How to Read and Understand Your Organization's Financial Statements

Introduction 

The key objective of the organization’s financial statements is to provide stakeholders with information regarding the general performance of the organization. Financial statements information is useful for critical decision-making processes. Academic researchers, practitioners, investors, creditors, and management utilize financial statements to analyze the firm’s business operations, investment activities, management, legal compliance, financial position, and general performance of the company. Organization performance analysis is critical in making sound investment decisions. Therefore, it is required of organizations to provide understandable, clear, and accurate financial statements for effective decision making. Consequently, there are accounting regulatory bodies which provide organizations with standards and guidelines. They include General Accepted Accounting Principles, Financial Accounting Standards Board, and International Accounting Standards among others. 

There are various consequences which are attributed to failure by an organization to following accounting standard when reporting financial statements. This paper analyzes the effect of fraudulent activities on an organization, and some of the recommendations to help the organization avoid such consequences. 

Repercussions of Failure to Include the Inventory Write-Downs in the Financial Statements 

It is required of every organization to follow the International Accounting Standards (IAS) when preparing financial statements. These standards include IAS1 for the presentation of financial statements, IAS2 for inventories, IAS7 for a statement of cash flows, among others. IAS2 defines inventories as assets held for sale. The regulation requires inventories to be recorded at the lower cost and net realizable value (NRV). IAS requires disclosures of accounting policy for inventories, carrying amount, amount of write-down, amount of any reversal of write-down, and cost of inventories. Write-downs are considered as expenses which reduce net incomes. 

During the Internal Revenue Audit, it was found that the company included inventory write-downs on the tax return but omitted the information financial statements. This is termed as concealment of a transaction. Internal Revenue Manual (IRM) Section 6 of Chapter 10 (Examination of Returns), Part 4 (Examining Process), defines fraud as false explanations regarding understated or omitted income and or concealment of income sources. The failure to include write-downs in financial statements has damaging financial and ethical repercussions. 

As a global partner in the accounting firm, I am entitled to inform the CFO and the CEO of the Fortune 100 Company about the financial and ethical repercussions of negative IRS assessment. The IRS auditors found out that the inventory write-down information was stated in tax returns with a motive of reducing payable tax whereas the information was omitted in the income statement. Fraud charges can cause severe financial consequences if the organization is found guilty of committing fraud. If guilty, the organization will be charged a civil fraud penalty which is three-quarters of the owed tax attributable to the fraud as well as interest. Instilling such penalty leads to loss of revenues which could have been used to expand operations. Also, organization’s wrangles with the authorities will scare investors and creditors away reducing the organization’s financing. Imposition of penalty will reduce the organization’s net earning thus reducing the number of earnings per share received by the shareholders. As a result, the stakeholders will deem the organization as an unreliable investment option, and ditch it for firms paying high earnings per share, causing a severe financial harm to the organization. 

Tax evasion/ fraud is an unethical business practice. Thus, when found guilty, the company could face dire social and ethical consequences. This unethical will damage the organization’s reputations. Investors, creditors, and customers who are the major stakeholders will lose confidence in the organization. The number of investors willing to invest in this organization will reduce, the company might lose its customer network, or creditors will lend their money to other institutions instead. Also, the CFO and the CEO can face prosecution if found to be liable to the fraud. 

Recommendations 

Fraud charges have severe consequences on the organization. Therefore, I will recommend some actions to the CFO and CEO to enable the firm to mitigate the consequences resulting from fraud claim and prevent the same thing from happening in the future. According to the Internal Revenue Manual, the presence of only one fraud indicator is not sufficient to sustain the fraud. Therefore, I would recommend to CEO and CFO to assemble an effective legal team and follow correct legal procedures to challenge the fraud claim legally. There is still a chance that the firm is not guilty of the claim. Winning the legal battle might save the organization from the severe repercussions of negative IRS assessment. 

The CEO and the CEO should also adopt the right strategy to eradicate the culture of fraudulent activities and create the right and legal culture. First, the organization should organize education and training program to create awareness among the workers regarding the right financial statement practices. The training should focus on ensuring all workers are conversant with the required accounting standards and guideline when creating financial statements. Also, they must be informed on the repercussions of fraudulent practices on the organization and persons involved. 

The company should create a fraud-free environment by creating and implementing fraud regulations policies. The CEO and CFO must ensure that the developed policies are adhered to by everyone and penalties imposed on individuals who fail to meet the requirement of these policies. They should also conduct continuous monitoring and evaluation of employee’s performance and behaviors to help detect any fraudulent activity. Other activities that can help the organization avoid concealment include separation of accounting function from the transaction function, developing and implementing an effective whistleblower program, matching cash flows with revenues, analysis of swings in assets and liabilities, and performing financial entry double-checking. 

The CEO and CFO have got major obligations to ensure that these recommendations are effectively implemented. The CEO is to play a big role in organizing education and awareness training, initiating policy creation process, and creation of a fraud-free environment. CFO is responsible for the organization’s financial activities. The CFO has an obligation of ensuring that all financial statements are recorded accordingly, all values are adequate, there is no omission, and that the general financial statement guidelines are adhered to. 

Negative Results on Stakeholders 

The federal tax regulations allow for the write-down of some of the company’s inventory in case of incidences of loss, damage, or the inventory has no value. However, it is a requirement by IRS that the write-down value must be determined using IRS approved valuation methods such as cost method/ market value method. Also, the firm should adhere to all the guidelines and standards of the Internal Revenue Service. Financial statement practices which do not meet financial IRS requirements can lead to additional tax and penalties. 

An IRS audit which generates additional tax and penalties has a severe impact on stakeholders including shareholders, creditors, and customers as well as the financial statement of the organization. Additional taxes and penalties reduce the net earnings (earnings after tax and interest) which reduce earnings per share received by shareholders. When such penalties and additional taxes are imposed, the dividend amount received by shareholders will reduce. This will make shareholders question the reliability of the investment. The company will attempt to adjust to the additional taxes and penalties by increasing the prices of its products which has a direct effect on its customers. Additional taxes, as well as penalties, reduce the overall revenue; the company will have fewer amounts available to pay its creditors reducing the expectation of creditors. The company’s creditors will find the business no longer attractive due to low income. 

Generally, additional taxes and penalties have a negative impact on the firm’s financial statement. In the statement of net position, the value of retained earnings and owners’ equity will reduce. Also, there is a decrease in the value of earnings after tax and interest (net earnings) in the income statement. Additionally, the value of net cash flows in the statement of cash flows will also reduce. The impact of additional taxation and penalties on the stakeholders also influence the company’s financial statements. Withdrawal of investors/ shareholders and creditors, as well as a decrease in the customer’s network, has got a harmful effect on the company’s finances. 

Federal Tax Laws and Regulations Related to Inventory Write-Down 

Internal Revenue Service (IRS) allows an organization to write down some of its inventories in the cases where the inventory is damaged lost or have no value (FASB, 2015). When recording inventory write-down value in the financial statements, it is advisable to use an appropriate valuation method which is approved by IRS. One of the IRS approved valuation methods is cost method which entails the addition of all direct and indirect costs of inventories. According to the International Accounting Standards (IAS), the values of inventories are recorded at the lower and net realizable value (NRV). It states that write-downs to NRV are treated as expenses in the period in which the write-down happened. IAS requires disclosures of accounting policies for inventories, inventory carrying amounts, cost of inventories, write-downs, and reversal of write-down (FASB, 2015). 

There have been numerous court cases and rulings related to the inventory write-downs in the United States. For instance, a case dated back in 1986 (COSMAS v. HASSETT) where Inflight declared an inventory write-down of $2.5 million. In the financial report,1986 10K, Inflight indicated the main cause of $2.5 million inventory write-down was as a result of the cancellation of anticipated sale to customers in the PRC. Nicholas Cosmas had been charged with fraud in relation to inventory write-down. These court cases have many others have been witnesses in the US regarding fraud and inventory write-down. Another court case was witnessed in 2016, American Trust Savings Bank v. Phila. I9ndemnity Ins as a result of $ 508,000 inventory write- down. After $ 508,000 inventory write down, American Trust Savings accused Phila. Indemnities INS of improper inventory management, damage of inventory and violation of loan agreement with America Trust. 

Generally Acceptable Accounting Principles Regarding Stock Option 

Controversy regarding compensation using stock options has increased due to the new generally accepted accounting principles (GAAP) requirements. The manners in which stock options are nowadays accounted for in the organization’s financial statements have changed. Under GAAP, organizations are no longer needed to expense stock options on the income statement, even though they are also viewed as a form of compensation like wages ( Aboody et al., 2004 ). This requirement has caused a lot of controversies and debates among observers and practitioners. The new method of accounting for stock options has had varying implications for the organizations ( Aboody et al., 2004 ). 

The failure to expense stock options in the financial statements has led to the failure of the organization’s financial statement to reflect the true performance of the company. It has also caused a significant distortion in the organization’s earnings reported in the financial statement. A study by PricewaterhouseCoopers (PwC) on 100 publicly traded emerging firms revealed that expensing of stock options in these countries resulted into a median reduction in earnings of 16.5% ( Aboody et al., 2004 ). Stock options are expenses a company incurs during its operation when this value is ignored, the resulting earnings will be high and not reflect the accurate performance of the organization ( Aboody et al., 2004 ). 

The Financial Accounting Standards Board (FASB) issued a statement in 1995 known as accounting for Stock-Based Compensation which recommends that the fair value of the stock-based options should not be included in the income statement as an expense. FASB’s main argument for this recommendation is that accounting for employee compensation cost should be in terms of the fair value of the amount paid which is the fair value of stock granted (FASB, 2015). This proposal was opposed until FASB allowed the companies to use intrinsic value instead of the fair value in its final report. Intrinsic value method is associated with no cost being assigned to stock options thus there is no compensation expense recorded on the income statement. The benefit of using intrinsic value is that organizations will not have to expense the fair value of employees’ stock options against earnings. However, the effect of including stock options as expenses in the income statement will be significant. Companies prefer intrinsic value method over fair value method because it is easier to determine the compensation value under the intrinsic value method. 

Recommended Plan 

Due to the inflated earnings as a result of failure by organizations to include stock options as expenses in the income statement as well as the unjustified size of some executive stock options plans, a reform is required in the area of stock options. The reform should recognize stock options as a means of executive compensation as well as how the stock options can be included in the income statement as expenses. In order to achieve reform in the area of employees’ compensation, it is suitable to use strict performance-based option plans. The issue of executive insiders reaping huge gains while shareholders lose their retirement savings should be a thing of the past with the use of strict performance-based option plan. Also, there should never be a reward for mediocre performance as witnessed wit standard stock options during bull markets, a period when almost all stock prices rise. The new plan should replace the old one such that the management is only rewarded when the company outperforms the market. Under the new plan, the organization is expected to state clearly if the stock option plans for the executive needs above average performance so that the executives can benefit from the exercise of options. 

Lease Reporting Under GAAP and International Financial Reporting Standards 

U.S GAAP’s scope is only leases involving property, plant, and equipment, while leasing in IFRSs broadly applies to assets with certain exceptions. In US GAAP, leased classification is based on whether it meets certain criteria while in IFRSs lease classification is according to the substance of the transaction. Specific criteria are provided for sales-type leases in GAAP while in IFRSs there are no specific criteria for sales-type leases. Land and buildings are accounted for as a single unit in GAAP unless land accounts for 25% of the leased property, while in IFRSs, land, and buildings are assessed separately. In both cases, rate implicit is used in discounting minimum lease payments. GAAP permits special accounting for leveraged leases, while that is not the case in the IFRSs. 

Proposal for Future Lease Transaction 

Since the company is considering leasing a substantial portion of the asset in the future, the company requires an elaborative lease policy. The leasing policy should be elaborative enough to assess the possible effect of the substantial future leasing on the overall portfolio of a company. For instance, risk-weighted lease receivables have an impact on an organization’s risk position. The policy should be elaborative enough to consider all the risk factors before carrying out the lease. Additionally, the organization should consider the future transaction, that is, which accounts to include in the balance and which ones should be kept off-balance sheet. The company can get assets off-balance sheet either through securitization or loan sales. 

Off-balance financing involves pooling various contractual debt receivables like Auto Loans, Commercial mortgages and Residential mortgages, consolidating and selling them through securities. The originator, the owner of the pooled assets, transfers the pooled assets to a special purpose vehicle (SPV) also known as the Issue. The function of the issuer is to offer tradable securities to the originator in exchange of the pooled assets. The major benefits of off-balance sheet financing include a reduction in funding cost, transfer risk, liquidity, and reduction in asset liability mismatch 

The argument for International Financial Reporting Standards 

IFRS standouts out as one of the best leasing standards because of its broad scope; the lessor has the right of using other assets in addition to equipment, property, and plant. Also, there are no specified criteria to be met when classifying a lease. For the global market and cross-border leases, IFRS standards of leasing are the best international accounting standard to use because it is not limited to certain assets. When conducting cross-border leases, one a lease intangible assets such as brands and trademarks under the IFRS. However, the lack of criteria for classification can sometimes cause ambiguity when classifying lease types. There are no distinct criteria to be followed when classifying leases under IFRSs. 

The implication of SAS 99 

Statement of Auditing Standards (SAS) No. 99 is an audit statement about the consideration of fraud in financial statement audit ( Beasley, 2003 ). SAS 99 describes fraud and its characteristics, analyze how an organization might be susceptible to material misstatement due to fraud, requires the gathering of information used for determining risks of misstatement due to fraud, identify the risk using information gathered, evaluate entity’s programs for managing risks, provides guidance, and describe documentation requirements ( Beasley, 2003 ). 

Fortune 100 Company did not consider Statement of Auditing Standards (SAS) No. 99 in preparation of the financial statement. The organization should have used SAS No. 99 in preparing financial statements to avoid the frauds that were detected during the IRS audit. SAS No. 99 provides the company with the right strategy and documentation for managing the risk of fraud. 

Restatement 

Restatement of financial statements involves revising the organization’s published financial statements for due to suspicion of errors or material inaccuracy ( Kaplan & Atkinson, 2015 ). The company’s audit results showed that there was the omission of inventory write-down while its value was included in the statement of returns. The resulting error could have been attributed to many reasons. First, there was non-compliance with generally accepted accounting principles could have led to an error. Second, it could have been a pure act of fraud to reduce the number of tax payables. Also, it could have as a result of simple clerical error due to lack of entries double checking. 

The financial restatement is crucial in ensuring accurate data is issued. A failure to issue restated financial statements have got some consequences. When a company fails to issue a restatement of financial statements, errors that might have occurred during accounts entry may go unnoticed thus the financial statements might not reflect accurate data about the company’s performance. Also, failure to issue restatement increases the risk of a company y being found guilty of fraud. Additionally, it can also reduce the confidence of shareholder as a result of inaccurate financial statements. 

Economic Effects of Restatement 

Restatement of financial statements is important for all the organization’s stakeholders including employees, creditors, investors, and customers. Restatement of financial statements increases the accuracy of the data of the organization. The employees become confidence in evading fraud and preparing statements according to the general guidelines of accounting principles. The clarity and accuracy of financial statements raise the confidence of investors and creditors in the performance of the organization. They are able to determine accurate entity performance indicators thus can identify the organization’s performance trend. 

Conclusion 

Fraudulent activities are very harmful to organizations. The effect of any fraudulent activity is felt by all the stakeholders of the company including customers, employees, shareholders, and creditors. Such malpractices affect an entity both financially and ethically. A firm should consider adopting an effective strategy to ensure a complete eradication of such malpractices. Such strategies include creating a fraud-free environment, adopting strict policies, and following generally accepted account guidelines when preparing financial statements. The organization should also adopt a practice of restating financial statements to enhance the accuracy of the financial statements. 

References 

Aboody, D., Barth, M. E., & Kasznik, R. (2004). SFAS No. 123 stock-based compensation expense and equity market values.  The Accounting Review ,  79 (2), 251-275. 

Beasley, M. S. (2003). SAS No. 99: A new look at auditor detection of fraud.  Journal of Forensic Accounting ,  4 (1), 1-20. 

Chen, J. (2015). Off-Balance Sheet Financing and Bank Capital Regulation: Lessons from Asset-Backed Commercial Paper. 

Financial Accounting Standards Board (FASB). (2015). Accounting Standards Codification (ASC) 330.  Inventory . 

Holmes, E. E. (2018).  A Case by Case Analysis of FASB and its Public Accounting Application  (Doctoral dissertation, University of Mississippi). 

Kaplan, R. S., & Atkinson, A. A. (2015).  Advanced management accounting . PHI Learning.