In an ideal world, every company’s financial reporting would always be 100% error-free.Financial statements contain vital information about a company’s health, and internaland external stakeholders need to be able to rely on their accuracy to make criticalmanagement and investment decisions with confidence. Unfortunately, inaccurate reporting cansometimes occur, either due to unintentional error or — in the worst situations— deliberate fraud. Inaccurate reporting can have painful and costly consequences,including poor business and investment decisions, regulatory fines and reputational damage.Understanding the causes, risks and ways to mitigate errors can help companies avoidfinancial reporting inaccuracies and the problems they can cause.
What Is Financial Reporting?
Financial reporting is the process of communicating financial data to external and internalstakeholders. It includes core financial statements, such as the company’s quarterlyand year-end income statement, balance sheet and statement of cash flows.
External stakeholders, such as investors, shareholders and creditors, use a company’sfinancial reporting to evaluate its financial health and creditworthiness. Other externalshareholders include regulatory agencies like the IRS and the Securities and ExchangeCommission (SEC), which require financial reporting for legal and compliance reasons.Internal stakeholders, such as the company’s CEO and other top managers, use financialreporting to gauge performance and inform decision-making, and as a foundation for buildingbudgets and projections.
Whether it’s used for external or internal reporting purposes, the underlying financialdata must comply with accounting standards such as the Generally Accepted AccountingPrinciples (GAAP), used in the US, or the International Financial Reporting Standards(IFRS), used in many other countries. External reporting of the core financial statements,plus other required schedules and documents, must follow strict guidelines defined byregulatory agencies and GAAP/IFRS reporting standards. Internal financial reportingtypically includes the core financial statements but can also be customized to meet theneeds of internal stakeholders.
Key Takeaways
- Accurate reporting in financial statements and other documents is vital for internal andexternal stakeholders, who rely on the information to make critical management andinvestment decisions.
- Inaccurate financial reporting can be due to unintentional mistakes or, in some cases,fraud.
- The risks of inaccurate financial reporting include bad operational decisions,reputational damage, economic loss, penalties, fines, legal action and even bankruptcy.
- Companies can ensure accurate financial reporting by employing a network of internalcontrols, fortified by financial software that helps prevent and detect errors.
Why Is Accurate Financial Reporting So Important?
Accurate financial reporting is vital to external and internal stakeholders that rely on theinformation for decision-making for several reasons:
- Investors need an accurate profile of a company’s financial health when decidingwhether, and how much, to invest in the company. Investors use the information infinancial reports when deciding whether to buy stock in publicly traded companies.
- Creditors, such as banks, the Small Business Administration (SBA) and credit cardcompanies, rely on the accuracy of an organization’s reporting to analyze itscreditworthiness and establish appropriate credit lines.
- The company’s CEO and other senior managers rely on internal financial reportingfor day-to-day decisions, such as when to buy inventory or how to set product prices.Executives also use internal financial reporting as a tool for stewarding thecompany’s strategic direction.
Financial reporting needs to be timely as well as accurate — even the most accurateinformation can be worthless if it’s out of date or it’s not available whenneeded. In addition, external financial reporting must meet deadlines defined by regulatoryagencies.
How Does Financial Reporting Go Wrong?
Many financial reporting errors are accidental. Given the plethora of standards andregulations governing financial reporting, combined with the pressure for timeliness,it’s easy to see how companies can make mistakes. But there are also examples ofdeliberately inaccurate financial reporting by unscrupulous characters. Whether unintendedor not, errors in financial reporting can have serious consequences.
Causes of Inaccurate Financial Reporting
Many factors can contribute to inaccuracies in financial reporting, including inadequatelytrained staff, error-prone manual processes and inconsistent accounting methods.
Inadequately trained or incompetent staff across the company candirectly and indirectly cause accounting errors. For example, warehouse staff maymiscount inventory, and salespeople may make mistakes in travel expense reports— both of which can cause accounting errors.
Accounting personnel who are not up to date on accounting standards andregulatory requirements. GAAP, SEC and IRS standards and guidelineschange frequently — recent examples include the changes to lease accountingdefined in ASC 842 and the tax changes included in the Tax Cuts and Jobs Act (TCJA).Members of the accounting team may fail to stay current on the latest information,especially when they’re struggling with heavy workloads.
Manual processes. To err is human. Manual processes increase thelikelihood of simple accounting mistakes, such as transposing digits, misplacing adecimal point, double-counting or failing to record an activity in a ledger.
Unclear communication between those setting accounting policy andthose responsible for implementing it can cause errors. Examples of disconnectsinclude misunderstandings about how to handle accounting estimates, such as reservesfor possible bad debt.
Poorly integrated financial systems can create data havoc, resultingin errors through improper mapping of information between different systems and theneed for manual intervention in the flow of data.
Inadequate review processes can result in errors slipping through,such as imbalances in intercompany accounts. This is often the result of poor timemanagement, inadequate resources or misplaced priorities.
Inconsistent accounting methods among departments or subsidiariescan cause errors in financial statements. Examples include using differentmethodologies for inventory valuation or revenue recognition, and incompatibletransfer pricing.
Chart of accounts misuse. Incorrect treatment of transactions, suchas miscoding an invoice in the accounts payable process or misclassifying expensesas revenue, are errors that can obscure financial reporting.
Fraud. Schemes in which employees deliberately misstate or omitinformation in financial statements are relatively rare — but they are also the costliest type ofworkplace fraud that companies suffer.
Impact of Inaccurate Financial Reporting
Financial reporting inaccuracies can have far-reaching consequences for the company, as wellas for investors and other external stakeholders.
Wasted time and resources. Companies can spend a significant amountof time trying to track down and fix financial reporting errors and dealing with theconsequences. It’s frustrating for everyone involved and can lead to strainedrelationships, as well as job dissatisfaction.
Bad decisions. Inaccurate information can lead to poor decisions.This is especially important when it comes to internal financial reporting, which isoften the basis of operational decisions, such as product pricing, as well asworkforce hiring and firing decisions.
Cash-flow problems. Over reporting cash flow can cause the companyto be short on cash when paying bills or payroll. Conversely, underreporting cashflow can mean missing opportunities for investment income or interest.
Fines and penalties. Inaccurate or late reporting can lead topenalties and fines from the IRS and local authorities. If an IRS audit finds that acompany underpaid its taxes due to inaccurate financial reports, the company ischarged interest and penalties on top of settling its tax bill.
Reputational damage and loss of credibility. Inaccurate financialreporting undermines the credibility of a company and its management — even ifthe errors are unintentional. Lenders may consider that applicants with financialreporting errors are riskier and charge them higher interest rates or even refuse tolend them money. Investors become wary when they lose trust in a company’sfinancial information.
Stock markets are unforgiving when companies need to rescind or revise financialreporting: Share prices often fall and valuations sink. A household appliancemaker’s stock price dropped almost 3% when the company said it needed torestate its financial results, because some assets had been erroneously recorded byunauthorized employees. On another occasion, the same company needed to revisefinancial statements due to incorrect recording of expenses. Because those revisionstook longer to correct than expected, the company missed a reporting deadline andits stock price took a 9% hit.
Bankruptcy. When inaccurate financial reporting is a result offraud, the impact can be ruinous. Intentional misrepresentation of financialstatements can result in legal action, arrest and imprisonment of executives,penalties and fines. The SEC Division of Enforcement investigates and administersenforcement actions for these cases. In one prominent example, a major energycompany was investigated by the SEC for inflating earnings reports using deceptiveaccounting practices. As the full extent of the inaccuracies became apparent, theformerly high-flying company saw its stock price plummet from a high of $90 pershare to less than $1. The company ultimately filed for bankruptcy. Severalexecutives were imprisoned, and employee pension plans became almost worthless.
In another example, a food manufacturer was accused of inflating its profit on keyproducts and reporting inaccurate earnings. Although the company never admitted toany wrongdoing, its stock lost 20% of its value in a single day.
How to Keep Financial Reporting Accurate
The primary methods used to ensure accuracy of financial reporting are internal accountingcontrols and external audits.
Controls. Controls are internal processes or policies that are putinto place to reduce the likelihood of errors. While controls are not iron-cladsafeguards, especially in cases of orchestratedfraud, they are meant to provide a reasonable level of protection againstfinancial reporting misstatements. Controls are such important financial reporting“circuit breakers” that the Sarbanes Oxley Act requires public companiesto issue an Internal Controls Report demonstrating that adequate financial controlsexist for their assets and financial records.
There are two basic types of controls: prevent and detect. Preventive controls aredesigned to prevent errors before they occur. They aim to keep financial data cleanbefore it flows into financial statements. Typical preventive controls includesegregation of duties, user access restrictions for accounting systems, physicalsafeguarding of assets, requiring multiple levels of approval with formal delegatedauthority for actions such as purchasing goods and paying invoices, and employeescreening and training.
Detect controls work at the back end of the accounting process to identify errors orirregularities for investigation and correction. The most common detect controls areaccountreconciliations that compare internal financial data to externaldocumentation, such as comparing general ledger cash accounts to external bankstatements. Other detect controls include comparing actual activity to budgets orforecasts, conducting physical inventory cycle counts, regular testing by internalauditors and periodic external audits. Because detect controls alert companies toerrors after the fact, it is important that they are conducted in a timely way.
External audits. A common misconception is that the best way toensure correct financial reporting is to have external auditors audit thecompany’s financial statements. While this is certainly a best practice— and a regulatory requirement for public companies — audits do notguarantee perfection. Instead, auditors provide a written opinion of the accuracy ofthe statements, following an audit process based on Generally Accepted AuditingStandards (GAAS). The best result is a “clean” or“unqualified” audit opinion, which states that the financial reportingis free of material misstatement and that management of the company is ultimatelyresponsible for preparation of the financial statements. Alternatively, auditors canrelease opinions that indicate possible problems with the financial statements. Forexample, they may release a “modified” or “qualified”opinion when there is an unresolved disagreement with company management. Modifiedopinions are rare, because most companies rectify the disagreement before the auditis finished. “Disclaimed” and “adverse” audit opinions bothindicate significant problems with the financial statements and are also very rare.
How Can NetSuite Help?
While no accounting software can fully guarantee that it eliminates unscrupulous,premeditated fraud, NetSuite FinancialManagement includes many built-in controls to help prevent and detect errors orinconsistencies in financial data and reports. By integrating these functions into a singlesolution, NetSuite Financial Management helps companies avoid introducing manual errors intothe transaction flow. It helps enforce compliance with company standards by means of toolsthat create a consistent accounting approach. It also includes preventative access controlsthat enable administrators to customize privileges for each user. NetSuite’s multibookcapability allows companies to record a transactionto multiple sets of books at once that comply with GAAP and IFRS. In addition tosaving an enormous amount of time, this feature also reduces the potential for errors whenmeeting different requirements.
Conclusion
Ideally, financial reporting should always be accurate and timely. In reality, unintentionalerrors and fraud can lead to inaccuracies in financial statements and other importantcommunications. The risks to the company are significant, ranging from poor operatingdecisions to reputational impairment and even bankruptcy and legal action. Understanding thetypical causes of inaccuracies and deploying a net of internal controls, including powerfulfinancial software, can help reduce the likelihood of errors.
#1 Cloud
Accounting
Software
Free ProductTour
Inaccurate Financial Reporting FAQs
What are the dangers of inaccurate financial reporting?
There are many dangers of inaccurate financial reporting, including bad operating decisions,reputational damage, penalties and fines, loss of market capitalization and even legalactions against the company and its management.
How do you ensure accuracy in financial reporting?
There is no foolproof way to ensure accuracy in financial reporting, but a companywideenvironment with extensive internal controls and robust financial software can help preventor detect inaccuracies in a timely way.
How do you avoid inaccurate financial reporting?
Strong internal controls in the financial reporting process are a best practice for avoidinginaccurate financial reporting. These controls, such as segregation of duties, accountreconciliation and robust automated financial software, can help companies prevent errorsfrom happening and increase their ability to detect any that do occur.
What are financial reporting risks?
Because financial reporting is so important to internal and external stakeholders, there aresignificant risks if errors appear in financial statements or other communications. Internalstakeholders risk making poor operating decisions. External stakeholders risk makingill-informed decisions about investing in the company, becoming a trading partner orextending credit. Because of the potential impact of inaccuracies, agencies regulate andenforce standards for public financial reporting, and transgressions can be costly, evenleading to legal action.
