Peeling away financial reporting issues one layer at a time

On Reconciliations and Financial Analysis

I have three things to write about today, which for the sake of length and ease of future reference, I will publish as three separate posts.  This is the first one.  

The FASB has recently proposed a materiality standard for disclosures — both quantitative and “qualitative” — coupled with an amendment to its conceptual framework.  More on this later.  My previous post was, coincidentally, about the benefits of quantitative disclosures in the form of reconciliations (or roll forwards) of the balance sheet captions, so I want to pursue that topic before moving on to the FASB’s latest proposals.

Red Flags in Reconciliations

Bob Jensen, retired accounting professor and lifeblood of the 700-member AECM listserv, frequently has something to share about my posts.  On reconciliations, he wrote in part as follows:

“…[D]isaggregated reporting of account balance changes between the beginning and end of the year [even] all the way down to individual journal entries will not uncover this type of earnings management fraud [i.e., improper capitalization of expense a la Worldcom and Toshiba] unless details about the transactions being journalized are disclosed. That would be difficult to do for thousands or millions of transactions. We rely upon the auditors to investigate details of the contracts, invoices, and other supporting documentation of the transactions.

Bob is correct to point out that reconciliations are not panaceas, and that auditors — on paper at least — play an important role in curtailing earnings manipulations.  But, his comments also indicate that I need to clarify why I regard comprehensive balance sheet roll forwards as valuable sources of information to both auditors and analysts.

As in all financial analysis, a realistic expectation of roll forwards is not to directly detect a problem, but to “red flag” areas where, if a problem (e.g., the sorts of fictitious journal entries that Bob has in mind) exists, it is likely to have affected the financial statements. In an auditing setting, this kind of financial analysis is part of the “analytical review,” which should precede sample size determination. The auditor has limited capacity to sample, so she wants to sample as efficiently as possible. Analytical review of roll forwards is one of the tools an auditor will use, if available in sufficient detail, to formulate a sampling strategy.

If, for example, expenditures were improperly deferred, then a roll forward of prepayments and long-lived assets might highlight that the debits to these accounts were significantly higher than in the prior year(s), absent a ready explanation. Consequently, an auditor would devote more sampling resources to these classes of transactions.

With respect to the analysis of issued financial statements, if roll forwards were disclosed in the annual report, then analysts would see more or less the same thing that the auditors saw (probably not what the auditing profession would like to see happen!) — and direct their limited attention accordingly. The SEC staff reviewers could also easily identify trends in the reconciliations without having to request supplemental information from issuers, and could evaluate whether MD&A adequately explains them. If trends in reconciling items have not been adequately explained in MD&A, then the red flag of earnings manipulation waves more vigorously.

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IMHO, there is only one good reason why the joint IASB/FASB proposal to require detail roll forwards was quashed — issuers don’t want the public to have them.

Upcoming “Interview” on Disclosure Effectiveness 

On September 21st, this notice was posted on AECM, by University of Maryland accounting professor, Jim McKinney:

“I have an opportunity to moderate a recorded interview for later broadcast with a current member of the FASB Board, a controller for a large public corporation, and a national managing partner for disclosure of one of the Big four regarding disclosure effectiveness for the SEC Historical Society. I am supposed to come up with a list of potential questions. Although I have a few of my own, I thought that some of the active participants of this forum might have some suggestions that I could add to my list. You can reply to me at jmckinney@rhsmith.umd.edu or if others don’t mind to the listserv.” [emphasis added]

Coincidentally fresh off my latest blog post, this was my reply to Jim:

“See my latest post on reconciliations of balance sheet accounts: http://bit.ly/1LgJHYe.

This is an area that I have been writing about since 2010. I hope that you will ask [reformatted as a bulleted list]:

  • Why disclosures shouldn’t (couldn’t) begin with detailed reconciliations;
  • Why the FASB/IASB joint proposal for detailed reconciliations stalled; and
  • Why a new “disclosure framework” without specifically addressing the role of reconciliations will yield higher quality financial reporting.

Note also, that the SEC once had proposed roll-forwards of “valuation and qualifying accountants,” and that proposal was also torpedoed.”

Jim’s reply to me:

“Thanks for the great suggestions! I will add them to the list of potential questions that will be answered. I propose a list and they decide what they will and will not answer.” [emphasis added]

Wow, that’s one heckuva format for an “interview.”  The interviewees not only get the questions in advance, they can choose which ones to dodge — and nobody will be the wiser.  With all due respect to Jim, it sounds more like a dog and pony show.  And what this should have to do with the SEC Historical Society, I have no idea.

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But whatever it turns out to be, you can rest assured that I will be keeping tabs.

2 Comments

  1. Reply Paul October 11, 2015

    Another important reason for disclosure of reconciliations is the lack of articulation in financial statements. Users can’t use the income and cash flow statements to reconcile beginning and ending balance sheet amounts. As a result, users can only estimate the most important cash inflows and outflows. Preparers have been fighting the direct method of cash flow reporting for similar reasons.

  2. Reply Doug October 28, 2015

    Please.

    If you think the financial statement user is going to waste his/her time tieing out detailed reconciliations you are on drugs. The fact of the matter is that the VAST majority, say 90%, of finance and accounting professionals, operate with the highest integrity, and this smacks of regulatory overkill, hence why it stalled. A rollforward is not a reconciliation, and a reconciliation is not a rollforward. Big difference.

    One final note. If a user can’t piece together the interface between the income statement, cash flows, and balance sheet, he/she doesn’t understand how to read them in the first place. Torturing the finance staff with additional disclosures of questionable value only serves the enrich the auditors who have to opine on them anyway, so you gain nothing.

    Doug

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