How to prepare for a yearend financial statement review

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How to prepare for a yearend financial statement review

October 31, 2017      In construction accounting No Comments

A review is the middle ground between a full audit and a compilation. When do you need a review? Typically companies get a review because their bonding company or bank is requiring it. A change in size, growing to the point where outside assurance is needed, or doing a specific project that is going to kick them into a higher risk pool will trigger a request for a review. Additionally you will see reviewed financial statements if you are going to put into place a line of credit that is substantial relative to the businesses size or net income. I have also seen clients required to get a review whenever they were going into a new geographical area or a new type of work.

A lot of commercial contractors that move from a compilation to a review feel overwhelmed with the information needed by the outside accountant to prepare the reviewed financial statements. When companies are preparing to have a reviewed financial statement, they tend to give the outside accountant information that he or she does not need or in a format that is not useable. It is important to have a format and the information, not only in the way that the accountant likes, but also in the order that the accountant likes. Anything you do towards this goal will save you money and time, because the outside accountant will be able to process the information quickly.

Here is a brief explanation and some helpful steps to save you time and money.

First off, there are three levels of financial statement services offered by outside accountants: Audits, Reviews, and Compilations.

Audits

An audit provides the highest level of assurance on an organization’s financial statements.  An audit provides assurance that an organization’s financial statements are free of material misstatement and are fairly presented based upon the application of generally accepted accounting principles. An audit is not meant to detect fraud, only to confirm that generally accepted accounting principles (GAAP) is being followed.

Reviews

A review provides limited assurance on an organization’s financial statements.  During a review, inquiries and analytical procedures present a reasonable basis for expressing limited assurance that no material modifications to the financial statements are necessary; they are in conformity with generally accepted accounting principles.  This “does it make sense” analysis is useful when the organization needs some assurance about their financial statements, but not the higher level of assurance provided by an audit.

Compilations

A compilation provides no assurance on an organization’s financial statements.  The CPA takes financial data provided by the organization and puts them in a financial statement format that complies with generally accepted accounting principles.  There are no testing or analytical procedures performed during a compilation.

We are going to discuss Reviews in this post.

Review Accountant

The first step, once you are required to get a review, is to contact your current outside accountant. Your outside accountant will tell you if they do reviewed engagements or not. If this is a new relationship, you need to ask if they understand construction financial statements. This is critical! If they don’t understand construction and under/over billings, this reviewed financial statement can create a big mess for the contractor. You can produce a set of financial statements that are incorrect and can negatively affect the bonding and banking relationship. If you are not with an outside CPA that understands construction, it is probably time to shop for someone new. A CPA that understand construction will give you the best product and be able to assist you with information useful for your operations. (Atlas CFO does not do reviews.) We help you prepare the internal information for the accountants that do reviews. I used to do reviews. I have a real appreciation for it. There are some awesome outside accountants out there that do reviews for contractors. It makes a huge difference to be with a great one who understands your industry!

What does the typical review process look like?

Engagement Letter

A review starts with an engagement letter describing the services and fee for the outside accountant to produce the reviewed financial statements. Most of the time the report is comparative, but if it is the first year, you can do something called a balance sheet only review. This saves the reviewer some work, saves the client (you) money and produce nearly the same result required by most bonding companies and bankers.

Information Access

Now that you’ve signed the engagement letter you are ready to work with your outside accountant! Some accountants will provide you with a list of information they require and some will not. In my opinion, that is where the confusion starts. A lot of the time, you do not know what they are going to ask for. Sometimes they say, “Oh, I’ll just take a look and then I’ll give you a list.” UGH! That usually doesn’t work, because by the time you get that list, you are busy and moving on to something else. It is always better to get that list up front. The review accountant usually asks for a financial statement (the balance sheet and income statement) in the beginning. Sometimes they will ask for a trial balance. Some will ask for access to your entire accounting database. All of those are reasonable and based on the accountant and what they are used to working with. It is also dependent on the accounting software that you are using. If you are using QuickBooks, they will ask for a copy of your database. Some software, such as Foundation, has a portal that is available for outside accountants. Each software handles it a little differently.

Information prep – Balance Sheet

When I’m preparing for a review, I print the balance sheet first. The reason I print the balance sheet first is because it acts as bookends. It also acts as a snapshot of your company as of a certain time. I am going to assume, in order to keep it simple, that you are a 12/31 year end. You are going to take a picture of your balance sheet as of 12/31. Then you will make sure that is the best picture and the most accurate picture as of that date. You do need to use all information available to you. If it is now March and you are looking back at 12/31, you are going to use the knowledge that you have to make sure the balance sheet is correct. You don’t have to pretend that you don’t know something, you want to make sure that you use all knowledge available to you. The other reason I use balance sheets is because balance sheets are bookends. You have an end of the year balance sheet as well as a beginning of the year balance sheet (or last year’s yearend balance sheet). In between your bookends is your income statement. If your beginning balance sheet is good and your ending balance sheet is good, then your income statement is good. It may be in the wrong category or it may need to be re-classed, but you would be pretty confident that net income is right if your balance sheets are right. If your two balance sheets are wrong, net income is wrong. If one balance sheet is wrong, net income is wrong. This is critical. The balance sheet has to be proper. Whenever I am preparing for the review, I print the balance sheet first and I start at the top. I find proof and I reconcile every account on my balance sheet. If I can’t figure out what that balance should be, I put it off to the side and come back to it. There isn’t a single account on the balance sheet that I don’t know what is in it, why it is there, who it is owed to, who it is owed from, when I’m going to pay it, how much I’m going to pay, I know everything about it. I have found that it is critical to have that kind of knowledge before you turn it into the review accountant. It takes a little time, but it is well worth the time to reconcile the balance sheet. At this point, you want to look at the balance sheet section on our checklist. You want to prepare, obtain, reconcile, and format everything on that list. Some of these things you may not know how to do, but you can usually ask your outside accountant or you can ask us. We plan on having a video on it coming soon.

Information prep – Income Statement

I look for some very specific things on the income statement. I run a comparative income statement in order to compare this year to last year. I want to understand everything that is different between the two years. I also want to make sure that things make sense. Did we have $10,000,000 in revenue this year? Does that make sense to me or are we more of a $5,000,000 company? Little questions like that may help you to understand if your financials are right. I look at the margin (gross profit), which is revenue minus direct expenses, to see whether profit makes sense. In a construction industry you will see anywhere from 10-40% in gross margin. It really depends on how you allocate cost. If you see something like 90% this year vs 30% last year that is not a reasonable gross margin and needs investigating. I also look for any accounts that have changed drastically over the year or any larger account balances. If we have a large account, such as wages, I run through it to make sure I recognize everything in it. Likewise utilities typically aren’t your largest expense, but make sure you have 12 payments in it. Things that are easy like rent, utilities, phone usually require a quick look to make sure you have 12 months of expenses in each. Once I am done with just my general review on the income statement, I make sure that I prepare any information that is needed by the outside accountant. Refer to the list.

Cash Flow and Retained Earnings Statements

In a reviewed financial statement, there are a couple of statements; the statement of cash flow and the statement of retained earnings. Sometimes the statement of retained earnings is collapsed into the statement of income. The statement of cash flow is always separate. The most important thing to know about the statement of cash flow is to make sure you have cash from operations. This is the first major category on your cash flow statement. The reason why you are interested in making sure you have cash from income is that shows you are making money. Even if you have negative net income, it will go a long way showing you have cash from operations on that cash flow statement.

Disclosure Section

The disclosure section is the notes to the financial statement. The best way to do this is to get last year’s notes, if you have them. If you don’t have last year’s notes and this is the first year you are doing it, you can ask for a sample copy of notes. There are things like your largest concentration with your customer, your largest concentration for geographic area, how you do business, where you operate, what kind of business you are. This disclosure section is sometimes more important than even the financial statements. A lot of times it gets ignored. Making sure you have the proper information that is getting disclosed can ensure that the bonding company or banker reads your financial statement from cover to cover. I have some examples of what is in the notes section in the checklist.

Supplemental Information

Typically for contractors, supplemental information is the job schedule and sometimes a listing of G&A expenses. The thing that people do not know about supplement information is that it is totally negotiable. You can make it zero supplemental information. You do not have to have the job schedule separately disclosed in the reviewed package. In fact you can negotiate with your banker to have that outside of the review in order to save yourself a little bit of money and headache for the reviewer. You are trying to give the reader of the financial statements additional information that they cannot otherwise obtain through the rest of the financials and the notes section. You do not have to disclose every single job. You can consolidate a bunch of jobs that are smaller. Say most of your jobs are $1,000,000 and you have a bunch of jobs that are $50,000 and less. You can consolidate all of those jobs into a line item and save yourself the headache of having to individually list them all.

After you have given all of this information to the review accountant, they will then give you back a draft of the review. You will want to read it word for word, cover to cover, to make sure you help your outside accountant out and all of the information is proper. Then you are ready for issuance assuming there are no other changes. At this point, the outside accountant will give you any changes or adjustments to the financial statements. (Look for a future blog concerning this!) You will be given the reports and you will send them to the people that requested them, typically bonding and bankers.

Done! You are usually so ecstatic to have this done. It is ok to do a happy dance!

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