How CPAs Analyze Financial Statements in Dissolution (Divorce) Cases

Information Provided by: Mark Kohn, CPA, CFE, CVA, ABV, CFF

What do forensic accountants look for when they review financial statements of a business provided to them by counsel? What are the signs that there are irregularities taking place? What are the typical types of financial statements?

There are three standards and three types of financial statements. The three standards are audits, reviews and compilations. The three types are balance sheets, income statements, and statements of cash flows (these sometimes have other names). This article will explain the standards, the types, and then the techniques used to analyze them. Keep in mind that these standards and types apply to financial statements prepared under generally accepted accounting principles (GAAP); the forensic accountant then studies these financial statements and conducts certain testing that will be described below, and he may report his findings to a court in a format that does not conform to the above standards and types.

Standards of Financial Statements

The first matter that is examined is what is called the standard of accountants’ services rendered in preparation of the financial statement. Generally, the higher the standard by the company’s CPA’s, the lower will be the intensity of analysis by the forensic accountants. One therefore looks to see what standard of financial statement is being presented and who prepared them. An audited financial statement is one that is tested to the greatest degree by the company’s CPA’s; a reviewed financial is tested to some degree, and a compilation does not have to be tested at all.

A compilation (a compiled financial statement) can simply be a presentation in the proper form of financial statement of financial information taken directly from the company’s records without any further analysis. In other words, to prepare a compiled financial statement, an accountant can simply look at a company’s general ledger or other financial information, accept the company’s numbers as being accurate. The accountant then simply collects the company’s numbers and puts them together on a piece of paper that is in the correct format of classical financial statements. There is no requirement to actually analyze the numbers to see that they are accurate. There are many accountants who prepare compilations with much better quality than this-they demand backup for many of the numbers and do other work, but that is not required for a compilation.

The second standard of financial statement is a review, and an accountant who prepares a reviewed financial statement is required to perform various analytical testing of the numbers so that the amounts appear reasonable.

The third standard is an audit, where the accountant performs a much greater level of testing of the numbers.

To illustrate the differences between the three standards, a company that sells goods on credit will have accounts receivable. To prepare a compilation, an accountant need only call up the company’s controller/bookkeeper and ask what is the amount of the accounts receivable. Whatever the controller/bookkeeper tells him goes on the financial statement as the amount of the accounts receivable. To prepare a review, the accountant will probably look at the company’s accounts receivable printouts, will compare this year’s amounts with prior year’s amounts, will compare this year’s amount of accounts receivables with this year’s sales, do the same for the prior year, and thereby try to see if the amount of accounts receivable appears reasonable. To prepare an audit, he will not only do what is done at a review level, but will actually send out letters to many of the customers asking them to write him back confirming that the amounts that the company said are owed are actually owed.

Therefore, in a dissolution matter, if a forensic accountant is given financial statements to analyze, he first tries to ascertain the quality of the statements. He will perform much more analysis if he is given compilations than if he were given an audited financial statement. He would also look at the firm preparing the financial statement.

A balance sheet (many firms call it a statement of financial condition) has two groups of numbers, both of which equal each other: they balance. The first group of numbers identify the assets of the company. The assets are reported on a cost basis, so that if, for example, a building was purchased many years ago for $500,000, and is worth two million dollars today, the balance sheet would show a building with a cost of $500,000. (The forensic accountant would then adjust the balance sheet to reflect that the current value is two million.) The second group identifies the liabilities and capital. The theory is that assets are acquired by either borrowing money or by investing money, and so the assets equal the sum of the borrowings and the invested capital. Looking at it a little differently, if one were to subtract the liabilities from the assets, one would arrive at the amount identified as capital.

Assets = Liabilities + Capital

Assets — Liabilities = Capital

To determine the net worth of the company, one looks at the capital amount; this represents the net assets that are left after paying off, or deducting, the liabilities. The capital on a financial statement would be what is called the book value of the company, and it represents the net worth of the company using historical costs. After appraisal adjustments by the forensic accountant, the capital would represent the real net worth, using current fair market values.

An income statement identifies the gross income or receipts of a business and then the expenses incurred, arriving at a number that represents the net income of the business.

A statement of cash flows identifies the financial history of the company from a cash basis point of view. It will also show how the cash flowed during the period-what was borrowed, what was invested, etc.

A balance sheet presents the financial condition of the company at a certain date-usually the last day of the fiscal year. An income statement and a statement of cash flows present a financial history of a period of time, usually for the current fiscal year. Thus, a set of financial statements for a typical company will be a balance sheet dated the last day of the year, and an income statement and statement of cash flows for the period of the past year.