A Clean Profit and Loss Does Not Mean You Have Clean Books

Your P&L can look perfectly reasonable while your books are wrong.

Over my 30+ year career, I've seen companies believe their books were clean because their income statement looked reasonable.

Revenue looked right.

Expenses seemed reasonable.

Net income was about where management expected it to be.

So everyone assumed the books were in good shape.

But when you start digging into the balance sheet, you can sometimes find a very different story.

The Balance Sheet Is Where Problems Can Hide

Your balance sheet contains the assets, liabilities and equity that your company has accumulated over time.

Unlike many income statement accounts that effectively start over each year, balance sheet balances carry forward.

That means an error doesn't necessarily disappear at the end of the month or year.

It can sit there.

And sit there.

And sometimes grow.

That's why one of the accounting principles I've come to believe strongly in is:

If you aren't actively reconciling your balance sheet accounts, there's a good chance your financial statements aren't as accurate as you think.

A reconciliation shouldn't simply mean that someone checked a box on the monthly close checklist.

You should know what makes up the balance.

If Accounts Receivable says $5 million, can you support the $5 million?

If accrued expenses are $750,000, can someone explain what's included?

If an intercompany receivable says another subsidiary owes you $2 million, does the other subsidiary have the corresponding payable?

If cash says $10 million, does it reconcile to the bank?

Those questions sound basic.

But basic accounting controls are often where significant problems begin.

The $14 Million Bank Reconciliation

I saw an extreme example of this recently.

I was working with a client where the bank reconciliation was missing approximately $14 million of activity.

Yes, $14 million.

A significant portion of that activity was sitting in accounts receivable and accounts payable.

That's important because those are balance sheet accounts.

You could have substantial errors between cash, AR and AP without necessarily seeing a $14 million error running through the current P&L.

There were also expenses that had not been properly recorded, so the problem wasn't entirely confined to the balance sheet.

But if management were simply reviewing the income statement every month and asking,

"Does this look reasonable?" they could easily miss what was happening.

How did the situation develop?

The company had lost its Controller and didn't backfill the position.

The work didn't disappear when the Controller left.

Reconciliations still needed to happen.

Transactions still needed to be investigated.

Cash still needed to be reconciled.

Balance sheet accounts still needed owners.

Without the appropriate resources and accountability, problems accumulated.

Eventually, someone has to clean them up.

I've Seen the Same Problem With Intercompany Accounts

Earlier in my career, I encountered a different version of the same problem involving intercompany accounting.

There were roughly 20 intercompany balances involving foreign operations that needed to be worked through.

For every balance, we had to ask some fundamental questions.

Was the transaction recorded by both entities?

Were both sides recorded for the same amount?

Was the balance recorded in the appropriate foreign currency?

Was foreign currency translation or remeasurement being handled appropriately?

Did the receivable at one company actually match the payable at the other?

When nobody owns those questions, discrepancies accumulate.

One month becomes two.

Two becomes six.

Eventually, the organization has a collection of old balances that nobody completely understands.

Every Significant Balance Sheet Account Needs an Owner

One of the simplest improvements a company can make is assigning responsibility for its balance sheet accounts.

Ideally, every material balance sheet account has an owner.

That person should be able to explain:

What is this balance?

What makes it up?

Does it reconcile to supporting documentation?

Are there old items that need to be investigated?

Did anything unusual happen this month?

What needs to be cleaned up?

You don't necessarily need to treat every $500 account with the same level of scrutiny as a $10 million cash account.

Prioritize based on size and risk.

But don't assume that an account is harmless simply because nobody pays much attention to it.

Don't Forget the "Miscellaneous" Accounts

Some of the accounts I'd pay particular attention to are the ones people tend to overlook.

1. Credit card accounts are one example.

2. Miscellaneous Accounts Receivable is another.

3. Miscellaneous Accounts Payable.

4. Intercompany accounts.

5. Clearing accounts.

6. Prepaids.

7. Accrued expenses.

These can become dumping grounds.

Someone doesn't know exactly where something belongs, so it gets parked there temporarily.

Temporary has a way of becoming permanent.

Six months later, someone asks:

"What makes up this $400,000 balance?"

And nobody knows.

That's when the archaeology begins.

Reconciliation Is Only the First Step

There's another important distinction.

Finding a problem isn't the same as fixing it.

If your reconciliations identify old or unexplained balances every month and they continue appearing on the next month's reconciliation, you haven't solved the problem.

You have documented it.

There should be progress toward clearing old items and correcting the underlying processes that created them.

That might mean fixing how transactions are recorded.

It might mean changing an upstream process.

It might require additional training.

It could require better systems.

Or it might simply require assigning clear responsibility.

Whatever the answer, the goal isn't just to produce reconciliations.

The goal is to produce reliable financial statements.

Don't Stop at "The P&L Looks Right"

Reviewing the P&L is important.

Variance analysis is important.

Comparing actual results to budget and prior periods is important.

But none of those replaces a disciplined balance sheet reconciliation process.

The P&L tells you how the business performed.

The balance sheet helps tell you whether you can trust it.

So at your next month-end close, don't stop after asking:

"Does the P&L look right?"

Ask:

"Do we know what's in our balance sheet?"

That second question may tell you much more about the quality of your books.