Fitch Ratings has issued a useful guide to spotting aggressive accounting techniques that companies may be tempted to adopt in challenging times.
Fitch notes 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.
Key points from the report:
Audit Does Not Replace Analysis: 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. While auditors are the first line of defence and serve as a deterrent, a principles-based IFRS accounting framework gives management a great deal of flexibility in making accounting policy choices.
Estimates Prevail: The objective of accounting principles is to provide a true and fair view of a company‘s financial performance during an accounting period as well as its financial position at year end. Estimates are a major input into all accounts but also increase the scope for manipulation while still playing within the letter of the law. Breaking the rules – through fraud or illegality – is far less widespread than ―creative‖ accounting but opens up more options to manipulate accounts.
Themes and Techniques: The report is less focused on fraud or illegal practices but rather looks at common forms of manipulation of financials within the framework provided by IFRS.
For details, see Accounting Manipulation