DEAR ENTREPRENEUR, THE YEAR END IS HERE
With 31st March, the financial year round the corner, few entrepreneurs wanted to know what they need to be cautious about from the finance perspective of their business. Here are few things that you as the business owner should do, before closing your books for the year. I have illustrated it with a simple example.
An entrepreneur running an entity called ABC, was pulled up by the investors during the Board meeting. The reason being, during the last Board meeting for the financial year ending March, it was projected to close the year with a profit of 18%. However in the subsequent meeting, the audited financials revealed a loss of 6%. There was no significant event before the year end that caused the projected profit to become a loss. Hence the investors were not only unhappy with this let down but it also caused a decline in the trust levels as it affected some important business decisions.
So what were the reasons behind the profit becoming a loss? A scrutiny of the books revealed that ABC had failed to take into account many aspects of the business before committing to the investors on the year end numbers.
If you are an entrepreneur or a business head in charge of your P&L, remember that you can take some precautionary steps to avoid if not minimise the difference between pre-audited and post-audited numbers.
Here are the factors that contributed to the profit to turn into a loss, post the audit. Are you vulnerable to some of these areas? Check them out.
ABC’s customer had made a payment in February as an advance for the work that was to happen over the next nine months. This entire amount was treated as revenue by ABC. According to the auditors, ABC should have allocated only the current year’s share as revenue. The revenue that pertains to the work meant for the next year needs to be recognised in the following financial year only. This incorrect treatment of advance was one of the reasons for the decreased profit of ABC.
Lesson –Money received as an advance is not to be treated as revenue.
2. Unpaid invoices
ABC was not yet paid by a customer for the services rendered in the current financial year. ABC did not take into account any revenue from this customer. Although the amount is not yet received, auditors state that you have to disclose it as revenue in the current financial year as the work is already completed. The amount yet to be received to be disclosed as dues to be recovered from customer. By accounting for this revenue, the profits of ABC increased.
Lesson – If the work for the customer is complete (or in progress), the (prorated) amount to be disclosed as revenue even if the amount is not collected.
ABC had missed to raise an invoice for the work completed for one of its customers. The auditors included this amount in the revenue as the work was completed. In another instance, one of the projects of ABC was spilling on to the next year & ABC did account for any revenue from this project for the current year end. The auditors want the work in progress to be quantified and stated as revenue. Both these factors further increased the profit of ABC.
Lesson – Check if the work completed for all your customers has been included as revenue.
4. Prepaid expenses
The auditors stated to recognise expenses that pertain to the current period only as an expense in the profit and loss account. Remaining amount should be expensed in the next year only. The annual maintenance charges for ABC’s computers was Rs.240,000 per annum for the period 1st July to 30th June of next year. In the current year (1st April to 31st March), ABC expensed the entire amount. Instead ABC should charge expenses for only nine months from 1st July to 31st March an amount of Rs.180,000. Remaining Rs. 60,000 to be shown as expense in the next financial year. Due to this, the expenses of ABC reduced by Rs.60,000.
Lesson – Check the duration of your expenses. Charge your P&L with only the part pertaining to the current financial year.
5. Provision for Depreciation
As depreciation does not involve a physical cash outflow, ABC did not provide for depreciation of its assets. However, assets need to be depreciated. During the course of the audit, ABC was told to provide for depreciation which decreased their profits.
Lesson – Although there is no cash outflow, assets need to be depreciated and hence a provision needs to be made.
6. Other Provisions
ABC had missed to make provision for many other items. The auditors state that it is prudent to provide for expenses and accruals before closing your books of accounts for the financial year. ABC had missed to include provisions for the following :-
- Provision for gratuity – ABC had not provided for gratuity for its employees. Although gratuity needs to be paid only after the completion of a stipulated years of employment with the same employer, it is required to provide for gratuity in each financial year.
- Provision for bonus – ABC had the practice of paying bonus in the following December of each year to its employees, for the year ended March, Although the pay-out is in December, bonus provision is required to be made. So yet again, ABC margins reduced.
- Provision for leave salary – As employees of ABC were entitled for leave encashment, provision for leave salary of employees who had not yet availed their leave at the year-end had to be made in the books of ABC which was insisted upon by the auditors. Thus this created a rift between the pre and post audited numbers.
- Provision for insurance – ABC had decided to opt for insurance of its employees, fixed assets etc. Although the payment was due only in April, the term was effective from January. The provision was yet to be made in their books as at the year end. This provision increased the expenses of ABC.
- Provision for bad debts – ABC was doubtful of receiving some moneys due from one of their customers. Although they were following up for the payment, the auditors wanted to provide for bad debts in the book of ABC as the auditors operate on a conservative basis.
- Provision for expenses – ABC failed to provide for expenses such as communication costs, energy costs and other expenses as they had not yet received the bills for payment. The auditors wanted these expenses to be included even though the payment was not effected. This again decreased the profits.
- Provision for payables – There were some software licences that were procured by ABC in January and it was paid post the year end. However, the auditors wanted this amount to be reflected as a provision for payables. This was another reason that widened the gap between the pre and post audited numbers.
- Provision for audit fees – Although the auditors are paid their fees after the audit completion, a provision for the audit fee payable to the auditors needs to be included in the books, which ABC had missed.
- Provision for interest payable – There was a loan taken by ABC which bore an interest. The interest amount payable was not considered by ABC, which had to be provided for.
Note – The above is not an exhaustive list. You will have to customise it according to your business.
Lesson – Irrespective of whether you have paid for your expenses or not, you have to take stock of all your dues and provide for the expenses at the year end.
7. Fixed assets verification
Before the year end, it is a healthy practice to physically verify your fixed assets and ensure that they are in good working condition. This also acts as a good internal control procedure. ABC missed to conduct a physical verification of their assets. When the auditor verified, they discovered that some assets were damaged and some were missing. These had to be written off, which caused the profits to decline further. So fixed asset verification emphasises that the assets are in existence and not a dummy book entry. Bank balances, deposits etc. require confirmation from the relevant authorities. By enforcing the verification of fixed asset, you can prevent the writing off, of any missing or mal functioning asset which can lead to differences in the bottom line of the business.
Lesson –Verify the assets of the business. The assets need to be reflected at their book value in most cases. If assets cease to exist, the book value of such assets to be written off.
8. Cash in hand
The cash balance needs to be physically counted and signed off with the denominations held as at the year end. Ideally the cash in hand should be minimal. However this could vary depending on the size and volume of your business. ABC had not accounted for the expenses that were paid by cash. Although it did not have a huge impact, accounting these expenses attributed to reduced profits.
Lesson – Account for amount spent as cash.
9. Bank reconciliation
ABC had issued few cheques during the last week of March. Some of these cheques were not presented for payment to the Bank as on 31st March. As these cheques were already issued, the auditors expensed them which further deflated their profits of ABC.
Lesson – As a best practice the bank accounts should be reconciled periodically (daily, weekly or bi-weekly, depending on the volumes). Stale cheques should be written off. Accrued bank interest should be accounted for. Provide for bank charges.
10. Loans and advances
ABC had provided loans to staff which was wrongly expensed. The auditors stated that these are to be reflected in the Balance Sheet as receivable and not to be reflected in the profit and loss account. If any interest is receivable, then the interest amount alone should feature in the profit and loss account.
Lesson – Loans and advances are to be featured in the Balance Sheet and not the profit & loss account.
11. Profit or loss from currency fluctuation
ABC was dealing with some transactions in foreign exchange. The auditors restated the foreign currency payables and foreign exchange receivables with the exchange rates prevalent as at the year end. The difference between the rate accounted in the books and the yearend exchange rate is to be stated as a foreign exchange gain or loss arising from currency fluctuations. In the case of ABC it was a foreign exchange loss, which contributed further and resulted in the overall loss for the entity.
Lesson – Remember to restate the foreign exchange payables and receivables at the currency exchange rate prevalent at the year end.
12. Tax liability
As per the pre-audited numbers, ABC had a profit. Based on those numbers, ABC had computed a provision for taxation. However, ABC had missed to include other statutory payments (such as provident fund, tax deducted at source, Goods and Services Tax etc.) which again caused a difference with the audited numbers.
Lesson – For better tax planning, check with your tax consultant. Remit statutory payments within the respective due dates.
Thus, the difference between the pre-audited and post audited numbers can be significant which can catch you unaware. This also results in under (or over) estimating your advance tax payments, can mess your financial planning and can even create embarrassing moments with the investors and the Board Directors. So plan and act accordingly.
Trust this has given you some insights into what is required to be done by you as an entrepreneur to close your books at the yearend so that the audit adjustments are at a minimum. For more such pointers, refer to my book “What The Finance” available on online portals.