Accounting & Audit Alert- Predicting future performance
CPAs typically report historical financial performance. But sometimes they’re hired to predict how a company will perform in the future.
Prospective reporting options
There are three types of reports to choose from when predicting future performance:
- Forecasts. These prospective statements present an entity’s expected financial position, results of operations and cash flows. They’re based on assumptions about expected conditions and courses of action.
- Projections. These statements are based on assumptions about conditions expected to exist and the course of action expected to be taken, given one or more hypothetical assumptions. Financial projections may test investment proposals or demonstrate a best-case scenario.
- Budgets. Operating budgets are prepared in-house for internal purposes. They allocate money — usually revenues and expenses — for particular purposes over specified periods.
Though these terms are sometimes used interchangeably, there are important distinctions under the attestation standards set forth by the American Institute of Certified Public Accountants (AICPA).
Factors to consider
Historical financial statements are often used to generate forecasts, projections and budgets. But accurate predictions usually require more work than simply multiplying last year’s operating results by a projected growth rate — especially over the long term.
For example, a high-growth business may be growing 20% annually, but that rate is likely unsustainable over time. Plus, the business’s facilities and fixed assets may lack sufficient capacity to handle growth expectations. If so, management may need to add assets or fixed expenses to take the company to the next level.
Similarly, it may not make sense to assume that annual depreciation expense will reasonably approximate the need for future capital expenditures. Consider a tax-basis entity that aggressively took advantage of the expanded Section 179 and bonus depreciation deductions in 2018, which permitted immediate expensing in the year qualifying fixed assets were purchased. Because depreciation is so boosted by these tax incentives, this assumption may overstate depreciation and capital expenditures going forward.
Various external factors, such as changes in competition, product obsolescence and economic conditions, can affect future operations. So can events within a company. For example, new or divested product lines, recent asset purchases, in-process research and development, and outstanding litigation could all materially affect future financial results.
Some companies create prospective financial reports as part of their annual planning process. Others use these reports to apply for loans or to value the business for corporate litigation, buying out a retiring owner or a merger or acquisition. Whatever the reason for creating prospective financial statements, it’s important that the underlying assumptions be realistic and well thought out. Contact us for objective insights that are based on industry and market trends, rather than simplistic formulas and gut instinct.