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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.