The Preparation of Financial Statements - Module 5 of 6

The Preparation of Financial Statements

The Principles of Accounting

Accounting has been called the "language of business"[1] and an understanding of accounting principles is necessary to decipher financial statements. Historically, the Financial Accounting Standards Board, abbreviated F-A-S-B and pronounced “FAZ-BEE,” has been the private sector organization responsible for promulgating the rules of accounting.[2]  The Securities and Exchange Commission is a federal agency that has jurisdiction over publicly-traded companies. While the SEC has mandated certain reporting requirements for those companies, the agency has traditionally deferred its authority to FASB with regard to establishing the rules of accounting.   

In 2002 Congress passed the Sarbanes-Oxley Act,[3] abbreviated S-O-X, and pronounced "socks."  SOX was passed in the aftermath of several financial scandals that caused the collapse of several large firms including accounting firms that had prepared their clients’ misleading financial statements. The economic dislocation caused by the failure of firms like Enron and WorldCom caused an average loss per American household of $60,000.[4] Consequently, SOX requires that key members of management personally attest to the accuracy of a company's financial statements and it attaches criminal penalties for non-compliance.[5]  SOX further delegated to the SEC the selection of a private organization to set accounting standards and the SEC exercised its mandate by choosing FASB.

FASB was formed in 1973 and, through its pronouncements, it has established the Generally Accepted Accounting Principles, abbreviated G-A-A-P, and pronounced as "GAP."[6]  GAAP indicates how and when something is to be recorded in financial statements. Still, the rules don’t provide unequivocal guidance in all situations.  Sometimes accountants will encounter a choice between different rules, such as whether to record an expenditure as an expense or cost.  Sometimes, there is no applicable GAAP provision, yet these decisions can make profound differences when portraying the financial health of a business in financial statements.[7]

FASB relies on several foundational assumptions for the establishment of GAAP.[8]  First, a business is assumed to exist as a going concern in perpetuity, without any foreseeable termination date. Furthermore, the owners of the business are considered to exist separately and independently of the business, so the wealth of business owners is irrelevant to determining the health of a business on paper.  Another principle is that the business's operations can be divided into discrete time periods for the purpose of financial analysis.  All reportable transactions in the financial statements are to be observable and denominated in measurable monetary units.  Revenue is assumed to be earned when the activities that generate that revenue are completed or nearly completed.[9] 

There are further assumptions underlying GAAP.  Revenues and expenses should be “matched,” which means that when incurring expenses, a business will allocate them to the time period during which the benefits generated by the expense contributed to the receipt of revenues. The preference is to conservatively understate earnings, values and cash flows rather than to overstate them.  Assets are recorded at their historical acquisition cost, not fair market value.  Financial statements must report transactions consistently and not apply different principles to the same transaction.  Also, the information reported in financial statements must be meaningful, not trivial.[10]

The Principles of Auditing

An audit is an external and independent review of a business’s accounting practices and internal controls.[11]  The Auditing Standards Board of the American Institute of Certified Public Accountants, or A-I-C-P-A, developed a set of standards for conducting audits called Generally Accepted Auditing Standards or G-A-A-S, pronounced "GAS.”  However, given the auditing failures that led to the Enron and associated scandals, SOX created the Public Company Accounting Oversight Board, abbreviated P-C-A-O-B, to adopt or establish auditing rules for publicly-held companies, subject to the approval of the SEC.[12] 

Auditors perform two essential functions.[13]  The first is verifying the facts that support the financial statements, such as physically inspecting inventory to ensure that the reported quantities are accurate.  The other is reviewing how information is portrayed in financial statements, such as classifying an acquisition as an asset purchase or as an expense.  For an auditor, that may mean issuing audits critical of the client. 

There are several types of reports an auditor may issue.[14] An auditor may issue a report that is “unqualified,” which is also called a "clean audit."  This does not mean the financial statements are free from error or fraud; rather, it simply means the audit provides reasonable assurance that the financial statement “presents fairly”[15] a company's financial position in the opinion of the auditor. 

As an alternative, an auditor may release an opinion that is similarly unqualified but accompanied by explanatory statements, such as that the audit includes the work of another auditor, the audit reflects a change in accounting principles or their application or that the financial statements include departures from standard accounting principles. 

As another option, an auditor may issue a “qualified opinion” that validates a company's financial statements but includes exceptions, such as the lack of adequate accounting records, lack of adequate opportunity to properly observe physical inventory counts or noncompliance with GAAP rules. 

Alternatively, an auditor's report may constitute an “adverse opinion,” which means that the company's financial statements do not fairly present the company's financial position according to GAAP. If an audited publicly held company receives an adverse opinion, it will be barred from filing financial statements with the SEC, so a publicly-held company has a strong incentive to avoid adverse opinions.  Also, an adverse filing will likely impair any company in raising capital or borrowing money. 

A final option an auditor may exercise is a “disclaimer of opinion.”  Suppose an auditor is not afforded the opportunity to observe physical inventories.  Rather than issue a qualified or adverse opinion, an auditor could issue a disclaimer of opinion in situations where records or observations are incomplete.

Prior to SOX, companies were allowed to hire auditors as consultants and the auditors consequently had a strong interest in positive audits.  Auditors that do not maintain proper independence and detached judgment can compromise the integrity of their work by overstating revenue, underreporting expenses and making other misrepresentations.  SOX now requires publicly-held firms to retain auditors that are fully independent of the firms they audit.[16] 

As an alternative to an audit, an accounting firm may perform what is called a "review" of a company's financial statements, which gives the limited assurance that no modification to the company's financial statements is necessary to achieve compliance with GAAP rules. Another alternative to an audit is what is called a "compilation," which is a preparation of financial statements according to GAAP that an accountant provides without an accompanying opinion.[17]  

Note that there are important differences in the roles of lawyers and auditors. An auditor must exercise independent judgment and fidelity to the public interest while a lawyer has a duty to protect the client and maintain the client's confidences.[18]   

Gray Areas in Financial Accounting

While preparing financial statements, sometimes accountants, auditors, lawyers and managers intentionally commit fraud. They intend to deceive their shareholders and the public about illicit activities and the firm's financial position. But, other times, financial reporting reflects interpretative "gray" areas where a set of financial statements or their audits conform to the rules of GAAP, but do not exhibit an accurate representation of the business.  The questions will frequently be those of intent and judgment.  Was there an intent to deceive a firm's investors or the public?  Did the preparers of the financial statements exercise sound judgement in the application of GAAP?  If there are anomalies in the financial statements, to what extent do these financial distortions affect their accuracy?  Are these errors "material" or merely computational oversights?[19]    

Businesses, of course, want to present their financial health in a favorable light to investors.  Compiling optimistic representations of a business is called "earnings management."[20]  One such approach, for example, is listing accounts and transactions separate from the balance sheet.  These listings are called "off-balance sheet" transactions and they may not be permissible under GAAP.  Secret acquisition of a company to elude regulatory obligations would be illegal but chronicling potential lawsuits that may be filed against the company in the future as a contingent liability is generally permissible.[21]  

There are several ways to skew financial statements to present a misleading depiction of the financial health of a business.[22]  One is to engage in "big bath" accounting.  When a business reorganizes or acquires another entity, that action can have a dramatic impact on the business's stated revenue. It may, therefore, use the classification of the transaction or its timing to affect the reporting of its financial impact.  Accountants will give the transaction the "big bath" treatment by improperly allocating all of its costs to the present year, to preserve the profitability of subsequent years.  Another technique is what is called "cookie jar reserves," which involves underestimating or overestimating the impact of certain transactions. 

For example, Acme Corporation sells power tools directly to consumers but does not provide any accounting for warranties and return polices in order to inflate its revenue reporting. 

Another approach used to distort financial statements is the premature recognition of revenue.  Similar to the previous example, assume Acme sells its power tools and records its revenue immediately without waiting for the expiration of the return period.  Not accounting for prospective returns overestimates Acme's sales revenue.

Responsibility Conflicts

There are some areas of tension that arise in the course of accounting and auditing for legal professionals.  In the audit process, the obligation of legal professionals to observe the attorney-client privilege and maintain the confidentiality of their work product may clash with the auditor's requirement of public disclosure.  Tension may also arise when an attorney must provide a statement on the likelihood of possible litigation as a contingent liability the auditor must address.[23]  A chance of litigation that is only "slight" need not be disclosed, but "reasonably possible" litigation must be provided in the footnotes of a company's financial statements. An estimated liability in the company's accounts is made for litigation that is "likely."[24]

For example, Acme Corporation markets electric cars with known battery failure issues.  Acme's counsel does not want to provide information about possible litigation to Acme's auditors because it may reveal trade secrets, sensitive marketing data and confidential communications.  Acme's auditors claim that this is a significant issue of liability that must be listed under its disclosure obligations.  Without commenting on the merits of any pending litigation, Acme's lawyers merely indicate the presence of possible litigation in the footnotes of Acme’s financial statements.

Another critical issue of possible tension that is affected by GAAP is the distribution of earnings to shareholders by corporations.[25] If the corporate directors declare excessive dividends, the firm's existence may be imperiled. Such declarations may be innocent misinterpretations of a company’s financial position or may be a malicious attempt to raid the company coffers. In measuring the financial integrity of a company's dividend payments, two approaches have evolved, though minimum standards are found in state statutes that govern corporations.  One approach is to rely on the balance sheet, to determine if dividend payouts exceed the value of capital in excess of a corporation's stock computed at par value, which is the stated value of a share of stock.  This excess is called “surplus.” [26]

For example, assume Acme Corporation's total value is $1,600,000, which is found by subtracting liabilities from assets. Acme has 100,000 shares outstanding at $10 per share for a total value of $1,000,000 in common stock.  The difference between Acme's total value and its common stock is $600,000 in surplus, which is therefore the upper limit of how much Acme may declare in dividends.  Acme's directors declare a stock dividend of $800,000.  While Acme's shareholders might be happy to get such a dividend, it could violate the state's corporation statute and may make Acme subject to a lawsuit.

Another way to determine the extent to which a business may declare dividends is the insolvency approach.[27] This involves determining whether a business can pay its obligations as they become due, called the "equity insolvency test." Another way of measuring solvency is to ensure the business’s assets are at least equal to its liabilities after the surplus distribution; this is called the "balance sheet equity test." A business may need to satisfy both tests under the state's laws.[28] Excess payouts that violate these tests would be unlawful.

One of the most vexing issues in the determination of surplus distribution limits is the concept of book value versus fair market valuation.[29]  Recall that a balance sheet prepared in accordance with GAAP reflects acquisitions and payments at cost, not present fair market value. But fair market value may be a far more accurate indicator to gauge the propriety of a surplus payment to shareholders. Sometimes, a company may "write-up," or increase, the value of certain assets or liabilities, or alternatively, it may "write-down," or decrease, the values on its balance sheet in order to more accurately reflect its financial reality.

Sample Cases

In one case that a commentator calls "perhaps the best-known dividend case ever,"[30] Randall v. Bailey[31], a New York court approved the use of fair market value to ascertain whether a dividend payout was proper. While fair market value may be used in certain situations, there are interpretative issues in using fair market value and changing the values of assets and liabilities. The process is fraught with conjecture.[32]

At times, accountants can become part of regulatory litigation.  In one famous case, United States v. Simon,[33] a senior partner and a junior partner in a large accounting firm with an international reputation certified the legitimacy of a company’s receivable that collateralized what they knew to be valueless stock. Since the accountants knew that the receivable was largely uncollectible because the collateral lacked value, they were convicted of “drawing up and certifying a false or misleading financial statement.”[34]  The judge ruled that compliance with GAAP shows good faith when an accountant’s motives are in question, but that such a showing is not conclusive.[35]

In another important case, United States. v. Couch,[36] the U.S. Government sought to enforce an IRS summons in the course of an investigation to obtain a business owner’s financial records in the possession of her accountant. The business owner tried to shield her records by claiming the Fifth Amendment privilege against self-incrimination.  The Supreme Court ruled that the privilege did not apply and, since there was no expectation of privacy in the records, the fourth amendment’s protection against unreasonable searches and seizures did not apply either. The Court observed that there is no accountant-client privilege of confidentiality.[37]  The accountant was thus directed to comply with the IRS summons.     

In our final module, we’ll look at some of the financial tools used in the process of generating fair and accurate financial documents.