Recognizing the Limitations of External Financial Statements - dummies

Recognizing the Limitations of External Financial Statements

The external financial statements do not provide all the accounting information that managers need to plan and control the financial affairs of a business. Managers who look no further than the external financial statements are being very shortsighted — they don’t have all the information they need to do their jobs.

The accounts reported in external financial statements are like the table of contents of a book; each account is like a chapter title. Managers need to do more than skim chapter titles. As the radio personality Paul Harvey would say, managers need to look at the rest of the story.

Managers are problem solvers. Every business has problems, perhaps even some serious ones. However, external financial statements are not designed to expose those problems. Except in extreme cases — in which the business is obviously in dire financial straits — you’d never learn about its problems just from reading its external financial statements.

Seeking out problems and opportunities

Business managers need more accounting information than what’s disclosed in external financial statements for two basic purposes:

  • To alert them to problems that exist or may be emerging that threaten the profit performance, cash flow, and financial condition of the business

  • To suggest opportunities for improving the financial performance and health of the business

A popular expression these days is “mining the data.” The accounting system of a business is a rich mother lode of management information, but you have to dig that information out of the accounting database. Working with the controller (chief accountant), a manager should decide what information she needs beyond what is reported in the external financial statements.

Avoiding information overload

Business managers are very busy people. Nothing is more frustrating than getting reams of information that you have no use for. For that reason, the controller should guard carefully against information overload. While some types of accounting information should stream to business managers on a regular basis, other types should be provided only on an as-needed basis.

Ideally, the controller reads the mind of every manager and provides exactly the accounting information that each manager needs. In practice, that can’t always happen, of course. A manager may not be certain about which information she needs and which she doesn’t. The flow of information has to be worked out over time.

Furthermore, how to communicate the information is open to debate and individual preferences:

  • Some of the additional management information can be put in the main body of an accounting report, but most is communicated in supplemental schedules, graphs, and commentary.

  • The information may be delivered to the manager’s computer, or the manager may be given the option to call up selected information from the accounting database of the business.

Business managers and controllers must communicate — early and often — to make sure managers get exactly what they need. No one wants to waste precious time compiling reports that are never read. So, before a controller begins the process of compiling accounting information for managers’ eyes only, be sure there’s ample communication about what each manager needs.