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Devil’s in the Details

Understanding Financial Reporting

David M. Shapiro

Abstract: This is an introduction to financial ­reporting for


MBA students, beginning accounting students, and other
professionals who need a quick tune-up on the s­ ubject. It
is based on a course I taught for ­graduate s­ tudents about
financial reporting. Topics ­ include an introduction to
­financial reporting; key concepts in fi ­ nancial ­reporting
(assets, liabilities, net ­
assets, ­
valuation m ­ ethods, net
income, comprehensive i­ncome, and key financial
­
ratios); financial information l­iteracy; ­
­ understanding
­liquidity, solvency, cash flow, and the cash statement;
understanding profitability; the i­nvestor’s perspective;
the use and misuse of financial reporting information,
and more.

Keywords: cash statement, financial analysis, financial


ratios, financial reporting, misuse of financial reporting

Introduction to Financial Reporting


There are two overarching essential ­ imperatives:
(1) ­Understand the information disclosed; (2) U
­ nderstand
the incompleteness of the information ­ presented.
These imperatives require recognition that there are
David M. Shapiro is a fraud risk and ­differences among the following concepts:
financial crimes specialist. He is an
expert on financial investigations
and law enforcement. His extensive, ■■ Evidence: This includes accounting and corroborative
diverse background includes work data such as invoices, cash disbursement records, and
as an assistant professor within City so on. Evidence comprises the ingredients of facts;
University of New York (CUNY), FBI
evidence is perception based (for instance, listening
special agent, prosecuting attorney
in New Jersey, corporate investigator to the chief financial officer [CFO] in a webinar during
in New York City, and certified public an investor update), and analytic based (for instance,
accountant in New Jersey. ­identification of and drawing of inferences from financial
ratios derived from comparative financial statements).
■■ Fact: This includes statements compiling the m ­ eaning of
sets of evidence such as statements of financial ­position,
operating statements, and so on. The character of facts
ranges from undeniability that is practicably certain to

© Business Expert Press 978-1-94784-399-8 (2018) Expert Insights


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Devil’s in the Details

allowing high levels of doubt that a­ pproach the U.S. by the Financial Accounting Stan-
falsehood: Financial reporting facts are dards Board (FASB). However, occasional
statements of probable truthfulness. references are made to governmental
■■ Opinion: This includes lay opinion such ­entities’ financial reporting, with account-
as opinion editorials in the newspaper ing and financial ­ reporting standards set
and expert opinion such as the p ­ ublic by other bodies. These two types of enti-
auditors’ report. Laypersons may be ties’ financial reporting are similar in many
right about ­expert domains. For instance, ­respects but not identical. Nongovernmen-
­Enron’s financials were not representative tal for-profit entities are more focused on
of ­accounting facts, and experts may be capital a­ccumulation than governmental
wrong about items properly within their ­entities, which are more f­ocused on using
domain. See also Enron. Other things being their ­resources in support of their p ­ ublic
equal, an expert’s opinion about an item mission while maintaining a rainy-day
within their domain should be given more cushion.
weight and credibility than lay opinion Financial reporting is a form of self-reporting.
about the same item, with the Enron and However, financial audits by independent
similar accounting and auditing failures registered public a ­ ccounting firms (i.e.,
alive in one’s mind as an important caveat. public auditors) are required for publicly
filing companies under the U.S. Securities
(Disclosure: I was briefly an associate and Exchange Commission (SEC) disclosure
r­ estructuring officer under the chief restruc- system. The public ­auditor opines after
turing officer in the Enron bankruptcy.) conducting procedures consistent with gen-
Financial reporting is founded on erally accepted auditing ­standards (GAAS),
­accounts, of which there are two fundamen- which may be compared with the broader
tal types: (1) Permanent (real) ­accounts standards published by the U.S. Government
on the balance sheet, also known as state- Accountability O ­ ffice that are commonly
ment of financial position. These account known as generally accepted government
balances accumulate period-over-period. auditing standards (GAGAS), whether the
They are broken down into assets, liabili- financial statement assertions are in com-
ties, and residual value (also known as net pliance with generally accepted accounting
assets, shareholders’ equity, net p
­ osition or principles (GAAP) in all material respects.
fund balance, depending on the attendant Lenders and other ­investors may demand
circumstances); (2) Temporary (nominal financial audits from debtors or investees
accounts on the operating statement, also as a condition of investment. Additionally,
known as the income statement or state- state securities, banking, and insurance
ment of activities. These account balances regulators may ­require ­audited financial
are closed out to zero at period’s end and statements as a condition of a­ uthorization
accumulated again during the subsequent to conduct business.
period; they are broadly broken down into Importantly, GAAP, while defining
revenues, gains, expenses (or expendi- the economics and financial position for
tures, depending on the context), losses, ­accounting and financial reporting pur-
and other changes or offsets such as sales poses, is not the functional equivalent of
discounts, merchandise returns, and so on. economic reality. It is a proxy for e ­ conomic
This article is primarily focused on the position based on the rights and o ­ bligations
analysis of financial reporting for nongov- (see assets and liabilities) e ­ nforceable
ernmental entities such as publicly traded ­under the state law enforcement regime in
companies and not-for-profit ­organizations, place. For instance, in the U.S., determina-
that is, organizations under accounting tion of accounting and financial reporting
and financial reporting standards set in standards for the private sector has been

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Devil’s in the Details

delegated to the FASB under the statutory that are recorded and reported in the
inspection and oversight of the SEC with residual value accounts.
respect to public filers. The FASB defines
GAAP. Also, in the U.S., most states have These equations summarize the domain
­adopted the financial reporting standards of basic financial statements comprised
pronounced by the ­Governmental ­Accounting of permanent and temporary account
Standards Board (GASB), ­requiring public balances.
sector agencies under their jurisdictions Users of the financial information within
to use GASB pronouncements, standards, financial reports generally expect the
and principles where ­applicable. Thus, ­information to be characterized by:
GASB defines GAAP. Both standards set-
ters are Financial Accounting Foundation ■■ Timeliness: Information needs to be
(FAF) organizations. Additionally, federal ­disclosed without undue delay.
governmental entities’ financial reporting ■■ Relevance: Information needs to be accu-
standards and their GAAP are set by the rate and complete in the disclosure and
Federal Accounting Standards Advisory presentation of accounts.
Board (FASAB). ■■ Reliability: Information needs to be based
Auditors examining financial statement on credible empirical data or evidence.
assertions test for the following attributes ■■ Understandability: Information needs to
in audit evidence: be clearly and transparently presented.
■■ Comparability: Information needs to f­ ollow
■■ Existence or occurrence; for instance, is similar conceptual frameworks among
the account balance supported by real similar entities.
transactions? ■■ Consistency: Information needs to
■■ Completeness; for instance, are any trans- follow similar conceptual frameworks
­
actions omitted from the account balances? period-over-period.
■■ Valuation or measurement; for instance, is
the account balance accurately quantified? In brief, financial reporting is both a
■■ Rights and obligations; for instance, are quantitative exercise, as accounts and
the reporting entity’s assets and liabilities ­transactions are specifically valued
supported legally? in ­monetary terms, and a qualitative
■■ Presentation and disclosure; for instance, ­exercise, as management assumptions and
are the transactions properly classified in ­estimates are generally assessed against
the accounts and described in the notes objective risk and subjective uncertainty.
to the financial statements? Users should understand the meaning of
­financial ­reports and how they may be
There are two fundamental equations in used in trend or longitudinal analyses. For
accrual basis financial reporting: instance, how does the reporting ­entity
compare against itself over several ­periods?
1. Assets − Liabilities = Residual Value; for Also, how may they be used in industry
instance, shareholders’ equity. or cross-­sectional analyses; for instance,
2. Revenues + Gains (Realized and U
­ nrealized) − how did the ­reporting entity perform
Expenses (or E ­ xpenditures) − Losses against industry benchmarks during the
(Realized and Unrealized) = Changes in same time ­period? Panel data comprised
Residual Value, which are also affected of ­longitudinal and cross-sectional studies
by contributions such as investments are especially insightful.
in the reporting entity and distributions The overarching goal of financial r­ eporting
such as dividends to shareholders (collec- is the faithful representation in words and
tively, non-income-related transactions) numbers of relevant economic phenomena

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