Financial Planning and Analysis (FP&A)
Financial Statement three vital points to read them Fluently
Understanding why and how financial statements are prepared is essential to knowing how to read them. The three vital points are Methodology, Accuracy, and Timeliness. Each of these vital points impacts the other. Therefore, understanding where the organization stands in each vital area will help you read and understand the statements fluently. The methodology is how accounting is done; consider this the grammar rules used when writing a paper for English class. Accuracy is how closely you follow the rules of a given Methodology; think of this as the grade you would get on your paper. Timeliness is how long it takes to produce the financial statements: consider how much effort/time is dedicated to creating the paper. Let’s take a moment to examine how each vital point impacts the other.
There are three Methodologies: Cash, Accrual, and GAAP. We will review briefly today; I will go more in-depth in later posts about each Methodology.
Cash is simple to both understand and easy to produce. The transaction is recorded at the time the cash exchanges hands. Accuracy and Timeliness have no practical impact on this Methodology; all you need to know is what flows in and out of the bank. Only organizations with straightforward business models (i.e., early start-ups, businesses that get paid when the goods/services are provided)
Accrual is starting to get more sophisticated. The transactions are booked in the correct period. Accuracy and Timeliness will be an issue in this methodology. Given unlimited time Accuracy will be perfect. Timeliness is as important as accuracy, so we must balance perfection and information dissemination. The rule of thumb here is that closing the month should take one to five days. Anything longer than that, the information starts to become stale.
GAAP is the most sophisticated and time-consuming. GAAP has the rules set by the Financial Accounting Standards Board (FASB). The rules can change yearly and take a sophisticated accountant to ensure compliance. In addition, Accuracy is tested and approved by an external audit. With the higher standards, typically, there are more resources (headcount) to achieve Timeliness or one to five days.
So, which is better? The transactions and goals of the business determine that. For example, a multi-million-dollar, closely held company might pick the Cash Basis. Due to the information being kept to a few stakeholders. And on the other hand, you could have a per-revenue company with many stakeholders that need the info audited and disseminated in a standard format; then you might pick GAAP.
The key to understanding what is best suited for your organization is understanding the trade-offs of each methodology in supporting the organization’s goals.
If you want to dive deeply into your organization, please let me know by scheduling an introductory meeting with me.
In my next post, I will be discussing the three financial statements. I am looking forward to talking with you soon.
Great content!