We are often asked, “Why do I have to sign this letter?” The letter being referred to is the management representation letter. As to the why, because you as management, the owner, the board, are making specific assertions that we, the independent accountant’s are relying upon.
An important part of management’s representation is the concept of materiality. The representation letter typically includes this paragraph, “Certain representations in this letter are described as being limited to matters that are material. Items are considered material, regardless of size, if they involve an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.”
In this section you are agreeing to the concept that the dollar value alone is not necessarily indicative of materiality. I will use a real-world example (one we are currently facing) to explain: Way back in November 2013, an association approved a special assessment. Interest was to start December 1, 2013 if the full amount of the special assessment wasn’t paid by November 30. Unpaid interest earned was about $3,500. The manager did not accrue the interest for those who hadn’t paid by December 31. Was it material? Dollar-wise probably not. But had it been known that over 30% of owners had not paid their first payment – which would have been obvious had the accrued interest been included – it is quite probably that a reasonable person’s judgement may have been changed.
So what are some of the specific representations you are making? Regarding the financial statements, you represent:
- You understand that you are responsible for the preparation and fair presentation of the financial statements. This is true even if you entrust the preparation of the financial statement to the outside accountant.
- You acknowledge your responsibility to design, implement and maintain an internal control system and you have fulfilled this responsibility. This is a big issue; go back to the example above, obviously the control system to ensure that all relevant information was provided in the financial statement was not working properly.
- You acknowledge your responsibility to design, implement and maintain an internal control system to prevent and detect fraud. Fraud, by the way, is not just about people stealing it is also about ensuring the financial statements are not intentionally misleading.
- Related party relationships and transactions have been accounted for and are disclosed. This could be as simple as renting the building from an LLC owned by the majority shareholder or as complex as contracting with a company where the controller is a silent partner. You are stating that these types of transactions have been fully documented and are properly disclosed to a reader of the financial statements.
- Any important events that happened after the balance sheet date are accounted for and/or disclosed. This means, if you decide to pay a large bonus to key employees after the year-end, at a minimum it needs to be fully disclosed and more likely properly accrued since the bonus no doubt stems from the profit of the year.
These are by no means all the things you are representing regarding the financial statements. But you get the idea; you have the primary responsibility for all the financial information and making sure it gets in the financial statement. You can and should bring it up to your accountant (or whoever is preparing the financial statement) if you have the slightest concern that it is something that should be included.
When is that you ask? The fact it is on your mind means it should probably be disclosed. The old saying, “When in doubt, let it out.” definitely applies to your financial statements. Don’t try to suppress bad news or fluff up the good. You, as management and the board (if it exists) have an obligation to ensure the truth is provided so that the reader can make an informed decision.
If you need help with preparing financial statements or designing an effective internal control system, feel free to contact us through our website. We have worked with many large and small businesses, non-profits, and associations as auditor and also consultants. We are here to be of service to you.