Financial Statements

James Curtis has been the senior partner in a consulting engineering practice for 15 years. Lately he’s been troubled by the progress of his firm, but when he arrived at my office late and out of breath, he seemed in high spirits.

“You know we’ve had some problems in our firm for the last two or three years,” he began. “Up to now, we’ve missed the boat in forging business associations.”

“I don’t follow you.”

“More firms are becoming involved in informal partnerships, joint ventures and other kinds of commercial communities. One member of the community might have access to a large client base, another member might have technical expertise.”

“How would that apply to your firm?”

“We’ve been approached by XYZ Corporation to join them in a new venture. The company is branching out from manufacturing into property development overseas. We would provide expertise for some prospective industrial parks.

“That sounds great,” I said. “But more precisely what do you mean by ‘join them in a venture.'”

“It’s speculative at this stage. XYZ does not want to pay us for our initial involvement. They want us to show our confidence in the project by fronting our own costs, at least until they become real projects. In the meantime, they are bearing some of the promotion expenses.”

“Your firm’s finances aren’t all that strong. It sounds a little risky to me.”

“That’s my fear exactly. Our executive team wants to jump in, but we’re afraid we may be getting in over our heads. I’ve brought the financial statements for XYZ. I want you to look them over and tell me what you think.”

I glanced at the package. “Financial statements are analyzed using ratio analysis,” I explained. “Ratios are used to determine the financial strength of companies as well as their manufacturing and management efficiency. You need a serious report. I’d like some more information. I’d like to receive four or five years’ annual reports, so we can develop a trend analysis.”

“All right,” James said. “But in the meantime how would you approach reviewing another company’s financials if you were in my position?”

“First, I’d look at the Auditor’s Report to see if it has any qualifications. A qualification in the report might tell us that the company is following some accounting convention that is unusual or some other irregularity. Then I’d look at the footnotes.”

“I always thought of accounting as being black and white,” James said.

“It’s not. For example, I’d pay careful attention to the company’s notes dealing with revenue recognition and inventories. Revenue should be recognized only when goods are shipped after a sale has been made. You want to make sure customers are not buying on consignment with the ability to return goods. You want to see how inventories are valued. They should be carried at cost — not at the market value of the goods, unless market is lower than cost. Of course, if market value is below cost, there is a problem. You want to see what kind of inventory write-offs they have experienced. Significant inventory write-offs may be a sign of poor management.

“Anything else?”

“I’d want to see if any costs have been capitalized.”

“What does that mean?”

“Capitalized costs are amortized over a number of years instead of being expensed in one year.”

“Like depreciation?”

“That’s the most common example. But some companies treat other costs that way. If XYZ is capitalizing development or promotion costs, they may be trying to hide a cash flow problem. That would worry me. Also I’d look at the company’s current assets and liabilities to make sure that the company is solvent, at least in the short term.”

“There’s a lot to think about here,” James said.

“Yes, and you shouldn’t simply limit the review of financial statements to prospective corporate partners. You might do it before taking on a major new client. You can save yourself some grief by reviewing them before problems exist.”

HANK T. BULMASH C.A.

BULLMASH CULLEMORE

CHARTERED ACCOUNTANTS, TORONTO