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The inter-connectedness of financial information

When I was a financial statement auditor, any exception that could potentially cause problems from the perspective of financial reporting reliability had to be investigated further to understand its magnitude and implications on other areas of the financial statements.  For example, a control failure with regard to compliance with applicable revenue recognition criteria at the time of sale could mean expansive controls testing, increased scrutiny of revenue transactions during the substantive audit testing phase, or a combination of both.  It could also mean increased scrutiny of the balance sheet (accounts receivables) to the extent that sales are typically made on credit.  The reason being that recording sales on credit impact more than one account — revenues and accounts receivable.  And finally, when sales are recorded, the cost of goods and services are recorded as well, resulting in changes to the balance sheet (inventory, reserves against specific inventory sold, etc.) as well as the P&L (cost of sales).  The same applies to any other accounting transaction or entry because journal entries in an entity’s books are double entry, meaning at least two accounts are impacted at the same time.

As a forensic accounting professional, it is critical to have a comprehensive understanding of financial statements and their inter-dependence.  In this context, today’s post will discuss fundamental attributes of financial statements and how financial information is so inter-connected.

Financial Statements

I think it’s important to begin by defining the most common financial statements:

  1. Balance Sheet (also referred to as statement of financial position or statement of financial condition).  This financial statement presents current and non-current (or long-term), assets and liabilities and owners’ equity.  Depending on who the owners of an entity are, the equity section may be labeled differently (e.g., stockholders, shareholders, members, etc.)
  2. Statement of Income (also referred to as profit and loss [P&L] statement, statement of operations, statement of financial performance, or statement of revenue and expenses).  This financial statement presents revenues and expenses from the entity’s core, or continuing operations, non-operating income and expense, and provision for income taxes.
  3. Statement of Cash Flows.  This financial statement presents the three areas of cash inflow or outflow for the period: (1) from operating activities, (2) from investing activities, and (3) from financing activities.
  4. Statement of Changes in Equity.  This financial statement reconciles the beginning of the period equity accounts with the end of the period equity accounts.  Auditors commonly refer to this type of presentation as a “roll-forward” because the account balances are presented in such a manner as to show the transactions or activities that caused the account balances to increase or decrease throughout the period.

These statements are commonly referred to as the “face of the financials” because they are placed prior to the accompanying notes and they represent the key information, in summarized or statement format, that are relied upon by financial statement users.  One thing I want to cover here is that both the SEC (Regulation S-X, Rule 1-01, paragraph (a)(3)(b)) and the AICPA (Statement on Auditing Standards No. 62, codified as AU 623, paragraph 2) have defined the term “financial statements” to also include the accompanying notes, or footnotes.

As a side note, this understanding of the term “financial statements” from the SEC and AICPA is critical in the context of a dispute absent any definition to the contrary.

Basis of Accounting

Now that we’ve defined the most common financial statements that entities, forensic accountants, or legal counsel deal with in disputes or investigations, I think it’s important to note that one’s understanding of the relationships within financial information is heavily affected by the basis of accounting that an entity has applied in preparing its financial statements.  There are a number of accounting bases to note:

  • Accrual or GAAP basis – revenues and expenses are recorded once earned/realized or incurred, respectively.  For example, revenues could be recorded prior to cash coming in (earned and realizable) or after cash comes in (earned and realized), depending on the nature of the arrangement and whether or not the performance obligations to the customer have been met.
  • Other comprehensive basis – this is sort of a “catch all” for any basis that doesn’t fit into the accrual basis.  AU 623, Special Reports, (paragraph 4) does a really good job of identifying what types of accounting bases are included in this category.  Here’s a list:
    • Basis to comply with the requirements or financial reporting provisions of a governmental regulatory agency to whose jurisdiction the entity is subject (e.g., rules of a state insurance commission).
    • Basis used to file its income tax return for the period covered by the financial statements
    • The cash receipts and disbursements basis of accounting (“cash basis” used by many smaller companies)
    • A definite set of criteria having substantial support that is applied to all material items appearing in financial statements, such as the price-level basis of accounting
  • Liquidation basis – the financial statements are prepared with the anticipation of an entity ceasing all of its activities.

By the way, the financial statements are required to disclose the basis of accounting used to prepare the financial statements.  A reader can find this information in a few different places.  First, the independent auditor’s report, or opinion, is required to disclose the basis of accounting as per AU 410, Adherence to Generally Accepted Accounting Principles (see paragraph 2 and footnote 1).  Second, FASB Accounting Standards Codification (ASC) 235, Notes to Financial Statements, requires that management of the entity disclose the basis of accounting used in preparing its financial statements (see 235-10-50-3).  This is generally disclosed within footnote 1 immediately following the face of the financials under a header such as “Basis of Presentation.”

Relationships, but not just within the financial statements

As I briefly mentioned in the beginning, revenue typically moves in line with accounts receivable (for sales made on credit), deferred or unearned revenues (for sales made where customers made pre-payment) and/or cash.  When revenue is recorded, the associated expenses to sell the good or service are recorded (cost of sales, cost of goods sold, etc.) and inventory is reduced.  Expenses typically move in line with accounts payable (for goods or services received), accrued liabilities (for goods or services received, but a corresponding vendor invoice has not been received), stock-based compensation, etc.  Property, plant, and equipment (PP&E) accounts typically move in line with accounts payable (for purchases made on credit) or cash.  These examples are relatively simple.  However, cash isn’t always moving at the same time that the entry is recorded (accrual basis vs cash basis).  Further, more complex or sophisticated transactions can raise difficult questions as to what corresponding account should be affected and for how much.  If fraud is suspected, the identification of corresponding accounts can prove to be very difficult.  Entities whose financial statements are required to be audited may also be required to be audited from an internal controls over financial reporting perspective.  Mixing internal controls implications with financial statement issues can also be challenging.

Relationships also exist between financial and non-financial data.  For example, when I was an auditor, I performed analytical procedures to prove out relationships among revenue accounts.  In one instance I obtained “click” data from operations personnel for a web-based lead generation provider and analyzed the data to understand whether or not the revenues recorded by the entity for the period were reasonable.  Benchmarking against other periods of time, other revenue streams, or industry peers (to the extent the information is available) is also effective.  In order to effectively perform these types of analyses, it’s important to understand the main drivers for accounts being analyzed.

Applicability

I worked on an investigation involving alleged fraudulent financial reporting with regard to sales transactions.  A whistleblower internal to the entity provided a tip with some details of the sales transactions in question.  My team conducted various interviews and reviewed multiple sales transactions to decide if the whistleblower’s allegations were factual.  What was not made clear until later in the engagement is that a high-level sales person had entered into an undisclosed side arrangement (that is, undisclosed to the accounting department and in the entity’s financial statements) with a key customer of the entity.  The nature of the side arrangement actually changed the terms of the sales agreement such that revenue was prematurely recognized by the entity in its financial statements.  This ultimately turned into the termination of the high-level sales person, a restatement of the entity’s financial statements, reputational issues for the entity, and whole host of other problems and costs.

So, I put forth a simple question:  based on this fact pattern, which financial statement accounts are misstated?  The obvious answer is revenue.  But, what is the offsetting account?  Accounts receivable, deferred revenue, or cash?  And, we cannot forget the associated direct costs to sell and inventory that were recorded.  What about the implications on the effectiveness of the entity’s internal controls over sales transactions?  If an individual of influence contributed to the fraud, what does this say about the potential that the individual could have influenced other aspects of the entity’s business, and, therefore, other aspects of the entity’s financial statements?

In the context of an investigation, understanding these types of relationships is critical to performing a thorough, robust investigation that will satisfy stakeholders, regulators, creditors, and any other parties of interest.

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Significant vs. critical accounting policies

Securities and Exchange Commission (SEC) registrants following SEC rules and regulations must disclose their significant and critical accounting policies in their filings with the SEC.  For those well versed in the financial reporting profession, the disclosure requirements may, on the surface, seem the same.  However, I can’t tell you how many people, even some heavily experienced in the industry, that do not understand the difference between these two disclosure requirements.

The SEC has released guidance and insight on the distinguishing factors registrants should consider between these two disclosure requirements.  Today’s post will generally cover the disclosure requirements for both policy definitions.  I’ll also address the reason why understanding the differences between these disclosure requirements is critical for forensic accountants assisting their clients in determining whether or not a registrant complied with SEC regulations.

Regulation S-X and disclosure of significant accounting policies

SEC Regulation S-X governs the form and content of annual financial statements not only for SEC filings but also for shareholder reports of SEC registrants.  This regulation is comprised of 12 articles, with Article 3 discussing the general instructions for financial statements.

Accounting Principles Board (APB) Opinion No. 22, Disclosure of Accounting Policies, adopted in 1972 states in paragraph 12:

Disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. In general, the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue and allocation of asset costs to current and future periods.  (emphasis added)

The next paragraph states,

Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for recognition of profit on long-term construction-type contracts, and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive.

Another relevant accounting standard is Statement of Position (SOP) 94-6, Disclosure of Certain Significant Risks and Uncertainties, issued in 1994.  Paragraphs 1 and 2 state:

The central feature of this SOP’s disclosure requirements is selectivity: specified criteria serve to screen the host of risks and uncertainties that affect every entity so that required disclosures are limited to matters significant to a particular entity. The disclosures focus primarily on risks and uncertainties that could significantly affect the amounts reported in the financial statements in the near term or the near-term functioning of the reporting entity. The risks and uncertainties this SOP deals with can stem from the nature of the entity’s operations, from the necessary use of estimates in the preparation of the entity’s financial statements, and from significant concentrations in certain aspects of the entity’s operations.  (emphasis added)

Significant accounting policies are to be disclosed in the notes to the financial statements in accordance with Regulation S-X.  Notice the emphasis on materiality (in APB 22), inferred in SOP 94-6 by the use of the word “significantly.”  However, there is no mention of an integral component to classify a policy as “critical”, which I will discuss next.

Regulation S-K and disclosure of critical accounting policies

SEC Regulation S-K governs qualitative information about the registrant, such as the nature of its business, its properties, legal proceedings, its executives and officers (including executive compensation), and management’s discussion and analysis of the results of operations (MD&A).  In May 2002, the SEC issued a proposed rule called Disclosure in Management’s Discussion and Analysis about the Application of Critical Accounting Policies.  As far as I can tell, the proposed rule has not been adopted by the Commission.

In summary, if adopted, the scope of disclosures related to critical accounting estimates within a registrant’s MD&A section would broaden beyond those contemporaneously required. The SEC summarized the proposed rules, in part, stating:

The proposals would encompass disclosure in two areas: accounting estimates a company makes in applying its accounting policies and the initial adoption by a company of an accounting policy that has a material impact on its financial presentation. Under the first part of the proposals, a company would have to identify the accounting estimates reflected in its financial statements that required it to make assumptions about matters that were highly uncertain at the time of estimation.  (emphasis added)

Notice the words “highly uncertain” describing accounting estimates.  The SEC proposed that a company would have to answer two questions, with a “yes” to both questions, in order to conclude that an estimate meets the disclosure criteria of a “critical accounting estimate.”

  1. Did the accounting estimate require us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made?
  2. Would different estimates that we reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, have a material impact on the presentation of our financial condition, changes in financial condition or results of operations?

In essence, the above proposal encapsulates what the SEC believed back in 2003 must be established to qualify an accounting estimate as “critical.”

The following year in December 2003, the SEC released an Interpretation titled Commission Guidance Regarding Management’s Discussion and Analysis of Financial Condition and Results of Operations as a means of improving the disclosures by registrants with respect to critical accounting estimates, among other things.

Specifically, the SEC’s guidance on preparation of disclosure of critical accounting estimates is that companies consider:

whether they have made accounting estimates or assumptions where the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and the impact of the estimates and assumptions on financial condition or operating performance is material.  (emphasis added)

If these criteria are met, companies should disclose the details within their MD&A.

The SEC made it clear that, “[s]uch disclosure should supplement, not duplicate, the description of accounting policies that are already disclosed in the notes to the financial statements. The disclosure should provide greater insight into the quality and variability of information regarding financial condition and operating performance. While accounting policy notes in the financial statements generally describe the method used to apply an accounting principle, the discussion in MD&A should present a company’s analysis of the uncertainties involved in applying a principle at a given time or the variability that is reasonably likely to result from its application over time.”

Understand what standard or guidance was applicable at the time

This should go without saying, but forensic accountants must always keep in mind the “date stamps” associated with (1) accounting standards, (2) SEC rules and regulations, (3) SEC proposed rules, and (4) SEC interpretations.  Understanding the timing of authoritative (or even non-authoritative, as in the case of a proposed rule) guidance relative to the facts and circumstances in a dispute is critical to assessing whether or not a client adequately complied with the rules at that point in time.

Applicability

Disclosure of accounting estimates deemed significant means the estimates have a pervasive or material impact on the financial statements (e.g., revenues, fixed asset depreciation, inventory pricing).  Critical accounting estimates, however, reflect subjective, judgmental, highly uncertain, susceptible to change accounting estimates. Therefore, the threshold to disclose critical accounting estimate policies is different than the threshold to disclose significant accounting estimate policies.

I recently assisted a defendant in a litigation matter that dealt with, among other allegations, allegations that the defendant did not adequately disclose sufficient details with respect to certain accounting estimates stemming back a few years prior to the financial crisis of 2008.  The plaintiff’s counsel argued that the accounting estimate was both “critical” and material and should have been treated as such from a disclosure standpoint.  I assisted the client defendant in putting together a case that it was not possible at the time to know that the accounting estimate would be material.  If you recall, one of the requirements of a critical accounting estimate has to do with materiality.  Although the accounting estimate was potentially subjective and susceptible to high estimation uncertainty, I assisted the client in formulating a position that the accounting estimate did not meet the materiality requirement for disclosure as a critical accounting policy.

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