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Lucubrate Magazine, Issue 34, July 27th, 2018
Changes in Accounting Estimates and Errors. Strangely this IAS seems almost to be two standards in one and we’ll address both separately. Bear in mind that all accounting standards exist to ensure consistent and comparable treatment across all financial statements.
- Accounting Series – article No: 15
- Accounting Theory – Advanced Part 5
By Peter Welch, Georgia, CEO GlobalCfo.LLC.
Finally, courtesy of IFRSbox, the working papers needed to derive a statement of cash flows have been included. Having done these statements personally I can vouch for their complexity and necessity of meticulous details and documentation. No question it is a critical statement, and continuing our discussion of last week.
Working capital (Current Assets less Current Liabilities):
Illustration: PricewaterhouseCoopers 2017
Illustration: PricewaterhouseCoopers 2017
As you read in the last article, changes in working capital is a major component of adjusting net income to a cash basis, using the functional methodology. Though non-cash adjustments seem significantly more important, when you review the analysis, depreciation is the major adjustment with others effectively netting out. The purpose of the discussion last week was to target that when you consider the most likely line-item for ‘manipulation’ it was revenue/accounts receivables.
Try Buying a Mobile Phone without Proper Documentation
Consider how changing the terms of sales (underwriting standards), say from net 30 days to net 180 days and no income verification would have on reported revenue. In all likelihood, sales would significantly increase as would accounts receivables. However, the potential for credit losses/write-offs also increases, albeit a judgment/management-call. The balance sheet would likely shelter the strategy at least for one fiscal year and current reported net income would reflect a material increase along with a probable stock-price increase, the primary objective. Try buying a $1000 mobile phone without proper documentation and paperwork and 6-months credit without income verification or credit reports! Based upon board agreements, a stock-price trigger-point, to pay bonuses can be worth substantially more to individuals than worrying about future write-downs to accounts receivables and a year-on-year decrease in net income.
If you think that could never happen, for comparison strategies, the mortgage/housing crash of 2008 was primarily the result of virtually non-existing underwriting standards deliberately implemented that created massive losses when comingled with the then current economy/employment environment (http://www.academia.edu/33126238/Global_Financial_Crisis_and_the_concepts_of_risk_and_return_-who_contributed . House prices/demand increased significantly and eventually many walked away defaulting on mortgage loans.
All other possible considerations, when you review what is ‘working capital’ above are relatively easily cross-referenced and any ‘unusual adjustments’ would most likely be red-flagged either visually or through the notes to the financials as well as reviewing prior-year financials. Obviously, misrepresentation of financial information towards presenting a fraudulent net income can occur anywhere but revenue manipulation is far more common. Our discussion of ‘revenue’ manipulation is very important from the perspective of avoiding accounting becoming or perceived as just a clerical exercise of recording journal entries. Developing financial statements is also a vigilant exercise of constant financial analysis, review, along with comparison and due diligence. Noteworthy also is that the Foreign and Corrupt Practices Act (FCPA) is being carried out by US regulators, the Securities and Exchange Commission and the Department of Justice and is the testimony to where liability and accountability are deemed to fall.
An excellent book on this topic is Financial Shenanigans (How to detect accounting gimmicks and fraud in financial reports) by Howard M. Schilit and Jeremy Perler. Without departing too far from IAS 7, let’s note some comments from this book.
1. Recording Revenue Before Completing Any Obligations under the Contract
- Recording Revenue Far in Excess of Work Completed on the Contract
- Recording Revenue Before the Buyer’s Final Acceptance of the Product
- Recording Revenue When the Buyer’s Payment Remains Uncertain or Unnecessary
Changing the Revenue Recognition Policy to Record Revenue Sooner
Software maker Transaction Systems Architects, Inc., jump-started its sluggish revenue growth by shifting future-period sales into earlier periods.
(IAS 7 discussions above)
Watch for Cash Flow from Operations That Begins to Lag Behind Net Income. A red flag that should have alerted investors to take a closer look at Transaction Systems Architects’ revenue recognition was a trend in which the company’s cash flow from operations that started to materially lag behind reported net income.
Warning of Premature Revenue Recognition: Cash flow from operations materially lags behind net income.”
Moving back now to IAS 7, and to the IFRSbox worksheets above, the other two key areas of required presentation are, per IASB,
“ Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Financing activities are activities that result in changes in the size and a composition of the contributed equity and borrowings of the entity.”
Thus, from a presentation and more importantly a faithful representational perspective, a stakeholder and reader can discern where to focus attention and ask the pertinent questions. Effectively, IAS 7, reports cash derived from operations, i.e., the contribution of net income, and what management decisions resulted in a reduction of available cash (investing activities) and besides net income where else did funds come from (financing activities). Other than adjustments to net income from an accrual to a cash basis, most changes in assets and liabilities reflect investments or sources of funds as can be seen from the above worksheets. Balance sheet items, however, such as PP&E (Property, Plant, and Equipment) comingle additional acquisitions (investments) along with depreciation that is added back to net income. In other words, some line-items need to be segregated into one or more categories for IAS 7 presentation purposes. Of course, when you consolidate/net the reported information, it must be equal to the difference between the prior and current year.
Wrap-up
To wrap-up this week’s article, that we’ll conclude next week, let’s turn our attention to IAS 8 or Accounting Policies, Changes in Accounting Estimates and Errors. Strangely this IAS seems almost to be two standards in one and we’ll address both separately. Bear in mind that all accounting standards exist to ensure consistent and comparable treatment across all financial statements. IAS 1 demanded a format for presenting financial statement information and line-items to be included. Inventory, IAS 2, dictated the permitted overhead allocation/cost model codifying what could be included in inventory carried-forward along with disallowing LIFO. And as discussed IAS 7 dictates a standard cash flow statement format.
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(Illustration on top: Courtesy of IFRSbox)
Lucubrate Magazine, Issue 34, July 27th, 2018
Categories: Accounting, Law, Magazine
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