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FINANCIAL MANAGEMENT

A guide to understanding financial data

Law practice owners, especially those operating smaller firms, tend not to be super-knowledgeable about financial statements and the financial state of their operations, according to Brenda M. Clarke, a partner at Seigneur Gustafson LLP in Lakewood, CO.

“They look to their staff, their office managers, their (financial) controllers, to help guide them,” says Clarke, adding that it is quite common for smaller firms to plug financial information into their accounting software without a real understanding of what it all means.

“The primary objective of financial reporting is to communicate understandable information that is useful in making business decisions. To achieve this objective, the information must be accurate and complete, timely and in the proper format,” says the certified public accountant and business appraiser.

Having a good recordkeeping system in place is extremely important, especially to law firm owners and the management team.

“If you’ve got a good recordkeeping system you are going to be able to monitor the success or failure of your firm.”

Good recordkeeping is also vital to budgeting, obtaining financing and new sources of capital, tax return preparation and legal requirements, and profit distributions.

Two types of accounting

Clarke says there are two types of accounting—financial and managerial.

Financial accounting is used by external decision-makers to evaluate a business. It is usually communicated through financial statements.

Managerial accounting is used primarily by internal decision-makers. It is not limited to financial statements and can be used for other types of reports.

“As an accountant or an officer manager in a professional services firm, you wear a lot of different hats. As far as the accounting goes, you have to be concerned with the business as a whole,” she says.

That includes looking at the business from the prospective of an employer, your responsibility to your staff, and taking responsibility for client trust funds.

Clarke says accounting principles are the rules and guidelines that companies must follow when preparing financial statements.

There are several important accounting principles and concepts governing the preparation of financial statements. They include the following:

  • The Business Entity Concept: This concept states that the transactions associated with a business must be separately recorded from those of its owners or other businesses. It requires the use of separate accounting records for the organization which completely exclude the assets and liabilities of any other entity or the owner.
  • The Historical Cost Concept: One of the basic underlying guidelines in accounting, this requires that assets be recorded at their cash amount, or its equivalent, at the time that assets are acquired. Clarke says this principle is extremely important when analyzing financial statements.
  • The Principle of Conservatism: This principle states that one should always err on the most conservative side of any transaction. Most of the time, this means minimizing profits by recording uncertain losses or expenses and not recording uncertain or estimated gains.
  • The Materiality Concept: This concept states that financial information is material to the financial statements if it would change the opinion or view of a reasonable person. All important information that could sway the opinion of a financial statement user should be included in the financial statement.
  • Consistency: This concept states that companies should use the same accounting treatment for similar events and transactions over time.
  • The Matching Principle: This principle states that expenses should be recognized and reported when whose expenses can be matched with the revenue those expenses helped to generate.

Six major steps in the accounting process

Clarke says there are six major steps to the accounting process, as follows.

  1. Analyzing: Looking at events that have taken place and determining how they affected your business.
  1. Recording: Entering the financial information about the events into the accounting system through electronic accounting software or other means.
  1. Classifying: Sorting and grouping similar items together rather than merely keeping a simple diary of numerous events.
  1. Summarizing: Aggregating many similar events to provide information that is easy to understand.
  1. Reporting: Putting your results, such as financial statements, in writing.
  1. Interpreting: Diving into the results through ratio analysis or other comparisons to industry.

Basic components of accounting

Transactions are typically recorded in one of five categories, namely assets; liabilities; equity; income/revenue; and expenses.

“Assets are the economic resources that have probable future economic benefits,” she says. “Liabilities represent the firm’s obligation to pay debts and typically you are going to see them on the financial statement as either current or long-term.”

Clarke says equity is often the trickiest financial statement account. “It is the difference between the value of the assets and the liabilities, so it is what’s left over for the owners.”

Revenues are the inflow of assets of an entity based on production and delivery of goods and services, while expenses are outflows or other uses of assets or incurrence of liabilities or both, during a period as a result of delivering or producing goods or rendering services.

“The fundamental accounting equation is Assets = Liabilities + Owners’ Equity. This accounting equation is what keeps financial accounting in check,” says Clarke.

Companies prepare four financial statements: balance sheets, income statements, cash flow statements and owners’ equity statements.

“When you look at only one statement, you don’t really see the full picture, but taken together, these financial statements can tell the reader a lot about a firm’s financial health and prospects,” says Clarke.

Conclusion

In summary, you need to have an open line of communication with the people you work with and know what information they are most interested in receiving.

Describe only the important details. Prepare an executive summary that you can refer to when presenting financial information to your management group. And be careful not to use jargon, warns Clarke. “Make sure you understand your audience and you speak to them in a manner that they understand. Do not try to prove your knowledge by boring your audience.”


Editor’s picks:

Use weekly financial reporting to keep partners aware of cash flow


Financial Reporting Beyond the Budget


The Office Manager’s Guide to Understanding Financial Data


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