What Are the Risks of Inaccurate Financial Reporting?

In an ideal world, every company’s financial reporting would always be 100% error-free. Financial statements contain vital information about a company’s health, and internal and external stakeholders need to be able to rely on their accuracy to make critical management and investment decisions with confidence. Unfortunately, inaccurate reporting can sometimes occur, either due to unintentional error or — in the worst situations — deliberate fraud. Inaccurate reporting can have painful and costly consequences, including poor business and investment decisions, regulatory fines and reputational damage. Understanding the causes, risks and ways to mitigate errors can help companies avoid financial reporting inaccuracies and the problems they can cause.

What Is Financial Reporting?

Financial reporting is the process of communicating financial data to external and internal stakeholders. It includes core financial statements, such as the company’s quarterly and year-end income statement, balance sheet and statement of cash flows.

External stakeholders, such as investors, shareholders and creditors, use a company’s financial reporting to evaluate its financial health and creditworthiness. Other external shareholders include regulatory agencies like the IRS and the Securities and Exchange Commission (SEC), which require financial reporting for legal and compliance reasons. Internal stakeholders, such as the company’s CEO and other top managers, use financial reporting to gauge performance and inform decision-making, and as a foundation for building budgets and projections.

Whether it’s used for external or internal reporting purposes, the underlying financial data must comply with accounting standards such as the Generally Accepted Accounting Principles (GAAP), used in the US, or the International Financial Reporting Standards (IFRS), used in many other countries. External reporting of the core financial statements, plus other required schedules and documents, must follow strict guidelines defined by regulatory agencies and GAAP/IFRS reporting standards. Internal financial reporting typically includes the core financial statements but can also be customised to meet the needs of internal stakeholders.

Key Takeaways

• Accurate reporting in financial statements and other documents is vital for internal and external stakeholders, who rely on the information to make critical management and investment decisions.
• Inaccurate financial reporting can be due to unintentional mistakes or, in some cases, fraud.
• The risks of inaccurate financial reporting include bad operational decisions, reputational damage, economic loss, penalties, fines, legal action and even bankruptcy.
• Companies can ensure accurate financial reporting by employing a network of internal controls, fortified by financial software that helps prevent and detect errors.

Why Is Accurate Financial Reporting So Important?

Accurate financial reporting is vital to external and internal stakeholders that rely on the information for decision-making for several reasons:

• Investors need an accurate profile of a company’s financial health when deciding whether, and how much, to invest in the company. Investors use the information in financial reports when deciding whether to buy stock in publicly traded companies.
• Creditors, such as banks, the Small Business Administration (SBA) and credit card companies, rely on the accuracy of an organisation’s reporting to analyse its creditworthiness and establish appropriate credit lines.
• The company’s CEO and other senior managers rely on internal financial reporting for day-to-day decisions, such as when to buy inventory or how to set product prices. Executives also use internal financial reporting as a tool for stewarding the company’s strategic direction.

Financial reporting needs to be timely as well as accurate — even the most accurate information can be worthless if it’s out of date or it’s not available when needed. In addition, external financial reporting must meet deadlines defined by regulatory agencies.

How Does Financial Reporting Go Wrong?

Many financial reporting errors are accidental. Given the plethora of standards and regulations governing financial reporting, combined with the pressure for timeliness, it’s easy to see how companies can make mistakes. But there are also examples of deliberately inaccurate financial reporting by unscrupulous characters. Whether unintended or not, errors in financial reporting can have serious consequences.

Causes of Inaccurate Financial Reporting

Many factors can contribute to inaccuracies in financial reporting, including inadequately trained staff, error-prone manual processes and inconsistent accounting methods.

1. Inadequately trained or incompetent staff across the company can directly and indirectly cause accounting errors. For example, warehouse staff may miscount inventory, and salespeople may make mistakes in travel expense reports — both of which can cause accounting errors.

2. Accounting personnel who are not up to date on accounting standards and regulatory requirements. GAAP, SEC and IRS standards and guidelines change frequently — recent examples include the changes to lease accounting defined in ASC 842 and the tax changes included in the Tax Cuts and Jobs Act (TCJA). Members of the accounting team may fail to stay current on the latest information, especially when they’re struggling with heavy workloads.

3. Manual processes. To err is human. Manual processes increase the likelihood of simple accounting mistakes, such as transposing digits, misplacing a decimal point, double-counting or failing to record an activity in a ledger.

4. Unclear communication between those setting accounting policy and those responsible for implementing it can cause errors. Examples of disconnects include misunderstandings about how to handle accounting estimates, such as reserves for possible bad debt.

5. Poorly integrated financial systems can create data havoc, resulting in errors through improper mapping of information between different systems and the need for manual intervention in the flow of data.

6. Inadequate review processes can result in errors slipping through, such as imbalances in intercompany accounts. This is often the result of poor time management, inadequate resources or misplaced priorities.

7. Inconsistent accounting methods among departments or subsidiaries can cause errors in financial statements. Examples include using different methodologies for inventory valuation or revenue recognition, and incompatible transfer pricing.

8. Chart of accounts misuse. Incorrect treatment of transactions, such as miscoding an invoice in the accounts payable process or misclassifying expenses as revenue, are errors that can obscure financial reporting.

9. Fraud. Schemes in which employees deliberately misstate or omit information in financial statements are relatively rare — but they are also the costliest type of workplace fraud that companies suffer.

Impact of Inaccurate Financial Reporting

Financial reporting inaccuracies can have far-reaching consequences for the company, as well as for investors and other external stakeholders.

1. Wasted time and resources. Companies can spend a significant amount of time trying to track down and fix financial reporting errors and dealing with the consequences. It’s frustrating for everyone involved and can lead to strained relationships, as well as job dissatisfaction.

2. Bad decisions. Inaccurate information can lead to poor decisions. This is especially important when it comes to internal financial reporting, which is often the basis of operational decisions, such as product pricing, as well as workforce hiring and firing decisions.

3. Cash-flow problems. Over reporting cash flow can cause the company to be short on cash when paying bills or payroll. Conversely, underreporting cash flow can mean missing opportunities for investment income or interest.

4. Fines and penalties. Inaccurate or late reporting can lead to penalties and fines from the IRS and local authorities. If an IRS audit finds that a company underpaid its taxes due to inaccurate financial reports, the company is charged interest and penalties on top of settling its tax bill.

5. Reputational damage and loss of credibility. Inaccurate financial reporting undermines the credibility of a company and its management — even if the errors are unintentional. Lenders may consider that applicants with financial reporting errors are riskier and charge them higher interest rates or even refuse to lend them money. Investors become wary when they lose trust in a company’s financial information.

   Stock markets are unforgiving when companies need to rescind or revise financial reporting: Share prices often fall and valuations sink. A household appliance maker’s stock price dropped almost 3% when the company said it needed to restate its financial results, because some assets had been erroneously recorded by unauthorised employees. On another occasion, the same company needed to revise financial statements due to incorrect recording of expenses. Because those revisions took longer to correct than expected, the company missed a reporting deadline and its stock price took a 9% hit.

6. Bankruptcy. When inaccurate financial reporting is a result of fraud, the impact can be ruinous. Intentional misrepresentation of financial statements can result in legal action, arrest and imprisonment of executives, penalties and fines. The SEC Division of Enforcement investigates and administers enforcement actions for these cases. In one prominent example, a major energy company was investigated by the SEC for inflating earnings reports using deceptive accounting practices. As the full extent of the inaccuracies became apparent, the formerly high-flying company saw its stock price plummet from a high of $90 per share to less than $1. The company ultimately filed for bankruptcy. Several executives were imprisoned, and employee pension plans became almost worthless.

   In another example, a food manufacturer was accused of inflating its profit on key products and reporting inaccurate earnings. Although the company never admitted to any wrongdoing, its stock lost 20% of its value in a single day.

How to Keep Financial Reporting Accurate

The primary methods used to ensure accuracy of financial reporting are internal accounting controls and external audits.

1. Controls. Controls are internal processes or policies that are put into place to reduce the likelihood of errors. While controls are not iron-clad safeguards, especially in cases of orchestrated fraud, they are meant to provide a reasonable level of protection against financial reporting misstatements. Controls are such important financial reporting “circuit breakers” that the Sarbanes Oxley Act requires public companies to issue an Internal Controls Report demonstrating that adequate financial controls exist for their assets and financial records.

   There are two basic types of controls: prevent and detect. Preventive controls are designed to prevent errors before they occur. They aim to keep financial data clean before it flows into financial statements. Typical preventive controls include segregation of duties, user access restrictions for accounting systems, physical safeguarding of assets, requiring multiple levels of approval with formal delegated authority for actions such as purchasing goods and paying invoices, and employee screening and training.

   Detect controls work at the back end of the accounting process to identify errors or irregularities for investigation and correction. The most common detect controls are account reconciliations that compare internal financial data to external documentation, such as comparing general ledger cash accounts to external bank statements. Other detect controls include comparing actual activity to budgets or forecasts, conducting physical inventory cycle counts, regular testing by internal auditors and periodic external audits. Because detect controls alert companies to errors after the fact, it is important that they are conducted in a timely way.

2. External audits. A common misconception is that the best way to ensure correct financial reporting is to have external auditors audit the company’s financial statements. While this is certainly a best practice — and a regulatory requirement for public companies — audits do not guarantee perfection. Instead, auditors provide a written opinion of the accuracy of the statements, following an audit process based on Generally Accepted Auditing Standards (GAAS). The best result is a “clean” or “unqualified” audit opinion, which states that the financial reporting is free of material misstatement and that management of the company is ultimately responsible for preparation of the financial statements. Alternatively, auditors can release opinions that indicate possible problems with the financial statements. For example, they may release a “modified” or “qualified” opinion when there is an unresolved disagreement with company management. Modified opinions are rare, because most companies rectify the disagreement before the audit is finished. “Disclaimed” and “adverse” audit opinions both indicate significant problems with the financial statements and are also very rare.

How Can NetSuite Help?

While no accounting software can fully guarantee that it eliminates unscrupulous, premeditated fraud, NetSuite Financial Management includes many built-in controls to help prevent and detect errors or inconsistencies in financial data and reports. By integrating these functions into a single solution, NetSuite Financial Management helps companies avoid introducing manual errors into the transaction flow. It helps enforce compliance with company standards by means of tools that create a consistent accounting approach. It also includes preventative access controls that enable administrators to customise privileges for each user. NetSuite’s multibook capability allows companies to record a transaction to multiple sets of books at once that comply with GAAP and IFRS. In addition to saving an enormous amount of time, this feature also reduces the potential for errors when meeting different requirements.

Conclusion

Ideally, financial reporting should always be accurate and timely. In reality, unintentional errors and fraud can lead to inaccuracies in financial statements and other important communications. The risks to the company are significant, ranging from poor operating decisions to reputational impairment and even bankruptcy and legal action. Understanding the typical causes of inaccuracies and deploying a net of internal controls, including powerful financial software, can help reduce the likelihood of errors.

Inaccurate Financial Reporting FAQs

What are the dangers of inaccurate financial reporting?

There are many dangers of inaccurate financial reporting, including bad operating decisions, reputational damage, penalties and fines, loss of market capitalisation and even legal actions against the company and its management.

How do you ensure accuracy in financial reporting?

There is no foolproof way to ensure accuracy in financial reporting, but a companywide environment with extensive internal controls and robust financial software can help prevent or detect inaccuracies in a timely way.

How do you avoid inaccurate financial reporting?

Strong internal controls in the financial reporting process are a best practice for avoiding inaccurate financial reporting. These controls, such as segregation of duties, account reconciliation and robust automated financial software, can help companies prevent errors from happening and increase their ability to detect any that do occur.

What are financial reporting risks?

Because financial reporting is so important to internal and external stakeholders, there are significant risks if errors appear in financial statements or other communications. Internal stakeholders risk making poor operating decisions. External stakeholders risk making ill-informed decisions about investing in the company, becoming a trading partner or extending credit. Because of the potential impact of inaccuracies, agencies regulate and enforce standards for public financial reporting, and transgressions can be costly, even leading to legal action.