The weak economic environment could lead to more aggressive corporate accounting tactics, warns Fitch Ratings in a new report.
In the report, the rating agency says that “For many companies, 2011 was characterized by a strong performance in the first few quarters followed by a weakening later in the year. This, combined with a weak outlook for 2012, may prompt some to smooth results and resort to increasingly aggressive accounting techniques to manipulate performance metrics or achieve compliance with target ratios and covenants.”
The report details some of the more common forms of accounting manipulation such as aggressive revenue recognition, expense minimization, cash-flow enhancement, and debt exclusion, among other things. It notes that this sort of creative accounting is far more prevalent than outright fraud, as the accounting rules leave a fair amount of latitude for possible manipulation.
And, it cautions investors not to rely solely on auditors. “A clean audit report from a well regarded audit firm provides a good starting point for financial analysis. It should not, however, prevent analysts from applying their professional scepticism,” it says. “While auditors are the first line of defence and serve as a deterrent, a principles-based IFRS framework gives management a great deal of flexibility in making accounting policy choices.”
In terms of sniffing out these sorts of manipulations, Fitch says that historical analysis of a company, or a comparison of peer performance, “can often throw up red flags… For example, a sudden and unexplained improvement in a company’s operating margins in a given year could be a warning signal. A careful examination of the notes to the accounts should shed light on whether a company is aggressive in its interpretation of accounting standards.”