What to focus on if you want to prepare your financial statements correctly: selected aspects

Piotr STASZKIEWICZ
Audit Partner at RSM Poland

As I mentioned in my last article, as a practitioner, what I see every year in financial statements is that relevant disclosures are missing and there are errors to be corrected by the auditor. According to the information available to us, statutory auditors, more than half of the audited companies were advised to correct their financial statements. This means that most financial statements contain significant discrepancies, and companies fail to present their financial data in a reliable and clear way in their financial statements, at east before the audit. Many of these shortcomings result from insufficient knowledge and the involvement of companies’ management boards and members of supervisory bodies in financial reporting. This is also an important argument in favour of obligatory external audit of financial statements by independent experts, i.e. statutory auditors.

What are the most common errors I come cross in financial statements? How do they distort the representation of economic events, thus producing unreliable data that is later presented to owners and certain institutions? Hence, what needs to be focused on in order to avoid these errors, close the financial year properly and save yourself the stress involved with an auditor’s visit? I encourage you to read my article as I go on to discuss selected aspects.

Fixed assets and intangible assets

As regards fixed assets and intangible assets, the most common errors entail the following:

• failure to disclose and valuate assets subject to financial lease in accordance with the new IFRS 16 Leases standard that has been in force since 1 January 2019, as described in detail on our blog,
• failure to verify the depreciation rate and determine this rate on the basis of the economic useful life of assets.

In the first case, the reason behind the failure to disclose leased fixed assets is usually the lack of relevant analysis of concluded contracts and a result of the application of a tax approach, whereas in the second case, the reporting error stems from the behaviour of senior management, as they:

• either fail to organise and appropriately manage the flow of information on the used assets, pace of changes, planned downtimes or increased production, or anticipated replacement of old machines with new ones,
• or fail to present their assumptions/plans regarding the use of the acquired assets to financial and accounting services.

The awareness of how important it is to include the financial and accounting department in the information flow within an organisation will surely be of great help in reducing the risk of errors when presenting both fixed assets and intangible assets in financial statements.

Fixed asset write-downs

Continuing the topic of assumptions/budgets or the information held by management boards, I must mention the implications of a failure to regularly analyse the generated revenues (benefits) in relation to the assets involved. What may be challenged during an audit is, among others, the value of fixed assets if they do not bring any economic benefits. The auditor may also challenge the amount of deferred tax assets if budget projections (if the entity has any) do not provide for paying the tax in the future while using these deferred assets.

If you want to avoid auditor’s corrections and significant write-downs or avoid having any reservations in the auditor’s opinion or be refused the auditor’s opinion, you should perform an early analysis of the economic benefits of the assets and update your budget plans and projections with due consideration for taxation on an ongoing basis (and not just at the end of the financial year).

Stocktaking and time of revenue recognition

Stocks and sales revenues make a very broad subject. The only thing I would like to point out is a problem that is common and significant for the presentation and reliability of reporting, namely incorrect (i.e. too early) recognition of revenues from the sale of goods/finished products.

The Accounting Act does not define the timing of revenue recognition. The accounting science suggests that revenue should be recognised in the period to which it relates (accrual basis), provided that its economic benefits and related costs can be measured in a reliable way (commensurability principle).

In practice, these guidelines may prove insufficient. I am of the opinion that entities should apply International Financial Reporting Standards (hereinafter: IFRS)[1] to determine the timing of revenue recognition. That is because pursuant to the Accounting Act, in matters not regulated therein and in National Accounting Standards (hereinafter: NAS), entities may apply IFRS.

Companies should follow international guidelines, even if they do not prepare financial statements according to IFRS, because it will allow for a consistent and correct classification of the amount for a good or product, the control of which has been transferred to the purchaser, as revenues from sale. We wrote more about this subject on our blog in a series of posts on IFRS 15.

Example 1

If a purchaser does not collect the purchased goods before 31.12.2019, i.e. the purchaser of a car, for example, collects the goods from the car dealership on 5.01.2020, it is important that the vendor includes these goods in the stocktaking and recognises them in inventories at the end of the year, because the conditions of sale were not met, i.e. the transfer of control, including the benefits and risk, on the purchaser[2].       

Thus, applying the provisions of IFRS, you may avoid significant distortions of the balance sheet (inventories and receivables), profit and loss account (turnover in revenues and costs of sold goods (products)), as well as net profit, because even though the sales invoice is dated December, it would be recognised in the following year.

Example 2

The opposite situation is also possible, i.e. the fact that the good/product was handed over before the end of the year does not necessarily mean it was sold, if the control over the purchased good was not transferred to the purchaser, as under the contract, the purchaser was supposed to have the good/product delivered to their plant, and the vendor did not do it before the end of the financial year.

Inventory: valuation

The correct valuation of inventory is often neglected, as well, while it is of paramount importance for the right picture of the entity’s assets and finances. The most common valuation error is about determining the value of inventory in relation to the attainable price and not the calculation of components, recognition of individual production costs or the principles of the issue of materials and goods. Companies do not draw conclusions from the analysis of the economic situation and market information. Despite the fact that they receive information about the prices and demand for their goods before closing the books for the passing year, they do not verify the attainable price of inventories after the balance sheet date, and thus the value of inventories is often higher than the attainable price.

Following relevant audit procedures, auditors suggest a revision of inventory valuation in such a case. The Accounting Act does not specify any principles about how to include the effects of events taking place after the balance sheet date in reporting; however, IAS 10 offers a helping hand here. In accordance with this standard, any events taking place after the balance sheet date, such as sale of inventories below their production price, should be, as a rule, included at the end of the previous financial year. The reason behind it is that in most cases there is a premise that inventories already lost their value at the end of the last year and a write-down should have been made.

Example 3

A product worth 100 u. produced in December 2019 was sold in February of the following year (before the financial statements were prepared) for 95u. Even though the difference is material from the point of view of financial statements treated as a whole, the company should make a write-down of 5 u. at 31.12.2019.

Financial instruments

Another quite common mistake is a failure to disclose financial instruments purchased to hedge a given currency transaction or to speculate. Like in the examples above, the failure to make a disclosure results from (a) the lack of information flow about such a contract being signed by the management with the bank and (b) the lack of awareness of the financial and accounting services.

Example 4

The Management Board of an entity purchasing materials in EUR feared a decrease in the value of PLN in relation to EUR and on 1.12.2019 they concluded a transaction consisting in the purchase of EUR 100 for PLN 420, as they expected that EUR 1 will cost more than PLN 4.20 in the future. The company is obliged to measure the acquired instrument at the end of the 2019 financial year at such a value as is determined on the balance sheet date, and related to the execution at the end of February 2020. If the forward exchange rate of 31.12.2019 concerning the execution of the instrument executed on 28.02.2020 is above PLN/EUR 4.20, revenues shall be recognised; otherwise – financial costs.

Apart from the calculation and valuation of financial instruments, information about them must be disclosed in the notes. It is provided for both in the Accounting Act and the Regulation of the Minister of Finance on financial instruments.

Valuation and presentation of liabilities and provisions for liabilities

As regards provisions, as in the case of financial instruments, the biggest error is not having them, despite the obligation to create them on the basis of previous events that oblige the company to do so. Companies do not create provisions for unused holiday leave, provisions for guarantees or jubilee awards, even though the necessity to do it is derived from the principle of matching revenues and costs. However, provisions for unused holiday leave is a category that tends to be omitted by companies due to the fact that “employees will use their unused holiday leave by the end of September of the following year”, as it is often explained.

Example 5

At the end of 2019, the amount of unused holiday leave reached 100 days; assuming that the average salary is at the level of PLN 5,000, the company should create provisions for unused holiday leave in the amount of about PLN 28,000. And it does not matter that at 30.09.2020, 100% of those overdue holiday leave days were taken because operating expenses were not commensurate with the revenues from the core business (employees who did not take their holiday leave contributed to the generation of higher revenues). The amount of provisions for unused holiday leave should be included under”Accrued expenses” for a simple reason: the amount is certain and can be calculated accurately, it is not an estimate, like e.g. a provision for retirement benefits recognised under “Provisions”.

Another frequent and significant error is a failure to charge interest on financial liabilities or a failure to disclose trade liabilities, even though the service has been performed or the control over/benefits from the purchased good has been taken over but it was received after the balance sheet date. This is related with the time of recognition of costs/purchase of goods, the operating principle here being similar to the one described for revenue recognition.

Example  6

At the end of January of the year following the year for which financial statements are prepared, a transport company received a summary of overhauls/repairs of vehicles travelling in different European countries in the course of service provision. On the basis of this summary, the company will receive an invoice shortly before completing the work on financial statements; financial and accounting services should recognise this amount in the costs of maintenance services, and in the balance sheet under trade liabilities.

Another case is about creating provisions for audit services (“audit of the balance sheet”), for which an invoice will be provided after closing the financial statements. The service was performed in the year following the audited year, but it pertained to the reporting year. For this reason, the cost should be recognised in the reporting year, whereas the provision for the audit should be included under”Accrued expenses” (unlike in the above example of maintenance repairs of vehicles, the service is invoiced a day after preparing financial statements). This service pertained to the reporting year, and only the formal document, i.e. an invoice, will be delivered at a later date, i.e. once financial statements have been prepared).

As you can see, an experienced auditor may detect many errors when verifying financial statements, and only some of them have been discussed above. What is more, auditors find quite a lot of quantitative and qualitative errors in the notes, the introduction to financial statements, the company’s management report or in cash flows, which we discussed in more detail in another post. If you add an entire group of errors like the lack of relevant disclosures, you may say that the period of closing the financial and fiscal year means hard work not only for the accounting department and the company’s management, but also for audit companies. You will find a manual on how to choose a good auditor on the list of our publications.

Should you have any questions or doubts, I encourage to contact me directly, e.g. via LinkedIn.