Now more than ever, organizations are being inundated with new accounting mandates from multiple sources spanning a wide spectrum of topics, ranging from accounting for income taxes to revenue recognition to inventory/cost of sales considerations. The application of accounting principles, and the ongoing guidance provided to companies toward achieving proper application, has touched on every aspect of the financial reporting process – for example, the timing of transactions, the amount to be recorded and the correct presentation in the financial statements.
To stay ahead of these ever-expanding challenges, companies need to get out in front of financial reporting issues before they become reputation-threatening. The increasing complexity of this environment drives the need for a risk-based process to sharpen management’s focus when evaluating internal controls related to financial reporting. For a pre-public entity, the understanding and continuous evaluation of an organization’s financial reporting risk profile (FRRP) is critical to senior management and directors. The FRRP is a proactive approach to identifying financial reporting issues and managing them to head off financial restatements before they occur, thereby enabling management to better focus efforts on more important matters and reduce reputation and public company readiness risks to an acceptable level.
Insight into the Issue
When significant financial reporting issues arise, executives and directors frequently have little advance warning. Unidentified or unresolved financial reporting issues can significantly delay filings with the Securities and Exchange Commission (SEC). Such issues, if left unmanaged, could result in restatements, material audit adjustments, unacceptable earnings variability, missed forecasts and/or significant deficiencies or material weaknesses in internal controls over financial reporting. Prescriptive measures, such as those required by the Sarbanes-Oxley Act of 2002, often have been reactive remedies trailing the financial reporting disasters of the day.
Recent Financial Accounting Standards Board (FASB) and SEC developments with respect to convergence of international accounting standards, “principles-based” accounting rules (which are intended to make reporting more transparent for investors, but are not necessarily easier for preparers to generate) and fair market accounting valuations (which will involve a higher level of subjectivity than the traditional historical cost model), as well as increasingly stringent filing deadlines mandated by the SEC, are likely to further complicate the financial reporting process.
Impact on Risk
Financial reporting is not an exact science – updated periodically, the FRRP strips away the “black box,” and makes transparent the drivers and magnitude of financial reporting risks for all to see. A robust FRRP creates awareness of the drivers of earnings variability, provides a sensitivity assessment of financial estimates and the underlying data, identifies financial reporting exposures and regulatory trends within the industry, proactively evaluates the reliability of estimation processes, and ensures consistency in the application of accounting standards – all of which lead to improving the overall quality of financial reporting.
Although regulatory and private sector initiatives involve reducing complexity in financial reporting, management must take the initiative to manage financial reporting risks within the organization’s business, operating results and financial reports. Management needs a profile assessment that identifies areas where clearer alignment of the organization’s reporting with the specific application of U.S. or international accounting principles and standards is needed.
An effective profile assessment also identifies risks arising from the following complexities:
• The application of detailed and complex financial reporting rules
• Numerous exceptions to basic principles
• Use of, or reliance on, estimates
• Complex business transactions
• Industry inconsistencies
Only by actively managing such financial reporting risks can management improve the financial reporting process and effectively sustain a high quality of reported earnings over time as changes occur both internally and externally.
Management must identify specific risks and sensitivities associated with current financial reporting practices and disclosures to understand and manage:
• Risk relating to the specific application of accounting principles and standards
• Consistency in applying financial reporting policies and rules
• Estimation, reliability and ongoing evaluation processes
• Forward exposure arising from changing rules or business transactions
Getting Started
- Begin with the development of scoping documents that prioritize the financial statement captions and footnote support and relevant financial reporting assertions. Because the recently approved SEC guidance and PCAOB standard will have companies and their external auditors apply a top-down, risk-based approach when scoping and executing their Section 404 evaluations, the completed FRRP is a great way to kick-start an assessment of the Section 404 scoping process because it points to the areas with the greatest inherent risk of material misstatement.
- Inventory your key financial elements, and for each ask appropriate questions, such as: Do we have a clear understanding of the critical accounting issues and the principles which apply? For each issue, is there policy or process documentation (e.g. a white paper or issue summary) addressing the issue? If so, is the documentation sufficiently robust to address current needs? Is it flexible enough to accommodate future changes?
- With the “issues documentation” in hand, consider additional assessments. If there are management letters from the external auditor, where have the findings been focused? Have underwriters and analysts raised any questions requiring attention? Are there any pipeline issues driving changes to the business model or accounting rules?
The FRRP is not another “one-off” assessment. Therefore, it should be updated periodically for change.