Spotting Financial Reporting Distortions

Sometimes the picture presented by a company’s financial reports offers a skewed view of what’s actually going on. Attendees of the Oct. 30 NACM teleconference were given some information on common distortions—both legal and illegal—that are sometimes presented in financial reports to disguise the true financial picture of the company. Dubos J. Masson, CTP, Cert ICM, presented the teleconference.

Masson pointed that some of the most notable examples of accounting irregularities or outright fraud in the past several years took place at such companies as Sunbeam, Waste Management, Tyco, WorldCom and Enron. He noted there is often a lot of pressure for managers to meet certain company financial goals that may cause them to engage in various accounting manipulations to make it appear that these goals have been attained. "Sometimes in the U.S. there’s a lot of negativity in not meeting the numbers." Some of the goals that can be achieved by changing certain financial numbers through various legal and illegal accounting methods include getting a higher share price on common stock and reducing share price volatility. "Many companies use their company’s stock as currency for acquisitions," Masson said. "Let’s not forget a lot of those managers have stock options." He also mentioned that managers’ bonuses are also tied into financial performance measures. However, even if the accounting methods are legal, changing the financial picture can still have negative consequences. "To fudge the numbers this year will mean you’ll have trouble making the numbers next year."

Another motivation for fudging accounting numbers is to make the income and balance sheets look better to improve the company’s credit position. There are also political motivations to skew the numbers, Masson said. He pointed to the example of oil companies that may want to minimize the degree of their profits in order to avoid a push by Congress to impose excess profit taxes on them. "There are a lot of reasons why companies may want to adjust." Sometimes adjustments are made off the balance sheets, as in the case of Enron.

Changes in the numbers can be made through changes in accounting policies or how the policies are applied. He said that GAAP (Generally Accepted Accounting Principles) provides a lot of flexibility for the application of accounting principles. Some things that may be done include putting bad numbers all into one year, taking special charges, or accounting for revenue on sales improperly. "It is considered to be improper to recognize revenue before the sale is complete. You want to be sure the company is properly recognizing revenue."

Sometimes honest mistakes or errors are made in accounting. However, what distinguishes errors from fraud is the intent to defraud. Even if outright fraud is committed, it may take some time to discover it. "Fraud does not always pop up right away," Masson said. "Enron showed us that. Even the (credit) rating agencies were fooled by Enron. We really need the SEC (Securities and Exchange Commission) and the courts to determine if fraud occurred."

In order to be able to detect fraud or misrepresentations on financial statements, Masson recommended thoroughly examining footnotes, as they often contain the detailed information about what accounting policy or application changes were made. "You’ve got to go through all the footnotes to know what’s going on." Also, he advised being vigilant over financial reports of companies that have gone through a structural change such as a merger or acquisition. "If a company is going through an acquisition or merger, that’s just an open invitation to accounting manipulation." Another tactic employed by managers to change the financial picture of a company in an inconspicuous manner is to make a number of small, non-material changes to the financial statements. While each change may be small, their accumulative impact may be material.

Masson cited the Sarbanes-Oxley Act of 2002 as Congress’ response to the major accounting scandals of the last several years, most notably at Enron. He noted that the law requires CEOs and CFOs to sign off on the validity of financial reports. He pointed out that despite the new measures taken to increase the transparency of financial reporting, there will still be accounting fraud committed by some company managers. "We’ll have Enrons in the future. I like to think in the meantime we’ll be a little more vigilant."
Source: NACM

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