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Financial Forecasts and Projections

FINANCIAL FORECASTS AND PROJECTIONS

Business entities need to plan for the future, must consider alternative management strategies and prepare capital and operating budgets, and must also consider alternative funding and cash budget possibilities. An important part of the planning process is the preparation of prospective financial statements that attempt to predict the outcome of the business entity's activities in future periods.

Financial forecasts and financial projections are prospective financial statements that present an entity's expected financial position, results of operations, and cash flows in future periods under two different conditions. Financial forecasts assume that the entity will continue to function in the manner in which it is currently functioning. For example, if the entity is a retail store chain, then it will continue to do business in the manner in which it is currently engaged. The financial forecast presents the predicted results for the next year. Financial projections, on the other hand, make one or more hypothetical assumptions about an entity's future course of action. For example, if the retail store chain were considering a Web site at which it would also sell merchandise in addition to the merchandise sold in the stores, a financial projection would provide expected results. Financial forecasts and projections should be distinguished from pro forma financial statements, which show the effect of a hypothetical future event on the historical financial statements results.

PREPARATION OF PROSPECTIVE FINANCIAL STATEMENTS

The preparation of prospective financial statements requires considerable knowledge of the entity's business and the factors that are likely to determine its future results. The following key factors related to future results must be considered in the preparation of such statements:

  • Factors related to the specific entity
  • Factors related to the industry
  • Factors related to the market
  • Factors related to the economy

Factors Related to the Specific Entity

The principal cost elements of the entity's doing business must be considered. Depending on the entity, these elements may include such costs as payroll and benefits, needed employees, raw materials, products the entity sells, freight or shipping, and advertising.

Another consideration is the availability of resources. For example, are the expert, specialized, or skilled workers available to meet the needs of the entity under the plan as initially proposed? Are the raw materials and/or products for resale available? Can the delivery system be organized to accomplish the task? Are the company's physical facilities sufficient for the uses and for the capacities contemplated?

Factors Related to the Industry

Factors related to the industry in which the entity is operating must be considered. Is the industry one in which companies are very competitive? Are competitive industries emerging? Is obsolescence emerging within the industry? Are there regulatory considerations and requirements? Is new technology being introduced into the industry? What are the economic conditions within the industry?

Factors Related to the Market

Market factors must be considered. What are the trends in business or consumer demand related to the services or goods being sold by the entity? Are competitive companies emerging, perhaps with new or different products? Is unique marketing required? Are there pricing developments to be factored into the forecast?

Factors Related to the Economy

Numerous factors related to the economy must be considered. What are the economic conditions in the country? What are critical economic trends? Is the economy inflationary, deflationary, or stable? What is the trend with regard to labor availability? What are the financing considerations in relation to the economy? What are interest rates? Are there significant factors related to long-term versus short-term financing? Is a public stock offering a possible financing option?

ATTESTATION SERVICES PROVIDED FOR FINANCIAL FORECASTS AND FINANCIAL PROJECTIONS

Forecasts and projections are important in an organization. They are also of great interest to financial analysts and others in the business environment who make decisions about future business behavior. Because of outsider interest, public accountants are engaged to provide professional services. There are three types of engagements that a certified public accountant may undertake in relation to financial forecasts and projections:

  1. Examination: An accountant evaluates the preparation, underlying support, and presentation of the financial statements, and expresses an opinion on them
  2. Applying agreed-upon procedures: Users establish the nature and scope of the engagement, and only the results of the procedures performed are provided
  3. Compilation: An accountant prepares the prospective statements from information and assumptions provided, and no assurance is given

Examination

The American Institute of Certified Public Accountants (AICPA) has prepared guidelines for prospective financial statements engagements. The person or persons who prepare the financial statements, called the responsible party, are usually the management of the company but may be outsiders, such as the management of an entity considering acquiring the company. The accountants who examine such statements must consider whether the sources of information used by the client are sufficient to support the assumptions reflected in the prospective statements. For example, external sources that should be considered include industry and government publications; reports on new information; digital, electronic, and mechanical technology; reports on new scientific developments; micro and macroeconomic forecasts; and reports on present and proposed legislation. Examples of internal sources that accountants consider include strategic plans, budgets, contractual agreements, purchase and sale agreements and commitments, intellectual property rights such as copyrights and patents, royalty and commission agreements, employee contracts and labor agreements, and financing and debt agreements.

When the examination is of a financial projection, the accountants must determine whether the hypothetical condition or course of action (which will not necessarily occur) is consistent with the purpose of the projection. The accountants must evaluate the support underlying assumptions in the same manner as is done for a forecast.

Upon completion of a financial forecast examination, assuming the accountants have collected sufficient evidence to provide a reasonable basis for the standard report to be issued, that report will state in part:

In our opinion, the accompanying forecast is presented in conformity with guidelines for presentation of a forecast established by the American Institute of Certified Public Accountants, and the underlying assumptions provide a reasonable basis for management's forecast.

Upon completion of a financial projection examination, the standard report would include a description of the hypothetical assumption and the opinion would state that the underlying assumptions provide a reasonable basis for management's forecast assuming the occurrence of the hypothetical assumption. The report will state in part:

In our opinion, the accompanying projection is presented in conformity with guidelines for presentation of a projection established by the American Institute of Certified Public Accountants, and the underlying assumptions provide a reasonable basis for management's projection [then the hypothetical assumption would be described and assumed to have occurred, for example, "assuming the establishment of a Web site which will "]

Financial forecasts are considered general-purpose financial statements that may be distributed to any interested party, whereas financial projections are considered limited-purpose financial statements only to be used by the responsible party who prepared the statements or by knowledgeable third parties. In both forecasts and prospective financial statement opinions, a warning must be included in the opinion that the prospective results may not be achieved.

If, in the accountants' opinion, the prospective financial statements depart from AICPA guidelines, or one of the significant assumptions does not provide a reasonable basis for the prospective statements, or the accountants could not apply some procedures that were considered necessary, the report would have to be modified.

Applying Agreed-Upon Procedures

Another type of engagement that certified public accountants may undertake is to apply only some procedures, which have been specified by the users, to the financial forecast or projection. An example of such an engagement might be to review the forecast in regard to sales, or payroll costs, or both. Limiting the procedures to only one item, or some of the items, on the prospective financial statements does not enable the accountants to provide an overall opinion. Because of the limitation in regard to the procedures performed, the report is restricted to the users who specified the procedures to be applied.

The standard applying agreed-upon procedures report will state in part:

At your request, we have performed certain agreed-upon procedures, as enumerated below, we make no representation regarding the sufficiency of the procedures described [a list of the procedures performed and related findings would be stated] we do not express an opinion on whether the prospective financial statements provide a reasonable basis for the presentation.

Compilation

A compilation of prospective financial statements by certified public accountants involves only the service of preparing the statements in whole or part from information and significant assumptions provided by the responsible party, usually a member of management. Because such an activity does not envision an examination or even applying agreed-upon procedures, no assurance is provided.

The standard compilation report on a forecast would state in part:

We have not examined the forecast and, accordingly, do not express an opinion or any other form of assurance on the accompanying statements or assumptions.

IMPORTANCE OF FORECASTS AND PROJECTIONS

Forecasts and projections have assumed extraordinary significance in U.S. business. The release of corporate managers' earnings forecasts has become common. Management forecasts have become an important source of information for financial analysts and investors. Stock prices show significant movements after the release of information that shows earnings will be higher or lower than current expectations.

However, some skepticism in regard to these forecasts exists on the part of financial analysts and governmental agencies, such as the Securities and Exchange Commission, because of the fear that forecasts may be biased at times in order to influence capital markets or may simply be inaccurate. In addition, prospective financial information is considered vital in relation to mergers and acquisitions as well as to such business entity management activities as budgeting. In these circumstances, it would appear advisable to obtain certified public accountant examinations and reports before the public release of prospective financial information.

see also Budgets and Budgeting; Finance; Forecasing in Business

bibliography

Coller, Maribeth, and Yohn, Teri Lombardi (1998). "Management Forecasts: What Do We Know?" Financial Analysts Journal (January/February): 58-62.

Guide for Prospective Financial Information (2002). New York: American Institute of Certified Public Accountants.

Hirst, D. Eric, Koonce, Lisa L., and Miller, Jeffrey S. (1998). "The Joint Effect of Management's Prior Forecast Accuracy and the Form of Its Financial Forecasts on Investor Judgment." Journal of Accounting Research 37 (Supplement): 101-124.

Bernard H. Newman

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