DETECTING EARNINGS MANAGEMENT AND
CREATIVE ACCOUNTING PRACTICES
Adapted from The Financial Numbers Game: Detecting Creative Accounting
Practices, by Charles Mumford and Eugene Comiskey, John Wiley and Sons,
2002.
Checklist to detect premature or fictitious revenue:
A.
What is the company’s revenue recognition policy?
1.
Before delivery or performance?
a.
Is it really earned?
2.
At delivery or performance?
a.
Is there a right of return or price protection? Has the
company provided adequately for returns or price
adjustments?
b.
Does the company offer side letters offering a right to return
or price protection not contained in the actual sale contract?
Do side letters effectively negate the sale?
B.
Was there a change in the revenue recognition policy?
1.
Did the change result in earlier revenue recognition?
C.
Are there any unusual changes in revenue reported in recent quarters?
1.
What is revenue for each of the last 4-6 quarters?
2.
Does any one quarter show unusual activity not explained by
seasonal factors?
3.
How do quarterly changes in revenue compare with the industry or
selected competitors?
a.
For companies with a strong seasonal effect, changes in
quarterly revenue should be calculated using amounts taken
from the same quarter of the previous year.
b.
If quarterly data are not available, or if quarterly data give
misleading signals, annual data can be used. Three or more
years of data should provide a sufficient number of data
points to get a meaningful indicator of potential problems.
D.
Review disclosures of related-party transactions.
1.
Is there evidence of significant related-party revenue?
a.
Is this revenue sustainable?
E.
Does the company have the physical capacity to generate the revenue
produced?
1.
What is the revenue per appropriate measure of physical capacity
for each of the last 4-6 quarters?
2.
How do the measures compare with industry or selected
competitors?
a.
Possible measures of revenue per physical capacity:
i.
Revenue per employee
ii.
Revenue per dollar of PP&E
iii.
Revenue per dollar of total assets
F.
G.
iv.
Revenue per square foot of retail or rental space
Are there signs of overstated accounts receivable or other accounts that
might be used to offset premature or fictitious revenue?
1.
Compare the percentage rate of change in accounts receivable,
PP&E, and other assets with the percentage rate of change for
each of the last 4-6 quarters.
a.
What are the implications of differences in the rates of
change in these accounts and revenue?
2.
Consider whether unexplained changes in other asset and liability
accounts might be explained by premature or fictitious revenue.
3.
Compute A/R days for each of the last 4-6 quarters.
a.
What are the implications of changes noted in A/R days over
the last 4-6 quarters?
b.
How does the absolute level of A/R days and changes
therein compare with the industry and selected competitors?
Does the company use the percentage-of-completion method for longterm contracts?
1.
Is the company experienced in applying the method?
2.
Has the company reported losses in prior years from cost
overruns?
3.
Depending on data availability, compare the percentage rate of
change in unbilled accounts receivable with the percentage rate of
change in contract revenue for each of the last 4-6 quarters.
a.
If unbilled accounts receivable is increasing faster than
contract revenue, it implies that the amounts recognized as
revenue are not being billed.
i.
Is there a particular reason why amounts being
recognized as revenue are not being billed?
ii.
Note that for some contractors, quarterly data may
give misleading signals. Certain key contract
benchmarks may not have been met during the
quarter, limiting amounts billed over that short of a
time frame. In these cases, annual data should be
used.
Checklist to detect aggressive capitalization policies:
A.
For cost capitalization generally:
1.
What are the company’s policies with respect to cost capitalization?
a.
Is the company capitalizing costs that competitors or other
companies in the industry expense?
b.
Does the company expense more, taking a conservative
approach?
c.
Are capitalized costs increasing faster than revenue over
lengthy periods?
d.
What do capitalized costs represent?
i.
B.
C.
D.
E.
F.
An identifiable asset with an ascertainable market
value?
ii.
Not an identifiable asset, whose market value, if any,
is tied to the general fortunes of the company?
1.
Can the benefit to future periods be
determined?
2.
What is the materiality of the asset to total
assets and shareholders’ equity?
2.
Do capitalized costs exceed market value?
For companies incurring software development costs:
1.
What proportion of software development costs incurred is being
capitalized?
2.
How does this percentage compare with competitors or other
companies in the industry?
For companies capitalizing interest costs:
1.
Should capitalization of interest costs be discontinued?
a.
Is the asset under construction complete and available for its
intended use?
b.
Do the costs incurred on the asset under construction give
an indication of exceeding net realizable value?
i.
Have there been construction overruns?
ii.
Have there been cost overruns?
For companies capitalizing direct-response advertising and related
expenditures such as customer acquisition or subscriber acquisition costs:
1.
Is persuasive historical evidence available that would permit
formulation of a reliable estimate of future revenue to be obtained
from incremental advertising or customer/ subscriber acquisition
expenditures?
2.
Is the company an insurance company that is properly capitalizing
policy acquisition costs?
For companies incurring oil and gas exploration expenditures:
1.
Does the company use the successful efforts method (expensing
option) or the full cost method (capitalization option) to account for
exploration expenditures?
2.
Are petroleum prices declining, suggesting that capitalized costs
may be impaired?
A policy of capitalizing the following costs should be considered at odds
with GAAP:
1.
Costs of start-up activities, including organizational costs and preopening costs
2.
Advertising, marketing, and promotion costs, excluding directresponse advertising, and general and administrative expenses
3.
Costs incurred on internally conducted research and development
activities and purchased in-process research and development
a.
Software development is excluded and can be capitalized
For software written for sale or lease – capitalization
begins after technological feasibility has been
reached
ii.
For software written for internal use – capitalization
begins after the preliminary project stage is complete
Has the company shown evidence in the past of being aggressive in its
capitalization policies?
1.
Is there an example of a prior year write-down of capitalized costs
that, in hindsight, should not have been capitalized?
2.
Has a regulator, such as the SEC forced a change in accounting
policies in the past?
Has the company capitalized costs in stealth?
1.
Examine unusual changes in and relationships with revenue of the
following: accounts receivable, inventory, PP&E, and other assets
i.
G.
H.
Checklist to detect extended amortization policies:
A.
Has the company selected extended amortization and depreciation
periods for capitalized costs?
1.
As data permits, how does the calculated average amortization
period for long-lived assets compare with competitors or other firms
in the industry?
B.
Be particularly alert for extended amortization periods in the following
situation:
1.
Company’s industry is experiencing price deflation
2.
Company is in an industry that is experiencing rapid technological
change
3.
Company has shown evidence in the past of employing extended
amortization periods
i.
Is there an example of a prior year write-down of assets that
became value impaired?
C.
For companies taking restructuring charges, examine activity in the
restructuring liability or reserve account
1.
Is there reason to believe that normal operating expenses are being
charged to the reserve?
Checklist to detect overvalued assets:
A.
Accounts receivable
1.
Compare the percentage rate of change in accounts receivable with
the percentage rate of change in revenue for each of the last 4-6
quarters
a.
What are the implications of differences in the rates of
change?
2.
Is the allowance for doubtful accounts sufficient to cover future
collection problems?
a.
Compute the A/R days for each of the last 4-6 quarters.
i.
ii.
B.
Is the trend steady, improving, or worsening?
Is the overall level high when compared with
competitors or other firms in the industry?
3.
Have economic conditions for the company’s customers worsened
recently?
a.
Are company sales declining?
b.
Are there other general economic reasons to expect that
customers are, or may be, having difficulties?
4.
Are sales growing rapidly?
a.
Has the company changed its credit policy?
i.
Is credit being granted to less creditworthy
customers?
b.
Have payment terms been extended?
Inventory
1.
Are inventories overstated due to the inclusion of nonexistent
inventories or by the reporting of true quantities on hand at
amounts that exceed replacement cost?
a.
Compute gross margin and inventory days for the last 4-6
months.
i.
Is the trend steady, improving or worsening?
ii.
How do the statistics compare with competitors and
other firms in the industry?
1.
Before making comparisons with competitors,
make sure that the same inventory methods
(LIFO, FIFO, etc.) are being used
b.
Do ongoing company events and fortunes suggest problems
with slackening demand for the company’s products?
i.
Are sales declining?
ii.
Have raw materials inventories declined markedly as
a percentage of total inventory?
c.
Are prices falling, suggesting general industry weakness and
an increased change that inventory cost may not be
recoverable?
d.
Is the company in an industry that is experiencing rapid
technological change, increasing the risk of inventory
obsolescence?
e.
Has the company show evidence in the past of inventory
overvaluation?
i.
Is there an example of a prior year write-down of
inventory that became impaired?
2.
Does the company use the FIFO method?
a.
Companies that use FIFO rum a greater risk that inventory
costs may exceed replacement costs
3.
Does the company employ the LIFO inventory method for at least a
portion of its inventory?
a.
Are LIFO adjustments being made for interim periods?
i.
C.
Has the LIFO reserve account remained unchanged
for interim periods?
ii.
If the LIFO reserve account has been adjusted during
interim periods, does the estimate of inflation used
appear reasonable?
iii.
How does the gross margin for interim periods
compare with prior years’ annual results?
b.
Was there a decline in LIFO inventory?
i.
Have the effects of a LIFO liquidation been disclosed?
ii.
What were the effects on gross profit and net income?
4.
What is the nature of the company’s environment with respect to
inventory controls?
a.
Do controls to guard against theft seem adequate?
b.
When a physical inventory is taken, how does the amount
compare with the books?
i.
Do the books consistently exceed the physical count
by a significant amount?
ii.
Are the books adjusted or are differences dismissed
as errors in taking the physical inventory?
Investments
1.
For debt securities held until maturity and nonmarketable equity
securities:
a.
Is there evidence of a nonmonetary decline in fair value?
2.
For debt securities and marketable equity securities that are
available for sale:
a.
Are investment losses included in stockholders’ equity that
might be taken to income?
i.
Might the designation of these losses be changed to
other-than-temporary?
ii.
Is sale of one or more investments imminent?
b.
Has the stockholders’ equity been buoyed by substantial
write-ups to market value that may disappear in a market
decline?
3.
For investments accounted for under the equity method:
a.
Is there evidence of a nontemporary decline in fair value?
Checklist for detecting undervalued liabilities:
A.
Accrued expenses payable
1.
What is the trend in accrued expenses payable?
2.
Compare the percentage rate of change in accrued expenses
payable with the percentage rate of change in revenue for each of
the last 4-6 quarters
a.
What are the implications for the differences in the rates of
change?
3.
B.
C.
D.
Does an improvement in selling, general, and administrative
expenses as a percentage of revenue reflect true operating
efficiencies?
Accounts payable
1.
Compute A/P days for each of the last 4-6 quarters
a.
Is the trend steady, worsening, or improving?
b.
How does the statistic compare with competitors’ and other
firms in the industry?
2.
Was there an unexpected improvement in gross profit margin?
3.
How does the percentage change in accounts payable compare
with the percent change in inventory?
Tax-related obligations
1.
What is the effective tax rate and how does it compare to the
statutory rate?
a.
Review the reconciliation of the statutory to the effective tax
rate or statutory to actual tax expense and identify
nonrecurring items
2.
What is the valuation allowance, if any, for deferred tax assets?
a.
Does it seem reasonable after carefully considering the
prospects for future taxable income?
Contingent liabilities
1.
What unrecognized contingencies are noted in a careful reading of
the footnotes?
2.
Given an understanding of the company’s business dealings, is
there reason to believe that an unrecognized contingent liability
exists?