“Accounting software, such as QuickBooks, can make the financial statements look credible with the click of a button, but if the information is not entered or coded properly to begin with, the financial statements can contain numerous and material errors.”
A businesses’ earnings are a critical basis for most economic damage calculations, cash flow analyses and business valuations. However, determining the accurate amount of earnings is usually not as simple as pulling the net income figure from a company’s audited financial statements.
For starters, most companies do not have their financial statements audited. Audited financial statements are those in which a certified public accountant (CPA) has examined the statements and offers an opinion as to whether or not the financial statements are free from material misstatement and are presented fairly in conformity with generally accepted accounting principles. Alternatively, some companies have their financial statements either “reviewed” or “compiled” by CPAs. These engagements offer lesser degrees of assurance. For compilations, no opinion is given by the CPA; rather the accountant simply prepares financial statements based on the information provided by the company. For reviews, the accountant performs some analytical procedures, but not to the extent of those performed under an audit.
Of course, some companies do not have external accountants involved at all. In these instances, you are left with internally prepared financial statements and/or tax returns. Internal financial statements are only as good as the person entering the data. Accounting soft ware, such as Quick- Books, can make the financial statements look credible with the click of a button, but if the information is not entered or coded properly to begin with, the financial statements can contain numerous and material errors. Finally, tax returns are signed under penalty of perjury so one would think they are reliable but oft en tax returns are subject to the same issues as internally prepared financial statements.
The following are three examples of how earnings could be misstated.
No. 1 – Underreported Revenue.
Earnings are misstated if not all of the revenue is recorded on the company’s financial statements. Skimming is an example of a scheme that results in underreported income. Skimming is the removal of cash from a business prior to its entry in the accounting system. Businesses in certain cash intensive industries are more susceptible to skimming. These industries include taxi cabs, bars and restaurants, and laundromats. In marital dissolution matters, the non-business owning spouse may be concerned that not all revenue was recorded if the business owning spouse routinely brought home large sums of cash from the business. One method of determining if a company has under-reported income is to analyze the relationships between certain business expenses and revenue. For example, there are industry studies for restaurants that include average cost of goods sold as a percentage of revenue. If your subject company’s cost of goods sold as a percentage of revenue are significantly greater than the industry’s average, you may want to take a closer look at your company’s revenue figures.
No. 2 – Personal Expenses.
Personal expenses should not be deducted when calculating the earnings of the company. Deducting personal expenses as business expenses result in the company’s actual earnings being under-reported. However, be aware that a party might claim that certain business expenses were actually personal in nature and should be added back to a company’s earnings as a means to artificially increase earnings. Examples of personal expenses can range from luxury cars, travel, vacation homes, and personal residence expenses such as real estate taxes and utilities to smaller amounts for country club dues and cellular phones. In order to identify if an expense deducted by the company is personal in nature or business related, it may be necessary to examine the underlying invoices for each transaction and/or interview key individuals. With respect to travel expenses, it may also be necessary to review copies of the airline tickets in order to identify the passengers and also examine the calendars of the individuals involved.
No. 3 – Incorrect Classifications.
A company’s earnings may also be misstated when transactions are misclassified in the accounting system. For example, if loans made by the company to the owner are classified as expenses, the company’s earnings will be understated. Loans made to a company’s owner should be treated as a receivable from the owner (an asset of the company) for the amount the owner is to repay. If the owner does not intend to repay the company, the transaction would be recorded as a distribution or dividend to the owner, not an expense. In addition, if payments made on a company’s outstanding debt are treated as expenses, earnings will be understated. These payments should be treated as a reduction of the loan amount. An examination of the financial statements may indicate possible mis-classifications. In addition, interviewing the company’s bookkeeper to gain an understanding of his/her background and experience may provide insight into how thoroughly the financial statements need to be examined.
Next time you receive financial information from your client or the opposing party, remember that not all financial statements are equally credible. If audited financial statements are not available, a forensic accountant can assist in determining a more reasonable estimate of the company’s “true” earnings and the resulting impact on economic damages calculations, cash flow analyses and business valuations. Jennifer Schiefert