In Pursuit of Profit
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During an audit, financial inaccuracies are typically uncovered that have broader business implications. Whether these inaccuracies are the result of fraud, mistakes, or ignorance, they can have deleterious effects. Internal audits may unearth problems that negatively affect financial statements and financing attempts, while federal tax audits can identify issues that result in costly fines and penalties.
Understanding which inaccuracies auditors find most often provides a foundation for self-imposed accountability. Focusing on areas where problems typically exist equips business owners with the information needed to improve financial accuracy and make smarter business decisions.
Furthermore, exercising extra caution around common problem areas protects the integrity of financial reporting, ensuring that the business’ financial position will be accurately represented to potential investors, existing shareholders, and state and federal authorities.
Data entry and bank reconciliation errors can occur in even the most fastidious financial environments. Occasional human error is unavoidable, which is why financial records should be regularly reviewed by a third party to look for mis-keyed or improperly transcribed items. Like people, technology is not perfect either. Errors can also occur with automation when system glitches occur, settings are changed, or software updates are pushed.
Most errors are simple mistakes, rather than the result of malicious intent. However, irrespective of intent, errors can affect cash flow as well as financial records. One-off errors can be costly, but errors that are carried through from one reporting period to another can plague an organization by perpetually skewing reporting. It may seem counterintuitive, but these ongoing errors are sometimes harder for external auditors to find because they span so many financial periods.
When expenses or transactions are omitted from the books, the effects ripple through the organization. Financial records, tax filings, and profitability calculations are all affected in the wake of omissions, making effective cash flow management is nearly impossible.
Much like errors, missing inflows and outflows of cash can be the result of earnest mistakes. However, omissions are a common fraudulent tactic as well. For instance, corrupt owners or unscrupulous employees may fail to report incoming petty cash or customer invoices to embezzle funds that would otherwise be counted towards business revenue. Fraudsters typically rely on the sheer volume of financial data to conceal their activity, hoping that their omissions will avoid detection while legitimate transactions are scrutinized. Over time, omissions can cost a business greatly, thwarting profitability initiatives and, in extreme cases, even bankrupting the business.
Forensic accounting is primarily concerned with uncovering this type of financial inaccuracy during an audit to stop fraud and provide documentation that can be used to litigate disputes.
Inflated Bad Debt
Writing off outstanding accounts receivable as bad debt ensures that revenue is not overestimated in a given accounting period (month, quarter, or year). While this is a best practice, bad debt calculations must be reasonable, or revenue will swing in the other direction. Inflated bad debt needlessly reduces revenue expectations, causing the business to appear less profitable than it really is.
While it is always a bit of a guessing game, reasonable bad debt estimates can be made when rules are in place to guide the calculation. Without parameters to shape ongoing bad debt numbers, business owners and bookkeepers are left to apply their own assumptions and subjective guidelines. Less experienced business owners or bookkeepers may accidentally write off invoices as bad debt too soon or fail to account for special financing terms on individual customer accounts when calculating bad debt estimates. Poor collections practices can exacerbate this problem, allowing customers to continually pay late without penalties. The result is a lag between invoicing and payment, which muddles bad debt estimates.
An auditor can determine if bad debt is being calculated correctly or if it is unintentionally being inflated.
Misclassified Assets and Liabilities
While assets and liabilities seem like straightforward accounting concepts to people who are financially minded, less savvy business owners can get confused when categorizing business items.
Liabilities are all the business’s obligations (i.e. debt and long-term costs). Business owners usually understand the liabilities and equity side of the balance sheet, but some struggle with grasping the full breadth of the assets side.
Everything that the business owns (inventory, equipment, raw materials, furniture, etc.) is an asset, but assets also include prepaid business expenses (rent, web hosting, domain name registrations, etc.). This is a common oversight because business owners tend to misclassify these expenses as liabilities. When assets and liabilities are confused, a balance sheet is destroyed, and the business’s financial position is misrepresented. This is especially dangerous when an organization is negotiating financing, engaging in partnerships, or applying for funding from lenders.
Incorrectly adding to liabilities portrays the business as less financially advantageous to invest in, which can scare off lenders. Conversely, adding to the assets improperly makes the business’s financial position look more promising than it is, dishonestly drawing in investors. This can lead to subsequent legal repercussions if financiers decide to sue the business for misrepresenting its financial position.
When auditors ensure the accuracy of assets and liabilities, they are performing a critical role in preparing the business for investors.
Discrepancies in Receivables and Payables
Delays in crediting accounts receivable (AR) and accounts payable (AP) can result in cash flow discrepancies. For businesses operating on NET-30, NET-60, or NET-90 payment terms, delays are inescapable. However, organizations that expect immediate payment from customers and practice quick payment to suppliers and vendors should work toward eliminating AR and AP delays wherever possible to avoid discrepancies. Using automation is a popular way to handle receivables and payables quickly to avoid the lags that can result in financial reporting errors. Routine receivables and payables audits ensure the timeliness of ongoing financial reporting.
Errors are avoidable
… and we can help! Please reach out to Eric or Todd here and let them know that you need help with discrepancies or want to be prepared for an audit.