Your financial statements need to be a fair representation of your company’s financial position and operating performance, especially when third parties (e.g., creditors, investors, et cetera) are involved.

If you are applying for credit for your business, you will be asked for financial statements, including a Balance Sheet.  While most small business owners don’t undergo a review, compilation, or audit of your books for third party creditors (these can be very expensive), you still want to be confident of your company financials.  A lot of small business owners do not seem aware of the gravity of submitting business financials to third party creditors.

The following list is an example of what to think about when dealing with the financial statement element of LIABILITIES.

Be aware of schemes that understate liabilities (what you owe) on your company’s Balance Sheet and make sure you are not guilty of any of them.  Do NOT do any of the following, as these understate liabilities:

  1. Understate Accounts Payable (examples below)
    • Not recording purchases or recording the purchases after the end of the year
    • Overstating purchase returns or purchase discounts
    • Making it appear as if liabilities have been paid off or forgiven when they have not
    • Symptoms that A/P is understated include: Balances appear too low, purchase or COGS numbers are low, purchase returns or discounts numbers are high.
    • Ratios to examine to test: Acid-test ratio, Current ratio, AP/Purchases, A/P/COGS, AP/Total Liabilities, AP/Inventory
  2. Understate Accrued Liabilities
    • Common accrued liabilities accounts are: Salaries payable, payroll taxes payable, rent payable, utilities payable, interest payable.
    • Ratios to examine to test: Various accruals/# of days to accrue, Various accruals/Related expenses
  3. Recognize Unearned Revenue as Earned Revenue
    • Recognizing revenues instead of recording a liability helps to make the company’s financial statements look better because it understates the company’s liabilities and overstates the revenues and net income (e.g., recording a security deposit a tenant paid you as income.  This is a liability NOT income).
    • By manipulating the timing of revenue recognition, a company can either understate or overstate deferred revenue liabilities (e.g., a tenant prepays their rent for 6 months in October 2016 … under accrual method accounting, you would recognize only 3 of those months as revenue in 2016 and the other 3 months in 2017. So at the end of 2016 you would have a liability of the 3 months sitting on the Balance Sheet (note: this does NOT address tax laws which may make you pay taxes on all of the 6 months in 2016 since you received cash).
    • Ratios to examine to test: Unearned revenue/Revenue
  4. Underrecord Future Obligations
    • Future obligation examples include: warranty and service obligations
    • Ratios to examine to test: Warranty expense/Sales
  5. Not Record or Understate Various Types of Debt (notes, mortgages, etc.)
    • Either not reporting or understating debt to related parties
    • Borrowing but not disclosing debt incurred on existing lines of credit
    • Not recording loans incurred
    • Claiming that existing debt has been forgiven by creditors
    • Claiming that debt on the company’s books is personal debt of the owners or principals, rather than debt of the business
    • Symptoms include: Unreasonable relationship between interest expense and recorded liabilities, significant purchases of assets with no recorded debt, significant decreases in recorded debt.
    • Ratios to examine to test: Interest expense/NP, LT debt/Equity, Total liabilities/Total assets, Lease expense/Total Fixed assets

Disclaimer: Unfortunately, it is impossible to give comprehensive financial, accounting, or bookkeeping advice through the internet. Before relying on any information given in this article or on GetAGripOnAccounting.com, contact an accounting professional to discuss your particular situation.