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A Global Reach with a Local Perspective
www.decosimo.com
of Financial Statements: Anything Look Odd to You?
Shannon Farr - shannonfarr@decosimo.com| Sharon Hamrick – sharonhamrick@decosimo.com
Forensic Analysis of Financial Statements: Anything Look Odd to You?
If management is reluctant to share
information, an expert may know whether it should otherwise be
readily available
A financial expert will know whether the information
received is inadequate or has material errors
When and Why Would You Need a Financial Expert for Gathering and/or Requesting
Financial Information?
Primary examples
of information to request:
• Both externally-prepared financial statements and internally-prepared financial statements
• Detailed general ledgers (in excel)• Minutes from Board of Directors
and Stockholders’ meetings• Income tax returns – complete with
supporting schedules• Other items dependent upon type
of entity, industry, complexity
What Financial Information Should You Request in Addition to “Financial
Statements”?
Can alert an expert to unusual
items that may need to be explored
Can reveal differences between the
general ledger and the financial
statements issued
Can reveal information about
significant or unusual receipts,
payments, general journal
entries
Can also reveal whether items are
misposted or misallocated
Why the…Detailed General Ledger
Can reveal disagreements among management and
indications of the company’s relationship with its
shareholders
May provide information as to past, current or planned activity
such as borrowings, sale or acquisition of assets,
transactions with related parties
Why the…Minutes from Board of Directors and Stockholders’ Meetings
It can include information that may not be available in the financial statements, such as further description of non-deductible and non-taxable items
Depending upon the type of entity, it may include information as to ownership, distributions of cash or other property, charitable contributions, acquisition of property
Why the…Income Tax Returns
Other items to request,
depending upon the issues of the case,
may include
• loan applications, • leases, contracts,• bank statements and bank
reconciliations, • depreciation schedules, • payroll reports, payroll tax filings,• check registers, vendor registers,• accounts receivable and accounts
payable aging reports
What Other Items?
Auditor’s or Accountants’ Report
Balance Sheet
Income Statement (may include Retained Earnings)
Statement of Stockholders’ Equity (if changes in equity)
Statement of Cash Flows
Notes to Financial Statements
What Comprises a Complete Set of Financial Statements?
Balance Sheet
• A statement of the assets, liabilities, and capital of a company at a particular point in time.
Income Statement
• A statement that measures a company’s financial performance over a specific accounting period
• Summarizes how the business incurs its revenues and expenses through operating and non-operating activities.
• May include a reconciliation to retained earnings per balance sheet
Cash Flow Statement
• A statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents.
• Breaks the analysis down to operating, investing, and financing activities.
Basic Financial Statements
How Do These Financial Statements Relate to Each Other?
Interrelation between Basic Financial Statements and Their Components
Balance Sheet
Cash
Other AssetsTotal Assets
Liabilities
Stockholders’ EquityStockholders’ Equity & Liabilities
Statement of Cash Flows
Cash from OperationsCash from InvestingCash from FinancingBeginning CashEnding CashNet Change in Cash
Non –Cash Transactions
Statement of Stockholders’ EquityBeginning BalancesCommon & Preferred StockIssue of Par Value StockAdditional Paid-in-capitalTreasury Stock RepurchaseRetained Earnings (Net Income & Other)Net Change in Stockholders’ Equity
Ending Balances
Statement of Income
RevenueExpensesNet Income
• Most commonly observed presentation of financial statements upon which an auditor has expressed an opinion
• Provides generally principally-based standards for recording financial transactions and financial statement presentation
• Requires specific accounting methodologies and disclosures• Requires specific financial statement inclusion and presentation
Generally accepted
accounting principles (US GAAP)
• Commonly includes financial statements prepared on the cash basis of accounting, modified cash basis, or the basis of accounting used for income tax preparation
SPF(Special Purpose
Frameworks) (previously known as OCBOA)
What is GAAP? What Else is There?
• This is a type of SPF• Intended as an option for privately-held, for-profit small and
medium sized entities• Small and medium sized are not specifically defined• Blends aspects of GAAP and simplifications of some GAAP
reporting requirements • Not required, but an option for those entities
FRF for SME’s (Financial Reporting
Framework for Small &
Medium Sized Entities)
• Similar in many respects to US GAAP but there are significant differences in some areas such as consolidation, lease accounting, use of fair-value accounting, disclosures
• Efforts continue to converge US GAAP and IFRS into a single, global set of accounting standards
IFRS (International
Financial Reporting Standards)
What is GAAP? What Else is There?
GAAP is assumed
Unless the accountants’ report includes a
paragraph telling the reader something else
was used, and
The financial statement titles include “Balance Sheet” and “Statement
of Income”
How Do You Know What Basis of Accounting Was Used?
OCBOA would be disclosed
In the Accountants’ Report
If the financial statements do not use the financial statement titles of
“Balance Sheet” and “Statement of Income”
If descriptive captions are used, for example “Statement of Assets,
Liabilities and Stockholders’ Equity –Income Tax Basis”; “Statement of
Revenues and Expenses – Modified Cash Basis”
If Not Prepared in Accordance with GAAP
The two principal methods of keeping track of a business’s income and expenses:
The Difference Between Cash Basis and Accrual Basis
Cash Basis• An accounting method in which income is recorded when cash is
received, and expenses are recorded when cash is paid out.
Accrual Basis• A system of accounting based on the accrual principal, under
which revenue is recognized (recorded) when earned, and expenses are recognized when incurred.
What Does This Mean When Understanding a Set of Financial Statements?
Cash Basis
• Reflects income when cash is received and expense when cash is paid.
• It is often considered simpler than the accrual basis of accounting but because of the effect of the timing of receipts and payments does not reflect operating results as incurred
Accrual Basis
• Revenues and expenses are reflected in the financial statements based on when a transaction is incurred regardless of whether or not cash was received or paid out in that period.
• Conforms to the provisions of GAAP.• Employed by most companies.
• Combines elements of the cash basis and accrual basis; typically includes modifications to cash basis related to depreciation
Modified cash basis
• Reflects assets, liabilities, income and expenses as they are recorded on the entity’s income tax return.
Income tax basis
Other Bases of Accounting
What Level of Assurance is Provided Regarding the Financial Statements?
What is an Audit vs. Review vs. Compilation
• To obtain a high level of assurance about whether the financial statements as a whole are free of material misstatement thereby enabling the auditor to express an opinion on whether the financial statements are presented fairly, in all material respects.
Audit
• To obtain limited assurance that there are no material modifications that should be made to the financial statements.
Review
• To assist management in presenting financial information in the form of financial statements without undertaking to provide any assurance that there are no material modifications that should be made to the financial statements.
Compilation
Objectives of each, according to the AICPA:
Level of Assurance Obtained, according to the AICPA
What is an Audit vs. Review vs. Compilation
• The auditor obtains a high, but not absolute, level of assurance about whether the financial statements are free of material misstatement.
Audit
• Accountant obtains limited assurance that there are no material modifications that should be made to the financial statements.
Review
• Accountant does not obtain or provide any assurance that there are no material modifications that should be made to the financial statements.
Compilation
But Financial Statements Don’t Tell Us Everything…
Footnotes to Financial Statements
Accounting policies.
Accounting changes.
Related parties. Contingencies
and commitments.
Risks and uncertainties.
Nonmonetary transactions.
Subsequent events.
Business combinations.
Fair value. Cash. Receivables. Investments. Inventories. Fixed assets.
Goodwill and intangibles.
Liabilities. Debt. Pensions. Leases. Stockholders'
equity. Segment data. Revenue
recognition.
What Can Be Included in the Footnotes to Financial Statements?
Significant information that can be contained in footnotes includes debt refinancing, related party transactions, business segments and locations,
concentrations of customers, previously unknown debt, leases and contracts.
They can seem to be full of information that is not particularly helpful or informative.
Footnotes can be confusing and verbose in their attempt to provide information required to be disclosed.
Footnotes – Limitations and Possible Information Source
• The nature of many of the changes between prior year account balances and current year account balances should be revealed in other financial statements and the footnotes: • The change in cash should be reflected in
the statement of cash flows• The balances and changes in accounts
receivable and inventory should be disclosed in statement of cash flows and footnotes
• The balances and changes in short-term and long-term debt should be disclosed in statement of cash flows and footnotes
How Do Financial Statements Relate to One Another from Year to Year?
• Normally includes major categories of revenue and expenses such as:• Sales, cost of sales, operating expenses, other
income and expense, income tax expense• Some detail may be in footnotes such as income
tax expense• Footnotes should disclose, among other items:
• Accounting policies• How revenue is recognized• Nature of major concentrations in sales revenue• Major estimates made• Assets valued at fair value rather than cost• Depreciation policies
• Net income should equal the change in retained earnings from end of prior year to end of current year (unless there are dividends or other distributions per statement of cash flows)
• Net income should also equal the first line in the operating section of the statement of cash flows
How Do Financial Statements Relate to One Another from Year to Year?
Statement of Stockholders’ Equity
Not always included –only required if there are changes in elements of equity other than net income (loss) added to retained earnings
Reflects stock transactions such as
issue of common and/or preferred stock,
company purchase or retirement of outstanding stock, payment of dividends
How Do Financial Statements Relate to One Another from Year to Year?
Statement of Cash Flows
Beginning and ending cash
balances should tie to balance
sheet
Operating section reflects changes in current assets
and liabilities from prior year and
non-cash operating income
and expenses
Investing section reflects cash paid for net advances or collections on loans to related
parties, cash paid for fixed assets,
investments, other assets and the
proceeds received from sale of such
assets
Financing section reflects cash paid to retire or reduce
debt, cash received on new
long-term borrowings,
dividends and distributions paid, net borrowings or draws on lines of
credit
Non-cash section discloses transactions which occurred but which did not result in cash received or disbursed• Example is
seller-financing of fixed assets acquired
How Do Financial Statements Relate to One Another from Year to Year?
Where do you look to see what differences there might be between the “books” and the tax return?
Differences in the income between “book” and “tax” basis are recorded on Schedule M-1 of the income tax return
Depreciation expense – accelerated writeoff of fixed assets
Disallowed deductions – travel and entertainment, officers’ life insurance
Non-taxable income
Timing differences – charitable contributions, allowances, inventory costs
What If All You Have Are Income Tax Returns?
Basis of accounting used for tax return (accrual or cash most common)
Treatment of depreciation and information related to assets acquired during the year
Treatment of inventory
Assets, liabilities and equity at end of prior and current years
Corporate ownership, changes in ownership, distributions to owners
Other Important Information which may be Gleaned from Income Tax Returns
Schedule M-1 Reconciliation of Income (Loss) per Books With Income per Return
• 1) Net income (loss) per books (after income tax expense)
Additions: • 2) Federal income tax (expense per books) • 3) Excess of capital losses over capital gains • 4) Income subject to tax not recorded on books this year • 5) Expenses recorded on books this year not deducted on this return
• Depreciation • Travel and entertainment • Contributions carryover
6) Equals: Book income after additions
What’s Included on Schedule M-1?
• 7) Income recorded on books this year not included on this return • Tax-exempt interest
• 8) Deductions on this return not charged against book income this year • Depreciation • Contributions carryover
• 9) Equals: Total subtractions • 10) Book income (after additions and
subtractions) equal to tax net income before net operating loss deduction and special deductions
Subtractions:
• Net Income as reported on page 1 of income tax return
Net Income per Income Tax
Return
What’s Included on Schedule M-1?
Schedule M-2 Analysis of UnappropriatedRetained Earnings per Book• 1) Balance at beginning of
year
Additions: • 2) Net Income (loss) per books• 3) Other increases (itemize)• 4) Equals: Balance after
additions
What’s Included on Schedule M-2?
Subtractions: • 5) Distributions
• Cash• Stock• Property
• 6) Other decreases• 7) Equals: Total Subtractions
Schedule M-2 Analysis of Unappropriated Retained Earnings per Book• Balance at end of year
What’s Included on Schedule M-2?
Red Flags
Negative amounts in stockholders’ equity
Negative cash flow from operations
Current liabilities exceed current assets
Recurring losses
Disclosure of significant portion of revenue from one or a few customers
Red Flags Regarding Financial Health
Large differences between
internally-prepared financial
statements and those issued by
outside accountants.
Failure to provide detailed general
ledgers, bank statements, bank reconciliations
Failure to provide subsidiary
ledgers, such as accounts
receivable and accounts payable
agings
Inconsistent balances on
financial statements from
year-to-year
Inconsistent balances and information
among general ledger, financial statements and
tax returns
Incomplete income tax
returns – missing forms, no
supporting schedules, no
detail regarding carryforwards
Red Flags Regarding Reliability of Financial Information Received
Significant differences between operating results of
company and industry statistics
4th quarter or end of year operations
significantly improved over operating results of the prior 3 quarters
Significant fluctuations in
allowance/reserve accounts
Nature and significance of related
party transactions
More Red Flags
Off balance sheet accounting
Recording revenue before it is earned
Creating fictitious revenue
Diverting company revenue and/or assets
Boosting profits with non-recurring transactions
Shifting current expenses to a later period
Accelerating expenses or improperly recording expenses to reduce net income
Failing to record or disclose liabilities
Shifting current income to a later period
These Red Flags can be Indications of
Shannon Farr, CPA•ABV•CFF423.266.7230ShannonFarr@decosimo.com
On LinkedIn:www.linkedin.com/pub/shannon-farr-cpa-
abv-cff/36/636/a5
CONNECT WITH ME
The contents and opinions contained in this article are for informational purposes only. The information isnot intended to be a substitute for professional accounting counsel. Always seek the advice of youraccountant or other financial planner with any questions you may have regarding your financial goals orspecific situations.
Sharon Hamrick, CPA•CFF, CFE423.266.6191SharonHamrick@decosimo.com
On LinkedIn:www.linkedin.com/in/sharonhamrick
CONNECT WITH ME
The contents and opinions contained in this article are for informational purposes only. The information isnot intended to be a substitute for professional accounting counsel. Always seek the advice of youraccountant or other financial planner with any questions you may have regarding your financial goals orspecific situations.
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