Typical balance sheet problems
May 21, 2008
The balance sheet in an A/E or environmental firm is supposed to show what you have and what you owe. The difference between the two is the “net worth” of the company. It all sounds real simple, and it should be, but because there’s such a poor level of understanding of accounting by the professionals who own the firms in this business, some problems crop up.
Here are some of the more common balance sheet issues that need to be addressed in many A/E and environmental firms.
Owner’s equity or book value is used to determine firm value. These are two radically different things. Think about a person. If your value is only the difference in what you now have vs. what you owe, don’t you think that would be misrepresentative of your real value? You are still making money every day and will hopefully be doing that for a long time into the future. Some of that “earning power” has to be recognized as in your value today. The same applies to the company. It has future earning power. To simply ignore that and subtract assets from liabilities to determine net worth is misrepresentative of your firm’s value.
Accounting methodologies impact asset and liability values. If you think being on a cash basis really reflects what is happening in the business, you will not show any asset value for work you have performed but not billed. The only asset is an account receivable or cash— work-in-process is not recognized. How does this accurately reflect all of your assets then? Consider the following radically simplified example of a company doing $12 million a year in revenue and that bills for its services once a month on the last day of the month. If a balance sheet were assembled the day before bills went out, it would be about $1 million short in assets, i.e., accounts receivable, because those bills hadn’t gone out yet. That’s a pretty big difference in a firm that does $12 million a year and would result in what we’d all have to agree is an inaccurate accounting of assets minus liabilities!
Certain liabilities aren’t shown. One of the largest that is rarely reflected on the balance sheet of A/E and environmental firms is unfunded deferred compensation obligations. These are commonly promises made to specific principals or groups of principals to pay them so much money annually upon their retirement. These can be significant amounts of money and represent sizeable obligations for the firm in years to come. Yet often, there’s no mention of them in the balance sheet!
Pending litigation. A properly built-up balance sheet will make some attempt to reflect the potential impact of known lawsuits or claims that could be hanging out there like a black cloud. Again, many firms in our business have little or no reserve for lawsuits that they are already involved in, causing a significant misstatement of the company’s balance sheet.
Real estate. Many companies still own real estate that they carry on their balance sheets. This is fine, but over time, the depreciated value of a piece of commercial property is probably not anywhere close to its real value. The result is a grossly understated balance sheet “book value.” When this number is used for the basis of internal stock transactions, it will undoubtedly lead to hard feelings on the part of those who are selling.
It might be a good exercise to have your outside accountants tear into your balance sheet some time. Certainly larger companies with audited financials have a lot fewer of these problems but many small- and mid-sized firms with compiled financial statements have some or all of these issues in their balance sheets. Get to know your balance sheet and you will better know your entire business!
Originally published 5/12/2008
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