Keeping Up Appearances – how to spot accounting manipulation

IN 2011 MANY COMPANIES experienced strong performance in the first few quarters followed by a weakening later in the year. This, combined with a weak outlook for 2012, may prompt some to smooth results and resort to increasingly aggressive accounting techniques to manipulate performance metrics or achieve compliance with target ratios and covenants.

But how are these companies manipulating the figures, they can’t lie after all. The most common areas for manipulation techniques include cut-off manipulation, percentage of completion (POC) accounting, the capitalisation of expenses, the use of derivatives and operating leases, provisioning, and the accounting for subsidiaries and joint ventures.

More general techniques can include reorganising segments of the books, redefining key target ratios or timing the adoption of accounting standards. Forms of manipulation will also often vary between industry sectors. The retail, media and automotive sectors are more susceptible to revenue cut-off practices whilst construction, aerospace, defence and software companies are more obvious candidates for manipulating POC accounting.

While auditors are the first line of defence, a principles-based IFRS framework gives management considerable flexibility in making accounting policy choices. In particular, estimates are key to all accounts and while these must be based on reliable assumptions, they increase the scope for manipulation – without the need for fraud or illegal practices.

Other more obviously warning signs to look out for include a sharp unexplained improvement in a company’s operating margins, significant mismatches between the profit and loss and cash flow or a noticeable rise in trade debtor payments or deferred income.

At times, accounting standards can fall short in appropriately reflecting a company’s future financing needs. One such example is the accounting for subsidiaries under the equity method, which is determined by the legal form of ownership rather than the reputational or operational importance of a parent providing finance to a subsidiary. New standards will be more prescriptive in accounting for joint arrangements such as subsidiaries, but will remain limited to prevent manipulation. Proforma accounts are an important tool, but again analysts and auditors should be cautious about taking these at face value.

Jeanine Arnold is associate director of Fitch Ratings

Related reading

Life Belt with Computer Folders