Companies try to make informed decisions to deal with whatever challenge or opportunity may be around the corner. But they don’t have a crystal ball.
To plan for the future, company management uses prospective financial information. The most basic prospective information is an operating budget, which is usually prepared on an annual basis. Management uses this budget to monitor expected operating results against actual operating results.
The use of budgets allows management to make changes if actual results differ from expectations, thereby mitigating the impact of a downturn in revenue or an increase in expenses. However, as times change, a company may need more than just annual budgets to effectively make decisions about future operations or to interest lenders and investors in providing financing to the company.
Changes in business conditions – or the desire to expand – create the need to consider the impact of alternatives. If concerned with estimating future operating results based on an existing situation only, management can use a forecast to present that information. If management would like to consider different scenarios, projections based on hypothetical assumptions may be more useful.
Forecasts and projections can be prepared for one year, or multiple years, into the future. They may also be prepared for quarterly or monthly periods.
In any case, it is important to remember that, while prospective financial information can be a useful tool, it is inherently limited because future outcomes are impossible to predict.
Management can use projections:
- To obtain financing by showing prospective lenders how the company will repay debt in future periods
- To show potential investors how the additional capital invested will result in an increase in the value of the company over time or provide a return on the investment from operations
- To assist with decisions regarding expansion, investing in property, starting a new line of business or terminating an existing product or service
Projected financial information can be limited to cash flows, or it can be in the form of a full set of projected statements on the accrual basis.
Projections and forecasts are based on assumptions, which should be clearly presented so a user of the prospective financial information can evaluate their reasonableness. While forecasted financial information can be for general use, projected financial information must be restricted in use.
Accountants can assist in the preparation of forecasts and projections in a variety of ways. They can either examine or compile prospective financial information (from financial information and assumptions provided by management), depending on whether a level of assurance is needed.
The accountant can also perform “agreed-upon procedures” to forecasts or projections prepared by the client. All interested parties would agree to these procedures.
The accountant’s role in performing an examination includes reviewing the underlying documentation in support of the assumptions and assessing the reasonableness of the assumptions. The accountant who compiles the prospective information provides no assurance on the reasonableness of the assumptions.
In preparing the assumptions used in generating prospective financial information, industry knowledge, historical knowledge about the company and its operations, and an awareness of economic conditions and their impact on the company are crucial. In addition, the accountant should consider other factors, such as the impact of competition, interest rates, demographics and other relevant matters.
The accountant’s role may include guiding management in making reasonable assumptions and in modeling particular scenarios. But the ultimate responsibility for the assumptions and scenarios rests with management.
At a minimum, the accountant must issue a compilation report whenever the CPA firm is associated with prospective financial statements provided to third parties. If prospective information is for internal use only, a compilation report is not required, and the CPA acts solely in the role of a consultant to management in preparing the prospective information.
In either case, the accountant obtains an engagement letter to clearly indicate the role of the accountant and the limitations on the services provided.
Projections and forecasts can be generated using spreadsheet software with formulas that allow for an easy adjustment to amounts when assumptions change. Also, software products are available to handle more sophisticated modeling of various “if-then” scenarios and to generate a full set of prospective financial statements: balance sheets, income statements and cash flow statements.
Whenever there is a need to plan for the future or evaluate alternative plans for company operations, management can use prospective financial information as a tool in making decisions. And third parties, such as lenders or investors, may give prospective information more credibility if the accountant plays a role in reporting on that information.