When you obtain a client that requires an accounting cleanup, you should first establish a sound plan. You should also gain an understanding of the industry and how the financial data should be organized and reported. Expectations must be set between you and the client. The client should understand that this engagement could be an expensive process but will provide substantial benefits once completed.
Once expectations are set and the client signs the engagement letter the following processes should be performed:
1. Generate the financial statements from the accounting database which includes the balance sheet and income statement.
2. You should perform a broad review of the financial statements along with a review of the client’s entity structure.
3. Determine the complexities associated with the amounts reported and access if they properly report economic reality.
4. You should also scan the general ledger to understand the overall business activity.
5. Gain an understanding of the entire reporting infrastructure. This includes all subsidiary ledgers and separate reporting packages that upload to the general ledger.
Once you complete the initial review listed above you will start drilling down into the reporting functions. The following areas should be considered:
1. If the client has multiple entity structures that need to be combined using EXCEL or other manual processes, that will create additional time and add complexities to the cleanup process.
2. The chart of accounts should be reviewed to determine if each entity has a consistent account structure where they can easily be combined. Are the accounts being used to create the financial statements in line with industry standards?
a. Is the chart of accounts set up correctly to report economic reality?
3. Does the client have segments or classes set up in the database where financial information can be correctly report the financial position and results of operations can be reported by segment?
4. You may be required to alter the chart of accounts to increase the effectiveness of the due diligence process.
5. Are the financial statements being prepared using generally accepted account principles, the income tax basis of accounting or some hybrid reporting technique?
a. Most investment bankers want financial information to be reported using generally accepted accounting principles.
b. This can require restating numerous balance sheet and income statement accounts.
6. When using Generally Accepted Accounting Principles you must have cutoff procedures in place for accounts receivables/revenue, and accounts payable/disbursements.
a. This can create complexities where invoices have been entered in the wrong accounting periods throughout the year.
i. The purchasers may want to see month to month financial information.
ii. If so, you would need to reenter transactions in the correct accounting period where revenues and expenses properly match.
You will then start drilling down into the detail in the general ledger. The flowing processes should be considered:
1. Typically, you will start with the balance sheet in this process.
a. Cash should have been properly reconciled to the bank statement.
b. The accounts receivable subsidiary ledger should compare and agree to the amount recorded in the general ledger.
i. You would also look for delinquencies and slow paying accounts.
c. Fixed assets and accumulated depreciation will possibly need to be restated using Generally Accepted Accounting Principles.
i. Recording depreciation using the straight-line basis versus income tax methods.
d. We discussed cutoff to where accounts receivable, accounts payable, and other balance sheet accounts would be fairly stated at each month end.
e. After the balance sheet, you would start analyzing the income statement accounts.
i. You want to first understand revenue recognition.
ii. How does the client make money and when is it correctly reported?
iii. You would also make sure revenue is reported in the correct accounting periods.
iv. Are expenses reported in the correct categories?
v. Are expenses properly cut off and reported in the correct accounting periods?
f. Review detail postings to defined general ledger accounts to ascertain if transactions have been recorded correctly.
You would also analyze the general ledger to locate normalization adjustments to the benefit stream being used to value the company.
1. When analyzing the balance sheet, income statement and general ledger you should identify non-recurring transactions, discretionary spending, and onetime transactions.
2. This is more applicable to the quality of earnings analysis and the due diligence process that will follow the accounting clean up processes.
3. The transactions identified could be considered normalization entries to compute the value of the enterprise.
Benchmark databases should be used to analyze the company’s operating performance and make comparisons to industry averages.
1. Benchmark analysis provides additional information relating to the clients financial trends and the comparability to guideline companies.
2. This is a valuable tool to compare the client with industry standards. Areas of concern will be flushed out using this process.
You should compare the company’s financial statements with the tax returns filed with the treasury department. The tax returns were filed with an external agency so they help validate the correctness of the database.
1. You would review the client’s tax returns and compare the information contained in the tax returns with the information contained in the general ledger.
2. You would prepare a book to tax difference, where you would have timing differences and permanent differences.
3. Once you have prepared the financial statements using Generally Accepted Accounting Principles, you could expect to have numerous timing differences.
4. Review previously filed tax returns to determine if the client has used aggressive tax strategies.
The cleanup process should allow for a much better financial database and understanding of your client’s business. The information will also be ready for external reporting upon request. If having due diligence performed, your financial information can be immediately uploaded into a dropbox where all parties involved in the transaction can review the content.
We will also perform an analysis of the system of internal control. This will identify the transaction flow and control points.
1. We will identify all control points and outline the processes and procedures of all transactions that flow through the accounting and operating system.
2. We will identify control points to determine if protective and preventive controls are in place to safeguard assets.
3. You can sometimes create add-back entries to adjust the benefit stream to compute a higher valuation. If certain controls were in place it could increase the company’s cash flow and overall operating performance.
We will analyze the company’s human capital:
1. We will review human capital and determine the turn-over rate.
2. Does the company have adequate staffing in all areas of the business?
3. There could be ad-backs or reductions to the benefit stream as a result of this analysis.
We will also review all non-financial reports and analysis, such as dashboards, off-line systems, and supplementary schedules that management prepares on spreadsheets.
1. This can be very rich information where management has drilled down and provides quantities along with dollar amounts.
2. Company dashboards are a very good resource for nonfinancial data.
We will assist the company with developing a monthly or quarterly management discussion and analysis. This will provide a storybook about the company’s financial position and results of operations in difference predetermined intervals.