In working with attorneys in the United States and foreign countries, I’ve noticed that many of them are uncertain of what they are viewing when they analyze financial statements. While they know not to take financial statements at face value, they don’t know how to unlock what is behind what they see.
My overall approach when viewing financial statements is to remember the famous quote attributed to Benjamin Disraeli — “There are three kinds of lies: lies, damned lies and statistics.” I bring that level of skepticism to financial statement analysis.
My first step in reviewing financial statements is to put them into a relevant context by obtaining a company’s or individual’s financial history over multiple or sequential fiscal periods. This makes it more likely that I will spot trends and anomalies leading to a more complete picture.
These trends and anomalies are dependent on the business and activities of a company or private individual. The financial statements of a law firm will appear considerably different than those of an auto parts manufacturing firm. Capable financial analysis requires in-depth knowledge of the economic idiosyncrasies of each industry and individual or the knowledge of where to get the in-depth information. This applies to every area of legal practice involving financial statements, tax returns, securities and insurance just to name a few.
In my experience numbers are the result of events and circumstances not obviously reflected by the numbers themselves. Amounts must necessarily be considered and understood in the context from which they arise. Combining a panoramic perspective with a vertical perspective is a requirement for effectively analyzing financial statements and the documents that provide for their foundation.
When speaking about vertical thinking, I mean simply drilling down to determine whether everything classified in a particular category belongs there. When using exclusively vertical thinking, there is no perceived need for questioning or looking beyond the obvious. Here is an example of vertical thinking when looking at a financial statement: Financial records for an individual show that she has been depositing $5,000 per month into a bank account. Her submitted personal income tax return reflects a total of $60,000 in annual revenue. Her monthly bank deposits and reported annual income match. Under the vertical thinking scenario, the monthly income of $5,000 is presumed to be correctly classified in her financial statements.
Panoramic thinking is connecting and disconnecting information depending on how it both logically and intuitively relates to the numbers included in the financial statements. That means that I search out logical sequiturs and non-sequiturs, which are all parts of the context from which financial information arises. I consider this kind of thinking looking at the big picture.
When I analyze a financial statement using panoramic thinking I am examining one piece at a time in the context of the entire financial picture presented. As a result I am obtaining an unobstructed or a complete view of the financial statement, from every one of its angles. Using the same scenario as I used in the vertical thinking example, I might draw a completely different conclusion.
In the vertical thinking scenario, the financial statement reflects a woman depositing $5,000 a month into her bank account. She has also provided tax returns that show a reported annual income of $60,000. Upon further inquiry I may discover that the tax return on file with the IRS is materially different than the one that she provided to a credit authorizing authority. The annual income included in her financial statement maybe $60,000, but that $60,000 may in fact be loans or gifts instead of income. Any of these facts would alter my thinking about the truthfulness of the information contained in her financial statement.
I believe that accepting a financial statement at its face value for one period in a vacuum has the potential for allowing financial fraud. While taking a closer look on a panoramic basis may pleasantly or unpleasantly surprise you, not doing so may prove disastrous.
Miami-based forensic account Stanley I. Foodman is a former auxiliary special agent for the Florida Department of Law Enforcement and has worked as a consultant to the Miami office of the U.S. Attorney in the are a of civil RICO money laundering recoveries. Foodman is a member of the Society of Certified Fraud Examiners and a member of the Supreme Court of Florida Circuit Committees On The Unlicensed Practice of Law. He can be reached at email@example.com.
Monday, February 26, 2007
BY STANLEY I. FOODMAN
SPECIAL TO THE NATIONAL LAW JOURNAL