To illustrate the importance of a common structured and consistent language, imagine the confusion that would occur if I said I was going to sell you a black truck, and then presented you with a red truck instead. If you said, “I thought you were going to sell me a black truck, I don’t want a red truck” you may be confused if I replied, “This is a black truck – that’s what I call this color, even if everyone else refers to it as red.” The same confusion occurs when a company’s financial records are not accurate or are not prepared in a manner that is consistent with G.A.A.P.
The story of a business, no matter what size or industry, is told through its financial statements and reports. Those trained in reading financial statements (which, if not the buyer, will be their financial advisors) will use financial information to not only understand how profitable a business is, but also things like the cost of retaining customers, how quickly inventory turns over, clues about relationships with vendors, and whether the business generates sufficient cash flow to support growth with or without borrowing.
If a prospective buyer or their advisors are confused by a company’s financial statements because they are not based on standard accounting practices, it will often cause a buyer to lose interest and not move forward with an acquisition. If, despite the uncertainty, such a buyer does move forward with an acquisition it will often be at a reduced price or with less attractive terms in order to mitigate the risk associated with non-G.A.A.P. financial records.
Codiligent finds that some of the most common problems that derail business sale transactions are errors or inconsistencies in financial statements, or where financial statements have not been prepared in accordance with G.A.A.P. A buyer who finds an error or inconsistency on financial statements will wonder what else may be incorrect, inconsistent, or problematic with the business.
Business buyers will expect that accurate monthly financial statements are available within 15 days of the end of each month, that such financials will be error-free in accordance with G.A.A.P standards, and that tax returns will be consistent with the business’ internal financial statements, understanding that there can be differences between internal financial statements and tax returns due to tax reporting requirements and whether cash or accrual accounting are used on each.
If you are not confident of the quality of your company’s financial statements, getting expert assistance with this should be a top priority. Also, the greater the ability to increase confidence or certify that financial statements are prepared correctly, the easier it will be to sell your business. CPAs offer three degrees of certification that can be helpful in giving buyers confidence in the quality of your company’s financial statements: compiled financials, reviewed financials, and audited financials. Companies will be most marketable with audited financials, but many small and lower mid-market companies are unwilling to go to the time and expense of having audited financials. Reviewed financials is next best, followed by compiled.
For compiled financials, the CPA must comply with certain basic requirements of professional standards, such as having knowledge of the client's industry and applicable accounting principles, having a clear understanding with the client as to the services to be provided, and looking at the financial statements to determine whether there are any obvious deviations from G.A.A.P. A report on the financial statements is issued that states a compilation was performed in accordance with AICPA professional standards, but no assurance is given that the statements conform to G.A.A.P.
Reviewed financial statements require that the CPA perform an inquiry and analytical procedures in addition to the procedures for a compilation. Upon completion, a report is issued stating that a review has been performed in accordance with AICPA professional standards, that a review is less in scope than an audit, and that the CPA didn’t become aware of any material modifications that should be made in order for the statements to conform to G.A.A.P.
Audited financial statements involve a CPA performing all of the steps for compiled or reviewed statements, but also performing verification and substantiation procedures. Such procedures may include direct communication with creditors or debtors to verify details of amounts owed, physical inspection of inventories, inspection of minutes and contracts, etc. Also, the CPA gains a knowledge and understanding of the entity's system of internal control. The resulting CPA's standard audit report states that an audit was performed in accordance with generally accepted auditing standards, and expresses an opinion that the financial statements present fairly the entity's financial position and results of operations.