Reading 33 – Financial Reporting Quality: Red Flags and accounting warning signs

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http://www.docertifications.com/r33_l1

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a. describe incentives that might induce a company’s management to over-report or underreport earnings

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Motivation for over-reporting of earnings

1. Meet earnings expectation
2. Remain in compliance with lending covenants
3. Receive higher incentives and compensation

Motivation for under-reporting of earnings

1. Obtain trade relief (in terms of quotas or protections)
2. Negotiate favorable terms with creditors
3. Negotiate favorable terms with labor unions

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b. describe activities that will result in a low quality of earnings

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1. Following GAAP but selecting alternatives within GAAP which distort or bias reporting results to achieve a desired outcome
2. Using loopholes in accounting standards to achieve desired outcome. (For e.g. for capital lease, present value of cash flow should be greater than or equal to 90% of asset value. Thus by structuring transaction such that present value of cash flow sum up to 85%, then lease can avoid being classified as capital lease)
3. Using aggressive and unrealistic estimates and assumptions. (For example increase in depreciable life of asset or salvage value can increase reported earnings even though these increases might be aggressive)
4. Stretching accounting principles to achieve a desired outcome. (For e.g. some firms apply narrow rule for unconsolidated SPEs (Special purpose entities) to a broad level of transactions. This is done, as leverage is lower if SPEs are not consolidated)

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c. describe the three conditions that are generally present when fraud occurs, including the risk factors related to these conditions

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1. Incentives or pressures can lead to fraudulent financial reporting. (For e.g. pressure to meet analyst expectation of debt covenants can lead to fraudulent reporting)
2. Opportunities for fraud exist which lure managers to commit fraud (For e.g. if company has weak internal controls, then managers can freely indulge in fraudulent activities)
3. Attitudes/Rationalization – Individuals rationalize their fraudulent behavior. (For e.g. CEO will try to justify misrepresentation to wade through tough times which may be corrected during good period)

Incentives or Pressures

1. Risk factors related to incentives or pressures which may lead to fraudulent reporting
1. Threats to financial stability or profitability as a result of economic, industry or firms condition
2. Excessive third party pressure on management
3. Personal net-worth of management or board of directors is threatened
4. Excessive pressure on management or operating personnel to meet internal financial goals

Opportunities for Fraud – opportunities can be created owing to factors mentioned below

1. Nature of firm’s industry or operations might involve
1. Significant related party transactions (especially when those related parties are unaudited)
2. Ability to dictate terms and conditions to suppliers and customers
3. Significant estimates and judgments in accounting of assets, liabilities, revenues and expenses
4. Unusual or complex transactions (especially at year end)
5. Bank accounts or operations in tax havens without clear justifications
2. Ineffective management monitoring due to
1. Management dominated by single person or small group
2. Ineffective oversight by board of directors or oversight committee
3. Complex organization structure
1. High turnover in management
2. Difficulty in determining who is in control
3. Complex legal structure of organization (with complex web of subsidiaries)
4. Deficient internal controls due to
1. Inadequate monitoring controls infrastructure
2. High employee turnover in accounts and technology departments
3. Ineffective accounting or information systems

Attitudes and Rationalization

1. Inadequate code of ethics of a firm
2. Management’s obsession with meeting analyst expectations and to see an ever increasing stock price
3. Known history of violation of rules and regulations by management
4. Excessive participation by non-financial management in selection of accounting standards and determination of estimates
5. Inappropriate accounting to minimize tax outgo
6. Aggressive target commitments to third parties

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d. describe common accounting warning signs and methods for detecting each

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1. Aggressive Revenue Recognition – recognizing revenue too soon. Few examples are:
1. Bill & Hold arrangement – revenue is recognized before goods are shipped
2. Holding accounting period open after year end to increase reported revenue
3. Sales type lease wherein lessor recognizes sales and profit at the beginning of lease
4. Recognizing revenue before meeting all the conditions of revenue recognition
5. Recognizing revenue from swaps and barter transaction with third parties
2. Different growth rates for operating cash flow and earnings – In long term, relationship between these two should be fairly stable otherwise firm’s reporting standards are not adequate
3. Abnormal sales growth as compared to economy, industry or competitors – It may be due to superior management or aggressive accounting policies. Receivables which grow faster than sales can be due to aggressive revenue recognition
4. Boosting revenues with non-operating income and non-recurring gains – Non-recurring or non-operating income can be used to boost operating income. Onetime gains (like from sale of land) can be reported as recurring items by firms to manipulate revenue
5. Delaying expense recognition – Firms capitalize operating expenditure and then amortize it over a period of time rather than expensing it. This leads to lower expense
6. Abnormal use of operating leases – Firms can play around with accounting rules to convert an effective capital lease into operating lease
7. Hiding recurring expense by classifying them as extraordinary – Recurring items can be classified as extraordinary to lower actual operating expense
8. Abnormal gross margins as compared to industry peers – This can be either due to superior management or due to accounting manipulations
9. Extending useful life or salvage value of long term assets – This will result in lower depreciation expense and increased earnings. Later asset is written down as part of non-operating expense
10. Yearend surprises – This can be due to seasonality or due to accounting manipulations
11. Equity method of accounting – In this method, balance sheet is not consolidated but pro-rata share of earnings is reported. This boosts earnings while assets and liabilities are understated