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November, 2007
 
     
 

PROSPECTIVE FINANCIAL INFORMATION/FORECASTS

This month’s Accounting Newsletter examines Prospective Financial Statements
and Forecasts.  Most small and medium sized business owners know very little
about these accounting conventions. Prospective financial statements and
forecasts have a specialized meaning to accountants.  Forecasts, for example, are
often used internally in businesses, but few small and medium sized business
owners know how they are used in the financing process. This newsletter
discusses prospective financials and forecasts and how they may be used by
small and medium sized businesses.

WHO USES PROSPECTIVE FINANCIAL STATEMENTS AND
FORECASTS?

Financial statements are either historical or prospective in the periods covered in
them.  Historical financial statements categorize, summarize and present  actual past
revenue and cost transactions. Sometimes, however, a business may want to
prepare financial information that may be based on expectations of future
performance. Management may base decisions on this prospective data.  However,
there are other times when “outsiders,” e.g. potential investors, lenders, government
agencies, regulators and the general public may have an interest in the financial
future of a company.

WHO PREPARES PROSPECTIVE FINANCIAL STATEMENTS AND
FORECASTS?

Just as in all financial reports and statements issued by a business, management is
responsible for the financial information contained therein. But, just as with historical
financial statements, the involvement of a CPA gives the prospective financial
information more reliability and objectivity.  Accordingly, a CPA may be engaged to
compile, examine, or apply agreed-upon procedures to prospective financial
information or forecasts.  The CPA may also be engaged to assist the client in:

     - obtaining debt or equity financing;
     - deciding whether to lease or buy an asset;
     - assisting in a merger, acquisition, or disposition; or
     - helping to plan a variety of anticipated transactions.

A CPA’s involvement in issuing a “report” on prospective financial statements and
forecasts is governed by authoritative literature and standards promulgated by the
American Institute of Certified Public Accountants (AICPA) and the Securities and
Exchange Commission (SEC).  This literature makes a distinction between
prospective financial statements that are
financial forecasts and those that are
financial projections, and distinguishes between general and limited use of
prospective information.

HOW DO FINANCIAL FORECASTS DIFFER FROM FINANCIAL
PROJECTIONS?

A financial forecast reflects a business's expected financial position, results of
operations, and cash flows based on the
responsible party's assumptions reflecting
conditions that party
expects to exist and the courses of action expected to be taken
during the prospective period.   A forecast is expressed with the best knowledge and
belief of the responsible party--i.e., the person or persons, usually management
representatives, accountable for the assumptions that underlie the financial forecast.
A
financial projection, on the other hand, reflects an entity's expected financial
position, results of operations, and cash flows
given one or more hypothetical
assumptions. In other words, a projection is usually prepared as if in response to the
question, ''What would happen if _________________?

WHY DOES GENERAL USE DIFFER FROM LIMITED USE?

General use of prospective statements is use by those with whom the responsible
party is not negotiating directly. Conversely, if the parties are negotiating directly, the
use of prospective statements must be
limited. Limited use includes filing with a
regulatory agency or arranging for a bank loan--i.e., circumstances in which third-party
recipients have the opportunity to ask questions of, and negotiate directly with, the
responsible party.  Only a financial forecast (or a forecast supplemented by a
projection) and not a projection by itself is appropriate for general use. However, a
forecast alone may be appropriate for limited use.

WHAT ARE PRO FORMA STATEMENTS?

A distinction is also made between prospective financial statements and pro forma
statements
. In pro forma statements, future or hypothetical transactions or events are
applied to
historical financial statements for purposes of estimating the effect on the
historical statements as if the transactions or events had actually taken place during
the period covered. Thus, although the transactions or events used for pro forma
statements are indeed suppositional in nature, they apply to recorded financial data
and lead to financial statement presentations that remain essentially historical.

WHAT IS CONTAINED IN PROSPECTIVE STATEMENTS AND
FORECASTS?

Prospective financial statements and forecasts (and projections) should be in a
format similar to that used for the historical statements that will be issued for the
prospective periods covered, unless the responsible party and potential users agree
on a different format.  Financial forecasts and projections should take the form of
complete sets of basic financial statements or should be limited to specific types of
information. Otherwise, the information might be considered a partial presentation
appropriate for limited use but not general use. The details of each financial
statement may be summarized or condensed so that only major items are presented.
In addition, the usual supporting notes associated with historical financial statements
do not need to be included, although significant assumptions and accounting policies
must be disclosed.  Moreover, a caveat that the forecasted and projected financial
results may not be achieved should be included.

CONCLUSION

Prospective financial statements and forecasts are widely used within certain
industries, e.g. the textile industry or in the factoring sector of the financial market.  
They are also widely used in private placement memorandum and other financial
prospectuses.  Banks, private investors, government agencies, e.g. the Small
Business Administration (SBA) and others may utilize prospective financial
statements and forecasts to evaluate the ability of the small or medium sized
business to perform after an influx of capital has been or will be injected into the
business.  Thus, knowledge of this important accounting convention may be helpful to
small and medium sized businesses in their quest to find financing; both long and
short term.  Although the small and medium sized business owner or the
management thereof are the primary source of the financial information that is
reported in the prospective reports, the role of a competent CPA cannot be
underestimated.