The headlines today are dominated by stories of accounting improprieties, questionable auditor relationships and management teams that suffer from a lack of integrity. Nomenclature and phrases such as SPE, earnings management, swaps, channel stuffing and self-dealing are being tossed around from Capitol Hill to Wall Street and from corporate board rooms to office coffee rooms. While these same headlines continue to serve us a daily dose of billion-dollar scandals with names such as Enron, WorldCom, Adelphia and Xerox, the fact is that the majority of financial reporting restatements issued are dominated by public companies with revenues of less than $500 million.

A recent study³ entitled "A Study of Restatement Matters, for the Five Years Ended Dec. 31, 2001," looked at a total of approximately 980 restatements over this five-year period (Figure 1). This study has revealed that 77 percent of all public-company restatements during the past five years have been by companies with annual revenues of less than $500 million (Figure 2). Further, 51 percent of all restatements during the past five years have been by companies with revenues of less than $100 million.⁴ Interestingly, this is the market segment where most private companies reside. Although not subject to public company pressures and reporting, private companies face similar market and business conditions, yet we have no access to whether financial reporting problems exist.

Data collected in the study also suggests that many companies filing restatements due to accounting misstatements seek bankruptcy court protection within a year. The companies that file for bankruptcy do so within an average of 344 days from the filing of the restatement. This one-year early warning period may afford banks and other investor groups the ability to minimize their losses, investigate and possibly seek recourse against inappropriate company management behavior. In order to understand what steps may be taken to monitor companies more closely and identify potential improprieties that might lead to a restatement, one must first understand the common factors that ripen the environment for misstatements.

The Root Causes of Misstatements

The root causes of financial reporting misstatements generally start with market and company-specific factors. Market-specific factors such as economic recession, market transformation and competitor innovation are factors that cannot be controlled by the company and must be adapted to. In a weakening economy, companies find it more difficult to meet their original profit targets. Well-managed companies will be proactive in managing down the expectations of analysts and shareholders, even at the expense of a lower stock price in the short-term. Other companies may adopt more aggressive accounting practices to meet earnings expectations (and may even resist appropriate public disclosures). Company-specific factors such as undesirable product mix, poor risk management, excessive cost base, design failures and general inefficiencies in the business are directly attributable to company management decisions. These factors help to create an environment in which the business underperforms and helps to set the stage for another root cause—excessive pressure on management.

History shows that when put under severe pressure, even good people may do bad things, like "cook the books" to meet expectations. The Treadway Commission found that fraudulent financial reporting frequently came about as "the culmination of a series of acts designed to respond to operational difficulties." What tended to happen, the commission concluded, was that initially, "the activities may not be fraudulent, but in time they become increasingly questionable until finally, someone steps over the line."⁵ The demands placed on management by shareholders, analysts, board members and lenders are no different in any well or poorly performing public company. According to CFO Magazine (September 1999), 60 percent of CFOs have felt pressure to manage earnings. This pressure is often most strongly felt by those in middle management, including controllers and divisional personnel.⁶ The pressure intensifies as lofty financial goals are put in place and management incentives and compensation are directly linked to those goals. Often, management appear in denial as weeks and months pass with management unable to change course and right the ship by admitting flaws in the strategy or operation.

Many times the cause centers on opportunity. Financial reporting misstatements could not occur without the opportunity that is fostered by an environment where poor internal controls exist. This may start with an ineffective or non-existent internal audit department. Additionally, unintegrated information systems relied on for financial reporting purposes can invite the problems associated with human error in reconciliation of transactions. Finally, the opportunity for misstatements is often found in organizations characterized by dominant managers and disempowered employees. Dominant managers often control the ultimate financial reporting function as well as the auditor relationships. Stereotypically, they tend to make all vital decisions regarding accounting positions and 10-K language discussing operating results; as well as the footnotes to the financial statements. The disempowered employee, while doing most of the legwork, is shielded from any significant decision-making and input regarding the final product. While the dominant manager creates an environment where authority is neither challenged nor questioned, the disempowered employee is content to stay the course for fear of being chastised and possibly losing his or her job.

Another cause of misstatement reflects organizations with a flawed character or attitude. The "tone at the top" set by management permeates the entire organization and creates a culture with the potential for unethical behavior. These organizations lack any form of ethics leadership by senior management. Anti-fraud, ethics or compliance programs are generally not present or strictly enforced, and there exists a lack of pressure placed on the organization to improve ethics.

---

Financial reporting misstatements could not occur without the opportunity that is fostered by an environment where poor internal controls exist.

---

Types of Misstatements

Of all restatements published from 1997 through 2001, revenue recognition issues dominate with slightly more than 20 percent of the total (Table 1). In 2000, many observers believe there was a sharp increase in restatements as the technology bubble burst and the SEC made revenue recognition a hot-button enforcement issue in 1999. Companies began to pay closer attention to methods of revenue recognition that came to light with the publication of the SEC's Staff Accounting Bulletin 101. Many high-tech software companies fell victim to questionable accounting that was addressed by the American Institute of Certified Public Accountant's (AICPA) release of SOP 97-2 and the subsequent correct application of software revenue recognition. Revenue recognition misstatements include sham sales, recognizing revenue before all the terms of the sale are complete, improper sales cutoffs, improper use of the percentage of completion method, unauthorized shipments and improper recording of consignment sales.

Additional areas where misstatements were most commonly found include improper acquisition accounting (primarily through inappropriate utilization of merger-related reserves), improper capitalization of assets, inappropriate inventory and accounts-receivable valuation, vendor rebates and marketing support, manipulation of contracts and related party transactions.

Potential Warning Signs

When looking for signs of potential misstatements, it is useful to first focus on the relationship between the company's income statement and balance sheet. This is best performed by comparing cash from operating activities to net income. In addition, how does cash from operations compare to sales, accounts receivable and inventory? A thorough ratio analysis performed every reporting period is a practice that may be helpful in the early identification of potentially improper accounting methods. The existence of irrational ratios or trends over consecutive reporting periods will likely raise red flags and questions to be directed toward management concerning the business.

Operating efficiency measures such as changes to gross profit margin and discretionary expenses as a percentage of sales are good measures of a company's performance. Periodic drops in gross margin are a sign that a company's performance is suffering and there is greater potential for earnings manipulation. Ratios focusing on the relationships between accounts receivable and sales will help to raise questions to determine whether sales are real. Examples of questions that may arise include: Is accounts receivable turnover decreasing? Are "days sales outstanding" increasing over time? Do the accounts receivable show any signs of deterioration?

Analysis of the relationships between inventory and cost of sales is also helpful in flagging potentially misstated asset valuations and inflated profits of an organization. When analyzing the financial statements over time, look for unusual trends in the following areas: Is inventory increasing faster than sales? Is inventory turnover decreasing? Are shipping costs decreasing as a percentage of inventory? Is inventory rising faster than total assets? Are payables increasing in tandem with inventory? Finally, is cost of sales falling as a percentage of sales?⁷

Comparing the company's performance to that of the industry is another valuable analytical tool. Look at the company's performance over time and compare its sales and profitability trend to that of the industry. How is the subject performing relative to the industry in down as well as up markets? Does the company's performance look believable? Our experience is often that if the company's financial performance looks too good to be true, it probably is not true.

Other warning signs to consider include complex transactions with no apparent economic benefit from the structure, excessive related-party transactions, confusing notes to the financial statements, aggressive accounting positions and high employee turnover in key finance areas.

Conclusion

It is evident that while all companies are vulnerable to financial misstatements, the data indicates that small companies are more susceptible than large. Although the root causes are similar for all companies, performing in-depth diligence and analysis may raise potential warning signs of a financial reporting problem. Evaluation of the company's performance in comparison to the industry may identify areas requiring further clarification. Additionally, performing a thorough evaluation of the style of a company's management will assist in understanding the "tone at the top." Finally, when performing analytics, always look critically at key relationships between the financial statement accounts and categories. Knowing the warning signs to look for in an organization may help uncover problems before the result becomes inevitable.

Footnotes

¹ Michael C. Sullivan is a director in Huron Consulting Group's Corporate Advisory Services practice. He has a wide variety of experience in the reorganization of companies and in performing forensic accounting studies and fraud examinations, and has been appointed as examiner in a number of matters. Return to article

² Darrin K. Wald is a manager in Huron Consulting Group's Corporate Advisory Services practice. He has a wide variety of experience in the reorganization of companies and in performing accounting due diligence for financial as well as strategic buyers. Return to article

³ Prepared by Huron Consulting Group LLC. Return to article

⁴ The study includes all public companies filing 10-K/As and 10-Q/As from 1997 through 2001, including the Enron Corp. restatement, which was disclosed in an 8-K filing. The study defines restatement as any restatement of financial statements that was the result of an error, as defined by Accounting Principles Board Opinion No. 20. It excludes restatements due to changes in accounting principles and non-financial related restatements. For a copy of the study, please contact the authors at [email protected] or [email protected]. Return to article

⁵ Young, Michael R., Accounting Irregularities and Financial Fraud, A Corporate Governance Guide, Harcourt Professional Publishing, 2000. Return to article

⁶ Duncan, James R., "Twenty Pressures to Manage Earnings," The CPA Journal, July 2001. Return to article

⁷ Wells, Joseph T., "Ghost Goods: How to Spot Phantom Inventory," Journal of Accountancy, June 2001. Return to article