Misleading Financial Information

The blog posting Two Dangerous Financial Illusions looked mainly at sales and profitability and how these can often be misleading. Let’s look at some more areas where misleading financial information may present.

Overvaluation of Receivables

Whenever a company undergoes an audit (and to a lesser degree a review), there are certain items on the financial statements that warrant extra scrutiny. A main one is accounts receivable.

One common way that accounts receivable may be over-valued is when inadequate provision is made for bad debts. This is why auditors normally test receivables to determine collectability. It is not uncommon for there to be strong disagreement between a company’s executive management and the outside CPA firm. I actually have seen this become a fairly heated exchange. Why? Quite simply, the management of a company often does not want to acknowledge that sales may not be collectible, thus reducing profitability and future cash flow.

It is not just accounts receivable where this happens. It can also occur with notes receivable and investments. I recall a situation with a company I once worked for where they had purchased Certificates of Deposit with a savings and loan institution. A financial crisis put this particular savings & loan into deep financial trouble. There as quite a battle between the V.P. of Finance and the outside auditors over what value should be stated for the investment. I don’t recall how it finally worked out, but the point is this could have been a case of overvaluation. Just like receivables, this is an area that auditors normally conduct a fairly extensive evaluation to justify the value investments are carried at on the balance sheet. Again, a write down will reduce profits and impact cash flow.

Is Inventory Valuation Real?

Inventory is an area where a company can quickly get in trouble. From an asset management perspective this can be as simple as carrying too much inventory, and the more inventory that is carried the greater the likelihood of another issue; overstatement of inventory. Overstatement of inventory can occur because some items are no longer saleable or the price at which they can be sold is greatly reduced. This means that the value at which the inventory is carried has been impaired. Just like receivables, this can be an area of heated debate between management and outside auditors. In fact, both inventory and receivables valuations can lead to strong disagreements within a company as well. Again, just like a write down of receivables a write down of inventory will reduce profits and impact cash flow. Overvaluation of inventory can be very serious.

One other thing to keep in mind with inventory is confirming it actually exists. I uncovered a situation one time where a company had an extra inventory listing that was added to their inventory stock status report to make inventory details agree with the general ledger. As it turned out, the general ledger was misstated and the extra inventory listing was bogus. What I found most frustrating about this was that the company had undergone audits by a CPA firm for several years. A normal part of an audit is to observe the counting of inventory. If this was occurring (and I doubt it was consistently) then this missing or bogus inventory should have been detected. This was a serious issue that eventually put this company out of business. That was a shame as the business had been very profitable.

So What’s the Point?

There are two main points I want to make about misleading financial information:

  1. Make sure you have at least a fundamental understanding of what is behind the numbers on a financial statement and how they were derived
  2. When reading financial statements that you are not familiar with, at first take them with a grain of salt until you have more information to support the numbers

These two cautions are to encourage you not to form conclusions too soon. Remember the old axiom that things are not always what they appear.

Oh, one other thing. If you are involved in the financial results for your company, it is a good idea to regularly review the valuation of things like receivables and inventory. Smaller, regular adjustments are more palatable than one big adjustment. The cumulative impact may be the same, but don’t forget that there is a psychological impact on the readers of financial information to consider.

These are issues where a Part-time CFO or Controller can be extremely helpful. Let us know if you need help.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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