Financial statements contain critical information about a company’s financial position, cash flows, and results of operations. They paint a picture of the company’s financial position and business performance and help management, investors, and other stakeholders make more informed economic decisions.
Unfortunately, despite how carefully statements may be prepared, financial reporting errors can happen.
When there are errors in financial reporting, U.S. accounting standards require prior statements to be corrected and the corrections to be disclosed. The best approach, of course, is to prevent financial reporting errors before they occur. This involves knowing the red flags to watch for and having the right tools and resources in place, including expert corporate accounting and financial reporting software and guidance.
What are the causes and risks of inaccurate financial reporting, and what are some preventative measures accountants can take? This article will look to address these questions and more.
What are financial statement errors?
A financial statement error is not an accounting change. Financial statement errors are errors in the measurement, recognition, presentation, or disclosure in financial statements stemming from mistakes in applying GAAP, mathematical errors, or the oversight of facts existing when the financial statements were prepared.
Who regulates financial reporting?
The Securities and Exchange Commission (SEC) is charged with regulating the financial statements of publicly held companies. For private companies, they may have their financial statements audited or reviewed by a CPA. The CPA will judge the information based on how well it complies with accounting standards.
What is a financial statement restatement?
The Financial Accounting Standards Board (FASB) defines a restatement as the revising of previously issued financial statements to reflect the correction of an error.
When a previous statement contains a “material” inaccuracy, restatements are required, but, unfortunately, FASB offers little guidance in defining materiality. Accountants are the ones responsible for determining whether a past error is “material” enough to need a restatement.
How do you correct financial statement errors?
Accounting professionals must do the following when there’s a restatement:
- Reflect the cumulative effect of the error on periods prior to those presented in the carrying amounts of assets and liabilities as of the beginning of the first period presented; and
- Make an offsetting adjustment to the opening balance of retained earnings for that period; and
- Adjust the financial statements for each prior period presented, to reflect the error correction.
It should be noted that if the financial statements are only presented for a single period, then reflect the adjustment in the opening balance of retained earnings.
If an accountant corrects an item of profit or loss in any interim period other than the first interim period of a fiscal year, and some portion of the adjustment relates to prior interim periods, they should do the following:
- Include that portion of the correction related to the current interim period in that period; and
- Restate prior interim periods to include that portion of the correction applicable to them; and
- Record any portion of the correct related to prior fiscal years in the first interim period of the current fiscal year.
Common errors in financial reporting
While there are several causes of mistakes, some of the more common financial reporting errors and reasons for restatements include, but are not limited to:
- Mistakes reporting equity transactions: For example, improper accounting for business combinations and convertible securities.
- Income statement and balance sheet misclassification: a company, for instance, may need to shift cash flows between investing, financing and operating on the statement of cash flows.
- Valuation errors related to common stock issuances.
- Recognition errors: this could occur, for instance, when accounting for leases or reporting compensation expense from backdated stock options.
- Complex rules related to investments, acquisitions, tax accounting, and revenue recognition.
What causes inaccurate financial reporting?
There are several causes for inaccurate financial reporting. Of course, sometimes companies commit fraud in their financial statements. However, even those with the best intentions can inadvertently produce inaccurate financial reporting.
Common missteps that can occur in preparing financial statements include:
No comparative data: Single-column reports are less informative than multi-column reports given the absence of comparative data. That’s why it is important to include comparative data in the financial statements and informational reports.
Lack of calculated differences: When there is no difference in calculations provided, this forces the reader to calculate those differences in their head or with a calculator. Not only is this time-consuming, but it increases the risk for errors. Make it easier for the reader to digest the data by including calculated differences.
Lack of perpetual cash flow forecasts: Cash flow forecasts should be prepared and updated periodically (i.e., monthly or quarterly) given the importance of cash flow to a company’s operations. It is important to prepare seasonalized income statements, projected balance sheets, and projected cash flow forecasts, and then update the cash flow forecast monthly, as necessary.
Insufficient training: A small company’s bookkeeper may not be well-versed in proper revenue and expense recognition principles. As a result, they may not always produce accurate financial reports. In these instances, proper third-party review procedures should be established to ensure that an accountant who has the right experience can review the company’s reports.
Lack of visual data: Infographics can be an effective way to summarize complicated financial information. This can make the data easier to understand and it is more aesthetically pleasing and appealing for the reader.
What are the risks of inaccurate financial reporting?
Errors in financial reporting can have serious consequences. Management uses internal financial reports to help them make wise business decisions about their company. Investors and other stakeholders use financial reports to better understand a company’s financial position and business performance.
When companies have inaccurate financial reports, they are likely to make business decisions that are unfavorable and even detrimental to the company’s survival. They can also find themselves tangled in legal troubles.
More specifically, inaccurate financial reporting can result in inaccurate projects and budgets, difficulty in obtaining financing, time wasted reconciling financial data, plummeting stock prices, and, if material enough to violate GAAP, hefty penalties.
Preventing errors in financial reporting
As noted earlier, the best approach is to prevent financial reporting errors before they even occur. Public accounting and consulting firm Baker Tilly outlines several preventative measures that can be taken.
- Keep a close watch for potentially susceptible areas in the financial reporting processes. This involves scrutiny of financial reporting steps involving complex accounting standards, significant use of estimates, and recently issued accounting standards.
- Help mitigate risks by implementing controls. Be sure to monitor their effectiveness over time.
- Throughout the decision-making process involving major estimates or matters of judgment, be sure to take into account qualitative factors, in conjunction with quantitative factors.
- Keep up with new standards, as well as evolving accounting standards, and determine what impacts they may have on the company’s financial reporting. To ensure that accounting standards are accurately and effectively applied, it is important to allocate sufficient resources.
How do you ensure accuracy in financial reporting?
One of the most effective ways to ensure accuracy in financial reporting is to have the right tools and resources in place. Ensure your financial reporting efforts are accurate by utilizing corporate accounting and financial reporting software to automate the process.
To learn more about current challenges accountants face, read “Top accounting issues in 2023”.