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Reliability of Financial Statements on U.S. Firms

Originally published: Apr-25-2007

Much of the information in this article was
provided by the Credit Research Foundation
.

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Finances - CalculatorYou go to your banker for a loan. You're required to provide a complete credit application including information about the state of your finances – your income, current outstanding loans, balances on your credit cards, etc. You don't find this inconvenient or invasive. You expect to be asked for this information. The banker has a right to know your financial position before granting you the loan. It's the way business is done.

The same holds true when a potential buyer asks you for credit terms. The extension of that credit is no less a loan than the one you receive from your bank. And, as the seller, you also are entitled to require credit information from the buyer, including financials if the credit amount requested is large.

But all financial information is not equal. Before you can make an educated decision on the creditworthiness of a buyer, you first need to assess the reliability of the financial data provided.

There are three basic types of financial statements: management prepared, unaudited (compilation or review), and audited. This article will take a look at the value and reliability of each type as it applies to U.S. accounting procedures.

Management Prepared Financial Statements

As the title implies, these financials are prepared by the company’s management and accounting staff and are only as trustworthy as the company and the employees compiling the information. If your potential customer is a small business, or is privately held, then such statements may be the only financial information available. In this case, “soft” information like bank and trade references, along with the report of a credit bureau (Dun & Bradstreet, Experian etc.) become increasingly important in determining the character of management.

Unaudited Financial Statements

Unaudited financial statements – both compilation and reviewed – are prepared by an independent accountant from the records of the company. Their value is mainly limited to the reliability of the company books, bookkeepers and management.

Compilation: The accountant prepares the financial statements from the company’s books and records, but does not provide any analysis of the data. These statements are generally for internal purposes.

Reviewed: As with compilation financials, the accountant prepares the material from the company’s books and records. But in this case, he performs limited inquiry and analysis. Thus, such financial statements provide some limited assurance to outside third parties of their accuracy and the fact that they conform to GAAP (Generally Accepted Accounting Principles).

Audited Financial Statements

Prior to the Securities and Exchange Act of 1934, no corporations in the United States were required to submit annual reports – audited or otherwise – to the government or to shareholders. The 1934 Act required all publicly traded companies to disclose, and have audited, certain financial information. The Act also established the SEC (Securities and Exchange Commission) to enforce the audit requirements.

Thus, audited financials offer the most reliability for creditors, and such statements of publicly traded companies are available freely on the internet via the U.S. government’s EDGAR website.

In the United States, independent Certified Public Accountants (CPAs) perform the audit and also offer their opinion on whether or not the financial statements are relevant, accurate, complete and fairly presented in conformity with GAAP. The measure for “fairly presented” is that there is less than a 5% risk that the statements are "materially misstated."

Auditor’s Opinions

The opinion of the independent auditor is provided in a cover letter along with the financial statements and defines the level of responsibility the auditor accepts. There are four types of opinion:

  1. Unqualified Opinion: the auditor is willing to take the maximum degree of responsibility. However, you should look for phrases in the auditor’s letter such as “except for” and “subject to”, which indicate that the auditor’s unqualified opinion is really somewhat qualified.
  2. Qualified Opinion: the auditor assumes the maximum responsibility for the reliability of the statements except for the items explained in the qualification.
  3. Disclaimer of Opinion: the auditor is unable to express an opinion due to serious scope limitations, and is, therefore, unwilling to assume any significant responsibility.
  4. Adverse Opinion: as a result of material noncompliance to GAAP, the statements are not fairly presented.

The Enron Debacle and Sarbanes Oxley

While audited financial statements are supposed to be reliable (and many are to a large extent), they are still, unfortunately, dependent upon the honesty of both the company being audited and the firm doing the auditing. In the case of Enron, the company succeeded in hiding important facts, including off-book liabilities, from its banks, shareholders and the government. The scandal that resulted from the discovery of this information ended up involving Enron’s “independent” accounting firm, Arthur Andersen, which lost its ability to audit public companies, which resulted in its ultimate demise.

Due to the Enron and other U.S. accounting scandals (Worldcom, for instance), there has been increased focus on internal control procedures, which became mandatory for all SEC-listed companies via the Sarbanes-Oxley Act of 2002.

Sarbanes-Oxley (commonly called SOX) was a Congressional response to the erosion of public confidence in the accounting and reporting practices of major companies. It is named after the two Congressmen sponsoring the act: Senator Paul Sarbanes (Democrat-Maryland) and Representative Michael G. Oxley (Republican-Oh).

The first part of the Act established a new, quasi-public agency, the Public Company Accounting Oversight Board, which is charged with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies. Some of the other major provisions include:

  • Requirement that public companies evaluate and disclose the effectiveness of their internal controls as they relate to financial reporting, and that independent auditors for such companies "attest" (i.e., agree, or qualify) to such disclosure.
  • Certification of financial reports by chief executive officers and chief financial officers.
  • Auditor independence, including outright bans on certain types of work for audit clients and pre-certification by the company's Audit Committee of all other non-audit work.
  • Requirement that companies listed on stock exchanges have fully independent audit committees that oversee the relationship between the company and its auditor.
  • Ban on most personal loans to any executive officer or director.
  • Enhanced criminal and civil penalties for violations of securities law, including significantly longer maximum jail sentences and larger fines for corporate executives who knowingly and willfully misstate financial statements.
  • Employee protections allowing those corporate fraud whistleblowers who file complaints with OSHA within 90 days to win reinstatement, back pay and benefits, compensatory damages, abatement orders, and reasonable attorney fees and costs.

Although Sarbanes-Oxley is approaching its 5th anniversary (July 30, 2007), the jury is still out regarding its efficacy. Proponents of the reforms believe the legislation was necessary and useful while critics believe it does more economic damage than it prevents.

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Much of the above information was provided with permission from the Credit Research Foundation (CRF).

CRF is an independent, member-run organization, consisting of a dynamic community of like-minded business professionals with a vested interest in improving and fostering the field of business credit -- more specifically--the practices and technologies of business credit.

Since 1949, the Credit Research Foundation has emphasized the role of education and research activities to aid business credit, accounts receivable and customer financial managers. CRF is the foremost non-profit, member-supported, education, and research organization dedicated to the credit and financial management community.

Membership in the Foundation is open to all individuals and businesses who have a vested interest in the credit, A/R and customer financial relationship.