Many accountants have been accused of being creative. Whilst this word is either used to tease the profession, or maybe insinuate skirting with accounting regulations, there is also some truth to this assertion. Accounting, unlike the physical sciences or engineering, where components have physical properties, is an art; the origins of accounting go back to mathematician Luca Pacioli. Pacioli, who had both skills as a magician and links with the artist Leonardo da Vinci, was an Italian monk who is now credited as the Father of Accounting Theory.
Though accounting principles are set out in standards, the standards themselves vary, with both the International Financial Reporting Standard (IFRS) and the Financial Reporting Standard (FRS102) being commonplace in the UK. The implementation of these standards is subject to interpretation by each individual, professional accountant, who must give a true and fair view of the entity on which they are reporting. However, the interpretation of the standards when preparing a set of accounts will vary depending on the individual’s background, commercial awareness, and risk appetite, amongst other factors.
Even assuming that the financial statements have been prepared by an appropriately qualified and skilled professional, practicing accountants would still expect to find considerable variation in their approaches, and therefore calculations of costs and profitability may vary between sets of accounts prepared for entities within the same industry (let alone the variations in approach that will appear due to differences in operations across a variety of industries).
Businesses cannot rely on the statutory audit alone for the purposes of gaining comfort around the detailed costs used in their accounts. The purpose of the statutory audit is to ensure that the accounts present a true and fair view of the company with no material discrepancies. The statutory audit process does not go into the level of detail required to confirm the accuracy of the costs, and further to this, many firms are classified as ‘small’ under the Companies Act, which states that businesses of that size do not require an audit, with the definition of small including companies with a turnover up to £10.2m and up to 50 employees.
Many insurance claims for stock loss or business interruption are reliant on calculating the accurate costs that have been, and will be, incurred by the insured. During these calculations, complexities can arise with discrepancies between the calculated accounting cost for an item and the actual cash cost paid. With the accounting cost calculated using one of a number of approaches, including either standard or activity-based costing systems, the discrepancy is further exacerbated by a difference in similar terminology between the accounting and insurance professions: for example, Gross Profit:
Accounting Definition: Accountants often calculate Gross Profit by deducting the total Cost of Sales from Turnover. For a manufacturing business the Cost of Sales might be the sum of the net value of Stock (Opening Stock less Closing Stock), Raw Materials, Sub-Contracting and Direct Labour Costs.
Insurance Definition: This approach can be distinguished from Business Interruption insurance policy wordings which define how Gross Profit should be calculated. A typical definition might read, “Gross Profit is the difference between the sum of Turnover plus Closing Stock and Work in Progress and the sum of Opening Stock / Work in Progress and Uninsured Working Expenses.”
Failure to correctly calculate Gross Profit in accordance with the policy wording can result in underinsurance, allegations of misrepresentation and ultimately the unnecessary failure of the business.
This difference in definitions of similar terminology can lead to either double counting of costs or failure to identify all costs when processing the claim, leading to the claim not accurately reflecting the costs of the insured. Further to calculation and terminology issues, discrepancies can arise due to other factors including the skills, experience and qualifications of the individual preparing the reports and forecasts. Inaccuracies that may arise in the reporting costs during the claims process include:
Not only is an understanding of the costing methodology required, and how it has been applied, but also an ability to ensure that it has been applied arithmetically correctly in line with accepted accounting standards.
The claims process will often require a forecast of future cashflows from the insured to allow interim payments to be made. During this process consideration should be given to the insurer’s liability under the Enterprise Act, including the understanding of the impact of the insured event, whilst taking into account normal seasonal trading variations or other changes in trading patterns not related to the insured event. The review of both pre-incident and post-incident trading positions becomes even more relevant in these current economic times, when trading patterns are less consistent in a COVID environment.
Your forensic accountant is able to work with all other stakeholders in the claims process to advise on the accuracy of the forecast, to undertake sensitivity analysis on the assumptions, and advise on potential factors that will affect the understanding and expectation of future cash flows. Many professional accountants will measure forecast accuracy as part of improving their own processes; during a period of distress, either due to economic conditions or a significant insured event affecting the people and trading of the organisation, forecasting accuracy may deteriorate as resources and skills are diverted and are also primarily focussed on managing the day-to-day operations.
Hawkins’ forensic accountants are able to assist on any claim. Contact us to have a free discussion, where we can provide some guidance and establish whether our support would be beneficial.
ABOUT THE AUTHOR
Alex heads up the Forensic Accounting service at Hawkins, is the Financial Director and a Chartered Management Accountant. Alex has experience undertaking investigations and reviews into business valuations, business failure and fraud.
Alex qualified as a Chartered Management Accountant in 2001 and practiced at KPMG undertaking corporate investigations for shareholders and providers of debt finance prior to joining Hawkins.