Proper classification of entries in the annual accounts- An essential task for SMEs

Accurate classification of entries in the book of account is a basic requirement for proper representation of financial standing before lenders and other stakeholders.

Recently we were approached by one construction company having many projects in its fold for advice on the difficulty in securing the bank loan despite having a good amount of own investment and healthy growth over a few years and he was willing to extend good collateral security to the comfort of the bank.

He said that the bank is not in favour because the financial ratio is not favourable. As per the initial assessment the current ratio, key ratio to decide on the working capital limit was below one. Something the banks consider not acceptable.

We started analysing the financial records of the year 2019-20. We found that the reason for the low current ratio was the wrong classification of the unsecured loan. To our dismay, we found that the unsecured loan was clubbed with sundry creditors. On the hand the firm has acquired fixed assets to that extent..  Of course in the first reading, anybody will get an impression the firm has diverted the short term creditors’  money to acquire long term assets.

Apparently the bank had drawn a conclusion that the party does not have financial discipline and has diverted the short term money for long term use.

Party indeed invested the money into the business in the form of an unsecured loan and he has no plan to get back that loan in the near future. Rather this amount was invested keeping in view the requirement of long term funding needs for the growth of the business.

Here the wrong conclusion on the part of the bank originated in the wrong classification of the loan from the promoters into the short term liability that too clubbed with sundry creditors.

Annual Accounts –an important document to represent our business:

Maintaining books of the account is the process of recording and maintaining financial transactions and information relating to a business, on a day-to-day basis. It ensures that records of the individual transactions are correct, comprehensive and updated with accuracy.

Some of the entrepreneurs treat book keeping as a low priority one and hardly look at it for its veracity and integrity. Further, they treat annual auditing of accounts is just a ritual for compliance and tax assessment. They do not see any significant relevance to their business plan. Still worse many boldly state that the books of accounts do not reflect the true picture of the business.

In fact, some SMEs failed in financial management due to weak or no accounting records. On the contrary, financial management is very crucial to the success of a small business. Many repent this when they hit the distress.

These opinions and  perceptions won’t help the entrepreneurs. The books of accounts are important for many reasons. Annual accounts are only documents that address the concerns of stakeholders – bank, suppliers, buyers, potential  investors, tax authorities etc.

Why SMEs should maintain proper books of account

To prepare Financial Statement: Balance sheet, profit and loss account, cash flow statement are the key elements for reporting to investors/ financiers/bankers on crucial information about the financial status of the enterprises, and books of account are a precursor for it.

To fulfil tax obligations: Paying tax is an obligation by law; beitincome tax, customs and other taxes and duties. To know the correct amount of obligation and to resolve any disputes, one needs adequate and accurate books of account

Legal requirement: There is a certain stipulation in the IT Act to file the returns and this requires to be backed by the books and account. Further Companies Act 2013 also requires every company to maintain their books of account.

Better financial management: At present, better financial management provides a better picture of the health of a company. To make forecasting of financial requirement, acquiring necessary capital and to analyse investment decisions, you should have adequate records of business transactions. Also, the review of the operating performance in relation to time periods or peer comparison can be effective only with proper accounting practice.

Long term sustainability: A thoroughly studied and prepared annual accounts throw many facts and expose the inefficiencies in managing the finances.  Thus it will eliminate scope for the surprise appearance of liabilities and financial stress.

Interacting with Accountant especially Auditor is important  task:

Proper preparation of our books of accounts is our primary responsibility and getting it thoroughly audited by a Chartered Accountant is an equally important job.

No accountant is interested to make a wrong representation of entries. However, for want of clarity or lack of evidence in the books about the nature of the transaction or by oversight, they may also err in the grouping of the data.

Further, the Auditor having gone through your books of accounts during the course of the audit may have observed deficiencies. Such observations are vital to improving our internal control and risk mitigation. Thus entrepreneurs should interact closely with their Auditor during the annual audit process. Their wisdom drawn from multiple engagements will help you to improve internal control. Also, it will eliminate the scope for errors.

Conclusion:

Accurate classification of the entries in the books of account is in the interest of the entrepreneurs. A growing business requires support from multiple sources including banks. Hence accurate representation of the annual accounts is important for winning the confidence of finance providers such as bankers and investors.