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Automating the Measurement of Qualitative Characteristics of Financial Report

The SEC is creating a so-called "RoboCop" to help them detect fraud in financial statements. The SEC is putting together what they seem to be calling an "accounting quality model". They describe the accounting quality model as "being designed to provide a set of quantitative analytics that could be used across the SEC to assess the degree to which registrants’ financial statements appear anomalous."

The SEC is not the first group to think of this idea.  Back in 2009, a paper, Quality of Financial Reporting: measuring qualitative characteristics, was written on this topic.  In the paper, the authors describe a 21-item index which, they say, can be used as a measuring tool which can reliably access the "quality of a financial report".

But what exactly is "quality"?  Well, the FASB describes that in SFAC 8: Conceptual Framework for Financial Reporting. And SFAC 8 is part of a combined, comprehensive framework being developed by the FASB and IASB together. Chapter 3 of SFAC 8, Qualitative Characteristics of Useful Financial Information, discusses what contributes to quality.

You can go read through those characteristics which contribute to quality.  I want to focus on two specific things which are mentioned: "faithful representation" and "free from error".

While IFRS emphasizes the overarching notion of the financial statements providing a "true and fair representation" of a reporting entity; US GAAP does not specifically use those terms.  US auditing standards require this, "presented fairly".  "True and fair" is the term I have used to describe quality of a financial report.  I still stand by those terms even if US GAAP does not specifically call for them.  What, "untrue" and "unfair" are OK?  I think not.

But, OK.  Perhaps one wants to stick to the letter of the law and go for only a "faithful representation". Notice the word "representation".  The FASB does not use the words "faithful presentation" which is what many SEC filers are focused on it seems based on looking at their information.  The "free from error" portion has two dynamics.  To make sure that an SEC filing is free from error, you can either (a) check things manually or (b) check things using automated processes.  Automated processes reduce the risk of errors as humans can make mistakes.  But, in order to automate processes you have to develop and express rules in the form that a computer can understand.

If you are creating a financial report, particularly a digital financial report such as an SEC XBRL financial filings, I believe the following question is a good question to ask yourself: What have you done to prove to yourself that you have created a true and fair representation of the financial information expressed using XBRL?

Here are the details which should be considered when asking that question.  Are these things true?

  • Comply with financial reporting standards: Clearly a financial report must comply with the rules (i.e., IFRS, US GAAP including applicable SEC rules, industry/activity practices, other common practices), and reporting entity choices where they have such choices.
  • Full inclusion/false inclusion: Everything which should be disclosed has been disclosed as deemed appropriate by the rules and the reporting entity choices.
  • Foots, cross casts, ticks and ties: A financial report foots, cross casts, and otherwise "ticks and ties". All mathematical relations must be intact. All nonnumeric relations must be sensible and logical.
  • All financial report formats convey the same message: A financial report can be articulated using paper and pencil, PDF, HTML, XBRL, or some other computer readable formats. While the format may change, the message communicated, the story told, should not change. Each format should communicate the same message, regardless of the medium used to convey that message.
  • Justifiable/defensible report characteristics: Facts reported and the characteristics which describe those reported facts should be both justifiable and defensible by the reporting entity.
  • Consistency between periods: Financial information expressed within one reporting period should be consistent with the financial information expressed within subsequent reporting periods, where appropriate. Changes between report elements which existed in both periods should be justifiable and defensible as opposed to arbitrary and random.
  • Consistency with peer group: If a reporting entity chooses one approach/report element and a peer chooses a different approach/report element; clearly some good, explainable reason should exist for such difference.
  • Useful, sensible, logical renderings: Renderings of facts, characteristics describe facts, parenthetical explanations which further describe such facts, and other such model structures should make sense, be logical, and ultimately be useful in understanding the information. While there may be differences of opinion as to how to format or present such information; there is significantly less or no dispute about the logic. Disclosures are informational, they relate to information without regard to formatting or other presentational artifacts. The term "notes" relate to organizing disclosures and are presentational in nature. Someone creating a financial report has far more latitude and discretion as to how to organize disclosures into notes than they do as to what must be disclosed.
  • Unambiguous business meaning: A financial report should be unambiguous to an informed reader. The business meaning of a financial report should be clear/unambiguous to the creator of the financial report and likewise clear/unambiguous to the users of that financial report. Both the creator and users should walk away with the same message or story.

How many of these items above can be automated?  Clearly, automating everything is not possible. I contend that quite a bit can be automated.  If you look at what the XBRL Cloud Edgar Dashboard provides, you get a sense of the possibilities.

But I believe that what XBRL Cloud is providing is only the tip of the iceberg. The paper mentioned above has some great ideas. The FASB and IASB are providing useful guidance.

While things like the HTML versions of SEC financial reports are very good at following the accounting disclosure rules keep two things in the back of your mind. First, I am pretty sure that running automated tests over a set of financial reports will show "lapses in concentration" and other things which contribute to disclosures being missed. I have found plenty of mathematical errors just in the process of using existing financial information when prototyping; no doubt errors will be found resulting in an improvement in quality by having the ability to use automated testing processes. Second, the efficiency of using automated processes, where possible (and it is NOT always possible), will reduce costs.

Taking all this a step further, using the same notion as the SEC's "RoboCop" and testing the quality of financial reports seems very feasible. I believe that this will provide value to both accountants creating financial reports and the consumers of that financial information.

Posted on Sunday, March 17, 2013 at 07:53AM by Registered CommenterCharlie in | CommentsPost a Comment

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