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Context in Financial Reporting

July 19, 2016

Here are some financial reporting illustrations of where something can be taken out of context. Sometimes very small changes can have a great effect. This needs awareness and understanding of the true situation.

In financial reporting sometimes a small change has to be considered in the right context. For instance can an $18,000 adjustment to a cost of sales item have any relevance to a company with $50 million in sales and $30 million cost of sales?

  • Suppose it causes a $10,000 loss to become an $8,000 profit? In effect the “fence” around the bottom line is gone. Wouldn’t that change people’s perception of the Company’s performance?
  • Suppose that same company and the same $18,000 change, but the profit is $8 million and there was an embezzlement of $230,000 by an inventory clerk? Would that change the impact of what happened? Probably not at all UNLESS it hid a defalcation involving an individual customer’s account receivable.
  • Suppose the person was in charge of the inventory?
  • What about if it was the controller? Would it affect your opinion?
  • Suppose it was the controller and it had been going on for four years and this year’s amount was $230,000 and last year’s $150,000 and $80,000 year before and $20,000 the first year?

I think context matters, but it needs an awareness of the big picture and an understanding of the consequences of what has occurred. Looking at the numbers and using ratio analysis sometimes doesn’t reflect the real issues and can present everything out of context.

In all due respects many audit procedures and review analytics deal with ratio and trend analyses, materially and the effect on the financial statements as a whole. Using all of the standard procedures and checklists properly makes is highly unlikely that an $18,000 item would show up any of the above. However, looking for an out of context possibility can perhaps remove the highly from the unlikely.

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