Different Situations, Different Financial Statements

Many years ago, when goodwill was amortized and not checked for impairment, I worked for Kraft foods. I was in a meeting with the new corporate Controller and the topic of what format to use for the P&L for the upcoming annual plan came up.?

I had come from an operating group that internally used its own income statement format. It was focused on variable contribution and fixed costs that were controllable by that operating group.?

The new corporate Controller was adamant about using the traditional corporate income statement format. Why? Because it was his job to look at all the costs, including those the operating groups couldn’t control.?

In particular, he wanted to include the amortization of the goodwill created by the many recent acquisitions. And while goodwill amortization is a cost no one can change, he wanted to see the return on the acquisitions.?

Needless to say, the operating groups and corporate had different needs and perspectives when viewing the income statement.

Which Financial Statements to Use When

Today’s newsletter is about the different types and formats of financial statements and what to use when. Much of the focus will be on the income statement — not because the balance sheet doesn’t matter, but because there are more variations with the income statement.

First, let’s get the biggest difference between financial statements out of the way: There are those used for external reporting purposes and those used by management to run the business. Most companies should have both, but they are not the same thing.

External Statements

The users of the external statements — typically owners, lenders, and other current or potential creditors — not only want to know the statements are accurate, but they also want them in a format similar to all the other financial statements they review. This allows them to make apples to apples comparisons.?

So, they want GAAP (Generally Accepted Accounting Principles) statements which determines not only how transactions are accounted for, but also how the financial statements are presented. What goes into income and what goes into expense? Is a given liability current and due soon, or is it long term? And so forth.?

Because GAAP financial statements must meet industry standards, variations are usually arcane in nature. The focus is on presentation; that is, where the individual accounts go on the financial statements.?

Internal Statements

With internal financial statements — those used by management — it’s an entirely different ballgame. As my experience with the corporate Controller highlighted, these can vary tremendously, depending on who uses them and for what purpose.

For management income statements, the principal difference from GAAP-format statements is that they are tailored to reflect the economics of the business. For example, sales discounts are often classified as “marketing expense” within the operating expense category for GAAP, and are assumed to be fixed. But they often vary quite a bit with sales or volume.?

In the Kraft Foods example , sales net of all sales’ variable expenses less variable product costs were laid out to show variable contribution in the operating group format. The idea was to value how much profit was gained by selling another case of product. In the food business, trade deals, discounts off invoice, and sales incentive paid periodically on volume, were a big variable expense (in a traditional income statement, this shows up in marketing expense).?We also broke out fixed expense between what could easily be controlled in the short term — salaries, advertising, and so forth — and what couldn’t, such as depreciation, rent, taxes, etc.

This was a powerful tool. When I then moved to corporate strategy at Kraft, I was assigned Duracell, whose financial performance had been horrible. Management blamed its woes on the gray market — product sold in Europe was being resold in the US at below what Duracell charged retailers. Duracell wanted government action to stop it.?

I looked at Duracell Europe’s income statement through the lens of variable contribution. After trade discounts were taken into consideration, Duracell was selling product in Europe for substantially less than in the United States after currency differences were considered. The problem was of their own making! The solution was to cut trade discounts in Europe, lose some volume in a small volume market, and raise prices in the large volume US market.

Sometimes the economic income statement gets a bit more complicated. For example, when I was in the rental car business, what mattered was how many cars we had to rent as well as how often they were rented (utilization). So, the company developed a financial statement that took utilization into account, as utilization was a big driver of month-to-month profit variances.

Another iteration of income statements relates to who is in control, especially regarding expenses. As the regional manager of seven profit centers in the same rent a car business, I cut costs by consolidating all back-office work into one office. Since regional management controlled the region office costs, they were not charged to the seven profit centers. At the region level, however, we looked at expenses as part of a region-wide income statement. Here, we had to make sure the profit centers made enough to both cover region overhead and meet region profit goals.?

Further, there can be more than one version of an income statement. For example, the income statement we used in the rent a car business to monitor monthly results was different than the income statement used when evaluating location profitability or when renewing real estate leases. For these other analyses, we allocated regional and other costs because we needed to look at ongoing profitability, not just month-to-month performance.

A few pointers…

• Ask how the income statement will be used. One format rarely fits all purposes. Often, the format used to hold managers accountable and monitor short term results should be different than what is used to monitor long term profitability, return on investment, and so forth.

• Invest in systems. Modern ERP and stand-alone general ledger packages allow for creating different financial statements from the same chart of account data. The investment in these is well worth what would otherwise require a collection of laborious spreadsheets.

• Let lenders see what they want. At times, lenders like to see your management financials because it helps them better understand your business. So let them. But, be prepared to reconcile the management income statement to the GAAP format.

Sometimes, the GAAP presentation of financial statements works for management purposes.? For example, a staffing company client of mine uses GAAP-format financial statements for management purposes, because sales are sales and there are no discounts, trade deals, etc., that would show up in operating expense. And the only variable expenses are those of the hired temps, so GAAP cost of sales is entirely variable.

Final Thoughts

Financial statements are intended to serve a purpose, whether that means sharing how a business is doing with outside entities or managing internally.

There is no one-size-fits-all format. It will vary based on who is interested and to what purpose the information is being reviewed. By matching the right statements for the right situation, you will ensure that your organization’s financial information is used effectively.

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Charlie Goodrich is Founder and Principal of?Goodrich & Associates, a management consulting firm that specializes in helping its business clients solve urgent liquidity problems. He holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia and has over 30 years' experience in this area.