While it's true, there is a misrepresentation and fraud in a financial statement (FS), the document is not inherently bad, it is the poor intentions of the preparer or company that is to blame.
As credit analysts, we always review and rely on FSs when underwriting surety bonds. We know there may be mislead our judgment or even downright deception. But the need to evaluate the financial report is unavoidable. It is considered a valuable "report card on the quality of management."
There are three levels of financial presentation by Certified Public Accounts (CPAs):
Compilation - a properly organized report where the numbers are not verified or evaluated by the CPA
Review - includes some checking "Review" of key elements
Audit - is the highest level and includes the CPAs statement that they have checked and believed the numbers are correct
The reader of the FS is entitled to certain expectations: A candid and complete presentation that informs the reader. Are they entitled to more than that? Does the reader sometimes expect too much?
Let's think what the FS really says, and what it does not ...
The Balance Sheet
This shows assets and liabilities. It describes the dollars in the company (assets) and who owns them (liabilities and stockholder's equity). You know many of the general entries: cash, accounts receivable, accounts payable, inventory, bank credit, the net worth / stockholder's equity section, etc.
The balance sheet has always been a date, such as 12/31/2017. It shows the status of these accounts on the one day. Credit analysts calculate the Working Capital aka Net Quick (NQ) which is a measure of short term financial strength. You can find the NQ by subtracting current liabilities from current assets. When the bond underwriter has the NQ number, it can be incorporated into the decision making.
What size bonds will be approved for this applicant? How much can they be allocated? The NQ figure is a benchmark that is used for the reminder of the year.
For many analysts, this is a great success for the following 12-15 months.
Let's move forward in one day, to 1/1/2018. "Happy New Year!" and let's check the bank account Some money has come in! The accounts receivable and cash changed Other changes have also occurred and so, if we calculate the NQ based on the 1/1 balance sheet, the NQ will probably be different from 12/31. Again, that's because the balance sheet shows the state of these accounts on ONE DAY. It is always changing!
The reality is that the working capital number is only correct for one day, then it is subject to change This is not possible And certainly the decision-makers must have benchmarks and a method for their determinations. It is very important
Financial Statement Fraud
The most common FS fraud It is the self-deception we commit by over relying on these "one-day numbers." To do so
Underwriters love to see a big cash account sitting on that top line. But that's a one-day number Is not it even more important to determine the amount of deposits for the first six months or year? Many analysts fail to ask for this info
Accounts Receivable and Payable - Here is another key area where the "one-day number" can easily be a historical perspective. Aged schedules of A / R and A / P are easy to get and one day more than one day. These documents are not automatically included in FSs, and underwriters may fail to ask for them.
Conclusion
As readers of these documents and analysts, let's not cheat ourselves over over the balance sheet or thinking it is more than a one-day snapshot. It should be scrutinized and viewed in harmony with other key underwriting factors such as mid-year financial reports and supporting documents.