Financial statement manipulation techniques and potential mitigants
The financial statement is the written report that depicts the financial condition of an organisation at a point in time. It usually contains the “Statement of Financial Position”, “Statement of Comprehensive Income”, “Cashflow Statement”, “Statement of Changes in Equity” and so on.
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Historically, chief finance officers or financial controllers are responsible for the finance processes, controls, policies and systems, including the integrity, accuracy and transparency of the financial statement.
According to IASB, qualitative characteristics of a financial statement include faithful representation and relevance.
The users of the financial statement include current and potential shareholders, tax authorities and the government, investors, lenders of capital, competitors, creditors, regulators, employees, and financial analysts.
Forms of manipulation
Historically, the custodians of finance in many organisations have engaged in various forms of financial statement manipulation for different reasons such as profit smoothening, meeting the expectations of analysts (Buy and sell side), meeting the expectations of shareholders, tying management’s bonus and salary to financial statement performance; especially earnings, and taxation.
The rest of the reasons are: bank obligation purposes, regulatory reasons (including government), audit reasons, to keep the confidence of suppliers and creditors, to sustain the confidence of customers, and manipulators for organisational gains and deceit.
Financial statement manipulation comes in different forms such as window dressing and profit smoothening, creative accounting, false accounting in order to achieve desired outcomes.
These have resulted in numerous financial scandals worldwide such as the Enron Scandal, Worldcom Scandal, Jet Airline Scandal, Tyco International, Adelphia, Global Crossing, Cendant, Freddie Mac, AIG, Sunbeam and Quest.
Earnings of a firm are the most studied numbers in financial statements analysis by financial analysts, especially in the capital market. This is because of the strong relationship between share price and earnings.
The implications of manipulation of financial statements have had negative impacts on investors, shareholders, organisations, regulators, individuals, capital markets, individuals, economy, financial system and the nation.
Historically, the managers of businesses understand their businesses more than other stakeholders and some use this privilege position to manipulate the numbers in some cases. The current culture in Africa where companies do not disclose much (or disclose little) information on the financial statement has further fuelled this anomaly.
This is contrary to the detailed disclosure done in the US. The ability to manipulate is strengthened by non-prescriptive nature of IAS/IFRS principles. It usually suggests that accounting transactions should be treated using several options. This is contrary to the US GAAP.
According to the “American Accounting Association”, only about seven per cent of experienced auditors successfully detect these unaided, while many analysts (equity analysts, credit analysts, rating analysts, etc) do not detect them.
Tricks and methods
One of the tricks is the manipulation of accounting conventions and policies that require judgments and experience. The accounting conventions and policies adopted by CFOs greatly influence the revenue, profit, cashflow and balance sheet figures reported in the financial statement.
Some examples are: Increase or decrease of asset economic useful life. The economic useful life of assets drives the depreciation recorded as expenses, which subsequently affects reported profit and balance sheet numbers.
Many CFOs have historically utilised this in influencing favourable financial statement parameters. An example is an asset which costs GH¢ 10m with a useful life of five years and yearly depreciation of GH¢2million. After one year, a change to the useful life from five years to 10 years changes the depreciation expense from GH¢2m to GH¢0.89m. Consequently, the profit increases by GH¢1.11m (and vice versa).
Another example is the usage of favourable / unfavourable stock valuation methods – “Last In First Out” (LIFO), First In First Out (FIFO), weighted average. This represents the valuation of stock (FG, WIP, Raw Material) held in the books and utilised as “cost of sales” and “closing stock” in the books of account.
It is generally agreed by finance experts that LIFO overstates the cost of sales and consequently understates the current year profit numbers; which is generally discouraged by regulators and experts.
However, many CFOs still use this when it suits their objectives. Furthermore, many finance professionals are of the opinion that FIFO understates costs and overstates profits during inflationary periods.
The generally accepted method is “weighted average method”, which calculates the average price of stock and utilises such values for book keeping purposes – internal and external. Note that the usage of “LIFO” makes sense for few lines of businesses such as trading in perishable goods.
One trick used by some CFOs is by increasing or reducing inputs into the computation of “Value in Use” – The concept of “Value in Use” is a mandate for determination of impairment under IAS 36. The standard mandates the carrying value of an asset to be compared to the recoverable value. If the recoverable value is lower than the carrying amount, the asset is impaired. The recoverable amount of an asset or a cash-generating unit is the higher of its fair value (less costs of disposal) and its value in use.
“Value in Use” is the present value of the future cash flows expected to be derived from an asset or cash-generating unit. Hence, the determination of this value has some elements of subjectivity which is usually manipulated by CFOs.
Such parameters include future cashflows by the business, cost of equity, terminal value of cashflow, discount rate, etc. Usually, the managers of businesses understand their businesses more than other stakeholders and they use this privileged position to manipulate this number; which is used in determining impairment values under IAS 36 on Impairment.
Improper treatment of Goodwill (IFRS 3) is another trick that can be used. Goodwill arises when one company acquires another, but pays more than the fair market value of the net assets (total assets - total liabilities). Consequently, the excess is classified as an intangible asset on the balance sheet.
However, according to IFRS 3, goodwill is never amortised. Instead, management is responsible to value goodwill every year and to determine if impairment is required.
If the fair market value goes below historical cost (what goodwill was purchased for), impairment must be recorded to bring it down to its fair market value. However, CFOs drive the assumptions and metrics used in assessing and amortising goodwill, especially as it relates to the valuation of the purchased asset.