33. Financial Reporting Quality : Red Flags and Accounting Warning Signs
A. Incentives that might induce a company’s management to overreport or underreport earnings :
Firms are motivated to manage earnings because of the potential benefits.
Management may be motivated to overstate net income to :
- Meet earnings expectations.
- Remain in compliance with lending covenants.
- Receive higher incentive compensation.
Managing earnings can also involve understating net income. Management may be motivated to underreport earnings to :
- Obtain trade relief in the form of quotas or protective tariffs.
- Negotiate favorable terms from creditors.
- Negotiate favorable labor union contracts.
Firms may also be motivated to manage the balance sheet. For example, by overstating assets or understating liabilities, the firm appears more solvent. Conversely, a firm might understate assets or overstate liabilities to appear less solvent in order to negotiate concessions with creditors and other performance ratios.
B. Activities resulting in a low quality of earnings :
Generally accepted accounting principles (GAAP) can be exploited by a firm to achieve a specific outcome while meeting the letter, but not the spirit, of the accounting standards; however, earnings quality will usually deteriorate. Low quality earnings are the result of :
- Selecting acceptable accounting principles that misrepresent the economics of a transaction.
- Structuring transactions to achieve a desired outcome.
- Using aggressive or unrealistic estimates and assumptions.
- Exploiting the intent of an accounting principle.
C. The three conditions that are generally present when fraud occurs :
Users of financial information should become familiar with the risk factors and warning signs of fraud. Statement of Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit (SAS No. 99), identifies three conditions that are usually present when fraud occurs. These conditions are known as the fraud triangle, and not all of the three conditions need to be present for fraud to occur :
- Incentive or pressure is the motive that exists to commit fraud.
- Opportunity exists when there is a weakness in internal controls.
- Attitudes or rationalization is a mindset that fraudulent behavior is justified.
Incentives and Pressures :
SAS No. 99 identified four risk factors related to the incentives or pressures that may lead to fraudulent reporting :
- Threats to financial stability as a result of economic, industry, or firm conditions.
- Excessive third-party pressures on management.
- Personal net worth of management or the board of directors is threatened.
- Excessive pressure on management or operating personnel to meet internal financial goals.
Opportunities for Fraud :
SAS No. 99 identified four risk factors related to the opportunities to commit fraud in financial reporting :
- The nature of the firm’s industry or operations.
- Ineffective management monitoring.
- A complex or unstable organizational structure.
- Deficient internal controls.
Attitudes and rationalizations :
SAS No. 99 identified the following risk factors related to attitudes and rationalization to justify fraudulent behavior :
- Inappropriate ethical standards.
- Excessive participation by nonfinancial management in the selection of accounting standards.
- A history of legal and regulatory violations by management on board members.
- Obsessive attention to the stock price or earnings trend.
- Aggressive commitments to third parties.
- Failure to correct known compliance problems.
- Minimizing earnings inappropriately for tax reporting.
- Continued use of materiality to justify inappropriate accounting.
- A strained relationship with the current or previous auditor.
D. Common accounting warning signs :
Common warning signs of earnings manipulation include :
- Aggressive revenue recognition.
- Different growth rates of operating cash flow and earnings.
- Abnormal comparative sales growth.
- Abnormal inventory growth as compared to sales.
- Moving non-operating income and nonrecurring gains up the income statement to boost revenue.
- Delaying expense recognition.
- Excessive use of off-balance-sheet financing arrangements including leases.
- Classifying expenses as extraordinary or nonrecurring and moving them down the income statement to boost income from continuing operations.
- LIFO liquidations.
- Abnormal comparative margin ratios.
- Aggressive assumptions and estimates.
- Year-end surprises.
- Equity method investments with little or no cash flow.
Follow this link to next chapter 34. Accounting Shenanigans on the Cash Flow Statement.
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