Internal vs. year end financial statements

Do you prepare internal financial statements for your board of directors on a monthly, quarterly or other periodic basis? Later, at year end, do your auditors always propose adjustments? What’s going on?

Most likely, the differences are due to cash basis vs. accrual basis financial statements, as well as reasonable estimates proposed by your auditors during the year end audit. By understanding the differences between the two statements, you may be able to minimize them.

The simplicity of cash

Cash basis financial statements are just that — based on cash. More specifically, under cash basis accounting, you recognize income when you receive payments and you recognize expenses when you pay them. The cash “ins” and “outs” are totaled by your accounting software to produce the internal financial statements and the trial balance you use to prepare the periodic statements. Cash basis financial statements are useful because they’re quick and easy to prepare and they can alert you to any immediate cash flow problems.

The simplicity of this accounting method comes at a price, however: Accounts receivable (income you’re owed but haven’t yet received, such as pledges), accounts payable and accrued expenses (expenses you’ve incurred but haven’t yet paid) don’t exist.

The value of accruals

With accrual accounting, accounts receivable, accounts payable and other accrued expenses are recognized, allowing your financial statements to be a true picture of your organization at any point in time. If a donor pledges money to you this fiscal year, you recognize it when it is pledged rather than waiting until you receive the money. Or, if you receive printing services for brochures this month, you recognize the expense now, rather than waiting until the invoice arrives next month.

Generally Accepted Accounting Principles (GAAP) require the use of accrual accounting and the recognition of contributions as income when promised, and often year end audited financial statements are prepared on the GAAP basis. Also, to allow for consistency and comparison with other organizations, the accrual method is preferred.

The need for estimates

Another difference between your internal and year end statements may be resulting amounts that need to be estimated to present an accurate picture. Your auditors also may propose adjusting certain entries for reasonable estimates. This could include a reserve for accounts receivable that may be ultimately uncollectible.

For instance, perhaps your organization consistently receives pledges for donations, and a receivable for these amounts is recorded accordingly. Historically, however, a small percentage of those pledges is never received. Or you believe a specific pledge is not fully collectible. This can result in the auditors proposing a reserve, which would lower your pledges receivable amount.

Another common estimate is for litigation settlement. Your organization may be the party or counterparty to a lawsuit for which there is a reasonable estimate of the amount to be received or paid. This may be booked as a receivable or a payable at year end, depending on the anticipated outcome.

Minimizing the differences

These accruals and estimates can be booked each month so that internally prepared financial statements are consistent with the year end audited financial statements. If your organization is not on the accrual system for both cash receipts and cash disbursements, take a close look at your accounting software. Chances are, your software has built-in modules for you to easily convert to accrual accounting.

At month end, these modules should inherently roll up to your internal financial statements, if you print them directly from the software. If you prepare the financial statements outside of the software, such as in Microsoft Word or Excel, you can easily print reports of these amounts and adjust your financial statements accordingly.

Estimates are a little more difficult. You can always take a look at the adjustments your auditors proposed last year and inquire as to how they came up with those estimated amounts. You can then make your own assumptions each month and book adjustments to the estimates as necessary.

Communicating to the board

Minimizing the differences between internal and year end audited financial statements should be a goal, because it will save time, and maybe audit fees, in the future. But if it isn’t cost-effective or feasible, then being able to communicate what differences do exist will help your board — and staff — better understand the financial statement process. •