The leading cause of financial restatements changes from year to year. As separate studies show the most common types of errors are revenue and expense recognition.
As it was reported in August 2007, Dell would restate more than 4 years of its financial results due to accounting adjustments that appeared to have been made to hit financial targets.
Most of the changes to the statements were related to the recognition of revenue and expenses.
What is a sale and how to book it?
In December 1999, the SEC (more about SEC) issued Staff Accounting Bulletin No. 101 (SAB 101) and outlined the 4 criteria for recognizing revenue:
1. Evidence of an arrangement
2. Delivery has occurred or services have been rendered
3. The price is fixed and determinable with payment obligation evident
4. Collectability is reasonably assured and any unpaid amount can be reasonably estimated
This guidance is provided because the general criteria of revenue recognition were sometimes difficult to interpret. In December 2003, the SEC released SAB 104, which includes a revised version of SAB 101.
A good example of the revenue recognition issue is Lucent Technologies with a case when Lucent was able to report continued sales growth due to early booking of its revenue on inventory that was shipped but could be returned at some point in the future. The restatement erased $680 million in revenues, the operating profit turned into a loss.
The expense recognition principle requires that expenses are matched with revenues (The matching rule). Expenses need to be matched with the revenue in the period when the company makes efforts to generate those revenues.
As we see, the balance sheet and the income statement must contain all relevant and correct information applicable to the period ending. This is why revenue and expense recognition principles are important.
Although operating a business is a continuous process, financial reports must have a cutoff point with adjusted transactions that span this point.
Adjusting entries and adjusted transactions are needed to ensure that the revenue recognition and expense recognition principles are followed. Otherwise it would be easy to manipulate with financial statements. Simply, adjustment is needed when “something” is overstated or understated. So we need to adjust “something” in order to have up to date financial statements with relevant numbers.
Accrual accounting encompasses revenue recognition, expense recognition and adjusting the accounts. We may recall the post about accrual accounting.
Adjusting entries can be classified as either deferrals or accruals:
1. Deferrals (Prepayments) can be prepaid expenses or unearned revenues
2. Accruals are either accrued revenues or accrued expenses
Every adjusting entry will include one income statement account and one balance sheet account. Cash account is not involved.
1. Prepaid Expenses (Deferred Expenses): expenses paid before they are incurred. Prepaid expenses expire with the passage of time or through use and consumption.
Simply: Assets overstated -> Expenses understated so Asset account is credited and Expense account is debited.
Examples of prepaid expenses include supplies, rent, insurance and property tax.
2. Unearned Revenues (Deferred Revenues): Revenues received in cash and recorded as liabilities before they are earned, revenues are subsequently earned by performing a service or providing a good to a customer.
Simply: Liabilities overstated -> Revenues understated so Liability account is debited and Revenue account is credited.
Examples of unearned revenues include rent, magazine subscriptions, airplane tickets etc.
1. Accrued Expenses: expenses incurred during the period have not been paid.
Simply: Expenses understated -> Liability understated so Expenses account is debited and Liability account is credited.
Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable.
2. Accrued Revenues: revenues earned during the period have not been recorded.
Simply: Assets understated -> Revenues understated so Asset account is debited and Revenue account is credited.
Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable.