A glimpse of the future.
Prospective financial information is any financial information about The future. Prospective financial statements--including forecasts and projections--are one category of prospective financial information. They offer a glimpse into the future by forecasting potential business outcomes. Lenders, investors and management frequently have questions about a company's future that can be answered only by such statements. CPAs will find that preparing prospective financial statements is both an art and a science.
Although the CPA's ultimate goal in producing prospective financial, statements is similar to historical presentations, the process is far different. A financial forecast represents what management expects to happen. It is more commonly used for an existing business, where the results are not contingent on a particular event. A financial projection, on the other hand, is based on one or more hypothetical assumptions. It reflects what could happen if certain events or circumstances actually occur. Examples include a start-up business that is contingent on investor financing, or a scenario in which sales triple each year. Although management may or may not reasonably expect to achieve these financial results, the projection shows what would happen if the assumptions came true.
In my years as a CPA, I have prepared forecasts, projections, budgets and financial models for start-up companies, mergers and acquisitions, litigation support engagements and expanding businesses. The process includes planning, research, preparation and delivery of the completed report. It requires CPAs to understand business structure, taxation, computer spreadsheet applications, economic trends and financial reporting requirements. A good general business sense is also essential. Although CPAs may not be able to predict the weather, we have become good at preparing financial models that can be used in forecasts and projections. As more CPAs in public practice prepare prospective financial statements, they may benefit from some of the insight I have gained about performing this valuable service.
ASK THE RIGHT QUESTIONS
Prospective financial statements have several applications and benefits. For a business, they are part of the normal budget process. They help a company establish both short-term and long-term financial goals. Lenders often require them when a company is seeking to borrow money. Investors use them to assess the potential of a business venture.
While particular companies will have other, more specific, questions they believe prospective financial statements can help them answer, in general such financial statements can help a company to decide
* Does the idea for the start-up company have the potential to succeed?
* Can the desired expansion of an existing business realistically be achieved?
* Will a company's projected internal rate of return be sufficient for an investor?
* Will a company's financial position at some future date make it a desirable acquisition candidate?
* Will a company's projected operating results satisfy the requirements imposed by a lender?
* Does the company have enough capital or financing to fund the growth in receivables or inventory that is likely to result from a proposed business expansion?
RULES AND REGULATIONS
The current authority on prospective financial statements is Statement on Standards for Attestation Engagements (SSAE) no. 1, Attestation Standards. The statement includes a description of its applicability, definitions, types of services provided, reporting requirements and engagement administration matters. The AICPA publication Guide for Prospective Financial Information expands on SSAE no. 1 and provides CPAs with practical advice. The flowchart in exhibit 1, page 37, shows the rules for the basic types of prospective financial presentations.
[Exhibit 1 ILLUSTRATION OMITTED]
The type of prospective financial statement a CPA prepares generally depends on its intended use. General-use financial statements are appropriate for use by persons with whom management is not necessarily working directly, such as in an offering statement for stock in the company. Restricted-use financial statements are for management use only, or for use by someone management deals with directly, such as a bank. The intended users of the prospective financial statements are identified in the accountants' report. The information the CPA presents can be a complete set of basic financial statements (balance sheet, income statement and statement of cash flows) or the so-called minimum specified elements, as defined in the AICPA guide. Exhibit 2, page 38, outlines the elements a CPA must include in prospective financial statements. A partial presentation--one that omits one or more of the minimum specified elements--and a pro forma presentation are not considered prospective financial statements.
Exhibit 2: Minimum Specified Elements in Prospective Financial Statements
Financial Statement Elements
* Sales or gross revenues.
* Gross profit or cost of sales.
* Unusual or infrequently occurring items.
* Provision for income taxes.
* Income from continuing operations.
* Discontinued operations or extraordinary items.
* Net income,
* Primary and fully diluted earnings per share.
* Significant changes in financial position.
* A description of what the responsible party intends the financial forecast to present; a statement that the assumptions are based on the responsible party's judgment at the time the prospective information was prepared; and a caveat that the forecasted results may not be achieved.
* Summary of significant assumptions.
* Summary of significant accounting policies.
At the first meeting with a client to discuss preparing prospective financial statements, the CPA'S goal should be to get an overview of the project, understand management's expectations and determine the major assumptions. For example, the CPA should ask questions about the entity's structure, its anticipated capital requirements and the business climate in which it operates. If the statements are for a proposed business operation that represents a major change from the past, the CPA should find out how realistic management's plans are. To do this, a CPA can ask questions such as
* What experience does management have in this particular industry?
* Are there plans for the company to go public?
* Will management be able to devote enough time and attention to a new business venture?
* What effect will the new venture have on existing operations?
Other questions the CPA asks will depend on the specific nature of the project.
Armed with this information the CPA can then tell the client exactly what he or she will do. I explain to clients that I will develop a financial model for a specific time period (usually three to five years), prepare the financial statements--including disclosure of the major assumptions--and attach a report on firm letterhead stating what I did. I let the client know there may be changes to the original assumptions and that they need to feel comfortable with the final product. It's also important to find out who will use the prospective financial statements--only management or some outside user such as a bank.
One of the most important steps is to identify at the outset as many assumptions as possible. The best way for a CPA to do this is to know how the company operates and understand the components of its historical financial statements. Gather as much industry data as possible and ask management all the questions that come to mind--especially those related to anticipated levels and timing of operations. Exhibit 3, page 40, lists some of the major assumptions a CPA might use in a financial model. It is not necessary to quantify all the assumptions just yet, but knowing that an assumption might exist allows the CPA to set up the model for later changes. For example, after I had already begun preparing a projection for a homebuilder, I learned the project was being developed in two phases. Phase two sales would start when phase one was 90% sold. Unfortunately, I had to redesign the model to allow for phase two.
Exhibit 3: Major Assumptions in a Financial Model
* Accounts receivable turnover.
* Inventory turnover.
* Accounts payable turnover.
* Terms of notes payable.
* Depreciation methods and lives.
* Sales growth rate.
* Gross profit percentage.
* Significant expenses.
* Inflation rate.
* Payroll tax rates.
* Income tax rates.
Another important aspect of financial modeling is the level of detail in the assumptions. A CPA should not oversimplify or ignore assumptions that are known to be reasonable. However, using overly detailed assumptions increases the possibility of error in the model. When possible, CPAs should use general assumptions. For example, rather than using individual gross profit margins for each product a company sells, use one overall gross profit margin for all sales. Alternatively, use two or three different gross profit margins and allocate a percentage of sales to each. As with many things, simplicity can contribute to the project's success. Always be sure, however, that the assumptions are meaningful by comparing them to the company's historical trends or to future industry trends.
Planning goes a long way toward achieving the success of the model. CPAs should think about how they want the financial statements to look, such as annual or monthly amounts and what supporting schedules they will include. Also consider how the electronic workpapers will be organized. I use Excel and put all workpapers and assumptions on one or two worksheets, with the financial statements on a separate worksheet.
There will be times when a client will ask a CPA to prepare a "quick and dirty" projection and clean it up later. While generally it only takes a few hours to prepare a very basic financial model from scratch, I have learned that it does not take much more time to set up the model properly from the beginning. As carpenters often say, "Measure twice, cut once."
PROPER FINANCIAL MODELING
When designing a financial model, it's easy to fall into the trap of assuming the formulas are correct. However, CPAs should always test the model by changing the assumptions. For example, if depreciable lives change from eight years to four using the straight-line method, depreciation expense should double. Also remember that a change to one assumption can result in many ancillary changes throughout the entire model.
Probably the most difficult aspect of preparing a financial model is remembering all of its components. A typical model could have thousands of formulas, some very simple and some so complex they make you wish you had studied more algebra. Since engagements can last several months, it may become difficult to remember how you designed the model and wrote a particular formula. One approach I use is to put all the assumptions in one area of the worksheet. Later, when I need to make changes, I only have to look in one place rather than sift through the entire spreadsheet. Another temptation is to use a previously prepared model from another engagement and tailor it to a current project. However, this generally does not work well because the previous model has been customized, and you run the risk of including a formula that does not apply.
CPAs need to do some research to develop and test their assumptions. Sources of data include historical financial statements, the Internet and industry and government publications. Economic data, both general and industry-specific, are also useful. A review of these data may lead to further questions or to changes in the assumptions. In developing a model for a proposed hospital, I considered statistics such as occupancy levels, room rates, personnel costs and the number of procedures the hospital performed.
Once you've prepared the initial model, it's a good idea to step back a bit and get a feel for how the numbers turned out: Is income reasonable, are ratios in line with historical or industry trends, are all the assumptions that you discussed with the client included? CPAs also should perform a detailed clerical check of the numbers. This is also the time to identify logical problems in formulas, such as
* Ending accounts receivable not in sync with the assumed turnover rate.
* Bonuses based on achieved income that are incorrect.
* Out-of-balance balance sheet.
THE MECHANICS OF MODELING
An electronic spreadsheet is a necessity when preparing a complex financial model. Most important, CPAs should design the model so there is minimal data input. Each assumption should be entered in the spreadsheet only once. Formulas should not contain any variables. The financial statements should be formula driven and any changes to the assumptions should flow through automatically to the workpapers and then to the financial statements. For example, if you use a word processor and one of your project's assumptions is that employee benefits are 15% of gross salaries, create a link within the word-processed document to the spreadsheet cell that contains the 15% assumption. Then if you change the assumption the document will automatically change. Depending on the number of assumptions or other financial data disclosed, this could be both a real time-saver and a way to make sure the data are consistent between the financial statements, the disclosures and the model itself. I save countless hours by using this approach because the assumptions change so often.
Try to incorporate as much of your workpapers, notes and other support directly into the spreadsheet, including comments about where and how you got each assumption. Also identify the model with the file name, version and date. Since you will need to make many revisions, it's important to keep track of which version of the model you are working on.
While CPAs aren't required to disclose every assumption, it may be necessary to disclose the major ones in the notes to the financial statements--depending on the nature of the engagement. Don't mislead the reader by omitting significant or sensitive assumptions--or hypothetical assumptions in the case of a projection. The method you use to disclose the assumptions can vary, such as a spreadsheet or word processor. Whichever option you choose, it's a good idea to link the data in the notes directly, to the model, as described above.
THE FINAL PRODUCT
Once all of the steps described above are complete, the CPA is ready to meet with the client again. At this meeting a good approach is to review the major assumptions first. This helps to refresh the client's memory about what you are trying to accomplish. As you make your way through the numbers, the client will want to make changes. Listen to the client's comments and be prepared to give your own opinion as a financial adviser. Also try to begin thinking about how each of the changes will affect the overall design of the model. Remember to keep things as simple as possible.
As you change the model, try to anticipate how those changes will affect net income, for instance. If the numbers do not turn out the way you thought, there may be a problem with a formula or the logic of the model. Experience has shown that management tends to overestimate future earnings. It's the CPA's job to keep the numbers as realistic as possible. If CPAs don't do this, a potential investor or lender could be turned off by numbers that aren't believable. Work closely with the client and make them prove the forecasted results to you. CPAs can ask questions such as
* How do you expect to go about generating increased sales activity?
* What caused the gross profit percentage to change?
* Have you budgeted for enough administrative personnel to handle the increased sales volume?
In the final analysis, don't be afraid to give your opinion. I always tell clients, "If it sounds too good to be true, it probably is."
The final product can take different forms but should always conform to AICPA guidelines for the required financial information and disclosures. It's helpful to format the prospective financial statements in a similar way to historical statements. This allows the client to make easy comparisons. Charts or graphs are also good communication tools for painting a picture of the future.
THE CPA AS ARTIST
While some companies prepare their own forecasts internally, there is a benefit to having an outside CPA prepare them. Having a CPA's name on the statements may give them more credibility, particularly if they are being used to secure bank financing or attract new investors. The CPA also benefits--preparing prospective financial statements will help others view the CPA as a business adviser and may lead to additional consulting engagements. The process also allows the CPA to gain a much better understanding of the client's business, including the impact of daily operations on its finances.
The process of preparing a financial model and prospective financial statements is a complex one, involving meetings with company executives, research into industry trends and a knowledge of electronic spreadsheet programs. The financial model you design will grow from a few general thoughts to a complex array of financial data and formulas. By the end of the project, you may feel you have created a work of art. More important, you will feel you have done something a little out of the ordinary and provided your client with a beneficial service.
AICPA Resource Guide
* Guide for Prospective Financial Information.
* Small Business Consulting Practice Aid 96-1, Developing Business Plans.
* Technical Consulting Practice Aid 92-6, Preparing Financial Models.
RELATED ARTICLE: EXECUTIVE SUMMARY
* LENDERS, INVESTORS AND MANAGEMENT FREQUENTLY depend on CPA-prepared prospective financial statements to answer questions and to help them make decisions about a company's future. Such statements are helpful in evaluating start-up companies, mergers and acquisitions and expanding businesses.
* THE CURRENT AUTHORITY ON PROSPECTIVE FINANCIAL statements is SSAE no. 1, Attestation Standards. CPAs can also get practical guidance from the AICPA publication Guide for Prospective Financial Information.
* AT A CPA's FIRST MEETING WITH A CLIENT TO DISCUSS preparing prospective financial statements, the goal is to get an overview of the project, understand management's expectations and determine the major assumptions. Identifying as many assumptions as possible at the outset is an important step.
* AN ELECTRONIC SPREADSHEET IS A NECESSITY WHEN preparing a complex financial model. CPAs should design the model so there is a minimal amount of data input. Incorporating as much of the workpapers, notes and other support into the spreadsheet will make it easier for a CPA to make the inevitable revisions the client will request.
* ALTHOUGH THE FINAL PRODUCT THE CPA DELIVERS to the client, can take on different forms, it should always conform to AICPA guidelines for the required financial information and disclosures. CPAs will find it helpful to format prospective financial statements similar to historic statements to allow the client to make easy comparisons.
ROBERT PENN, CPA, is a principal of Mann, Frankfort, Stein & Lipp, Houston. His e-mail is firstname.lastname@example.org.
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|Title Annotation:||prospective financial statements|
|Publication:||Journal of Accountancy|
|Date:||Jul 1, 1999|
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