Reporting historical financial performance is generally why CPAs are hired, but sometimes they are employed to predict a company’s future performance.
When it comes to predicting future performance, there are three types to choose from:
- Forecasts. These are based on assumptions about expected conditions and courses of action. Proposed statements like this provide an entity’s financial position, results of operations, and cash flows.
- Projections. Given one or more hypothetical assumptions, statements like this depend on the expected course of action and assumptions about conditions. Financial projections may examine investment proposals or demonstrate a best-case scenario.
- Budgets. For internal purposes, operating budgets are prepared in-house. They allocate money, typically revenues and expenses, for different purposes over specified periods.
These terms are interchangeable, however, there are notable distinctions under the attestation standards set forth by the American Institute of Certified Public Accountants (AICPA).
Factors to Consider
It is common to use historical financial states to generate forecasts, projections, and budgets. In order to calculate more accurate predictions over the long term, there is more to be done than merely multiplying last year’s operating results by a projected growth rate.
For example, to take a high-growth business to the next level, it is crucial for management to come up with a sustainable approach by adding assets or fixed expenses. It may be growing 20% annually, but that rate will likely dip over time. Factors such as the business’s facilities and fixed assets may lack the capacity to handle growth expectations sufficiently.
Assuming that annual depreciation expense will approximate the need for future capital expenditures would not make much sense either. Think about a tax-basis entity that aggressively took advantage of the expanded Section 179 and bonus depreciation deductions in 2018, which in turn permitted immediate expensing in the year qualifying fixed assets were purchased. This assumption may overstate depreciation and capital expenditures due to depreciation that is boosted by these tax incentives going forward.
Changes in competition, economic conditions, internal company events, and product obsolescence can affect future operations. For example, recent asset purchases, new or divested product lines, outstanding litigation, and in-process research and development could all potentially affect financial results in the future.
As part of their annual planning process, some companies may create prospective financial reports. Other companies can 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 essential that the underlying assumptions be realistic and well thought out.
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