Financial reporting: the abuse-prone areas: a refresher on those elements of financial reports that are most vulnerable to impropriety, along with suggestions for avoiding deception.

• Author: Darazsdi, James J.
• Position: Financial Disclosure

CONCERNS HAVE BEEN VOICED that the new regulations in the Sarbanes-Oxley legislation, as well as the new listing requirements of the various stock exchanges, may expose audit committee members to differential and higher levels of liability despite assurances to the contrary by the SEC. While there is no impenetrable safe harbor for audit committee service--or board service in any capacity--logic suggests that paying attention to the areas in accounting that have historically proved to be most susceptible to manipulations should afford directors a reasonable degree of protection.

Revisiting the results of research conducted on behalf of the Treadway Commission provides some important insights. Fraudulent Financial Reporting: 1987-1997--An Analysis of U.S. Public Companies, which was published in 1999, identified a number of company and management characteristics associated with financial statement fraud. While recent legislative initiatives remedy many of the deficiencies, such as director independence and financial literacy, several others warrant reexamination:

* Companies committing fraud were frequently experiencing net losses or were close to breakeven positions. Clearly, the pressures associated with financial performance were motivating factors.

* Top executives were frequently involved. Indeed, the chief executive was involved in 72% of the cases. The importance of having a CEO of unquestionable ethical standards cannot be overstated.

* Typical financial statement fraud techniques involved the overstatement of revenues and assets. This included the outright overstatement of revenues as well as the premature recording of them. Improper revenue recognition practices were, in fact, the single most frequently cited cause of financial statement restatements in four of the past five years.

Revenue recognition

While revenue recognition guidelines under Generally Accepted Accounting Principles (GAAP) can be complicated, there are several basic questions directors can ask to determine if revenue recognition is appropriate:

1. Has delivery occurred (and title passed) or, in the case of service industries, have services been rendered?

2. Is the price fixed or determinable?

3. Have we been paid or are we reasonably assured of payment?

   In most cases an affirmative response to these three questions indicates that revenue should be recognized.

   Estimates

   While inappropriate revenue recognition practices may be the most common method of manipulating...