Ensuring the Reliability of Financial Statements: A Practitioner’s Guide

Chief Financial Officers (CFOs) play a pivotal role in an organization’s success, balancing multiple responsibilities. Among these, four key roles stand out:

1. Presenting the financial position and performance of the business.
2. Steering the business aligned to strategic plan.
3. Raising capital to support growth.
4. Driving business efficiencies.

The first role—effectively communicating the financial position and performance—is crucial as it underpins all other strategic objectives.

The Importance of Reliable Financial Statements

Communicating the financial position and performance of the business is vital for two main reasons:

1. Business leaders understand their current standing and identify necessary actions to achieve their goals.
2. It clarifies roles and fosters collaboration among team members.

For these reasons, achieving this role effectively is essential. Financial communication must be timely, reliable (free from material errors), and accessible to all relevant stakeholders. A lapse in any of these areas means the CFO has not fulfilled this critical responsibility.

Achieving Reliability in Financial Statements

In this article, we focus on how to ensure the reliability of financial statements that CFOs use to communicate the business’s financial position and performance.

In practice, reliability in financial statements means:

1. All transactions are recognized and accounted for according to accounting policies or norms.
2. Numbers are displayed correctly in the financial statements.
3. All numbers are explainable and beyond doubt.

Measuring Reliability

Unlike production or sales, where Key Performance Indicators (KPIs) such as ‘number of defects per million products produced’ or ‘% of returns’ are common, KPIs for tracking the reliability of financial statements are rarely used. However, some potential KPIs include:

• Total number of errors identified post-preparation.
• Total amount of errors identified post-preparation.
• Reclassifications required.
• Unexplained variances.

While useful, these KPIs are often not systematically tracked, and corrections or reclassifications are not highlighted or monitored objectively.

How to Achieve Higher Reliability

Achieving higher reliability in financial statements often becomes a focus during financial scandals (e.g., Enron, WorldCom, Satyam). Such incidents have led to stringent regulations. For instance, in the US, regulators mandate process-based controls and fix ownership on C-suite executives (CFO and CEO) to ensure organization-wide adherence. In India, Internal Financial Control on Financial Reporting (IFC-FR) requires similar process-based controls, with the board responsible for compliance.

From a practical standpoint, there are five key approaches to improving reliability:

1. Follow a Clearly Defined Accounting Manual Accountants should adhere to a well-defined month-end close process that outlines how to record transactions for various activities, including recognition principles and accounting and disclosure treatments.
2. Undertake Checklist Reviews Maintain a checklist of items to review before finalizing financial statements. This quality check ensures that context-specific actions are addressed.
3. Automate All Accruals Automate major accrual items such as depreciation, prepaid expenses, revenue recognition, cost of goods sold entries, financial statement preparation, inter-company eliminations, and consolidations. Manual processes can delay communication and introduce material errors.
4. Implement a Maker and Checker Process In finance and accounting, having multiple pairs of eyes review the work is beneficial. In a maker-checker process, financial statements prepared by an accountant or finance analyst are approved by another individual, such as a finance controller or another analyst.
5. Adopt an Analytical techniques Use logical reasoning and pattern recognition to understand metrics and their context. This approach involves intuition and acumen, and includes:

• Flux or Change Analysis: Comparing current figures to previous periods to identify growth and trends.
• Budget Variance Analysis: Comparing actuals to the budget to understand performance direction.
• Key Performance Indicators (KPIs): Ratios between figures in financial statements that provide insights into profitability, returns, and efficiency.
• Common Size Statements: Financial statements presented as ratios to revenue or total assets, offering a clear perspective on each financial item’s proportion.

These analytical techniques should be used jointly to gain a nuanced understanding of financial performance.

Complementary Approaches

It is important to understand that these approaches are complementary, not substitutes. Each approach enhances the others, and all should be used depending on the company’s nature and business context. By following these five approaches diligently, you can consistently produce reliable financial statements, which form the foundation for effective strategic planning and execution.