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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Other areas to watch

LIFO Dipping, while not illegal, can have a positive influence on current earnings. Under LIFO we assume the most recently acquired inventory is sold first. (It is important to remember that inventory flow assumptions for accounting purposes have nothing to do with how the actual physical inventory is moved.) With the passage of time, and in an inflationary environment, old inventory can carry a low value relative to newly acquired inventory. By selling the old and cheap inventory, a company realizes greater profits on the sales. When confronted with LIFO dipping, directors need to know the business purpose cited by management to support the action. Near-term profit improvement may be very shortsighted if it jeopardizes long-term strategic objectives such as superior customer service.

By Relaxing Credit Standards--again, usually not an illegal action--a company can sell to previously unacceptable customers and thereby generate more revenue. Here as well, directors must know the business purpose supporting the change and must further assess the risk/reward equation associated with it. A sudden increase in sales, particularly during a period of poor sales by competitors, justifies the question, "Have we modified our credit policies?"

Finally, by Reducing Discretionary Spending, such as maintenance expense or advertising, management can affect current income in a positive manner. Directors can be alert to such actions by comparing current-period expenditures to those in prior periods. There may be legitimate reasons for management to take such actions, but directors need to know the rationale.

No abdication

It is important for directors to remember that while they can delegate responsibility for financial oversight to the audit committee, they cannot abdicate this responsibility. Every director must exercise reasonable care and diligence in fulfilling this duty. By closely monitoring the numbers--particularly in abuse-prone areas--and asking the right questions, directors can more effectively discharge their duties.

James J. Darazsdi, Ph.D., CPA, CMA, is president of RainMakers Management Consultants, a financial and strategic advisory firm in Galena, Md. A former chairman of the National Association of Corporate Directors, he currently is a director of four companies. He also serves as executive in residence at Washington College, Chestertown, Md., and teaches in the executive MBA Program at Wesley College, Dover, Del.

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