Addressing “What Could Go Wrong” in Financial Statement Reporting

When auditors think about approaching an audit, they often ask themselves, “What could go wrong that would cause the client’s financial statements to be materially misstated?” Because the answer to this question could lead to a daunting list of possible scenarios, auditors must first assess the risks and then determine how to address them.

Financial managers in any organization should be asking the same question. As leaders within an organization that’s constantly juggling many competing priorities, it’s up to them to ensure that everyone is doing their part to appropriately capture, record, and report all of the organization’s financial (and of course non-financial) activities.

In preparing the financial information for an organization, it’s important to consider the various financial statement assertions related to each account balance or transaction class. Although referred to as financial statement assertions, these are really assertions made by financial managers who are responsible for reporting the organization’s financial position, results of operations, and cash flows, as well as disclosing any other required information.

Financial Statement Assertions

1. Completeness: The assertion that the financial statements are thorough and include every necessary item for the period that the statements cover.
2. Existence: The assertion that assets, liabilities, and shareholders’ equity balances as of the date on the balance sheet actually exist at that date.
3. Rights and obligation: The assertion that all assets and liabilities included in the financial statements belong to the company — that is, the organization owns (and has ownership rights or usage rights) to all assets, and that liabilities listed on the financial statements belong to the company and not to a third party.
4. Valuation: The assertion that the amounts presented in the financial statements are accurate and based on properly valuing the balances and/or transactions based on their net realizable value.
5. Cutoff: The assertion that all transactions and events have been recorded in the correct accounting period.
6. Presentation and disclosure: The assertion that all appropriate information and disclosures are included in the organization’s financial statements and presented in a fair and easily understood way.

To feel comfortable that financial statements are fair and contain all relevant information, financial managers must ensure that there is a strong reporting framework. To determine what controls are needed, it is important to understand the “What could go wrong?” question — a.k.a. the risks that the balances or transactions are not properly reported or disclosed in the financial statements.

Below are four examples of what could go wrong and which of the management’s assertions they affect. Each example is followed by a list of potential (but clearly not all inclusive) controls that can be used to address these identified risks.

1. Financial Statement Closing Process

The financial statement closing process can affect virtually every account balance and transaction. Without proper controls in this process, the organization may materially misstate its financial statements. Below is a list of common questions to consider when preparing the financial statement close, followed by examples of controls that could address these questions:

• Q1: What ensures that the required eliminating entries are identified and correctly recorded? (Completeness)
• Q2: What ensures that valid journal entries are posted in a timely manner? (Completeness)
• Q3: What ensures there are no duplicate entries made? (Existence)
• Q4: What ensures that all accounts properly roll up into the correct financial statement line? (Presentation and disclosure)
• Q5: What ensures that the required footnote disclosures are made in the financial statements? (Presentation and disclosure)
• Q6: What ensures that financial statements are clerically accurate? (Presentation and disclosure)

Examples of controls that may address the identified risks above:

1. Consolidating schedules are reviewed by management (Q1).
2. Eliminating entries are reviewed by management (Q1).
3. Intercompany account balances are reconciled (Q1).
4. Financial accounting personnel review minutes from meetings of the board, finance committee, audit committee, etc. (Q5).
5. The financial reporting package is reviewed by the CFO or their designee (Q1-6).
6. The trial balance and account reconciliations are reviewed at the appropriate managers (Q1-6).
7. A generally accepted accounting principles (GAAP) checklist is used by anyone reviewing the financial statements (Q5).
8. The accounting system has programmed controls that map trial balance accounts to the financial statement lines (Q4).
9. All support for manual journal entries is reviewed prior to entry into the general ledger (Q2-3).
10. The accounting system will not allow duplicate journal entry numbers (Q3).

2. Contributions

Improper accounting for contributions can affect recorded revenue and net assets. Consider the following questions when developing controls:

• Q1: What ensures that contributions are recorded in the correct period? (Completeness)
• Q2: What ensures that transfers between net asset accounts are properly recorded? (Completeness)
• Q3: What ensures that contributions are properly classified as being with or without donor restrictions? (Presentation and disclosure)
• Q4: What ensures that contributions are managed in accordance with donor restrictions? (Rights and obligations)
• Q5: What ensures that contributions are properly valued? (Valuation)

Examples of controls that may address the identified risks above:

1. Accounting for new contributions is reviewed by appropriate managers (Q3-5).
2. Department revenue is compared to budgets and forecasts (Q1).
3. Financial statements and trial balances are reviewed by appropriate managers (Q1).
4. Interfund reconciliations are prepared and reviewed (Q2).
5. Restricted contributions are monitored for compliance with donor requirements (Q2-4).

3. Cash Receipts

Improperly recognizing and recording cash receipts can affect any areas of the financial statements that are specifically related to cash, including cash; investments; accounts and pledges receivable; and more. Below is a list of common questions to ask when considering the risks of misstating cash balances and transactions:

• Q1: What ensures that cash receipts and other activity are recorded in the correct period? (Completeness and cutoff)
• Q2: What ensures that cash receipts are properly coded in the general ledger? (Completeness)
• Q3: What ensures that cash receipts are recorded? (Completeness and existence)
• Q4: What ensures that duplicate postings of cash are not recorded in the general ledger? (Existence)
• Q5: What ensures that actual cash receipts recorded are equal to amounts deposited in the bank? (Valuation)

Examples of controls that may address the identified risks:

1. Bank reconciliations are prepared and reviewed in a timely manner (Q1, Q3-Q5).
2. Cash receipts are regularly reconciled to general ledger postings (Q1-4).
3. Past due accounts receivable are regularly reviewed (Q2).
4. Cash receipts are compared to customer remittances (Q3).
5. Log of checks and other remittances is compared to daily deposit (Q3).
6. Complaints about incorrect billings are reviewed (Q2).
7. Unapplied cash receipts are regularly reviewed and corrected (Q2).

4. Billing and Collections Process

Improper accounting for billing and collections can affect recorded revenue, contractual allowances, and accounts receivable. Consider the following questions/risks when designing controls:

• Q1: What ensures that revenue is recorded in the correct period? (Completeness)
• Q2: What ensures revenue and receivables are billed and recorded in the general ledger? (Completeness)
• Q3: What ensures that fictitious or duplicate billings are not recorded? (Existence)
• Q4: What ensures that bills properly reflect services rendered? (Valuation)
• Q5: What ensures that bills reflect correct gross charges and contractual discounts? (Valuation)
• Q6: What ensures that invoices correctly reflect supplies utilized? (Valuation)

Examples of controls that may address the identified risks above:

1. Edit reports summarizing incorrect or incomplete billings are reviewed and corrected (Q2).
2. Insurance master file rate changes are reviewed periodically (Q5).
3. Medical record face sheets are compared to invoices (Q3-5).
4. Patient days are reconciled to medical record statistics (Q1).
5. Monthly financial statements are compared to budgets or forecasts (Q1).
6. Patient complaints to the business office about incorrect charges are reviewed (Q3-6).
7. Subsidiary ledgers for revenue and accounts receivable are reconciled to the general ledger (Q2).
8. Sequential invoice numbering allows use of invoice number only once (Q3).
9. Revenue reports are reviewed by payor, service line, and patient (Q2, Q5).
10. System calculates room charges based on admission data and services performed (Q5).
11. System is configured to verify that all input is accurate (Q6).

Conclusion

In order for financial managers to have peace of mind, they have to know what could go wrong so that they can put appropriate processes and controls in place. The goal might be to prevent errors in the first place, or to detect errors and correct them in a timely manner so that all users of the financial statements feel confident that the organization’s statements are presented fairly.