by H2R CPA Team
A company's management team is often interested in painting the rosiest possible picture of a company’s financial performance. But aggressive earnings management, or “spin,” can mislead investors and lenders. Here are some ways U.S. Generally Accepted Accounting Principles (GAAP) can be manipulated to obscure the truth.
Creative accounting vs. cooking the books
Earnings management usually starts out small, but it can become increasingly aggressive and eventually cross the line into fraud if it goes unchecked. An external audit may help detect the red flags of earnings management, including:
Premature revenue recognition. Some companies recognize revenue early to make the income statement temporarily appear more attractive. This ploy is common when a company is applying for bank financing or up for sale.
Miscellaneous “cookie jar” reserves. Management can create a hidden reserve of funds during good times. Then the reserves can be tapped into to nourish earnings in lean times.
“Big bath” restructuring changes. Some companies overstate the costs associated with restructuring. This enables them to clean up their balance sheets and create reserves for a rainy day.
Immediate acquisition write-offs. Acquired companies may classify a portion of the purchase price as “in process research and development,” which they immediately write off. This reduces the amortization of the purchase price to future earnings.
Overreliance on EBITDA. Earnings before interest, taxes, depreciation and amortization (EBITDA) and other non-GAAP metrics have become popular ways to evaluate a company’s performance. But they aren’t usually audited, and they may be calculated differently from company to company.
EBITDA is generally intended to resemble cash flow. But this metric can obscure problems for start-up companies with major debt. Although their EBITDAs give these start-ups appeal, their debt service may mean they won’t be profitable for many years.
Too good to be true?
Pay attention when reviewing financial statements and corporate press releases — the opportunity and pressure to spin earnings is everywhere.
Contact H2R CPA at 412-391-2920 or email@example.com for more information on how to identify when a business may have engaged in “creative” accounting practices to improve their financial picture. Our team would be pleased to provide a complimentary consultation.
by H2R CPA Team
When accountants conduct an audit or review, they can’t test every transaction. Instead, they set a “materiality” threshold. This benchmark is used to obtain reasonable assurance in an audit — or limited assurance in a review — of detecting misstatements that could be large enough, individually or in the aggregate, to be material to the financial statements.
What is materiality?
Unfortunately, there’s no specific definition of materiality under U.S. Generally Accepted Accounting Principles (GAAP). But the Conceptual Framework for Financial Reporting under International Financial Reporting Standards (IFRS) says:
Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.
Several definitions of materiality exist. But the universal premise is that a financial misstatement is material if it could influence the decisions of financial statement users.
How do auditors determine materiality?
To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement.
The materiality threshold is typically stated as a general percentage of a specific financial statement line item. For example, let’s suppose Joe Auditor sets a materiality threshold of 1% of revenue for ABC Company. For 2017, the company reports annual revenue of $190 million, so its materiality threshold is $1.9 million.
During fieldwork, Joe unearths a clerical error that caused ABC to understate revenue by $1 million. Is this error material? Although a $1 million error may seem significant, it’s less than 1% of the company’s annual revenue. So, it’s immaterial to ABC’s overall financial performance.
On the other hand, if the company had overstated its revenue by $1 million due to a fraud scheme involving a senior executive, Joe may deem the misstatement as material because it involved a member of the senior leadership team and potential criminal activity.
Regardless of whether a misstatement of revenue is considered material, it may trigger a material misstatement in accounts receivable. In other words, the balances recorded as due from customers may be materially different from the actual amounts due.
It’s all relative
As these examples demonstrate, materiality is a relative concept. In practice, auditors must evaluate a material misstatement on a standalone basis and within context of a company’s financial statements overall. What constitutes a material misstatement for one company may not reach the materiality threshold for another. Materiality is a matter of professional judgment and your audit team’s experience.
Contact H2R CPA at 412-391-2920 or firstname.lastname@example.org to learn more about how we can assist you with your Assurance needs. Our team would be pleased to provide a complimentary consultation.
by Joseph M. Delisi, CPA, Principal
Despite the continuing decline in overall paper check usage, check fraud continues to pose a risk for many organizations. Since checks are passed person-to-person on their way to payment, they can easily be stolen, duplicated, altered or cashed illegally.
Are you concerned about check fraud losses at your business? Positive Pay may be the solution for you. It is essentially an insurance policy against unauthorized disbursements from your bank account. It is a service offered by banks for a fee, although some banks are now offering this service at no cost.
Here’s how it works: Positive Pay requires a company to transmit to the bank a file of checks issued each time checks are written. The file submitted to the bank contains the check number, date, amount, and bank account number. When those checks are presented to the bank for payment, they are compared electronically against the list of transmitted checks.
When a check presented for payment does not match the information on the file transmitted to the bank, it becomes an exception item. Before the bank processes the check for payment, it sends an image of the exception item to the client. The client then reviews the image, and instructs the bank to either process the check for payment, or return the check as unpaid. This allows the company to identify fraudulent checks before they are paid by the bank.
Positive Pay is an effective way to institute check fraud protection, stop bad payments, and reduce liability when dealing with a large volume of checks.
H2R CPA is pleased to assist clients in finding ways to protect themselves against fraud. Contact our team at 412-391-2920 or email@example.com for more information. We would be pleased to provide a complimentary consultation.
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