Identifying problems in a financial statements and figuring out how to minimize it in the first place, is a vital role the accounting people should strive in. Occurrence of problems are inevitable although, by virtue, it is presumably that financial reporting process always works the way it should and that the resulting financial statements are accurate.
Not only small medium businesses, the same issues also happened in giant-fortune 100 companies, otherwise big scandal such as Enron, WorldCom, Xerox, Quest, Tyco, and many more, never existed.
Possible reason for those problems could endless—ranging from unintentional errors to intentional deception or fraud—resulting financial statements sometimes contain errors or omissions that can mislead investors, creditors, and other users. There are, however, some basic paths or patterns about where and what the problems commonly occurred that accounting people can identify and prevent from happening. Through this post I am going to discuss about types of problems in financial statements and how to prevent them from occurring. Financial statement problems, in general, are classified into three categories—from which then a controller is able to develop more preventive procedures, policies, systems and tools that the entire company should follow and use:
1. Errors Category – This category result when unintentional mistakes are made in recording transactions, posting transactions, summarizing accounts, and so forth. Errors are not intentional and when detected are immediately corrected. Errors can result from sloppy accounting, bad assumptions, misinformation, miscalculations, and other factors.
2. Disagreements Category – This category result when different people arrive at different conclusions based on the same set of facts. Because accounting involves judgment and estimates, opportunities for honest disagreements in judgment abound. These disagreements often come about because of the different incentives that motivate those involved with producing the financial statements. An example of a disagreement might be differing views about what percentage of reported receivables will be collected or how long equipment and other assets will last.
3. Frauds Category – This category result from intentional errors. Fraudulent financial reporting occurs when management chooses to intentionally manipulate the financial statements to serve their own purposes, such as meeting Wall Street’s earnings forecasts as was the case with WorldCom.
Next, let’s explore each of the above category further. Read on…
Errors in the Reporting Process
Errors, and other problems, can occur in most stages of the accounting cycle. Let’s first describe the kinds of errors that can occur and then identify controls to minimize these errors.
1. Errors in Transactions and Journal Entries – Transactions such as selling products or services, paying salaries, buying inventory, and paying taxes, are entered into the accounting records through journal entries. For example, if $ 3,000 is paid to a management consulting firm:
[Debit]. Management Consultation Expense = $3,000
[Credit]. Cash = $3,000
An invoice from the law firm should support this entry. Errors could be occurred in the financial reporting process if (1) the invoice from the management consulting firm was lost and the professional consultant expense was not entered into the accounting records, (2) the amount entered into the accounting records was incorrect, or (3) the accounts involved were incorrectly identified.
2. Errors in Accounts and Ledgers – Even when journal entries properly summarize legit transactions, errors and misstatements can be occurred in the financial records because journal entry data are not summarized appropriately or accurately in the ledgers.
Using the previous example of paying a management consulting firm $3,000, errors could occur at the posting stage of the accounting cycle if the management consultation expense is entered in the wrong account in the ledger or if an incorrect amount is posted to the correct account. Posting the correct amount to the wrong expense account would result in the correct total for all expenses, but individual expense account balances would be incorrect.
A more severe error occurs at the ledger stage if amounts that should be included in asset or liability accounts are improperly included in expense or revenue accounts, or vice versa. Some examples are:
- Recording insurance expense as prepaid insurance (an asset);
- Recording purchases of goods for resale as inventory (an asset) when they should be reported as cost of goods sold (an expense);
- Recording money received from customers as revenue when it should be recorded as unearned revenue (a liability);
- Not reporting supplies used as an expense; and
- Many more
Disagreements in the Accounting Judgment
Let’s face the fact that accounting isn’t as exact as math—although many people may think in that way. Not only management and external users, even accountants themselves are constantly making judgments and estimates regarding the past and the future. For better understanding, let’s construct a case example.
So you have a lawn care and landscaping business, for example, it has become more and more successful, you have been able to obtain bigger and better jobs. Recently, you signed a contract to provide all the landscaping for a new condominium complex currently under construction.
The terms of the contract call for payment of one-half of the contract amount up front and the remaining one-half upon completion. You begin working on the condominium landscaping in early December, but it looks as though you will not finish until well into January. Preparing financial statements at the end of December, how much of the condominium contract should you report as revenue?
The answer depends on how close to completion the job is. If you are 25% complete, it makes sense to report 25% of the contract amount as revenue. If you are 75% complete, report 75% of the contract amount as revenue. The hard part is determining how much of the job has been completed.
Suppose you contact two landscapers (friendly competitors) and ask them to provide you with an estimate of how complete the landscaping job is at year-end. Would it be possible for these two people to arrive at different conclusions regarding the percentage of completion? Which one would be right?
Different people can look at the same set of facts and arrive at different conclusions. They’re not wrong, just different. In this case, the different estimates would result in different financial statement numbers. These different numbers could make the difference between your company showing a profit or reporting a loss.
Or, let’s have a look at another example:
Most of your customers pay promptly, but some take a little longer to pay. A few customers discontinue their lawn care service and never pay for some of the services they received. Your problem is that when you provide a service for a customer, you do not know if that customer will be an ‘on-time payer’, or a “slow payer,” or even never a “payer.” Recognizing that a certain percentage of your customers will be “no payers,” should you record a receivable (and a revenue) for the full amount of every sale?
Most businesses recognize that a certain percentage of receivables will be uncollectible, you know that. But, how should you arrive at the amount of your receivables that won’t be collected? Is it possible that your estimate will be slightly off? Could different people legitimately arrive at different estimates? Of course.
Those different estimates will then affect the results reported in the financial statements. There are many more estimates like these required when preparing financial statements for most companies.
Fraudulent Financial Reporting
Unlike erroneous, fraudulent financial reporting is intentional. To illustrate, consider the journal entry made previously related to Management Consulting Expense. Assume that a company’s accountant embezzles $3,000 and prepares the following journal entry to conceal the fraud:
[Debit]. Management Consultation Expense = $3,000
[Credit]. Cash = $3,000
The accountant could prepare the journal entry without supporting documentation (e.g., an invoice) or create a fictitious invoice from a phantom management consulting firm. Unless someone is watching closely, the theft may go undetected. Because the accountant made a fictitious entry to Management Consultation Expense, the accounting records appear to be correct, and the accounting equation still balances. Cash, an asset, is stolen, and the recognition of an expense results in owners’ equity being reduced by the same amount.
While this illustration is small and the dishonest act was committed by an employee against the company, it is intentional and results in financial statements that are incorrect. More serious financial statement fraud occurs when top management intentionally manipulates the financial statements in much larger amounts. In fact, there are many different ways for management to commit financial statement fraud. Examples are listing sales that don’t exist; not recording sales returns or uncollectible receivables; and not recording various expenses, understating liabilities, and overstating assets such as inventory or receivables.
Systematical Ways to Minimize Accounting Problems
Accounting is not either math or law. This is a business language—just like English, French, Germany, Chinese, Polsky, Indonesian, Korean, Japanese languages. With this sense, if falsehood can be written in English or any other languages, a misleading story can be expressed by financial statements as well.
By far, the vast majority of financial statements are as accurate as possible, and the preparers are honest. Most organizations, in systematically manner, build controls into their organization and financial reporting processes so that abuses are difficult. These systematical ways—called the “internal control structure”—are internal to the organization preparing the financial statements.
The American Institute of Certified Public Accountants (AICPA) has defined internal control as
“The policies and procedures established to provide reasonable assurance that specific entity objectives will be achieved.”
These internal controls protect investors and creditors and even help management in their efforts to run their organizations as effectively and efficiently as possible. If you encounter an organization or financial statements that do not have these controls and safeguards, one should exercise extreme care.
Most companies have the following five concerns in mind when they are designing internal controls:
- To provide accurate accounting records and financial statements containing reliable data for business decisions.
- To safeguard assets and records. Most companies think of their assets as including their financial assets (such as cash or property), their employees, their confidential information, and their reputation and image.
- To effectively and efficiently run their operations, without duplication of effort or waste.
- To follow management policies.
- To comply with the Foreign Corrupt Practices and Sarbanes-Oxley Acts, which require companies to maintain proper record-keeping systems and controls.
The responsibility for establishing and maintaining the internal control structure belongs to a company’s management. Until several years ago, this responsibility was only implied; there was no formal legal requirement.
In the wake of illegal political campaign contributions, however, business frauds, and numerous illegal payments to foreign officials in exchange for business favors, in 1977, Congress passed the Foreign Corrupt Practices Act (FCPA). As a result of this legislation, all companies whose stock is publicly traded are required by law to keep records that represent the firm’s transactions accurately and fairly.
In addition, they must maintain adequate systems of internal accounting control. Following the rash of reported financial statement frauds in 2001 and 2002, Congress passed the Sarbanes-Oxley Act (known as the corporate responsibility act) in 2002. This far-sweeping corporate reform act requires, among other things, that every company’s annual report contain an “internal control report,” which must:
- state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting;
- contain an assessment of the effectiveness of the internal control structure by management;
- contain an independent auditor’s assessment of the concurrence with the way management assessed the reliability of its internal controls; and
- contain an independent assessment of the reliability of internal controls by the independent auditor (this act, by the way, requires that the CEO and CFO of every public company prepare and sign a statement to accompany their financial statements that certifies the “appropriateness of the financial statements and disclosures contained in the report.”)
A company’s internal control structure can be divided into five basic categories:
(1) the control environment;
(2) risk assessment;
(3) control activities;
(4) information and communication; and
Next let’s briefly cover the control environment and control activities (sometimes called control procedures), as well as the need for monitoring (the areas of risk assessment and information and communication are left to courses covering the details of auditing).
1. The Control Environment
The control environment consists of the actions, policies, and procedures that reflect the overall attitudes of top management, the directors, and the owners about control and its importance to the company.
In a strong control environment, management believes control is important and makes sure that everyone responds conscientiously to the control policies and procedures. In addition, a company with a good control environment generally develops an organizational structure that identifies clear lines of authority and responsibility.
A complex organizational structure can make it easier to conceal dishonest transactions. Another element of a good control environment relates to independent oversight of significant management decisions. This oversight is generally exhibited through a board of directors which consists of individuals both internal and external to the firm. Every major company has a board of directors.
A good control environment would suggest that a subset of these directors should form an audit committee. The audit committee should be comprised of independent, outside directors (members of the board who are not officers of the company). The internal and external auditors would then be accountable to this audit committee.
Under the Sarbanes-Oxley Act, members of the audit committee must be financially literate. The audit committee must be directly responsible for the appointment, compensation, and oversight of the work of the external auditor and must have the authority to engage independent legal counsel or other advisors if it suspects any wrongdoing. External auditors who suspect wrongdoing in financial reporting should forward those concerns to the audit committee.
2. Control Activities (Procedures)
Control activities or control procedures are those policies and procedures, in addition to the control environment and accounting system that management has adopted to provide reasonable assurance that the company’s established objectives will be met and that financial reports are accurate.
Generally, control activities fall into five categories: (a) adequate segregation of duties; (b) proper procedures for authorization; (c) physical control over assets and records; (d) adequate documents and records; and (e) independent checks on performance.
The first three are referred to as “preventative controls” because they prevent problems from occurring. The last two are referred to as “detective controls” because they help catch problems that are occurring before the problems become large.
(a). Adequate Segregation of Duties – A good internal control system should provide for the appropriate segregation of duties. This means that no one department or individual should be responsible for handling all or conflicting phases of a transaction. In some small businesses, this segregation is not possible because the limited number of employees prevents division of all the conflicting functions. Nevertheless, there are three functions that should be performed by separate departments or by different people whenever possible:
- Authorization – Authorizing and approving the execution of transactions; for example, approving the sale of a building or land.
- Record keeping – Recording the transactions in the accounting records.
- Custody of assets – Having physical possession of or control over the assets involved in transactions, including operational responsibility; for example, having the key to the safe in which cash or investment securities are kept or, more generally, having control over the production function.
By separating the responsibilities for these duties, a company realizes the efficiency derived from specialization and also reduces the errors, both intentional and unintentional, that might otherwise occur.
(b). Proper Procedures for Authorization – A strong system of internal control requires proper authorization for every transaction. In the typical corporate organization, this authorization originates with the stockholders who elect a board of directors. It is then delegated from the board of directors to upper-level management and eventually throughout the organization. While the board of directors and upper-level management possess a fairly general power of authorization, a clerk usually has limited authority. Thus, the board would authorize dividends, a general change in policies, or a merger; a clerk would be restricted to authorizing credit or a specific cash transaction. Only certain people should be authorized to enter data into accounting records and prepare accounting reports. As an example of journal entries and misstated financial statements that were not authorized.
(c). Physical Control Over Assets and Records – Some of the most crucial policies and procedures involve the use of adequate physical safeguards to protect resources. For example, a bank would not allow significant amounts of money to be transported in an ordinary car. Similarly, a company should not leave its valuable assets or records unprotected. Examples of physical control are fireproof vaults for the storage of classified information, currency, and marketable securities; and guards, fences, and remote control cameras for the protection of equipment, materials, and merchandise. Re-creating lost or destroyed records can be costly and time-consuming, so companies make backup copies of records.
(d). Adequate Documents and Records – A key to good controls is an adequate system of documentation and records. Documents are the physical, objective evidence of accounting transactions. Their existence allows management to review any transaction for appropriate authorization. Documents are also the means by which information is communicated throughout an organization. In short, adequate documentation provides evidence that the recording and summarizing functions that lead to financial reports are being performed properly. A well-designed document has several characteristics: (1) it is easily interpreted and understood, (2) it has been designed with all possible uses in mind, (3) it has been pre-numbered for easy identification and tracking, and (4) it is formatted so that it can be handled quickly and efficiently. Documents can be actual pieces of paper or information in a computer database.
(e). Independent Checks on Performance – Having independent checks on performance is a valuable control technique. Independent checks incorporate reviews of functions, as well as the internal checks created from a proper segregation of duties. There are many ways to independently check performance. Using independent reviewers, such as auditors, is one of the most common. In addition, mandatory vacations, where another employee performs the vacationing person’s duties, periodic rotations or transfers, or merely having someone independent of the accounting records reconcile the bank statement are all types of independent checks.
In accordance with the systematical ways to prevent and minimize erroneous and problems, therefore, an accounting system should be designed to significantly reduce the possibility that problems, in whatever form, will make their way into financial statements. When it is discovered that the financial statements of public companies are wrong, for whatever reason, they must be restated (reissued with correct amounts).