The top line of an income statement for a for-profit business is revenue (or sales). Reporting this line item correctly is critical to producing accurate financial statements. Under U.S. Generally Accepted Accounting Principles (GAAP), revenue is recognized when it’s earned. With accrual-basis accounting, that typically happens when goods or services are delivered to the customer, not necessarily when cash is collected from the customer.

If revenue is incorrectly stated, it can affect how stakeholders, including investors and lenders, view your company. Inaccurate revenue reporting also may call into question the accuracy and integrity of every other line item on your income statement, as well as amounts reported for accounts receivable and inventory. So, auditing revenue is an essential component of a financial statement audit.

Audit standards

Under GAAP, you typically must follow Accounting Standards Codification (ASC) Topic 606, Revenue from Contracts with Customers. This standard went into effect in 2018 for calendar-year public companies and 2020 for calendar-year private entities. It requires more detailed, comprehensive disclosures than previous standards.
Under ASC 606, there are five steps to determine the amount and timing of revenue recognition:

1. Identify the contract with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when the entity satisfies the performance obligation.

When auditing revenue, auditors will analyze your company’s processes, including the underlying technology and internal controls, to ensure compliance with the rules. The goals are to ensure that your process properly records every customer obligation accurately and that revenue is reported in the correct accounting period.

Audit procedures

During fieldwork, auditors will scrutinize internal controls related to every phase of a customer contract, the appropriate segregation of duties, and the accounting processes governing the booking of revenue in the appropriate periods. They’ll also select a sample of individual customer transactions for in-depth testing. This may include reviewing contracts and change orders, inventory records, labor reports, and invoices to ensure they support the revenue amounts recorded in the general ledger. In addition to helping validate your revenue recognition process, testing individual transactions can uncover errors, omissions, and fraud.

Auditors will also analyze financial metrics to root out possible anomalies that require additional inquiry and testing. For example, they might compute gross margin (gross profit divided by revenue) and accounts receivable turnover (revenue divided by accounts receivable) over time to evaluate whether those ratios have remained stable. They might compare your company’s ratios to industry benchmarks, too, especially if demand or costs have changed from prior periods.

Eyes on the top line

Stakeholders — including investors, lenders, suppliers, customers, employees, and regulatory agencies — use the information included in financial statements for many purposes. If your revenue recognition process is flawed, it tends to trickle down to other financial statement line items, compromising the integrity of your financial statements. So, it’s important to get it right. Contact us to discuss audit procedures for revenue and ways to improve your revenue recognition process.

In today’s uncertain marketplace, many businesses are stashing operating cash in their bank accounts, even though they might not have imminent plans to deploy their reserves. However, excessive “rainy day” funds could be an inefficient use of capital. Here’s a systematic approach to help estimate reasonable cash reserves and maximize your company’s return on long-term financial positions.

What’s the harm in stockpiling cash?

An extra cushion helps your business weather downturns or fund unexpected repairs and maintenance. But cash has a carrying cost — the difference between the return companies earn on their cash and the price they pay to obtain cash.

For instance, checking accounts often earn no (or very little) interest, and many savings accounts generate returns below 2%. If a company has cash reserves while simultaneously carrying debt on its balance sheet, such as equipment loans, mortgages and credit lines, it will pay higher interest rates on loans than it’s earning from the bank accounts. This spread represents the carrying cost of cash.

What’s the optimal amount of cash to keep in reserve?

Unfortunately, there’s no magic current ratio (current assets divided by current liabilities) or percentage of assets that’s right for every business. A lender’s liquidity covenants are just an educated guess about what’s reasonable.

However, you can analyze how your company’s liquidity metrics have changed over time and how they compare to industry benchmarks. Substantial increases in liquidity — or ratios well above industry norms — may signal an inefficient deployment of capital.

Prospective financial reports for the next 12 to 18 months can be developed to evaluate whether your company’s cash reserves are too high. For example, a monthly forecasted balance sheet might estimate expected seasonal ebbs and flows in the cash cycle. Or a projection of the worst-case scenario, based on certain what-if assumptions, might be used to establish a company’s optimal cash balance. Forecasts and projections should take into account a business’s future cash flows, including capital expenditures, debt maturities, and working capital requirements.

Formal financial forecasts and projections provide a method for building up healthy cash reserves. This is much better than relying on gut instinct. You also should compare actual performance to your forecasts and projections — and adjust them, if necessary.

What’s the highest and best use of excess cash?

After prospective financial reports and industry benchmarks have been used to determine a company’s optimal cash balance, management needs to find ways to reinvest its cash surplus. For example, you might consider repurposing the surplus to:

• Invest in marketable securities, such as mutual funds or diversified stock-and-bond portfolios,
• Repay debt to lower the carrying cost of cash reserves,
• Repurchase stock, especially when minority shareholders routinely challenge management’s decisions, or
• Acquire a struggling competitor or its assets.

With proper due diligence, these strategies could allow your business to reap a higher return over the long run than leaving funds in a checking or savings account.

We can help

Contact us for help creating formal financial forecasts and projections and evaluating benchmarking data to devise sound cash management strategies. We can guide you toward more efficient use of capital while reserving enough cash on hand to meet your business’s short-term operating needs.