Turning Accounting Risks into Opportunities

10 Apr

Risks are inherent part of every process we undertake. Risks that accountants face related to the compilation of financial statements need to be understood to be managed. Legislation is often used to provide internal controls in the form of requirements to address known risks, for example, the Companies Act 71 of 2008 and the International Standard on Related Services (ISRS 4410). This article explores the risks that accountants should be aware of when compiling financial statements and what should be done to adequately navigate them.

Managing risks is knowing what is important and placing more focus on it. Identifying risks is the first step in this process. Below we guide you on the first step of risk management: how to go about identifying risks for your clients.

What are the Financial Statement Risks?

In accounting such risk manifests in the potential that the financial statements may contain errors or misstatements. Accountants face the task of considering various risks to ensure the financial statements' accuracy and reliability. This is not just an operational necessity enabling stakeholders to make informed decisions, but also an issue of complying with legislative requirements.

The background: legislation and standards

The Companies Act of South Africa plays a crucial role in setting the stage for risk management in financial reporting. Sections 29 and 30 require companies to prepare financial statements that:

Fairly present the company's state of affairs and business performance,
In line with the prescribed financial reporting standards.

While ISRS 4410 does not specifically require accountants to manage accounting risks during the compilation engagement, it does provide a framework with specific requirements to ensure that financial statements are compiled responsibly and accurately. These requirements reinforce the importance of risk management in accounting practices.

In addition, when financial statements need to be reviewed or audited, accountants should be able to proactively identify and act on areas that may have higher risk.

Overall Risk Accountants Should be Aware Of

The overall, or high level, risk in accounting may be due to the external environment such as economic recessions or shifts in industry regulations. stay informed and ready to adjust financial statements as needed, aligning with the broader objective of providing a true and fair view as mandated by the Companies Act.

For example, there may be a new tax law on the treatment of employee incentives.

Misapplication of Laws: Incorrect or non-application of new tax regulations could lead to improper reporting and tax liabilities.
Delayed Implementation: Not quickly adjusting to new laws may result in back taxes, penalties, and interest charged by SARS.
Legal consequences: This may cause unhappiness among employees which can result in complaints, lawsuits or other actions.

Indicators of Fraud Risk

Fraud risk encompasses intentional acts of deception, from asset theft to inflating a company's financial performance. Accountants must employ vigilance and skepticism, implementing robust internal controls and regular audits to mitigate these risks. This aligns with the legal imperatives to maintain accurate financial records and report financial information transparently.

Fraud risks relating to financial information can be broadly categorized into two main types: fraudulent financial reporting and misappropriation of assets. Both types of fraud can have significant implications for the accuracy and reliability of financial statements. Understanding these risks is crucial for accountants, auditors, and financial professionals to safeguard against financial misstatements and losses.

Fraudulent Financial Reporting

Fraudulent financial reporting involves intentional actions by management, employees, or the organization to provide false or misleading information in the financial statements. This type of fraud is aimed at deceiving financial statement users about the organization's financial performance or financial position. Examples include:

Overstating Revenues: Recording sales prematurely or that never occurred to inflate revenue figures.
Understating Expenses: Delaying the recognition of expenses or not recording them to make the company appear more profitable.
Manipulating Asset Valuations: Overvaluing assets, such as inventory or property, to enhance the financial health of the company.
Missing Disclosures: Failing to disclose relevant financial information or providing misleading information in the notes to the financial statements, affecting the users' decision-making process.

Misappropriation of Assets

Misappropriation of assets, also known as asset misappropriation, involves the theft or misuse of an organisation's assets. This type of fraud does not necessarily directly affect the financial statements' bottom line but can indirectly impact financial performance and position if significant. Examples include:

Cash Theft: Stealing company funds, which may involve skimming receipts or fraudulent disbursements, such as fake invoices or payroll fraud.
Misuse of Company Assets: Using company assets for personal gain, such as personal use of company vehicles or embezzling resources.
Inventory Theft: Stealing physical goods or inventory, which can lead to discrepancies in inventory records and financial statements.

‘Red flags’ You Can Look Out For

Companies can be at high risk—both in terms of manipulating financial numbers and misusing company assets—when certain circumstances exist. Understanding these conditions can help in identifying red flags early and implementing preventative measures. Here are some situations that can increase a company's vulnerability to fraud:

1. Lack of Internal Controls

Poor management oversight and supervision providing employees with an opportunity to commit fraud without being caught.
Management override is evident whereby internal controls are bypassed by people in authority.
Inadequate separation of duties when one person is responsible for too much (i.e. recording, approval, and reconciliation of the transaction), creating an environment ripe for fraud.

2. Financial Pressure

Financial difficulties may result in companies being pressured to alter their financial statements to appear more financially stable to investors, lenders, or other stakeholders.
Unrealistic performance targets can pressure employees or management to manipulate numbers to meet targets, leading to bonuses or other incentives.

3. Rapid Business Growth or Expansion

Fast-growing companies may outpace their ability to implement robust financial controls, leaving gaps that can be exploited for fraud.
Rapid expansion into new, different markets or regions can introduce complexity and regulatory challenges that may be manipulated for fraudulent purposes.

4. Complex or Unusual Transactions

Hard-to-understand deals or complex, unusual transactions can be used to hide fraudulent activities, as they are harder to uncover. Make it a general rule to understand how transactions work. If you cannot understand something, it may be purposefully misleading.

5. Cultural Issues

While the following aspects are harder to uncover, they may indicate serious problems.

Toxic workplace culture where a company’s culture prioritises results over ethical behaviour, or where whistleblowers are punished, can encourage fraudulent activities.
Lack of ethical leadership acts unethically or turns a blind eye to unethical behaviour, it sets a tone that fraud is acceptable.

6. Technological Changes

Rapid IT changes where new technologies are implemented without adequate security and control measures may open new avenues for fraud.
Vulnerabilities in cybersecurity can lead to unauthorised access to sensitive financial information, increasing the risk of fraud.