. Even if this year is a mad scramble to get the statements done and issued in time, plant the seeds for next year.

1. Move as many processes away from the year end as possible. Rather than posting things to suspense accounts and leaving it to year end to deal with them, do the full job at the time. For example, calculate the gain/loss on the sale of assets at the time of the sale, rather than at year end. Adjust your depreciation calculations as you go. Check and clear amounts accrued at the last year end in the first month, not the twelfth.

2. Failing to plan is planning to fail. Have your year end processes documented and prepare checklists to ensure that every step is done and checked. Make sure everyone is aware of their tasks and deadlines. Check to see if there are any new requirements for this year end and build them into your plan.

3. Search for time wasters. It may be too late for this year, but now is a good time to update your accounting structure and system for next year. If you find that there are certain accounts that require a lot of manual reconciliation or analysis, see if a change to the account structure would make it easier. For example, if foreign and domestic sales are in the same account in the system, but have to be disclosed separately, consider creating new accounts to separate them in the system. This step can save a lot of time preparing year end tax returns if the tax reporting requirements are baked into the accounting system along with the financial reporting requirements.

When it comes to your end of year financial statements:

1. If you’ve decent systems virtually all of the work should have been done BEFORE the end of the year as by preparing ACCURATE monthly management accounts you will have sorted out any issues likely to give you problems so make sure you’re doing these.

2. Do them as early as possible. Historic end of year financials are a complete waste of time at the best of times!

3. Ensure they are as easy to understand as possible and unless you have a complex business, providing you’ve taken a reasonable approach ignore any Accounting Standards best suited to large public companies. Simplicity is best!