The SEC is cracking down hard on corporate earnings management ? but is your board? Everything from abuse of special charges to stuffing the sales pipeline is now under fire, and income accounting standards that were acceptable just a few years ago are now drawing SEC queries. Since your audit committee will find itself on the spot (and maybe in court) for these revenue figures, what questions should you be asking now?
1. Earnings trickery tends to sneak in through grey areas, such as the subjective items on the balance sheet, according to Jim Roth, president of the AuditTrends audit training and accounting firm. "Look in unusual items that require significant judgments, such as reserves, accruals, and estimates," he suggests. "There is a lot of room there for manipulation. Reserves, especially, are most commonly used for income management." It's easier to hide voodoo numbers under headings that are already fuzzy.
2. Change is good -- except in accounting. "Look for significant variances from prior years or from budget. Ask why we have this now. Look at the overall picture for unusual items," says Roth. Changes in general accounting treatments of revenue are also a red flag. "If the auditor says that the accounting board changed a rule, and the company has decided to make the change, ask if it's required, what the effect on income and executive compensation will be, and, if the change is such a good idea, why the company didn't do it earlier."
3. Bringing income recognition policies into compliance with new SEC standards is also good -- but look to see what it does to earlier company figures. "Definitely look into changes this year to meet the SEC rules," recommends Roth. "It could mean that something was being done wrong earlier. Ask management and the internal and outside auditors why, in their view, it was done this way before, if they are comfortable with it, and whether it was typical."
4. When asking such questions, hold out for solid answers. "Beware any kind of explaining away without fully explaining," cautions Roth. "If accruals of income have increased by 50 percent in the last year, and the auditor says that this is just normal fluctuation, well, that's not good enough. Ask exactly why it was handled this way."
5. Earnings management is a weed that springs from a poor overall sales environment. Mike Young, author of the book "Accounting Irregularities and Financial Fraud" (Harcourt) and a partner in the New York law firm of Wilkie Farr & Gallagher, comments that, "almost every accounting fraud starts with two things: Over-aggressive targets for performance, and an environment where failure to attain those targets is viewed as unforgivable."