A CFO recently told me that his monthly financial statements had a $1 million error in gross margin. Not so uncommon in a first draft, but five of his subordinates had already reviewed the statements and nobody caught the error (5 college graduates, 4 degreed accountants, 2 CPAs). The possible reasons for this breakdown include:
- Unqualified employees
- Untrained employees
- Too much work
- Failure to analyze the financial statements
- Unclear responsibility to review financial statements
- A lack of standards
In my experience people normally assume that 1 or 2 explain the problem. In fact, poor management reporting can highlight any of the six possible causes. Poor management reporting is one of the best indicators of company wide problems that I know of. Each of the six reasons highlights a larger issue in either human resources, operations, management or leadership.
I think that 1-5 are more obvious in how they relate to management disciplines, but perhaps standards requires further discussion. To what standard do you prepare your financial statements? There are three choices in reverse order of importance:
- GAAP (Generally Accepted Accounting Principles)
- Accurate (reflecting not only the form but also the substance of the transaction)
- Not misleading to the reader (the SEC's standard)
Most executives would say that they follow GAAP. This is a somewhat naive approach. Conforming to a particular accounting pronouncement fails to necessarily confirm that the substance of a transaction has been captured. If you pick the wrong pronouncement to account for a transaction, you follow GAAP but miss the transaction. For example, accounting for a transaction as a liability when it is really a derivative is a case where GAAP is followed but you have missed the substance of the transaction. Failure or slowness to recognize an impaired asset might be a case where the accounting is accurate but totally misleading. One could argue that the timing of an impairment is very subjective, which is exactly why the SEC sets their standard at "misleading". The standard for financial reporting is not GAAP or accuracy but the higher standard "to not be misleading". Establishing this standard, communicating it and enforcing it is the responsibility of both the CEO and the CFO and is a critical leadership responsibility.