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When Financial Statements Do Not Provide the Full Story

 

Analyzing financial statements helps reveal the creditworthiness of a customer, piecing together the figures to paint a picture of a customer’s level of risk. Beyond the traditional methods of financial statement analysis, credit scores, etc., creditors must also take internal controls into account as well⁠ should they have reason to believe something is amiss.

According to a recent article by The Street, the Securities and Exchange Commission (SEC) just settled its case with KPMG for $50 million. The case in question had little to do with financial statements, but rather, KPMG’s “employees … [who] cheated on internal training exams and altered past audit work based on stolen information,” according to the article. This, subsequently, heightened the credit risk of KPMG.

"KPMG's ethical failures are simply unacceptable," SEC Chairman Jay Clayton said in a press release.

As a creditor contemplates how to approach a potentially risky customer and internals can impact how creditworthy a customer is, they should not be the first piece of information analyzed or considered. Internals should be “corroborated after the fact,” said Charles Mulford, Ph.D., professor of accounting at the College of Management at Georgia Tech. Internals offer more context when analyzed next to a risky financial statement.

“Do you have reason to believe the company has the controls to accurately report transactions?” Mulford said. “... The idea that if you have strong controls, they have their stuff together, and you can rely on financial statements. But the controls go further.”

When considering internal controls, Mulford warned that not every company has its controls audited: Larger companies are required by law to be audited, but smaller ones are not. KPMG, a large corporation, likely received audits, making its internal control data more accurate than if the data were to come from a small company with no auditor.

With internal control data, creditors should remember the information may or may not be audited. Financial statements, conversely, are always audited, regardless of the size of the company. Whether a statement has been audited can impact the veracity of the data, and creditors should keep this in mind when considering methods to determine creditworthiness.

“It’s all a matter of, ‘Do they properly have the steps in place to evaluate collectability and accounts receivable?’” Mulford said. “Again, with good strong internal controls⁠—which you don’t see, but which directly impact the value and credibility of the financial statement⁠— the creditworthiness of the customer is determined.”

This story first appeared in NACM eNews.

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