By Russ Banham
Risk Management
At its most basic, business is about numbers: revenues come in and expenses are paid. Some adding, some subtracting, and profits are realized. But what if the underlying numbers are imprecise?
The result is a higher risk of an accounting restatement, an announcement that is usually followed by a sharp drop in a company’s stock value. Among public companies to recently experience this fate are General Electric, Kraft Heinz, and Seneca Foods in the United States and Carillion in the United Kingdom. All needed to restate their earnings, endured consequent stock declines, and GE and Kraft are even under investigation by the U.S. Securities and Exchange Commission (SEC).
These companies are just the tip of the iceberg. In 2018, restatements involving material inaccuracies in a prior year’s financial statement increased for the first time since 2006. Through September 2018, according to the SEC’s annual report, cases of accounting fraud enforcement actions by the commission increased 8.8% from the prior year. The aggregate penalties imposed by the SEC in such cases rose 70%—from $832 million in all of 2017 to $1.43 billion in just the first nine months of 2018. Following the agency’s announcement of a new strategic plan to bolster its use of data analytics, this is likely to rise as SEC investigations into the accounting practices of public entities are expected to become more thorough.
Typical reasons for restating earnings run the gamut from deliberate accounting fraud to innocent human errors to well-intended but mistaken applications of accounting principles (particularly newer accounting standards governing revenue recognition and leases, for instance).
Every minute in every business, people input financial data. This information travels across the enterprise from sales, operations, human resources and supply chain partners to finance professionals for analysis and input into financial statements. For the most part, this data is accurate. But when the numbers are entered or calculated incorrectly, these errors eventually find their way into the statement.
Given that automated accounting systems often manage day-to-day business activities, one might think that financial data errors are few and far between. However, a recent survey of more than 1,100 C-level executives and finance professionals by software provider BlackLine and independent research firm Censuswide suggests otherwise.
The survey indicates a great divide between opinions on data accuracy among finance professionals versus senior executives. Among members of the C-suite, 71% expressed complete trust in the accuracy of the financial data. Of the financial professionals—a group comprising financial controllers, accountants, analysts and internal auditors who prepare the financial statements and reports—only 38% felt the same way.
This disconnect should be unsettling for investors, employees and business partners, and especially for the CEOs and CFOs who must certify the accuracy of a public entity’s financial statement.
“People who sign their names on a filing to the SEC do it because they believe what’s been executed is accurate,” said Stephen Kasnet, chair and lead director of the board at both Granite Point Mortgage Trust and Two Harbors Investment Corporation. “If the finance professionals involved in putting together the financial statements are concerned about the accuracy of the data, a company’s senior management team and board have a serious issue that requires disclosure and remediation.”
Behind the Numbers
Accounting has always involved an acceptable use of estimates, appraisals and judgments in crafting a financial statement. These are presented in a structured manner to make them easily understood by stock analysts, ratings agencies, lenders and investors. Before the statement’s release, the figures are given an objective examination by an independent audit firm. In this work, the audit firm examines a sampling of the financial records (as opposed to every single item and transaction), which is perceived as providing “reasonable assurance” of the financial statement’s integrity.
But the financial statement does not necessarily contain hard facts and figures. “You’d think accounting is all about extremely objective numbers, but the fact is there’s a great deal of subjectivity involved,” said Michael Heric, a partner in the performance improvement practice at Bain & Company. “There is a tremendous amount of judgment in accounting, some of it driven by people’s expertise and some in the ways people view a specific issue.”
Making sense of a company’s financial performance requires belief in an outcome that is not necessarily proven. Nevertheless, the SEC has historically acknowledged and accepted financial measurements that are “based on estimates, judgments and models.”
“There’s a significant amount of judgment involved in determining things like the value of goodwill or how to present adjusted EBITDA [earnings before interest, tax, depreciation and amortization], resulting in so many different variations,” said Mark Brockway, a managing director at corporate governance software firm ISS Corporate Solutions. “Three companies in the same industry can have different definitions of their adjusted earnings. That makes it very difficult to compare one company with another.”
These judgments are compromised in this era of big data, in which large and complex data sets flow in from multiple sources across an enterprise, and many finance professionals feel like they are under siege. Indeed, 40% of the BlackLine survey respondents attributed their lack of confidence in the accuracy of their financial figures to being overwhelmed by so many data sources—nearly as many as cited human errors (41%).
“As companies acquire other companies, they typically inherit a hodgepodge of different IT systems that fail to ‘talk with’ their systems and rarely become fully integrated,” Brockway said. “Finance professionals are inundated with complex financial data coming from different systems, trying to make sense of it all. It’s a struggle.”
The Need for Accuracy
While nearly three-quarters of C-level executives express confidence in the numbers, they may just be too removed to know what is really going on, according to Erik Gordon, a professor who teaches corporate governance at the University of Michigan’s Ross School of Business. “Much of the C-suite doesn’t really understand accounting or auditing,” he said. “CEOs who come up on the operations or marketing sides of the business think if you follow GAAP [generally accepted accounting principles], that’s all you need to do. Others like the CMO or the CTO could not care less. This gives them a false sense of confidence that everything is buttoned up.”
As business gets more complex, this gets farther from the truth. “These aren’t the straightforward days of old when you made or bought a shirt for $10 and sold it for $20 and worried only about bad debts,” Gordon said. “Today, you’re making determinations on how to expense R&D and when to recognize revenue in a long-term service contract. Very complicated judgment calls are required.”
Making matters even murkier, the judgments are driven by data that may be less than precise. In addition to human error, the company’s financial and accounting system may not easily connect with all other IT systems across the business. When closing the books for reporting purposes, verifying the accuracy of financial data across all these systems is difficult.
“Many people input data into many systems, which then feed this data into the ERP system or the general ledger,” Heric explained. “When questions arise over data accuracy and quality during the period-end close, finance professionals spend a great deal of time manually reconciling the data across a large number of people and systems.”
Without visibility into financial data’s origin and flow, questions regarding accuracy arise. In such cases, finance professionals text or email colleagues for answers. However, there can be significant delays in their responses, and as the clock ticks toward the financial close, pressure increases. “People are working so hard to close the books in time that quick judgment calls are being made without the considered deliberations they require,” Gordon said.
Small wonder there are growing concerns about the accuracy of financial data. However, Mike Maali, U.S. leader for internal audit compliance and risk management solutions at PwC, said he is confident that the data in financial statements is accurate—insofar as materiality and absent instances of accounting fraud.
“There may be immaterial inaccuracies in the numbers, there’s no question about that, but material inaccuracies as a result of a process failure? I just don’t see it,” he said. “Were this the case, you’d have a massive volume of restatements occurring each day.”
While the BlackLine survey did not address material financial data inaccuracies, nearly two-thirds of the respondents (65%) said that a company they have worked for had to restate their earnings due to inaccuracies in financial data that were not identified prior to closing the books.
If this is true in even a fraction of the cases, that is concerning. “From what the finance professionals are saying about their lack of confidence in the numbers, not only are reporting errors prevalent, the inaccuracies are hidden below the surface,” said Mario Spanicciati, chief strategy officer at BlackLine. “In this era of high-profile misreporting scandals and an emboldened SEC, more restatements may be in the offing.”
Spanicciati is referring to the SEC’s release of its new strategic plan, detailing the agency’s work through 2019 and beyond, in which the commission included the goal of increasing its use of technology, data analytics and information-sharing to protect the interests of investors. The question is whether or not the new strategy will narrow the SEC’s acceptance of financial measurements based on estimates and judgments. Obviously, if this is the case, it heightens the need for accurate figures.
Data Tells the Tale
Imprecise data affects more than a company’s financial statement—41% of survey respondents cited an adverse impact on their ability to secure capital, slowing their growth prospects; 40% said it would increase their debt levels; and 42% projected significant reputation damage.
Financial data also plays a key role in forecasting, budgeting and developing key performance indicators. “You’re tracking sales metrics, R&D metrics, and operational metrics, all of which are being input by someone somewhere,” Heric said, noting that if the numbers “don’t tie in the financial statement, they’re not likely to tie in other aspects of running the business.”
That is bad news for C-level executives making business decisions based on these performance indicators. According to the BlackLine survey, 69% of respondents believe they or their CEO have made a significant business decision based on out-of-date or incorrect financial data.
What can be done to enhance confidence in the credibility of financial data? One suggestion is for directors of enterprise risk management and financial planning and analysis (FP&A) to align in strengthening the gathering, processing, modeling and reporting of data. ERM leaders oversee the management of strategic and operational risks throughout the enterprise, whereas FP&A analyzes financial metrics like sales and expenses for forecasting and budget needs.
“FP&A needs to transform to become more tightly connected with the business and enterprise risk management, establishing rules governing how financials flow from actions committed by the business to budgets to actions taken by the business to the financial statements to ensure everything ties out and enable greater transparency,” Heric said.
To provide greater clarity around earnings, Brockway recommended using economic value added (EVA) as a better measure of a company’s operating performance than traditional descriptions like adjusted EBITDA. EVA is sales, minus operating costs, minus the full cost of capital, multiplied by the money tied up in a company’s net business assets. The metric is essentially an estimate of the profit generated after setting aside a full cost of capital charge on each of a company’s business assets, as well as the returns for shareholders. Therefore, EVA is positive when the company earns a return on capital in excess of its cost of capital.
“The idea here is that a company isn’t really profitable until it is generating returns greater than what a shareholder would garner from another investment,” Brockway said. “It’s just a much better estimate of a company’s true economic profit, which would help correct the accounting distortions and provide comparability across different companies.”
Companies should also change their audit firm every few years to “provide a fresh set of eyes on the books from time to time,” he said. “If you have the same auditor working for the company for a long period of time, the firm can get too comfortable or complacent.”
For the many companies undergoing digital and data transformation, this is an opportune time to rethink how their financial data is processed. “Assuming a company develops completely digitized business processes, they should be able to do a 100% validation of the accuracy of the financial data,” Maali said.
“New companies have an advantage here in that they’re already using automated end-to-end financial and accounting software tools to make journal entries, reconcile accounts, and verify the accuracy of transactions in close to real time—there are no issues with multiple IT systems and outdated processes,” said Rick Rueth, a principal in The Hackett Group’s strategy and business transformation practice. “Older companies with legacy technology are behind the eight ball, but they can catch up.”
This assumes that CFOs make the necessary investments. “Frankly, a lot of finance chiefs are loath to spend money on their own needs, given the pressure to invest capital in growth strategies,” Rueth said. “They’re also under pressure to reduce the costs of the finance organization, but doing things on the cheap won’t work forever.”
Gordon agreed, noting that such investments could pay real dividends. “Automated software providing transparency into financial data across the organization is money well spent, but you still need smart people who understand the accounting principles to make the tough calls,” he said.
Most tellingly, he pointed out, the survey findings do indicate some C-level misgivings about data accuracy. “If 71% have complete trust, what does that say about the other 29%?” he said. “Certainly some of them are CFOs. And what they’re saying is they, too, lack confidence in the accuracy of the numbers. And that’s really scary.”
Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.