Financial reporting: the abuse-prone areas: a refresher on those elements of financial reports that are most vulnerable to impropriety, along with suggestions for avoiding deception

Directors & Boards,  Summer, 2003  by James J. Darazsdi

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CONCERNS HAVE BEEN VOICED that the new regulations in the Sarbanes-Oxley legislation, as well as the new listing requirements of the various stock exchanges, may expose audit committee members to differential and higher levels of liability despite assurances to the contrary by the SEC. While there is no impenetrable safe harbor for audit committee service--or board service in any capacity--logic suggests that paying attention to the areas in accounting that have historically proved to be most susceptible to manipulations should afford directors a reasonable degree of protection.

Revisiting the results of research conducted on behalf of the Treadway Commission provides some important insights. Fraudulent Financial Reporting: 1987-1997--An Analysis of U.S. Public Companies, which was published in 1999, identified a number of company and management characteristics associated with financial statement fraud. While recent legislative initiatives remedy many of the deficiencies, such as director independence and financial literacy, several others warrant reexamination:

* Companies committing fraud were frequently experiencing net losses or were close to breakeven positions. Clearly, the pressures associated with financial performance were motivating factors.

* Top executives were frequently involved. Indeed, the chief executive was involved in 72% of the cases. The importance of having a CEO of unquestionable ethical standards cannot be overstated.

* Typical financial statement fraud techniques involved the overstatement of revenues and assets. This included the outright overstatement of revenues as well as the premature recording of them. Improper revenue recognition practices were, in fact, the single most frequently cited cause of financial statement restatements in four of the past five years.

Revenue recognition

While revenue recognition guidelines under Generally Accepted Accounting Principles (GAAP) can be complicated, there are several basic questions directors can ask to determine if revenue recognition is appropriate:

1. Has delivery occurred (and title passed) or, in the case of service industries, have services been rendered?

2. Is the price fixed or determinable?

3. Have we been paid or are we reasonably assured of payment?

In most cases an affirmative response to these three questions indicates that revenue should be recognized.

Estimates

While inappropriate revenue recognition practices may be the most common method of manipulating earnings, it is certainly not the only technique available. Transactions involving management estimates also provide an opportunity for distortions. There are a number of circumstances that give rise to the need for estimates under GAAP:

1. Pension Actuarial Assumptions are an example. Companies that have defined benefit plans--that is, a plan that provides a specified benefit to a participant upon retirement--require the use of estimates, most notably in the areas of expected future returns on plan assets and expected inflation rates. Management is responsible for the reasonableness of these assumptions, which may have a material impact on reported profits. Actuaries can be helpful in reviewing management's estimates and offering an opinion on reasonableness to the board.

2. Depreciation is another area that often requires estimation. Subjectivity comes into play in determining the asset's useful life and assigning a residual value to it. Extending the life of the asset or inflating the residual value results in a lower charge against current earnings. Directors should be alert to significant changes in either of these variables.

3. Establishing an Allowance for Doubtful Accounts also involves judgment. Failure to reserve for an uncollectible receivable defers the ultimate loss to a later period and, again, overstates current income. Directors need to know the methodology used by management to establish this reserve, its historic accuracy, and management's level of confidence in it before passing judgment.

4. Establishing an Allowance for Inventory Obsolescence and writing off missing or damaged inventory requires judgment. Not unlike receivables, failure to recognize the expense associated with obsolete, missing, or damaged inventory inflates current earnings. This matter warrants particularly close attention in the case of perishable inventories and inventories in industries experiencing rapid change, such as technology.

5. If purchased Research and Development has an alternative future use, the amount should be capitalized. However, both the feasibility of future use and the amount expended may require some level of subjective assessment. The board must be diligent in holding management accountable for decisions reached in this area. Overcapitalization has the effect of reducing current expenses and overstating current income.

6. Restructuring Accruals, at times facetiously referred to as cookie-jar reserves, provide yet another potential area of accounting abuse. Excessive liabilities have the effect of understating current earnings. They can thereby provide a "bank" that can be drawn against in the future, as earnings enhancement is needed. Directors must understand the method used to calculate these reserves and must make management aware that they will be held accountable for the accuracy of such estimates.