After tracing the usefulness of financial information largely dependent on the type of recipient, it is time to consider the question of credibility. Reliability is linked to utility. For its purposes, financial information should be absolutely credible. This is a sine qua non condition.
A typical situation in this area, often encountered under crisis conditions, is the financing of banks subject to the fulfilment of selected financial indicators of the so-called Covenants.
When we are wondering what makes financial information unreliable and therefore not useful, there are financial information irregularities, the risk of these irregularities and the factors that make this risk conditional. In order to effectively address irregularities in financial statements, the risk of them arising and the factors on which these risks depend should be identified and the possibility of eliminating or minimising them should be considered.
There are many risk factors. The most common ones, most often encountered by statutory auditors during audit work, are:
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- high expectations from the external environment to meet unrealistic forecasts or optimistic press releases,
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- threats to company stability and profitability,
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- the risk of individual financial position of managers (e.g. bonuses),
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- factors relating to the specific characteristics of the business or industry, which result, inter alia, in the complexity of transactions, the existence of significant transactions with related entities or a dominant market position,
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- unstable or not adapted to the size and nature of the unit,
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- a malfunctioning internal control system, due to: ineffective controls, inadequate allocation of responsibilities and competences, insufficient supervision by the Management Board;
Risks related to expectations from the external environment and the implementation of financial forecasts relate primarily to public companies. The exchange rate and perception of the Company and its management depend on meeting the forecasts and announcements of analysts.
In cases where the assumptions may not be met and the position of the Management Board is at risk, the risk of introducing a deliberate error in the financial information that will allow for the creation of an additional ‘paper profit’ increases significantly.
The same happens when the company's stability and profitability are threatened. The typical situation often encountered in the context of the crisis is banks' financing, subject to the fulfilment of selected financial indicators of so-called covenants.
In order to ensure the continuity of funding, which may be threatened not only by the loss of the stability of the entity, but also by the reduction of profitability as a result of the increase in financing costs (as a result of the need for a new more expensive loan or interest rate increase by the existing bank), company boards often manipulate the results.
This is done by, for example, lowering the amount of up-to-date write-downs, incorrect estimates for provisions and accruals, or manipulating the degree of progress of long-term contracts.
The risk factor associated with the risk of individual financial position of employees exists in companies where bonus remuneration based on financial indicators takes place. In practice, this risk often applies to those in senior management who, through deliberately incorrect financial information, show the situation of the company better than in reality, want to provide themselves with the conditions necessary to obtain the bonus.
Other risk factors arising from: the specificity of the industry and the nature of the activity, the unstable or unsuited organisational structure, or the inadequacy of internal control systems, are the factors which cause or may cause a mess to the unit.
As is commonly known in the chaos environment, there are far greater possibilities of creating all kinds of errors that may be both deliberate and unconscious. In such an environment, the effectiveness of detecting irregularities is also significantly lower, giving potential dishonests an additional impulse to act.
How can we counteract these risks and materialise them? Surely, it can often protect an effective internal control system, designed and implemented in such a way that the controls correspond to the identified risk factors of irregularities. This system should be assisted by an efficient risk identification and management system.
In this respect, too, it is worth considering the use of the competence and experience of the statutory auditor, which is due to the knowledge of internal control systems and supervisory systems used in many different sizes and from different sectors.