Corporates

Accounting Ma nipulation February 2012

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Construction companies with long-term contracts are the most obvious candidates for using POC accounting, but advancing or deferring revenue is equally applicable to other sectors including aerospace and defence and software companies with multi-period service agreements. In the construction industry, for example, accounting policies allow for 95% of revenue to be recognised, when 95% of costs have been incurred for the construction of a bridge or toll road. Problems arise when a construction project that is close to completion has structural issues leading to the company having to recognise a loss, as the bridge or toll road is not structurally sound and therefore not operational. Profit estimates may be revised and, importantly, are always made prospectively, not retroactively.

How to Spot It

Warning signs

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for both the advancing sales and manipulation of revenue through POC accounting

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are strong revenue growth but increasing negative working capital movements in the cash flow statement due to increases in trade receivables. A noticeable rise in trade debtor days, unusual swings in deferred revenues or increases in long-term revenues at year-end compared with previous quarters or prior periods provide further indication of possible revenue manipulation. Of the two methods, POC accounting can be hardest to assess from public information

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significant mismatches between revenues and cash may well be justified. Later signs may be an increase in bad debt provisions or a substantially weaker second quarter that cannot be explained by seasonal effects. These may indicate that companies have either made downward adjustments to revenues, or orders have reduced as customers moderate their inventory levels. Here, a decrease in a comp

any‘s order backlog is a clear sign.

Disclosure of accounting policies in the notes to the accounts and comparison of these with industry peers can provide some further clues to revenue manipulation. Related-party disclosures are also important in questioning whether

a company‘s financial position and profit

or loss may have been affected by transactions and outstanding balances with such parties.

How to Adjust

Adjusting for cut-off manipulation or aggressive POC accounting is difficult. However, where manipulation is suspected, analysts should focus on the cash flow statement, which reflects precisely what revenue has been received and what costs have been paid. Cash flow from operations should enable a more robust analysis of the company in question. For POC accounting, analysis and financial modelling can be undertaken at a contract-by-contract level

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although this data is rarely available to normal market participants. Where necessary, analysts can make approximate adjustments to turnover and related cost of sales to normalise earnings and

net income and to more accurately assess the company‘s

underlying profitability. The differential in the actual increase in trade receivables and the level anticipated based on normalised trade debtor days can act as a guide for the adjustment to be made to turnover. Cost of sales and operating expenses can be adjusted for based on anticipated or historical EBITDA margins.

Minimising Expenses

For corporates, cost of sales and expenses are accounted for under the matching principle, which dictates that expenses are generally recorded during the same period revenue is earned. Again, this typically happens when a product has been delivered (or service rendered) and the risk and rewards of ownership has been transferred or a service has been performed. However, in an attempt to improve financial ratios, such as profit margins or leverage ratios, companies sometimes exploit estimates allowed by some accounting standards to defer costs to future years and where the need arises, to meet earnings targets. Some companies may be keen to bring forward expenses in order to reduce tax charges and payments in a given year.

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Companies can e xploit esti mates to defer or bring forward expenses.

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Red flags in clude strong rev enue growth but increasing working capital outflow.

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