UNDERSTANDING FINANCIAL STATEMENTS

UNDERSTANDING FINANCIAL STATEMENTS

WHAT ARE FINANCIAL STATEMENTS? Most commonly there are 3 types of financial statements: 1. Balance Sheet 2. Income Statement 3. Cash Flows

BREAKING IT DOWN: THE BALANCE SHEET Assets Things an organization owns that has value. Liabilities Amounts of money that a company owes to others. Equity capital or net worth ; The money left if a company sold all its assets and paid off all of its liabilities The balance sheet provides detailed information about a company s assets, liabilities, and equity. Compiled at a point in time.

BREAKING IT DOWN: THE INCOME STATEMENT Revenue How much the company has earned over a specific time period Expense Costs associated with earning that revenue over a specific time period Bottom line the net result of revenue minus expenses is the net earnings or loss during that period Think of income statements as stairs. You start at the top with the total amount of revenue made during the accounting period. Then you go down, one step at a time. Each step, you make a deduction for costs or other operating expenses.

BREAKING IT DOWN: CASH FLOW STATEMENTS Simply put, the statement of cash flows reports how money came into the company and how the money left the company. This statement tells someone whether the company generated cash. Operating activities cash flow from primary activities of a business. Investing activities cash flows from the purchase and sale of assets (property and equipment). Financing activities cash flow generated or spent on raising and repaying capital and debt.

WHAT ARE FINANCIALS USED FOR? Provide information about the results of operations, financial position, and cash flows of an organization Can be used in the following manners: Company management use the statements to understand liquidity, cash flows, and profitability of the organization Regulators Those who have a vested interest in the stewardship of the organization To make credit decisions for lenders may look for signs of liquidity, financial struggle Investment decisions Investors will use this information on deciding whether or not to invest Taxation decisions

INTERNAL CONTROLS

WHAT ARE INTERNAL CONTROLS? Definition: A process, effected by an entity s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations

WHY DO INTERNAL CONTROLS MATTER Reduce possibility of mismanagement, error and fraud Improves quality of information Protects your organization to reduce risk of loss Provides consistent practices to be followed by personnel Examples of control activities: 1. Authorization review by appropriate individuals 2. Retention of records Substantiate transactions 3. Supervision / monitoring Review of observation of processes 4. Security of assets Protecting property, equipment, and inventory 5. Segregation of duties different individuals perform authorization, custody, and record keeping

TYPE OF CONTROLS Entity-level Includes tone setting, oversight by board and senior management, governance policies, procedures and practices that affect the entire organization Preventive To keep errors or fraud from happening in the 1 st place Detective To detect an error or fraud after it has occurred Automated Refers to triggers embedded within IT system Manual Requires persons to perform

RESPONSIBILITY Who is responsible for internal controls? Governing board Management Staff Virtually everyone inside an organization! Who is NOT responsible? External auditors Based on over 1,000 interviews with sophisticated business decision makers and investors/shareholders, over 80 percent of this presumably knowledgeable group believed the job of the external auditor was to prevent fraud! Outsourced service providers

CHALLENGES Maintaining adequate segregation of duties because of lack of sufficient resources Recruiting competent and experienced individuals to serve on the board of directors and other committees Providing sufficient focus on internal control without taking management attention from the programs/mission Maintaining appropriate general and application controls over IT systems limited technical resources.

DESIGNING EFFECTIVE INTERNAL CONTROLS Review current internal control structure and identify weak or nonexistent controls Identify assets (and related transactions) susceptible to misappropriation Review systems and procedures relating to vulnerable areas and identify issues Develop controls to reduce the risk of misappropriation in vulnerable areas Consider cost/benefit relationship of the controls developed

DISBURSEMENTS CONTROLS THAT DON T WORK Two Signatures on every check Banks don t look at signatures on checks Executive Director approves all disbursements All but the fraudulent ones! Source: AICPA Not-for-Profit Section 14

CONTROLS OVER CASH DISBURSEMENTS Example 1 ED signs all checks. ED reviews bank statement. Organization is small enough that ED will recognize every disbursement. ED inquires of bookkeeper of every disbursement that is not familiar to the ED and becomes satisfied that the disbursement was authorized. ED initials every bank statement documenting control procedure. Source: AICPA Not-for-Profit Section 15

CONTROLS OVER CASH DISBURSEMENTS Example 2 ED signs all checks and authorizes all disbursements. Organization is large enough that ED will not recognize/remember every disbursement. ED initials a check register after signing checks and provides a copy of the check register to ED s EA. EA compares every disbursement on the end of month bank statement to amounts on check register. EA signs/initials each bank statement documenting control procedure. Source: AICPA Not-for-Profit Section 16

CONTROLS OVER CASH DISBURSEMENTS Online access to bank statements enables more transparency and can reduce risks. ED and EA can have read only access. Source: AICPA Not-for-Profit Section 17

CONTROLS OVER CASH RECEIPTS Rule #1 For every person who handles the money (checks and cash) before it goes into the bank, you need some sort of control process to make sure they don t skim. Rule #2 Limit the number of people who handle the money before it gets to the bank. Source: AICPA Not-for-Profit Section 18

CONTROLS OVER CASH RECEIPTS Controls over fundraising events Cash is handled by volunteers Raffle tickets are sold by volunteers Controls over contributions Promises to give On-line donations Credit Card Cash 19

CONTROLS OVER CASH RECEIPTS Controls over program receipts Diverse programs with multiple funding sources No single set of controls will work in every organization If someone were to steal, who would catch it? 20

CONTROLS OVER FINANCIAL REPORTING Monthly balancing procedures Justify each asset and liability account every month Agree to reconciliations and/or to subsidiary schedules Scan the general ledger for each account every month. Are entries into revenue and expenses appropriate? Departmental budget to actual comparisons Send to department managers Heavy reliance on manual spreadsheets Someone other than the preparer should periodically test the critical spreadsheet formulas. Source: AICPA Not-for-Profit Section 21

WHAT IS FRAUD?

FRAUD TYPES Fraudulent financial reporting Intentional misstatements or omissions (amounts or disclosures) designed to deceive financial statements users Misappropriation of assets Theft of an entity s assets TIP: It may be helpful to discuss the differences between legal and accounting fraud with staff and personnel. In some cases, staff and clients may approach fraud in its legal rather than accounting definition

FRAUDULENT FINANCIAL REPORTING Management override of controls Difficult to detect Management withholds evidence Misrepresentation of information in responding to auditor inquiries Falsification of documents Manipulation, falsification, or alteration of accounting records or supporting documentation Misrepresentations or intentional omissions Intentional misapplication of GAAP

MISAPPROPRIATION OF ASSETS Typically these types of misappropriations occur through Embezzlement of receipts Stealing assets Causing the entity to pay for goods/services it hasn t received

ASSETS SUBJECT TO MISAPPROPRIATION Cash Cash equivalents food stamps; tuition vouchers; lottery tickets; gift cards kept as inventory Inventories of supplies and physical assets that are Small in size High in value High in consumer demand Easily convertible to cash Lacking in ownership identification Equipment that is subject to personal or non-program use phones, cameras, computers, vehicles, tools, etc.

COMMON SCHEMES Embezzlement of cash receipts and fraudulent disbursements Diversion of physical assets inventory, supplies, equipment Procurement and contracting frauds Diversion of program benefits and assets Personnel frauds Time Theft Fictitious Employees

WARNING SIGNS Warning! An organizational culture of arrogance and management entitlement. Warning! Accounting policies relying too heavily on management s judgment. Warning! Accounting policies that seem too aggressive especially in light of accounting and finance staff expertise. Warning! Overly centralized control over financial reporting especially in organizations with larger or more adequate staff in the areas of accounting and finance. Warning! Departure of key senior management personnel.

WARNING SIGNS, CONT. Warning! Failure to listen to key accounting/finance personnel within the organization. Warning! Receivables growing at a faster rate than the related revenues. Warning! Periods of prolonged success especially when economic, industry, or organizational conditions indicate otherwise. Warning! Difficulty in paying bills on a timely basis or less timely than in prior years. Warning! Transactions lack economic purpose (may be indicative of kickbacks as well as misappropriation of assets or financial statement fraud).

THE FRAUD TRIANGLE Opportunity Incentive or Pressure First developed by criminologist Donald Cressey in 1953 Fraud Rationalization or Attitude

OPPORTUNITY Governmental and not-for-profit organizations may have a number of locations taking cash in payment of services. In the case of the not-forprofit organization, significant amounts of cash may be received at either central or offsite locations. Additionally, such cash may be collected by persons, such as volunteers, lacking knowledge of existing internal controls.

INCENTIVE OR PRESSURE Governmental organizations feel pressure to provide more or higherquality services at a time when elected officials are reluctant to increase tax rates or user charges. Not-for-profit organizations may have an incentive to overstate revenues and results in an effort to obtain additional grant funds or contributions from resource providers.

RATIONALIZATION OR ATTITUDE Employees of governments and not-for-profits are often paid less than their counterparts in the private sector. Some employees rationalize misappropriation as compensation for their low salary levels.

REVENUE: FRAUD INDICATORS Warning! Significant or unusual adjustments to receivables at or near year-end. Warning! Documentation relating to cash receipts is missing or altered. Warning! Cash flow from operating activities is inconsistent with actual cash flow. Warning! Significant or unusual entries to reconcile major revenue accounts.

REVENUE: FRAUD INDICATORS Warning! Warning! Significant or unusual adjustments to receivables at or near yearend. Documentation relating to cash receipts is missing or altered. Warning! Cash flow from operating activities is inconsistent with actual cash flow Warning! Significant or unusual entries to reconcile major revenue accounts.

THE TYPICAL EMBEZZLER Trusted Employee Dedicated and often works long hours Dislikes mandatory vacation policies Typical Fraud Steps 1. The fraud is committed 2. Perpetrators receive the benefits of the fraud 3. The fraud is concealed Resents cross-training Seen as likeable and generous Deceptive and usually an adept liar

WHAT CAN YOU DO TO PREVENT FRAUD?

HOW CAN WE PREVENT FRAUD? If the tone at the top is one of zero tolerance and if fraudsters are promptly disciplined, employees may be less likely to commit fraud. A positive and open work environment, at all levels of the organization, also helps in preventing, detecting, and deterring fraud.

BRAINSTORM What could go wrong? Who could steal and how? Engage in this process at least once a year Engage in this process whenever there is a change Key personnel Organization structure Systems Transactions Source: AICPA Not-for-Profit Section 39

QUESTIONS? This presentation is presented with the understanding that the information contained does not constitute legal, accounting or other professional advice. It is not intended to be responsive to any individual situation or concerns, as the contents of this presentation are intended for general information purposes only. Viewers are urged not to act upon the information contained in this presentation without first consulting competent legal, accounting or other professional advice regarding implications of a particular factual situation. Questions and additional information can be submitted to your Eide Bailly representative, or to the presenter of this session.

THANK YOU Pam Eggert Partner peggert@eidebailly.com 602.684.0876