Editor's Note: This article is part of Inc.'s bi-weekly primer on business terms in partnership with financial information company Sageworks.
As a business owner, it's essential to be not only an arbiter of all the financial resources available today, but also to find the meaning behind the numbers.
While technology has increased the availability of information, it can create more confusion than knowledge at times. It's smart data, not big data, that makes a difference, especially when it comes to finance. With some smart interpretation, however, numbers can tell the state of a company, a nation or the global economy.
Financial information about publicly traded companies mainly comes from mandatory quarterly and annual financial reports submitted to the Securities and Exchange Commission. These are subject to review and auditing by internal or independent accounting firms. Audit reports, when completed properly, can determine fairness and accuracy of essential financial metrics like assets, liabilities, income, expenses and profits. They can help evaluate a company's ability to operate, spend and invest. Having an audit is certainly better than not having one, and auditing is considered a benefit for stakeholders. Still, an audit can only evaluate what's contained in the financial statement and is limited by the accounting techniques of the company that produced it.
The most important part of financial statements and audits are often not the numbers themselves, but the notes that accompany them. The figures that appear on statements are the result of complex accounting methods, which are described in the footnotes of a statement. Footnotes will also include crucial revenue and profit trends.
"Companies very rarely want to mislead people, but it's the right and responsibility of every company to define what 'revenue' and 'expenses' mean in the context of its business model," says Sageworks chairman Brian Hamilton.
To evaluate the health of a company, you have to first understand how the company evaluates itself. As a business owner, you're entitled to build the accounting methodology that fits best for your business. You also have the responsibility to audit as you go - you'll get a constant, insightful picture of your own business's health that way.
Consider the example of Alibaba, the world's largest e-commerce company. The group owns a variety of companies, spanning many different businesses: cloud computing, online shopping, social media, online payment and mobile products. This makes for a serious accounting puzzle. Though the company is based in China, its financial statements are prepared according to U. S. standards, which require that companies report on major business segments that influence the "chief operating decision maker" on performance and resource allocation.
For Alibaba, there is no one decision maker, but instead a management committee comprised of many members of the company's management team. The company claims that its decisions are based on one business segment only: "online and mobile commerce and related services". Therefore, it only reports on that business segment. Alibaba also uses annual merchandise sales as an additional measurement for revenue. Any entity auditing Alibaba would be subject to these accounting quirks. In fact, Alibaba discloses on page 70 of its most recent prospectus, "these metrics may differ from the calculations published by third parties due to differences in methodology."
Accounting is not a science. It's a discipline that requires difficult judgment calls, and constant revision. Companies can make mistakes in their accounting methods, and pay a high price in penalties. Bank of America recently paid $7.65 million in a settlement with the SEC, for failing to deduct losses on a portfolio it acquired when it bought Merrill Lynch in 2009. The indiscretion was disclosed voluntarily, not found through an audit, in which case the penalty would have been much higher. Regardless, they're paying the price for bad bookkeeping. It's important to pay extra attention to new assets or acquisitions as your business grows. To an auditor, they're as much a part of your company as your original business, even if they aren't integrated on the front end.
Financial statements and the metrics they contain are the best resources for gauging the condition of companies and industries, and auditors work hard to make sure statements are as accurate as possible. The process of auditing comes down to taking a thorough, honest look at your numbers, and ensuring they reflect reality. Keeping detailed books is the first step to being your own auditor. Financial data is more accessible than ever before, but the smartest investors and businesspeople know that not even the best statement or audit tells a company's whole financial story. Consider the method behind the numbers and you can gain crucial insight into the real situation of a company, or give a better picture of your company to your own stakeholders.