Forensic Analysis of Financial Statements: Anything Look Odd to You? - Shannon Farr & Sharon Hamrick

1. A Global Reach with a Local Perspective
www.decosimo.com
of Forensic Analysis of Financial Financial Statements: Statements: Anything Look Anything Odd to You?
Look
Odd to You? Shannon Farr - shannonfarr@decosimo.com| Sharon Hamrick – sharonhamrick@decosimo.com

2. When and Why Would You Need a Financial
Expert for Gathering and/or Requesting
Financial Information?
If management is
reluctant to share
information, an expert
may know whether it
should otherwise be
readily available
A financial expert will know
whether the information
received is inadequate or has
material errors

3. What Financial Information Should You
Request in Addition to “Financial
Primary
examples
of
information
to request:
Statements”?
• Both externally-prepared financial
statements and internally-prepared
financial statements
• Detailed general ledgers (in excel)
• Minutes from Board of Directors
and Stockholders’ meetings
• Income tax returns – complete with
supporting schedules
• Other items dependent upon type
of entity, industry, complexity

4. Why the…Detailed General Ledger
Can alert an
expert to unusual
items that may
need to be
explored
Can reveal
differences
between the
general ledger
and the financial
statements issued
Can reveal
information about
significant or
unusual receipts,
payments,
general journal
entries
Can also reveal
whether items are
misposted or
misallocated

5. Why the…Minutes from Board of Directors
and Stockholders’ Meetings
Can reveal disagreements
among management and
indications of the company’s
relationship with its
shareholders
May provide information as to
past, current or planned activity
such as borrowings, sale or
acquisition of assets,
transactions with related parties

6. Why the…Income Tax Returns
It can include information that may
not be available in the financial
statements, such as further
description of non-deductible and
non-taxable items
Depending upon the type of entity, it
may include information as to
ownership, distributions of cash or
other property, charitable
contributions, acquisition of property

7. Other
items to
request,
depending
upon the
issues of
the case,
may
include
What Other Items?
• loan applications,
• leases, contracts,
• bank statements and bank
reconciliations,
• depreciation schedules,
• payroll reports, payroll tax filings,
• check registers, vendor registers,
• accounts receivable and accounts
payable aging reports

8. What Comprises a Complete Set of Financial
Statements?
Auditor’s or Accountants’ Report
Balance Sheet
Income Statement (may include Retained Earnings)
Statement of Stockholders’ Equity (if changes in equity)
Statement of Cash Flows
Notes to Financial Statements

9. Basic Financial Statements
Balance
Sheet
• A statement of the assets, liabilities, and capital
of a company at a particular point in time.
Income
Statement
• A statement that measures a company’s
financial performance over a specific
accounting period
• Summarizes how the business incurs its
revenues and expenses through operating
and non-operating activities.
• May include a reconciliation to retained
earnings per balance sheet
Cash Flow
Statement
• A statement that shows how changes in
balance sheet accounts and income affect
cash and cash equivalents.
• Breaks the analysis down to operating,
investing, and financing activities.

10. How Do These Financial Statements Relate
to Each Other?

11. Interrelation between Basic Financial
Statements and Their Components
Balance Sheet
Cash
Other Assets
Total Assets
Liabilities
Stockholders’ Equity
Stockholders’ Equity &
Liabilities
Statement of Cash
Flows
Cash from Operations
Cash from Investing
Cash from Financing
Beginning Cash
Ending Cash
Net Change in Cash
Non –Cash
Transactions
Statement of Stockholders’
Equity
Beginning Balances
Common & Preferred Stock
Issue of Par Value Stock
Additional Paid-in-capital
Treasury Stock Repurchase
Retained Earnings (Net
Income & Other)
Net Change in Stockholders’
Equity
Ending Balances
Statement of Income
Revenue
Expenses
Net Income

12. What is GAAP? What Else is There?
• Most commonly observed presentation of financial statements
upon which an auditor has expressed an opinion
• Provides generally principally-based standards for recording
financial transactions and financial statement presentation
• Requires specific accounting methodologies and disclosures
• Requires specific financial statement inclusion and presentation
Generally
accepted
accounting
principles
(US GAAP)
• Commonly includes financial statements prepared on the cash
basis of accounting, modified cash basis, or the basis of
accounting used for income tax preparation
SPF(Special
Purpose
Frameworks)
(previously
known as
OCBOA)

13. What is GAAP? What Else is There?
• This is a type of SPF
• Intended as an option for privately-held, for-profit small and
medium sized entities
• Small and medium sized are not specifically defined
• Blends aspects of GAAP and simplifications of some GAAP
reporting requirements
• Not required, but an option for those entities
FRF for SME’s
(Financial
Reporting
Framework for
Small &
Medium Sized
Entities)
• Similar in many respects to US GAAP but there are significant
differences in some areas such as consolidation, lease accounting,
use of fair-value accounting, disclosures
• Efforts continue to converge US GAAP and IFRS into a single,
global set of accounting standards
IFRS
(International
Financial
Reporting
Standards)

14. How Do You Know What Basis of
Accounting Was Used?
GAAP is assumed
Unless the accountants’
report includes a
paragraph telling the
reader something else
was used, and
The financial statement
titles include “Balance
Sheet” and “Statement
of Income”

15. If Not Prepared in Accordance with GAAP
OCBOA would
be disclosed
In the Accountants’ Report
If the financial statements do not use
the financial statement titles of
“Balance Sheet” and “Statement of
Income”
If descriptive captions are used, for
example “Statement of Assets,
Liabilities and Stockholders’ Equity –
Income Tax Basis”; “Statement of
Revenues and Expenses – Modified
Cash Basis”

16. The Difference Between Cash Basis and
Accrual Basis
 The two principal methods of keeping track of a
business’s income and expenses:
Cash Basis
• An accounting method in which income is recorded when cash is
received, and expenses are recorded when cash is paid out.
Accrual Basis
• A system of accounting based on the accrual principal, under
which revenue is recognized (recorded) when earned, and
expenses are recognized when incurred.

17. What Does This Mean When Understanding a Set
of Financial Statements?
Cash Basis
• Reflects income when cash is received and
expense when cash is paid.
• It is often considered simpler than the accrual
basis of accounting but because of the effect of
the timing of receipts and payments does not
reflect operating results as incurred
Accrual Basis
• Revenues and expenses are reflected in the
financial statements based on when a
transaction is incurred regardless of whether or
not cash was received or paid out in that period.
• Conforms to the provisions of GAAP.
• Employed by most companies.

18. Other Bases of Accounting
Modified cash basis
• Combines elements of the cash basis and accrual basis;
typically includes modifications to cash basis related to
depreciation
Income tax basis
• Reflects assets, liabilities, income and expenses as they
are recorded on the entity’s income tax return.

19. What Level of Assurance is Provided
Regarding the Financial Statements?

20. What is an Audit vs. Review vs. Compilation
Audit
Objectives of each, according to the AICPA:
• To obtain a high level of assurance about whether the financial
statements as a whole are free of material misstatement thereby
enabling the auditor to express an opinion on whether the financial
statements are presented fairly, in all material respects.
Review
• To obtain limited assurance that there are no material modifications
that should be made to the financial statements.
Compilation
• To assist management in presenting financial information in the form of
financial statements without undertaking to provide any assurance that
there are no material modifications that should be made to the
financial statements.

21. What is an Audit vs. Review vs. Compilation
Level of Assurance Obtained, according to the AICPA
Audit
• The auditor obtains a high, but not absolute, level of assurance
about whether the financial statements are free of material
misstatement.
Review
• Accountant obtains limited assurance that there are no material
modifications that should be made to the financial statements.
Compilation
• Accountant does not obtain or provide any assurance that there
are no material modifications that should be made to the financial
statements.

22. But Financial Statements Don’t Tell Us
Everything…

23. Footnotes to Financial Statements

24. What Can Be Included in the Footnotes to
Financial Statements?
 Accounting
policies.
 Accounting
changes.
 Related parties.
 Contingencies
and
commitments.
 Risks and
uncertainties.
 Nonmonetary
transactions.
 Subsequent
events.
 Business
combinations.
 Fair value.
 Cash.
 Receivables.
 Investments.
 Inventories.
 Fixed assets.
 Goodwill and
intangibles.
 Liabilities.
 Debt.
 Pensions.
 Leases.
 Stockholders'
equity.
 Segment data.
 Revenue
recognition.

25. Footnotes – Limitations and Possible
Information Source
Footnotes can be confusing and verbose in their attempt to provide
information required to be disclosed.
They can seem to be full of information that is not particularly helpful or
informative.
Significant information that can be contained in footnotes includes debt
refinancing, related party transactions, business segments and locations,
concentrations of customers, previously unknown debt, leases and contracts.

26. How Do Financial Statements Relate to One
Another from Year to Year?
• The nature of many of the changes between
prior year account balances and current year
account balances should be revealed in
other financial statements and the footnotes:
• The change in cash should be reflected in
the statement of cash flows
• The balances and changes in accounts
receivable and inventory should be
disclosed in statement of cash flows and
footnotes
• The balances and changes in short-term
and long-term debt should be disclosed in
statement of cash flows and footnotes

27. How Do Financial Statements Relate to One
Another from Year to Year?
• Normally includes major categories of revenue and
expenses such as:
• Sales, cost of sales, operating expenses, other
income and expense, income tax expense
• Some detail may be in footnotes such as income
tax expense
• Footnotes should disclose, among other items:
• Accounting policies
• How revenue is recognized
• Nature of major concentrations in sales revenue
• Major estimates made
• Assets valued at fair value rather than cost
• Depreciation policies
• Net income should equal the change in retained
earnings from end of prior year to end of current
year (unless there are dividends or other
distributions per statement of cash flows)
• Net income should also equal the first line in the
operating section of the statement of cash flows

28. How Do Financial Statements Relate to One
Another from Year to Year?
Statement of
Stockholders’
Equity
Not always included –
only required if there
are changes in
elements of equity
other than net income
(loss) added to
retained earnings
Reflects stock
transactions such as
issue of common and/or
preferred stock,
company purchase or
retirement of outstanding
stock,
payment of dividends

29. How Do Financial Statements Relate to One
Another from Year to Year?
Statement of Cash Flows
Beginning and
ending cash
balances should
tie to balance
sheet
Operating section
reflects changes
in current assets
and liabilities from
prior year and
non-cash
operating income
and expenses
Investing section
reflects cash paid
for net advances
or collections on
loans to related
parties, cash paid
for fixed assets,
investments, other
assets and the
proceeds received
from sale of such
assets
Financing section
reflects cash paid
to retire or reduce
debt, cash
received on new
long-term
borrowings,
dividends and
distributions paid,
net borrowings or
draws on lines of
credit
Non-cash section
discloses
transactions
which occurred
but which did not
result in cash
received or
disbursed
• Example is
seller-financing
of fixed assets
acquired

30. What If All You Have Are Income Tax
Returns?
Where do you look to see what differences there might
be between the “books” and the tax return?
Differences in the income between “book” and “tax” basis are
recorded on Schedule M-1 of the income tax return
Depreciation expense – accelerated writeoff of fixed
assets
Disallowed deductions – travel and
entertainment, officers’ life insurance
Non-taxable income
Timing differences – charitable contributions, allowances, inventory
costs

31. Other Important Information which may be
Gleaned from Income Tax Returns
Basis of accounting used for tax
return (accrual or cash most common)
Treatment of depreciation and information
related to assets acquired during the year
Treatment
of inventory
Assets, liabilities and equity at
end of prior and current years
Corporate ownership, changes in
ownership, distributions to owners

32. What’s Included on Schedule M-1?
Schedule M-1 Reconciliation of Income (Loss) per Books
With Income per Return
• 1) Net income (loss) per books (after income tax expense)
Additions:
• 2) Federal income tax (expense per books)
• 3) Excess of capital losses over capital gains
• 4) Income subject to tax not recorded on books this year
• 5) Expenses recorded on books this year not deducted on this return
• Depreciation
• Travel and entertainment
• Contributions carryover
6) Equals: Book income after additions

33. What’s Included on Schedule M-1?
• 7) Income recorded on books this year not
included on this return
• Tax-exempt interest
• 8) Deductions on this return not charged against
book income this year
• Depreciation
• Contributions carryover
• 9) Equals: Total subtractions
• 10) Book income (after additions and
subtractions) equal to tax net income before net
operating loss deduction and special deductions
Subtractions:
• Net Income as reported on page 1 of
income tax return
Net Income per
Income Tax
Return

34. What’s Included on Schedule M-2?
Schedule M-2
Analysis of Unappropriated
Retained Earnings per Book
• 1) Balance at beginning of
year
Additions:
• 2) Net Income (loss) per books
• 3) Other increases (itemize)
• 4) Equals: Balance after
additions

35. What’s Included on Schedule M-2?
Subtractions:
• 5) Distributions
• Cash
• Stock
• Property
• 6) Other decreases
• 7) Equals: Total Subtractions
Schedule M-2
Analysis of Unappropriated Retained
Earnings per Book
• Balance at end of year

36. Red Flags

37. Red Flags Regarding Financial Health
Negative amounts in stockholders’ equity
Negative cash flow from operations
Current liabilities exceed current assets
Recurring losses
Disclosure of significant portion of
revenue from one or a few customers

38. Red Flags Regarding Reliability of Financial
Large differences
between
internally-prepared
financial
statements and
those issued by
outside
accountants.
Failure to provide
Failure to provide
detailed general
ledgers, bank
statements, bank
reconciliations
subsidiary
ledgers, such as
accounts
receivable and
accounts payable
agings
Inconsistent
balances and
information
among general
ledger, financial
statements and
tax returns
Inconsistent
balances on
financial
statements from
year-to-year
Incomplete
income tax
returns – missing
forms, no
supporting
schedules, no
detail regarding
carryforwards
Information Received

39. More Red Flags
Significant
differences between
operating results of
company and
industry statistics
4th quarter or end of
year operations
significantly improved
over operating results
of the prior 3 quarters
Significant
fluctuations in
allowance/reserve
accounts
Nature and
significance of related
party transactions

40. These Red Flags can be Indications of
Off balance sheet accounting
Recording revenue before it is earned
Creating fictitious revenue
Diverting company revenue and/or assets
Boosting profits with non-recurring transactions
Shifting current expenses to a later period
Accelerating expenses or improperly recording expenses to
reduce net income
Failing to record or disclose liabilities
Shifting current income to a later period

41. CONNECT WITH ME
Shannon Farr, CPA•ABV•CFF
423.266.7230
ShannonFarr@decosimo.com
On LinkedIn:
www.linkedin.com/pub/shannon-farr-cpa-abv-
cff/36/636/a5
The contents and opinions contained in this article are for informational purposes only. The information is
not intended to be a substitute for professional accounting counsel. Always seek the advice of your
accountant or other financial planner with any questions you may have regarding your financial goals or
specific situations.

42. CONNECT WITH ME
Sharon Hamrick, CPA•CFF, CFE
423.266.6191
SharonHamrick@decosimo.com
On LinkedIn:
www.linkedin.com/in/sharonhamrick
The contents and opinions contained in this article are for informational purposes only. The information is
not intended to be a substitute for professional accounting counsel. Always seek the advice of your
accountant or other financial planner with any questions you may have regarding your financial goals or
specific situations.