Integrity of Financial Reporting Systems19/10/2022 0 By indiafreenotes
Our investment markets and our entire financial system all depend on integrity, honesty and transparency in financial reporting. Honesty means that the reporting of transactions reflects the total reality of what happened. Transparency means there’s no attempt at deceit for personal gain.
Integrity means that the accounting practices of a company adhere to a consistent set of principles such as GAAP or IFRS. When everyone follows the same accounting principles, stakeholders have greater faith that the story those financial statements tell is trustworthy.
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Foundation of a financial report (this is for US GAAP):
- Balance sheet. The balance sheet always has the concepts “Assets” and “Liabilities and Equity”. The value of both of those concepts MUST have the same value (i.e. the balance sheet balances.). Depending on the industry you might have “Current Assets” and “Current Liabilities” (i.e. a classified balance sheet). The computations for “Assets” and “Liabilities and Equity” foot. (In XBRL terms, you have XBRL calculations which prove that the balance sheet computations add up correctly, things roll up.) One could hang other things off the “Assets” and “Liabilities and Equity”; but you definitely have those two concepts and anything that does hang off those concepts adds up correctly.
- Income statement. It seems that there are two concepts what every company will always have: (1) “Income (Loss) from Continuing Operations before Equity Method Investments, Income Taxes, Extraordinary Items, Cumulative Effects of Changes in Accounting Principles, Noncontrolling Interest”, (2) “Earnings per Share, Basic”. There is a “step down” in the income statement; companies only have the steps if they have that component. The components are: Income from Equity Method Investments, Discontinued Operations, Extraordinary Items, Cumulative Effect of Change in Accounting Principle. If you have a noncontrolling interest, then net income is also broken down by what goes to the parent and what goes to the noncontrolling interest. If you have preferred dividends you need to break those out. You may, or may not, break Income from Continuing Operations out for Gross Profit. But, it seems that (a) one always has Income from Continuing Operations (i.e. if they don’t, are they a viable business?), (b) some easy to figure out step down of net income, and (c) earnings per basic share. (If I am wrong on this, this is the statement where I am probably making a mistake. There may be a better way of explaining this.)
- Cash flow statement. Every company has the concept “Cash and Cash Equivalents, Period Increase (Decrease)” (per the US GAAP Taxonomy) or call it “Net Cash Flows”. That concept can be broken down into three other concepts: Net cash flows from operating activities, Net cash flows from investing activities, and Net Cash Flows from Financing Activities. Companies will highly likely have operating cash flows, it could be that they have no financing or investing cash flows. It is conceivable that they don’t have operating cash flows because they are not operating companies. There are two other things which could be included in “Net Cash Flows”: Effect of exchange rate on Cash and Net Cash Flows from discontinued operations. Now, discontinued operations could be configured in a number of different ways, but it is always a part of “Net Cash Flows”. Effect of exchange rate on cash is a different story, Fine, one must be true. Either it is ALWAYS part of “Net Cash Flows” (this is what I see in 99% of filings) or it could be part of the reconciliation of cash (i.e. not part of “Net Cash Flow”). Whatever concept is used for “cash” in the cash flow statement must be the same concept used on the balance sheet. This business rule is ALWAYS true: “Beginning Cash + Net Cash Flows = Ending Cash”. (Or, alternatively, if exchange gain is NOT part of “Net Cash Flows”; then: “Beginning Cash + Net Cash Flows + Effect of Exchange Rate on Cash = Ending Cash”)
- Statement of Changes in Equity. The beginning and ending balances tie to the balance sheet. Net income shown in this roll forward ties to the income statement. (All the statement of changes in equity is, is a bunch of [Roll Forward]s. There is a [Roll Forward] for every equity account and shares and there is a [Roll Forward] for all the periods shown on the balance sheet.
- Some policies relate to financial statement line items. Some don’t. If they do tie to a line item, the fact that it does tie should be expressed.
- Some disclosures relate to financial statement line items. Some don’t. The ones that do tie to those line items (i.e. they are the same XBRL concept in the statement and in the disclosure). If the disclosure is supposed to foot, some business rule exists to show that (either an XBRL calculation or an XBRL formula). Things that should be tied together are tied together, be they because they relate to the same class of stock, same entity, same class of some other line item, or in some other thing which should be tied together.