Improving Financial Reporting through Financial Analysis

Improving Financial Reporting through Financial Analysis

By Karl Kern, Founder/President, Kern Analytics LLC

Financial reporting is the process of describing how businesses earn revenues, incur expenses, and generate cash flows.  An objective of financial reporting is to provide useful information.  One way to improve the ability in achieving this objective is through financial analysis.

A characteristic of useful information from financial reporting is relevance.  Relevance focuses on the effect that information has on decision making.  My experience in regard to relevance within financial reporting is in the use of a Miscellaneous Expenses account.  The purpose of this account is to communicate transactions that are outside the typical day-to-day activities within businesses. I have seen however the misuse of this account by treating it as a “dumping ground” for misunderstood transactions.  Using this account to record misunderstood transactions can affect relevance by failing to create insights into profitability.  The financial analysis, therefore, can improve useful information by developing clarity in the activities that affect the profitability of businesses.

A characteristic of useful information from financial reporting is reliability.  Reliability focuses on the amount of trust that people have in the information they receive.  Trust through financial reporting is established by two concepts: accrual accounting, recording revenues when earned and expenses when incurred, and conservatism, do not overstate assets and income.  Financial analysis can assess reliability through accrual accounting by analyzing expenses to ensure that they are recorded when they took place; for example, recording compensation when the work took place instead of when the person was paid.  Financial analysis can assess reliability through conservatism by analyzing accounts receivable that are uncollectable, inventory that is obsolete, and fixed assets containing expenditures that maintain rather than enhance useful lives.  Reliable financial statements go beyond the assessment of profitability by providing insights into a company’s liquidity and solvency.  Profitability, liquidity, and solvency are characteristics that establish the relationships between businesses and stakeholders so financial analysis serves an important role in not only maintaining but also improving such relationships.

So how can an FP&A practitioner assess the effectiveness of financial reporting processes?  Here are five tips that I have in order to establish a starting point in the process:

  1. Analyze accounts like consulting and legal to ensure expense, as well as liability accounts, are up-to-date, i.e. financial statements as of December 31, 2017 include amounts for services provided through that date.
  2. Analyze expense accounts to ensure proper recording of agreements like maintenance contracts on communications equipment.
  3. Use reports that can track inventory movement to determine the potential of obsolescence.
  4. Use fixed asset registers to identify expenditures that should have been expensed rather than capitalized.
  5. Look into the reconciliation of cash accounts to make sure they are current; many years ago I had to solve a problem in which 18 months of reconciliations related to a payroll account were not done and several reconciling items were not recorded in a timely manner.

Identifying strengths and weaknesses within businesses is critical in order for to not only maintain but also enhance their existences.  The identification process can be hindered due to useless information based on irrelevance and/or unreliability. Useless information can be identified and corrected through financial analysis.