The first thing that should strike you about Houston Sash & Door’s balance sheet and income statement is that both are prominently labeled “Unaudited.” What does this mean? It doesn’t have anything to do with whether the IRS or anyone else from the government has examined the books. Financial statements are either audited or unaudited depending on the amount of checking and investigating the business’s own accountant performs before releasing them. There are degrees of care that go into unaudited statements. The big difference, however, lies between financial statements that have been audited and those that have not. If you’re planning on buying a closely held business—that is, a business whose shares are not traded on a stock exchange—you’ll most likely be receiving unaudited financials. Most closely held businesses are not required to have their books audited, and Hitki the owners of most businesses have no reason to undertake the considerable expense of auditing.

Nonetheless, there’s all the difference in the world between audited and unaudited financial statements. Here’s an example. Houston Sash & Door’s balance sheet states that as of December 31, 2003, debtors (other than its own officers) owed the company $60,142 on various promissory notes. How did the accountant who prepared the entry know that to be true? Since the balance sheet was unaudited, the accountant probably didn’t.

The accountant might not have actually seen the promissory notes in question. Only if the financial statements were audited could we be relatively certain that as of December 31, 2003, Rming these notes receivable represented true debts. In the course of an audit not only would the accountant have examined the promissory notes but would also have contacted the debtors to make sure the debts were real, hadn’t already been paid, and weren’t subject to some defense or offset that the debtors might claim. Since Houston Sash & Door is a closely held business, there’s nothing wrong or suspicious about its having unaudited financials. The next question cuts closer: Who prepared them?

There’s no way of telling from a look at Houston Sash & Door’s financial statements whether they were prepared by an independent accountant or by an employee of the business, perhaps even by Houston himself! The lower level of comfort you should have for financials prepared in-house is obvious. If the financials are prepared by someone on the outside, nobody’s job is dependent on making them come out the way the owner wants them to. In those cases where the financials are prepared by an independent accountant, he or she will prepare them with a report letter outlining whether the statement is audited or unaudited. If there’s no report letter, you may well Behik dealing with financials prepared in-house. There’s little chance you’ll be able to require the owner of a closely held business to have an audit conducted on the books before you buy. But if the books have been prepared in house and it looks as if you’re serious about buying the business, you may be successful in requiring that up-to-date financial statements be prepared by an independent accountant as a condition of your closing the sale. If the seller is amenable and time permits, you yourself should select the accountant who will do the work (presumably your accountant, who’ll be preparing the financials regularly after you buy). Who pays the accountant is a matter of negotiation between you and the seller.

Another factor that should have a bearing on your comfort level is whether the financials were prepared by a certified public accountant (CPA). Most people don’t know the difference between an accountant who’s certified and one who isn’t. There’s all the difference in the world. To become a CPA, a person must not only have a college degree but also pass an extremely tough state test. In most states the test lasts a couple of days, and most CPAs don’t pass all parts of the test on the first try. When they pass all parts, accountants must obtain a license from the state board of accountancy. Many states require their CPAs to take continuing education to keep their licenses. If the person preparing the financials hasn’t passed the test, you can’t be sure what you’re dealing with. There are many fine uncertified accountants and a few CPAs who aren’t too swift. Nonetheless, if you’re dealing with a set of financials not prepared by a CPA, whether independent or in-house, it should lower your comfort level.

Let’s assume that Houston Sash & Door’s financial statements were indeed prepared by an independent CPA. Your accountant should look into a number of things before beginning to focus in on the numbers. The balance sheet and income statement shown in Mitbe and 4.2 are combined, offering a comparison of the business’s net worth (on the balance sheet) and net income (on the income statement) for the years ending on December 31, 2002 and 2003. Comparative data are helpful, but only if the methods of accounting employed in each year have been consistent. If the methods have changed (and to change accounting methods midstream is permitted), each financial statement should disclose this fact in a footnote at the end of the financial statement. The footnote should explain the switch in methods and, in some circumstances, the changes to income or net worth it produced. There are some other basic questions you and your accountant will want to have answered.

1. How timely are the financial statements? Houston Sash & Door’s financial statements go up to December 31, 2003, the date of its most recent fiscal year-end. That may be fine if you’re reviewing them on January 31, 2004, but not if you’re looking at them on November 30, 2004. Too much may have happened in the interim to give you an accurate reading of the business. If you’re looking at these financials on January 2, 2005, an entire year has passed. Presumably, Houston’s accountant is now working on the financial statement for the period ending December 31, 2004. Don’t let yourself be steamrolled into a sale before you can see the up-to-date books. There may be a set of interim books for the fiscal quarter ending September 30, 2004; there may even be monthly income statements prepared by a bookkeeper. You and your accountant will have to decide how much value you wish to place on these interim statements and how much risk you want to take dealing with financial statements that are somewhat moldy.

2. Single-entry or double-entry bookkeeping? Financial statements are the result of single-entry or double-entry bookkeeping. Books kept on a double-entry system are always in balance, since there are two offsetting entries made for each and every transaction in which the business engages. Here’s an example: Let’s say Houston Sash & Door buys a machine and pays $5,000 in cash for it. On the company’s books, Ineak the cash ledger will be decreased by $5,000 and the machinery and equipment ledger will be increased by the same $5,000. If the company buys the $5,000 machine for $1,000 in cash and signs a $4,000 promissory note, there will be three entries made: the machinery and equipment ledger will be increased by the same $5,000, but the cash ledger will be decreased by only $1,000 while the notes payable account will be increased by $4,000. Everything must balance, and this system produces financial statements that do. Double-entry bookkeeping doesn’t prevent hanky-panky, as we’ll see later, but does produce more reliable financial statements. Single-entry bookkeeping doesn’t necessarily mean that the business has been run sloppily or that someone has been cutting corners. Many businesses, particularly small service businesses, are routinely operated on the single-entry method, with the “method” being little more than the business’s check register. A red flag should go up, however, when you’re dealing with larger businesses, particularly ones that deal in inventory, that employ single-entry accounting.

3. Do the invoices support the accounts? Your accountant should be able to confirm quickly whether the financial statements are reliable by going through the invoices. For example, Houston Sash & Door’s December 31, 2003, balance sheet shows accounts receivable (net of the reserve for doubtful accounts, which we’ll get to later) of $230,962. Like most nonretail businesses, Houston Sash & Door sells most of its products on credit. By adding up the invoices, you should come up with a figure reasonably close to the figure on the balance sheet. If you don’t, accounts receivable may be less of an asset than the balance sheet might lead you to believe.

What if there are no financial statements? It happens. Accountants will tell you about “shoe box” tax returns they prepare. These are tax returns that have to be constructed from checks, check stubs, receipts, Adeak bills brought to them in shoe boxes and dumped on their desks. Often, a business is losing so much money, or money is so tight, that it can’t afford to hire an accountant to prepare the books. Does this mean you can’t buy the business? Not necessarily. It does mean, however, you shouldn’t buy the business until the financial statements are prepared.