This article is an extract from TLR – The Global Damages Review, 6th Edition. Click here for the full guide.
Financial damages analyses calculate the difference between the financial results that ‘would have’ occurred absent the actionable event, and what actually transpired.2 The assessment of the financial performance of an operating entity includes an examination of the entity’s historical operating results as recorded in its accounting records and reported on its financial statements.
For entities with stable operations, past financial results are often a good predictor of the ‘but-for’ results that the entity would have realised absent the event. In such circumstances, the analyst inherently assumes that the entity’s past, pre-event financial performance would have continued, absent the event. Some minor adjustments to the pre-event results may be required to reflect changes in circumstances, but often these changes are small in nature.
In other circumstances, pre-event financial results are a poor proxy for the ‘but-for’ scenario. However, this does not mean that the past results are irrelevant. Projecting what would have occurred in the but-for scenario still requires an understanding of how the entity’s revenues and costs vary as production or sales volumes change, commonly referred to as cost-volume-profit analysis. Deconstructing past financial results often uncovers important relationships between revenues, costs and volumes, which is information that underpins the analyst’s but-for financial projection.
Analysis of accounting records also informs the analyst’s assessment of the entity’s actual financial performance and position after the event.
Those involved in assessing financial damages should be interested in the accounting concepts, rules and practices underpinning the preparation of accounting records and financial statements because understanding the accounting framework provides important insight into what the data shows and also speaks to its inherent limitations. From an evidentiary standpoint, accounting records and financial statements are contemporaneous business records that often provide detailed explanations of past transactions and financial events, information critical to proving the financial effect of the event. One cannot evaluate the nature and purpose of past transactions without first understanding the rules governing how the transactions are documented in the entity’s financial records.
The discipline of financial accounting concerns the rules and practices by which an entity’s transactions are quantified, evaluated and aggregated in its accounting records, with similar transactions being grouped into an ‘account’. Each account is assigned an account number, and these accounts reside within the entity’s general ledger. Accounts are organised within the general ledger by classification. For example, different fixed-asset accounts (automobiles, computers, furniture, etc.) are grouped together under ‘fixed assets’ in the general ledger.
An accounting system with a relatively high number of accounts allows one to categorise transactions into more homogenous groups. For example, instead of having just one general ledger account for all automobiles, an entity may have separate accounts for automobiles at the head office, the warehouse and the manufacturing plant.
Periodically, the balances in similar accounts are aggregated and reported as a line item in the entity’s financial statements. For example, the balances in all of the automobile accounts would be added together and reported as the line item ‘automobiles’ on the entity’s balance sheet. Financial statements can be prepared for any period, but are most commonly prepared on a monthly, quarterly and annual basis.
Financial statements speak to three attributes of the entity’s financial circumstances, being:
- the financial position of the business at a point in time (on the balance sheet);
- the financial results (profit or loss) from operations over a specified period (on the income statement); and
- the change in the business’ cash position over a specified period (on the cash flow statement).
II International financial reporting standards
For sophisticated entities, financial accounting is governed by rules that provide a degree of standardisation in how similar transactions are recorded and presented on an entity’s financial statements. The International Financial Reporting Standards (IFRS) are a set of accounting standards developed to provide a standard global framework for public companies.3
The IFRS Foundation is a non-profit public interest organisation responsible for developing a global set of high-quality accounting standards. The Foundation’s objectives include improving comparability of financial information by enhancing transparency and quality, strengthening accountability by reducing the information gap between investors and business operators, and contributing to economic efficiency by helping investors identify opportunities and risks in business ventures.
IFRS is a principles-based system4 with broad guidelines, allowing for the use of the accountant’s professional judgement in their application. Professional judgement is required because a single set of standards cannot anticipate every possible nuance or situation. However, increased subjectivity in accounting standards may lead to reduced comparability across entities.
The most common measurement basis in financial statements is the historical cost of the item – the amount expended or received. For example, the historical cost of manufacturing equipment is the cost to acquire the machine; wages payable are recorded at the amount owing at the time the liability is incurred. In some circumstances other bases are used, including the realisable5 value (e.g., to set to market the marketable securities that the entity continues to hold on the balance sheet date) and present value6 (e.g., to measure the current value of liabilities associated with future pension obligations).
III Fundamental qualitative characteristics of financial reporting and accounting
i Faithful representation
It is a fundamental tenet of IFRS that financial information should represent the relevant economic phenomena in a manner that is complete, neutral and free from error.
A complete depiction of a phenomenon includes all the information necessary for the user to understand that phenomenon.
A neutral depiction means that the basis of reporting is free from bias in selection and presentation. This includes ensuring that phenomena are not discounted or afforded undue emphasis.
Free from error means that there are no errors or omissions. It does not mean accuracy in all respects. For example, a bad debt expense is management’s estimate of the proportion of accounts receivable that are likely uncollectible at a given point in time. This estimate is a faithful depiction if the amount is clearly described as an estimate and that the estimate has limitations.
Accounting standards are designed to provide relevant information to the users. Relevant information can make a difference in the users’ decisions, whether or not they take advantage of it.
Relevant information can have predictive value, confirmatory value or both. Data has predictive value if it is relevant to forecasting financial performance, and confirmatory data is used to confirm or amend previously held views and conclusions.
In a damages analysis, historical financial statements are relevant in both respects. The information is often predictive, and is thus used as a starting point to project future financial performance (absent the event). The data in financial statements can also be confirmatory to the extent that it speaks to the financial effect that the event has had on the financial performance or position of the entity.
That said, an entity’s accounting and financial reporting systems are set up to fulfil statutory reporting requirements and provide management with key operational information; the systems are not often specifically designed to accommodate what can be the somewhat unique information requirements in an exercise to prove financial loss. This limitation on the usefulness of accounting systems in the context of proving financial loss has been ameliorated in recent years as modern accounting systems store data in relational databases, and these systems are capable of aggregating transactional data in a customised format that is responsive to the somewhat unique needs of the damages expert.7 However, even with these technological advances the accounting and reporting systems are but one source of relevant information concerning the affairs of the business. For example, the state of the entity’s relationships with its customers, suppliers, lenders and employees, or management’s expectations for the future will not be evident in financial statements and the general ledger alone. Thus, the analyst must examine other relevant financial information, such as contracts, agreements, financial forecasts and industry information.
The challenge in financial reporting is to distil a large volume of what are often complex transactions into a relatively brief, understandable format. The premise underlying IFRS is that the user has a reasonable knowledge of the business and that the user will review the financial statements diligently.
Given the natural tension between the competing objectives of relevance and understandability, financial statements cannot be all things to all users – certain users may need to seek additional information from other sources (including the accounting records underpinning the financial statements), and the assistance of financial and accounting experts.
For example, if the analysis involves valuing the shares of the business, the analyst will examine the data reported in the financial statements, but this information is often at too high a level to complete the picture. For example, management salaries are an expense amount reported in aggregate on the financial statements that is often examined in greater detail to determine which costs are required to operate the business as opposed to amounts incurred for tax planning or other purposes. The financial statements commonly report total salaries expense as a line item on the income statement, but not who was paid what during the year. For that level of detail, the analyst must refer to the source accounting records, including payroll records and general ledger account detail.
Information is material for financial reporting purposes if its omission or misstatement on the financial statements could influence the user’s evaluations or decisions. The determination of what constitutes a material item is largely a matter of professional judgement. For example, a US$100,000 misstatement in a small business may be material, but may not be for a large multinational entity.
In a damages analysis, the threshold of materiality is often much lower than the level governing the preparation of the entity’s financial statements. As such, the analyst will often examine the underlying accounting records, which have more detailed and disaggregated information (that is not material to present on the financial statements).
Comparability refers to the consistency of an entity’s results across time periods and is enhanced when similar events and transactions are treated consistently in the entity’s accounting records. Comparability also refers to the ability to benchmark results among different reporting entities.
There is a natural tension between relevance and comparability; more rigid accounting rules may result in a one-size-fits-all approach in reporting what can be a somewhat heterogenous set of transactions. Broader guidelines that leave more to the accountant’s judgement may provide the flexibility needed to better capture the essence of the transactions (enhancing relevance), but these judgements are subjective, possibly leading to variances in accounting treatments and reducing comparability.
vi Timeliness and cost
Timeliness and costs are constraints to financial reporting. In regard to timeliness, information is only relevant to the extent it is available to the decision makers before they have made their decision. The longer one takes to prepare the financial statements, the less relevant that information is to the decision maker, even if the interim time is spent gathering more precise data. Similarly, the cost of producing additional analysis may outweigh the value and materiality to the user.
IV Elements of the financial statements
The five elements of financial statements are assets, liabilities, equity, revenues and expenses.
An item that meets the definition of an element should be recognised if:
- it is probable that any future economic benefit associated with the item will flow to or from the entity; and
- the item has a cost or value that can be measured with reliability.8
The financial statements also include notes, which provide further information on amounts reported in the financial statements and other issues affecting the business.
In some circumstances, where an item is not recognised in the financial statements, note disclosure is included. The amount of the potential benefit or cost need not be certain to be reported.
i The balance sheet
The financial position of an entity at a specific point in time is reported on its balance sheet, which separately lists the entity’s assets9 and liabilities,10 the net of which is the entity’s equity position.
Assets are reported (on the balance sheet) when the cost can be reliably measured, and it is probable that future economic benefit will flow to the entity.
Economic benefits include items that furnish capacity to produce goods or services (e.g., equipment), items that can be exchanged for other assets held by another entity (e.g., inventory) and items that can be used to settle a liability or can be distributed to the owners of the entity (e.g., cash and marketable securities).
Many long-term assets are depreciated across their useful lives, under a systematic process where an expense is recorded and the asset’s carrying amount is reduced each period by that same expense amount.
The entity need not own the item to expect to receive future economic benefit. For example, a leased item may be classified as an asset because the entity will realise long-term future economic benefits from the lease, even though the entity does not own the underlying leased item.
Assets can be classified as tangible or intangible.11 For example, manufacturing equipment is a tangible asset, as its economic benefits derive from its physical properties. In contrast, a patent is an intangible asset because the value of the asset comes not from the physical legal document evidencing the patent, but rather from the legal rights of the patent. Assets are periodically tested for impairment, and the value is written down if the future benefits are lower than the carrying value. While these analyses can be useful information in the context of a damages analysis, it is important to appreciate that the carrying value of assets on financial statements are set in the context of financial reporting, not in the context of litigation, and often more detailed analyses is required to prove financial loss.
Liabilities are the present obligations of the entity. In this context, the obligation is a duty or responsibility to act or perform in a specific way. For example, accounts payable arise when the entity has received goods or services and has undertaken to pay for those goods and services at some point after delivery. Some obligations are legally enforceable by contract (e.g., loans) or statute (e.g., taxes payable). In other cases, an obligation may arise from voluntary business decisions. For example, if an entity decides to rectify a complaint even though not legally required to do so, the total future cost of rectification may meet the liability test.
Liabilities are recognised when the cost of the liability can be reliably quantified. Where this is not the case (e.g., when the outcome of a pending lawsuit is uncertain), the entity may still be required to provide information concerning the obligation in the notes to the financial statements.
Equity is the difference between the reported values of the entity’s assets and liabilities. It is the residual interest attributable to the owner of the entity. This ‘value’ to the shareholders reflects valuation rules applied in the context of financial reporting; in most cases the fair market value of the shareholder’s equity will be different.
Equity can be broadly organised into two categories:
- amounts contributed by the owners of the entity; and
- retained earnings, being the cumulative net income that the entity has earned in the current and past reporting periods that has not yet been distributed to the owners.
v The income statement
The entity’s financial performance (i.e., profit) is measured as the difference between its income and the expenses it incurs to earn the income. The net result is the entity’s net income (or loss) for the period and this is reported on the entity’s income statement.
Income is the economic benefits flowing to the entity in the form of cash or enhancements to its assets, or reductions to its liabilities. Income includes benefits derived from normal operations (the sale of goods or the rendering of services) and amounts from unusual or non-recurring activities such as the gain on the sale of manufacturing equipment (where proceeds exceed the carrying cost of the item). For the purposes of financial reporting, it is often the case that income from core activities and unusual and non-recurring income amounts are segregated on the income statement so that the user can more easily evaluate the results from the entity’s core operations.
Expenses are the outflows of economic benefits from the business that the entity undertakes in the expectation that the outflow will provide resources, such as goods, services or efficiencies to the business in furtherance of its objective of earning income.
The matching principle is a tenet of financial reporting, stating that expenses are to be reported in the fiscal period in which the economic effect from the expenditure is realised.
In many circumstances matching the expenditure and economic effect from the expenditure is simple. For example, wages are paid in return for services rendered by employees, and for most of the year the cost and economic benefit are realised in the same fiscal year. However, consider the circumstance at year-end (say, 31 December); employees have provided services in the last two weeks of December and are paid for these services in January of the following year. If one were to record the expense when the wages were paid (in January of the following year), there would be a mismatch between the year in which the economic benefit was received and the year in which the expense was recorded in the financial statements.
Accrual accounting applies the matching principle, under which expenditure is accrued, to reallocate the expense from the period of the payment to the period in which the economic effect from the expenditure was realised. In the example above, the wages expense is reallocated from January to the previous December.
Another common example of accrual accounting involves the accounting treatment for capital assets, such as manufacturing equipment. While the expenditure to acquire the asset occurs in one fiscal year, the economic benefit from the expenditure (provided by the continued use of the equipment over time) is realised over several subsequent years. In this circumstance it would be inaccurate to reflect the entire expenditure to acquire the equipment as an expense in the year of acquisition. Instead, the costs are spread over the economic life of the item, through depreciation expense. In essence, portions of the capital asset are transferred from an asset (on the balance sheet) to an expense (on the income statements) as the economic life of the asset is consumed over time.
Another category of expenses pertains to unusual and non-recurring non-operating expenses. These amounts often relate to reduced asset values arising when the reported value of an asset has diminished during the year, either because of market forces (e.g., in the case of marketable securities) or as a result of a loss on sale of an asset (i.e., where the proceeds from the sale are less than the carrying value of the item in the entity’s accounting records).
It is often the case that expenses from core activities are segregated from the unusual and non-recurring amounts so that the user of the financial information can more easily evaluate the results from the entity’s core operations.
viii Cash flow versus net income and the statement of cash flow
Net income, the difference between the entity’s income and expenses, is a measure of the profitability of the business. Profit is a useful measure of the long-term viability of the entity. However, cash flow is also vital to the business – an entity can be profitable and yet its ability to operate can still be threatened by a shortage of cash.
This disconnect between accounting profits and cash flow arises, in large part, from the matching principle and accrual method of accounting.
If all of the entity’s income and expenses are received and paid in cash, then its net income equals its cash flow. For most entities this is not the case. Consider that income is realised when the benefit has been earned, even if the cash is only received later. For example, a law firm may issue an invoice on day one, and recognise the income on that date, but will only realise the cash inflow on a later date (when the client pays the invoice).
The same holds true for expenditures. Consider the previous example of manufacturing equipment. It is acquired on day one and, because it is expected to contribute economic benefits over several years, it is recorded as an asset (typically at the cost to acquire the item). For simplicity, assume that the entity paid cash to acquire the asset. All the cash outflow is realised on day one even though no expense (which reduces net income dollar for dollar) has yet been recorded. Subsequently, the asset value is then reduced in increments to reflect that portion of the economic life of the asset that is consumed in operations each period, and the incremental consumption in any given period is reported as depreciation expense (which reduces net income) – but there is no cash outlay from this event.
The statement of cash flow reports the business’ sources and uses of cash over a specified period. Sources and uses of cash arise from the operating results of the business (net income adjusted to reflect changes in non-cash balances during the period); financing activities (increases in bank financing, repayments of bank financing, or changes in the amount of equity invested in the business); and investment activities (cash expenditures on items such as new investments in plant and equipment).
In terms of assessing financial loss, one examines the income statement, but in many cases the most accurate basis to measure the loss is based on cash flow, and the analyst will adjust the reported profitability to reflect the timing differences between net income and cash flow and then measure the entity’s financial loss based on the diminution in cash flow post-event.
In the context of quantifying financial loss, financial statements provide important information. However, in most cases, the aggregated data in the financial statements is at too high a level to establish the specific dollar value of a financial loss arising from an event. To isolate the financial effect of an event, the analyst must look behind the financial statements, to the entity’s underlying accounting and business records.