Corporates

Global

Accounting Manipulation
Why, How, What to Look Out For and How to Adjust
Special Report Aggressive Accounting: Why
Disguising a Weakening Performance: For many companies, 2011 was characterised by a strong performance in the first few quarters followed by a weakening later in the year. This, combined with a weak outlook for 2012, may prompt some to smooth results and resort to increasingly aggressive accounting techniques to manipulate performance metrics or achieve compliance with target ratios and covenants. This report examines some of the more common forms of accounting manipulation and how Fitch Ratings takes them into consideration in its credit analysis.

Figure 1

Revenue Growth Slows

2011 (Growth %) 25 15 5 -5 -15
Industrials Utilities Oil and gas RLCP TMT

2012

Manipulation: How
Audit Does Not Replace Analysis: A clean audit report from a well regarded audit firm provides a good starting point for financial analysis. It should not, however, prevent analysts from applying their professional scepticism. While auditors are the first line of defence and serve as a deterrent, a principles-based IFRS framework gives management a great deal of flexibility in making accounting policy choices. Estimates Prevail: The objective of accounting principles is to provide a true and fair view of a companys financial performance during an accounting period as well as its financial position at year end. Estimates are a major input into all accounts but also increase the scope for manipulation while still playing within the letter of the law. Breaking the rules through fraud or illegality is far less widespread than creative accounting but opens up more options to manipulate accounts. Themes and Techniques: This report is less focused on fraud or illegal practices but rather looks at common forms of manipulation of financials within the framework provided by IFRS. While not an exhaustive list, Fitch considers the more frequent techniques to be: Aggressive revenue recognition; Minimising expenses; Cash-flow enhancement; Debt reduction; General manipulation.

Source: Fitch

Accounting manipulation may increase in view of weak H211 performance and a bleak outlook for 2012.

Related Research
2012 Outlook: EMEA Corporates Adjusting for Fair Value of Debt (August 2011) Operating Leases: Updated Implications for Lessees Credit (August 2011) Global Lease Accounting Proposal (December 2010) Accounting & Financial Reporting 2012 Global Outlook (January 2012) Treatment of Corporate Pensions EMEA and Asia-Pacific (August 2011)

What to Look Out For

Tell-Tale Signs: Historical analysis of a company or a comparison of peer performance can often throw up red flags, which are highlighted in this report. For example, a sudden and unexplained improvement in a companys operating margins in a given year could be a warning signal. A careful examination of the notes to the accounts should shed light on whether a company is aggressive in its interpretation of accounting standards.

How to Adjust
Analysts
Jeanine Arnold +44 20 3530 1382 [email protected] Isabelle Katsumata +33 1 4429 9272 [email protected]

Adjustments: This report details how financial items may be excluded, added back, or reallocated to better reflect a companys underlying business. However, some accounting manipulations are more difficult to adjust for, especially if reliant on publicly available information. Debt levels in subsidiaries accounted for under the equity method is one such example.

www.fitchratings.com

6 February 2012

Corporates
Figure 2

How Accounts May Be Manipulated

Aggressive revenue recognition Cut-off manipulation Percentage of completion Minimising Cash flow expenses enhancement Capitalising costs Working capital payments Derivatives and Debt factoring and mark-to-market securitisation Provisions Future cash commitments Exceptionals Capitalising costs Debt reduction Consolidation methods Operating leases General manipulation techniques Reorganisation of segments Redefinition of key ratios Changes in accounting policies Accounting yearends

Source: Fitch

Revenue recognition is frequently a matter of interpretation and opinion.

Aggressive Revenue Recognition

Revenue is recorded when the risk and rewards of goods, ownership and control are transferred to the buyer or when services have been rendered. While accounting standards provide guidance on more general sales transactions including discounts, royalties and bartering transactions, there are instances where revenue recognition is more a matter of interpretation and opinion.

Cut-Off Manipulation: Advancing or Postponing Sales

Cut-off manipulation is a widespread form of manipulating a companys performance but the media, retail and automotive industries are more susceptible.

A well-known and simple technique is channel-stuffing (or trade loading), where a company delivers more goods to its customers and distributors than can be sold. This is generally considered inappropriate but in practice it can be a grey area and difficult to prove intent is the key criterion. The advancing of sales through discounts, special deals and favourable return policies are more clear-cut and widespread practices. They are used by companies in the media, retail or automotive sectors to inflate revenues in a particular year. However, sale volumes are more likely to reduce the following year and in some cases, where discounts affect the reputation or brand of a particular product, the negative impact on volumes and pricing can be longer lasting. There are audit methods that can moderate the use of excessive discount practices. In particular, provisions can be made for returns based on historical levels or for the level of returns that are made post year-end and prior to the publication of results a few months later. However, increased sales through discounts or special deals can also be spotted by the analyst by an analysis of quarterly margins. Automotive companies have been well-known to sell cars to franchises or auto dealers prior to year-end. Cooperation between car manufacturers and dealerships can vary between companies and countries. Dealers can be encouraged to offer greater discounts or provide preferential financing rates, particularly when they do not sell multiple brands. Increased sales of zero-kilometre registrations are an example of this. Even for products in the music or retail industry, with shorter product lives, such as newly released music albums or DVDs, assessing precisely whether a company has over-delivered goods to customers is only ever a best estimate.

Revenue recognition based on percentage of completion occurs in the construction industry and can lead to inflated revenues if assumptions are aggressive.

Percentage of Completion
Percentage of completion (POC) accounting for long-term contracts is also susceptible to manipulation as revenue recognition is based on estimates made by the entity or the way in which contracts have been specifically structured by management. Estimates can relate to either the stage of completion, or estimated costs to completion. Although estimates must be based on reliable assumptions, these can inflate revenue but also understate them in order to bolster revenues the following year as part of a smoothing exercise by management teams. POC accounting manipulation may be used when a company, faced with weak economic fundamentals, wishes to meet growth targets year-on-year.

Related Criteria
Corporate Rating Methodology (August 2011)

Accounting Manipulation February 2012

Corporates
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
Red flags include strong revenue growth but increasing working capital outflow.

Warning signs for both the advancing sales and manipulation of revenue through POC accounting 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 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 companys 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 companys financial position and profit or loss may have been affected by transactions and outstanding balances with such parties.

How to Adjust
Cash flow statements reveal details on underlying revenues and costs.

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 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 companys 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.

Companies can exploit estimates to defer or bring forward expenses.

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.

Accounting Manipulation February 2012

Corporates
Capitalising Costs
Auto manufacturers or pharmaceutical companies, whose costs can include high levels of R&D, can improve earnings by adjusting the cut-off point between research expenses and development costs. Research costs are expensed during the period incurred, while development costs, which are expected to generate future economic benefits, may be capitalised and then amortised over a longer period of time. This also has the effect of improving EBITDA and EBITDA margins.
In capex intensive sectors such as shipping, capital goods, oil and gas, and utilities, capitalisation of operating and maintenance costs occurs most frequently.

In the same way, capex-intensive companies, such as shipping or even capital goods companies may attempt to account for repairs as additions to fixed assets and thereby capitalise these expenses, rather than expense them appropriately in the period they are incurred. General overheads may not be capitalised although this has been observed when analysing some retail companies, which have sought to capitalise employee overheads when setting up new franchises. In the utilities sector, operating and maintenance costs may be inappropriately capitalised and deferred to future years. Capitalisation of interest, allowed under IFRS where debt has been used to directly fund fixed assets, can reduce interest expense in the profit and loss account. Although compliant with accounting standards, differences in a companys funding strategy can distort interest cover ratios as well as the bottom line. Capitalisation of interest is used across many industry sectors, but occurs most frequently in asset-heavy businesses such as oil and gas, utilities and industrials.

Capitalisation of interest can also distort interest cover ratios. Again this is more common in capex intensive industries.

How to Spot It
When a company capitalises expenses, the cash outflow is immediate (via capex or interest paid), but only a partial amount is offset against revenue immediately, with the remaining amount being depreciated or amortised over time. Capitalised expenses and interest, and amounts depreciated for the year will be disclosed in the notes to the accounts. Obvious signs of aggressive capitalisation include: i) a sharp improvement in operating margins; ii) higher development costs as a percentage of revenues compared with prior years iii) unanticipated increases in capex, inconsistent with company guidance and or market conditions; iv) unexpected increases in operating cash flow. Higher development costs as a percentage of revenue within the same industry sector can also be a warning signal of an aggressive accounting approach. A comparison with debt levels and weighted-cost of capital can provide some further indication of increased interest capitalisation.

How to Adjust
Fitch typically adjusts its analysis for capitalised expenses and interest costs.

Depreciation relating to capitalised development costs may be stripped out from depreciation in the profit and loss (P&L) account and the total development costs during a given period added back to operating expenses. This will have the effect of decreasing EBITDA. Interest capitalised may be added back to the interest expenses line in the P&L. Alternatively, cash interest (which under IFRS typically includes capitalised interest) can be used as the basis for ratios. These adjustments allow for a more satisfactory comparison between peers.

Accounting Manipulation February 2012

Corporates
Figure 3

Capitalisation of Development Costs

Approach to capitalisation Total development costs Capitalised in yr 1 Charge for the year Amortised in the year EBITDA (before R&D) R&D expense EBITDA Depreciation and amortisation Operating profit Adjustment to R&D expense Adjusted EBITDA Adjustment to amortisation Operating profit
Source: Fitch

Company A Company B (Amortisation over 10 years) Conservative Aggressive 100 100 As per accounts 0 -100 0 600 -100 500 0 500 0 500 0 500 90 0 As per accounts -10 As per accounts 600 0 No expense incurred by company B 600 -10 590 -100 Total development costs 500 10 Add back amortisation expense 500

Derivatives and Mark-to-Market

Speculative trades, particularly where these are not part of the companys ordinary course of business, can be a means of manipulating profits.

Derivatives, when used one year and not the next, but more specifically where they are speculative in nature, can also distort the underlying performance of a company. Where these are not granted hedge accounting, changes in fair values are recognised in the P&L. The use of derivatives can be prevalent in an industry which is sensitive to commodity prices, namely the retail, oil and gas and utilities sectors or conglomerates where companies can be acquisitive in nature. Commodity, FX and interest rate derivatives are the most commonly used instruments by companies for hedging purposes, but can be used speculatively to enable a company to boost profits temporarily, distorting its underlying performance. Material losses can follow the subsequent year. In the utilities sector, some of the large European integrated utilities have proprietary commodity and electricity trading operations. If they do not report these operations as a separate business segment, but are embedded in the generation business, gains in the proprietary trading business can lead to an improvement in reported operating margins of the generation business.

How to Spot It and How to Adjust

Under IFRS 7, companies must disclose information on hedge accounting, fair value hedging and changes in fair values in the notes to the accounts. It is therefore often possible to find out if a company appears to be using derivatives inappropriately and or speculatively. For companies in the commodity or utilities sectors, it may be difficult to distinguish between hedging (in the normal course of business) and speculative trading, unless the company specifically discloses it, or has a separate trading unit. For utilities where proprietary trading is embedded in the generation business, peer comparisons with generators using similar fuel sources would highlight any discrepancies in operating margins, as could a historical analysis of the operating margins of the particular generation business. Unexplained volatility or significant improvements in operating margins from year to year or against peers would provide a warning signal.
Provisions are largely subjective and can be used to smooth earnings through their release, or amalgamate bad news in one year for a one-off decline.

Provisions
Provisions are recognised where a company has a legal or constructive obligation, where payment is probable and the amount can be reliably estimated. While standards have been tightened in the last 15 years, by their very nature, provisions are largely subjective, and can be used to smooth profits despite poorer operating performances through their release, or

Accounting Manipulation February 2012

Corporates
amalgamate bad news in a single year to suggest a one-off exceptional decline in performance. For the most part, provisions are dependent on managements own view. While provisions can be based on a third-party opinion, for example legal opinions when assessing litigation claims, most accounting standards do not stipulate the use of independent experts. These purely supplement managements judgement. In the case of pensions, assumptions for discount rates, inflation and expected returns on plan assets, will vary from company to company and can lead to variations in the pension deficit for a particular company year on year.
Less common forms of provisions which can be manipulated include provisions made to artist advances, air miles and customer loyalty benefits and nuclear decommissioning.

Provisions can take various forms, including provisions for bad debt, inventory, restructuring, warranties and taxes. Less common forms include provisions for music and publishing companies. These can be in respect of advances made to artists, which are held as assets on the balance sheet, and managements expectations of future revenue to be generated by future albums or book releases over a number of years. Air miles and customer loyalty benefits in the airline sector can also be an issue. No two customer loyalty programmes are alike so assessing the probable future costs with regard to air miles is based on management assumptions. The accounting approach to nuclear decommissioning in the utilities sector will vary across companies according to estimates of the costs of decommissioning and assumptions on discount rates, among other factors. These can differ significantly. Impairment tests on long-term gas purchase contracts in the utilities sector contain a large subjective element. Recently, many of these contracts have been loss making, as the contracts were agreed on when gas prices were significantly higher than current prices. Inadequate impairment of assets can materially understate losses with regards to such contracts.

Inadequate impairment of assets can materially understate losses.

How to Spot It and How to Adjust

Generally, a careful look at a companys accounting methods in the notes to the accounts and a comparison with peer companies can help to indicate whether a company is more, or less, conservative than its peers in its assumptions. For more specific cases such as inadequate or over-provisioning for bad debt, a comparison with peers and prior periods of bad debt provisions both the charge in the year and the total bad debt provision as per the notes to the accounts as a proportion of gross accounts receivables or turnover can help. Any material discrepancies would be a red flag. A close look at restructuring provisions and whether a company tends to release these provisions subsequently will often reveal whether the company tends to use big bath provisioning to smooth earnings in subsequent years. Fitch compiles nuclear liability adjusted leverage ratios for utilities with significant nuclear generation portfolios, by incorporating an implicit annuity cost of decommissioning into the EBITDAR or FFO calculation. This helps address some, though not all, of the potential discrepancies between companies with regard to their assumptions in provisioning for nuclear liabilities. With respect to pensions, Fitch calculates pension adjusted leverage metrics, based on accounting valuations, but these primarily act as a guide to what is a significant pension liability worthy of further investigation. In order to reflect the wide variations seen in pension valuations over the economic cycle, Fitch will model the likely cash effect of pensions over a period of several years.
Where exceptional items repeat year after year, these should be viewed as ordinary operating expenses.

Accounting Manipulation February 2012

Corporates
Exceptionals
Fitch calculates pension-adjusted leverage metrics. Where these are significant, it will examine the effect of adjusting for pensions over several years.

So called exceptional items are frequently used to improve key comparative ratios such as EBITDA or EBIT. Under IFRS there is no definition of what exceptional items are or that these should be separately disclosed on the face of the P&L only material classes of similar items. Provisions, as mentioned above, are the most common form of exceptions, with restructuring costs the main culprit. Additional examples of exceptional items include gains but also losses on disposal. One-off gains above the EBIT or EBITDA line can inflate a companys performance for the year, particularly where assets have been undervalued. For real estate companies, buildings, except for those held by development companies, are typically held for the long term. Any gains or losses are not part of a real-estate companys day-to-day operations and should be excluded.

How to Spot It and How to Adjust

Comparisons of a companys historical financials, peers and a look at accounting footnotes (descriptions of exceptionals and other operating expenses) should provide the information needed to make the appropriate adjustments. Where exceptional items repeat year on year, these should, in Fitchs opinion, be viewed as reoccurring costs. An analyst should be cautious about taking pro forma accounts provided by management at face value. These can exclude or include exceptional items to suit managements purpose.

Cash flow and cash flow metrics are key in assessing a companys ability to service and repay debt, a concern that is likely to be most pertinent given the gloomy outlook forecast for 2012.

Cash Flow Enhancement

Internal cash flow generation is a key focus for credit analysts as it is cash flow and not profits that will be used to service and repay debt. It also filters out many of the subjective accounting judgments that affect the income statement. In particular, credit analysts will look to the underlying operating cash flow of a company and a companys non-discretionary cash outflows. These will typically include working capital movements but also maintenance capex (not growth capex). While cash flow, unlike the P&L, is not subject to accruals-based accounting and accounting estimates, cash flows and cash flow metrics may still be distorted through the manipulation of working capital movements and classification of capex.

Working Capital Movements Timing of Payments

Manipulation of operating cash flow generation can occur through timing of creditor payments and faster collection of debtor balances.

Frequently used manipulation methods include the delaying of payments to creditors or the faster collection of debtor balances just prior to the period end. Manufacturing or chemical companies, which can have material inventory levels but also input costs, will tend to delay payments prior to the period end to inflate positive working capital movements on the cash flow statement, hereby improving operating cash flow. Orders placed, which may require significant investment in inventories may be delayed until the period in which it will be sold. Discounts or other favourable contract terms can once again incentivise customers to pay early and reduce negative working capital movements. Retail companies are prime candidates for the use of such techniques, as illustrated by many companies which introduced sales in the UK before Christmas in 2011 earlier than the traditional January sales season. Equally, they are often used in industries where cash is typically received prior to the rendering of servicestransportation companies including airlines or holiday companies, which can bring forward flight sales to increase advanced payments for which costs will be incurred in a following period.

How to Spot It and How to Adjust

Comparisons of a companys historical financials and its working capital trends can often provide a preliminary indication of aggressive accounting. Specifically, a sudden lengthening in creditor days or shortening in inventory or debtor days just prior to period end can provide a warning sign. Noticeable increases in prepayment balances or movements in order back-logs are also an indicator.

Accounting Manipulation February 2012

Corporates
Fitch uses funds from operations (FFO) ratios, which exclude working capital movements and assumes there are no timing differences between when expenses are incurred and cash is paid. However, for the purpose of forecasting or determining underlying operating cash flow, working capital movements can also be adjusted to reflect normalised trading conditions. Material advance payments can be deducted from cash balances to assess underlying leverage.

Working Capital Movements Debt Factoring and Securitisation

Increased debt factoring or securitisation of receivables will boost cash flow in a particular year but is not considered sustainable.

Operating cash flow can also be enhanced from one year to the next through the sale of receivables to a third-party or through asset-backed security transactions. Amounts received by the company can temporarily boost cash flow in a particular year (usually seen as a workingcapital improvement), but this can often not be considered a sustainable practice given that it will reduce the level of unencumbered assets available to unsecured debt holders. Accounts receivable securitisation is typically available only to large companies with a broad customer base, where receivables experience minimal default, and receivables can be closely tracked in terms of customer concentration and receivables collections rates. It therefore lends itself to the automotive sector, telecoms and utilities industries, where it is used as one of many sources of financing.

How to Spot It and How to Adjust

Where a company retains the risks and rewards including ownership of the receivables to a third party, i.e. not transferred to the debt-factoring company or ring-fenced special purpose vehicle, the amount collateralised will be disclosed as debt on the balance sheet. However, typically, the main purpose of these instruments is to obtain funding without incurring debt and so there is often only limited disclosure within the accounts. Nevertheless, unexplained material decreases in trade receivables or a sharp decrease in trade debtor days are telling signals. Once again, using FFO ratios or normalising working capital forecasts are adjustment possibilities.

Capitalisation of Costs
Capitalisation of costs improve operating cash flow metrics as well as EBITDA margins.

A theme already discussed in terms of manipulating a companys performance metrics is the capitalisation of development, repair and interest costs. All these costs are classified under investing activities as a capex item rather than under operating cash flow and therefore they can help improve operating cash ratios.

How to Spot It and How to Adjust

See Minimising Expenses section. Expenditure which has been capitalised should be reclassified and in the case of a companys cash flow, development, repair and interest costs should be deducted from investing activities and included in operating expenditure.
Debt and leverage ratios can all be distorted by the timing of material payments including acquisitions, share buybacks or capex.

Future Cash Commitments

Debt, and consequently leverage ratios, can all be distorted by the timing of payments for acquisitions, dividends, capex expenditure or share buybacks. Generally, it is more common for companies to delay payments until after a period end so as to improve credit metrics, particularly for comparative purposes but also covenants or publicly announced targets. In the same way divestments may be brought forward to improve cash flows and debt levels, while still reflecting the contributions of the company or unit disposed of.

How to Spot It and How to Adjust

Comparisons with prior years, news items and company announcements are all indicators. Notes in the accounts for contingent liabilities may also draw an analysts attention to future payments. Less timely but equally symptomatic, are payments made or received in the subsequent period. In the case of acquisitions/disposals or material capex made after the period end, analysts should attempt to produce pro forma figures for EBITDA(R), debt and Interest, as a minimum in
Accounting Manipulation February 2012

Corporates
order to assess the underlying leverage and coverage metrics of a company. Fitch will also tend to look at forecasts and how leverage metrics improve or deteriorate over the medium term and not a one-point in time.

Debt Reduction
The level of a companys debt is a fundamental concern in assessing the credit worthiness of a given entity. Working capital manipulations and future cash commitments previously mentioned will clearly impact debt balances, but there are further techniques to manipulating the debt balances themselves.

Consolidation, the Equity Method and Joint Ventures

The method of accounting for subsidiaries or JVs can mean that cash balances are inflated or debt balances are understated.

The greatest impact to debt is often derived from the accounting for subsidiaries and joint ventures (JVs) and whether these are fully or proportionally consolidated or consolidated under the equity method. Again, accounting standards can be subjective, particularly when determining whether a company has control or only significant influence. This can mean that additional cash balances may be included or material debt balances excluded. In accordance with accounting standards, full consolidation of a subsidiarys debt arises where the parent legally controls more than 50% or there is evidence of control over the company. Where there is only significant influence, typical of a less than 20% shareholding, subsidiaries are consolidated under the equity method. Here, debt at the subsidiary level is not consolidated. Proportional consolidation of debt is more commonly used when accounting for JVs, although currently, companies have the option to choose between this method and the equity method. New standards to be adopted under IFRS from 1 January 2013 should limit manipulation to some extent going forward. For example, IFRS 11 is more prescriptive in the accounting for Joint Arrangements and focuses less on the legal form but on the right and obligations of a particular structure. Proportional consolidation must be applied for a joint operation, if a company has a direct interest and share in the assets and operations of an entity, whilst the equity method is applied if a company has an indirect interest, a more typical joint venture structure. However, these standards will not go far enough in reflecting financial liabilities that a company may need to finance. Debt at these companies will not be presented on the balance sheet or disclosed in the accounts, although a parent company may consider financial support important or necessary for reputational or operational purposes. In future, arrangements may be restructured in order to meet the requirements of more favourable consolidation methods. Evidently, accounting under the equity method can reduce debt substantially through the nonconsolidation of debt-ridden operating subsidiaries. This is widespread, from telecom companies to transportation companies to metal and mining companies. But equally, proportional consolidation can allow companies to improve cash flow balances, particularly in the oil and gas sector, whereby companies have consolidated cash-rich JVs.

Methods to reduce reported onbalance sheet debt include proportional consolidation (JVs and equity method), although new standards from January 2013, may limit some manipulation.

The use of equity accounting to increase cash balances is more common in the oil and gas sector where companies consolidate cash-rich JVs.

How to Spot It and How to Adjust

A careful reading of a companys accounting policies and notes should reveal how it has accounted for a joint venture, subsidiary, participation or investment. Where analysts are reliant on publicly available information, adjusting for debt is a very difficult task. Joint-venture accounts, where obtainable, are a good source of information, but analysts must pay close attention to any intercompany debt. Fitch usually has the benefit of access to management and company information, we will generally ask for a group structure diagram and details of where group debt is allocated. If the equity method has been used inappropriately, the debt is re-consolidated.

Accounting Manipulation February 2012

Corporates
Operating Leases
Fitch adjusts for off-balance sheet operating leases.

Operating leases are often preferred by companies to finance leases, in spite of commercial considerations, in the leasing of retail outlets, manufacturing equipment, aircraft, railcars and ships as commitments under these contracts are off-balance sheet. Proposals to capitalise obligations on the face of the balance sheet in the future will go some lengths to more accurately represent the underlying obligation. However, for industry comparative purposes, these proposals will continue to cause companies to favour operating leases over longer finance leases because the former typically have a shorter life and consequently a smaller associated liability. If issuers minimise the contractual lease terms and also eliminate renewal options in leasing arrangements, they can further significantly reduce liabilities associated with leases on the balance sheet.

How to Spot It and How to Adjust

Operating lease charges and finance lease obligations are disclosed in the notes to the accounts. Fitch would typically calculate the off-balance sheet liability equivalent of operating leases by applying a multiple to the annual rental expense and adding this to the companys debt.
Figure 4

Operating Lease Adjustments

Gross debt Annual operating lease expense Multiple applied Operating lease debt Total gross adjusted debt 180 8x 1,440 4,440 3,000

Fitch analysts currently apply a multiple of 8 times (x) total rental expense for issuers in North America, Western Europe and developed countries in the Asia/Pacific region. A multiple of 8x rent may be viewed as approximating the present value of assets owned or leased with a remaining economic life of 10 years at interest rates of 3.5% to 6% Further details on Fitchs treatment of operating leases can be found in Fitchs special report Operating Leases: Updated Implications for Lessees Credit dated 5 August 5 2011 Source: Fitch

General Manipulation Techniques

Reorganisation of Segments and Redefinition of Key Metrics
General manipulation techniques are common to all industries.

Additional general telltale signs of creative accounting are the continuous reorganisation of segments, and redefinition of key metrics, particularly EBITDA, interest or key cash flow terms. These practices impact common financial ratios and covenant calculations but can also seek to confuse and prevent adequate comparisons on a like-for-like basis, masking decreases in turnover, deteriorations in margins or underlying cash flow generation. These are especially common among international conglomerates, particularly when they are acquisitive, as companies have the opportunity to disguise big bath provisioning or reorganise their segments more favourably. Similarly, automotive companies will generally disclose their manufacturing operations and their finance operations separately, but reporting may differ among companies. Although the finance operations of some automotive companies are banks in their own right and subject to banking regulation, there are some companies where the financial services business is within a division. Analysts will tend to look primarily at the manufacturing segment when assessing an automotive companys profitability and cash flow metrics. However, the debt allocated to each segment should be a primary concern. Debt disclosed under the finance segment should be checked for reasonableness and compared with leased assets and receivables from sales financing. Where debt is considered overstated in the finance division, an adjustment to debt in the manufacturing segment may be made to more accurately reflect the underlying credit metrics of the automotive company. However, so far this has happened extremely rarely.

Accounting Manipulation February 2012

10

Corporates
Reclassification of Contracts
Most accounting treatments depend on a companys stated intentions - however these can change year-on-year. In the past, real estate and construction companies have been known to manipulate balance sheet metrics and particularly net income by reclassifying contracts from either work-in-progress, to fixed assets, to investments and discontinued items.

Changes in Accounting Policies or Estimates

Changes in accounting policies and estimates are often used to improve financials, particularly when these have not been made in response to changes in accounting standards. Adoption of the revaluation model to measure property, plant and equipment values in industries where it is not necessarily standard practice, such as in hospitality or leisure, can for example improve equity ratios from one year to the next. For capital-intensive businesses a key method of improving profitability is lengthening of asset lives and hereby depreciating assets too slowly.
Early adoption of new accounting standards should be taken into consideration when conducting peer analysis.

Timing of Adoption of Accounting Standards

Choosing when to adopt new accounting standards can also place companies in a better light from one year to the next. For some companies, the early adoption of IFRS 11 joint arrangements, in 2012, may be more beneficial than for peers in a weaker performing year, as debt could be shown to reduce even though underlying cash flow has been negative. This must be considered when trying to analyse a company in the context of its peer group.

Accounting Year-Ends
Accounting year-ends are more commonly changed to allow financials to be more successfully compared with peers. However, where year ends for subsidiaries are changed to no longer coincide with the year-ends of group companies, this has in the past enabled the manipulation of cash balances.
A detailed read of the accounts is essential to spot general manipulation techniques.

How to Spot It and How to Adjust

Where a company has abided by disclosure requirements as per accounting standards, these should all be clear from the principal statements or the notes to the accounts. The audit opinion of the accounts should be the analysts first port of call. This will highlight any accounting irregularities, fundamental uncertainties or questions regarding whether the company is a going concern. A sudden, unexpected change in the companys auditor can also be a telling sign. Restatements should be made for all comparative information in the financial statements and where necessary, narrative information provided. Changes in accounting principals are accounted for through retrospective adjustments. In the case of the reorganisation of segments, this should be clear from the segmental reporting required as per IFRS. Key red flags could be restatements and prior period adjustments for accounting errors, which can also include the application of unacceptable accounting methods. Pro forma financials are key in analysing a companys statements from one period to the next, but again analysts should apply an element of caution if these have been provided by management.

Accounting Manipulation February 2012

11

Corporates
Figure 5

Accounting Manipulation: Typical Methods by Industry Sector

Sector Retail Revenue recognition Cut-off manipulation Increase in sales through discounts or special deals Manipulating like-for-like sales growth through redefinition of metrics Increase in sales through discounts or special deals POC accounting Cost minimisation EBITDA before restructuring Capitalisation of overheads for new franchises Working capital management Inflation of stock/inventory Discounts or other favourable contract terms to incentivise customers to pay early Receivable securitisation Provisioning Bad debt provisioning Provisioning for stock obsolescence VAT provisions Debt reduction LBOs as off-balance sheet debt Change between the use of finance and operating leases

Telecoms/Media/ Technology

O&M cost capitalisation Amounts due under software agreements (IT)

Bad-debt provisioning Equity vs proportional consolidation of debt-laden Provisions for advances made to operational subsidiaries artists Nuclear provisioning Asset impairment e.g. valuation of out-of-the-money gas contracts

Utilities

Oil and gas

Pharmaceuticals Industrial

Revenues for UK regulated entities (water, gas) O&M cost capitalisation Receivable securitisation are based on RAV calculations, which can be Release of big bath provisions manipulated through estimates related to opex to smooth earnings and capex expenses could be made higher Proprietary trading in generation towards the end of a price-control to influence business not separately disclosed future price controls can improve op. margins Useful life of assets and depreciation Capitalised interest Aggressive inventory accounting O&M cost capitalisation WC manipulation Hedging gains Useful life of assets and depreciation Cut-off manipulation R&D capitalisation POC accounting (construction, real estate, aerospace and defence) Pre-registration and sales to dealers at preferential financing rates/other discounts (autos) Capitalised interest R&D capitalisation (autos) O&M cost capitalisation Useful life of assets and depreciation (metals & mining) Release of big bath provisions to smooth earnings Capitalised interest O&M cost capitalisation Useful life of assets and depreciation

Landfill provisioning, environmental, remediation reserves Litigation Provisioning for product stages

Equity vs proportional consolidation of cash-rich subsidiaries but without access to cash

Pre-selling inventory at discount; Bad-debt provisioning (chemicals) Provisioning for stock Receivables securitisation (autos) obsolescence Landfill provisioning Litigation

High debt levels of finance versus operational company (autos) Equity vs proportional consolidation of debt-laden operational subsidiaries Change between the use of finance and operating leases Equity vs proportional consolidation of debt-laden operational subsidiaries Change between the use of finance and operating leases

Transportation

Increase in sales through discounts or special deals (airlines) Cut-off manipulation

Discounts or other favourable contract terms to incentivise customers to pay early (Airlines)

Bad-debt provisioning

Source: Fitch

Accounting Manipulation February 2012

12

Corporates

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE.
Copyright 2012 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. In issuing and maintaining its ratings, Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. The manner of Fitchs factual investigation and the scope of the third-party verification it obtains will vary depending on the nature of the rated security and its issuer, the requirements and practices in the jurisdiction in which the rated security is offered and sold and/or the issuer is located, the availability and nature of relevant public information, access to the management of the issuer and its advisers, the availability of pre-existing third-party verifications such as audit reports, agreed-upon procedures letters, appraisals, actuarial reports, engineering reports, legal opinions and other reports provided by third parties, the availability of independent and competent third-party verification sources with respect to the particular security or in the particular jurisdiction of the issuer, and a variety of other factors. Users of Fitchs ratings should understand that neither an enhanced factual investigation nor any third-party verification can ensure that all of the information Fitch relies on in connection with a rating will be accurate and complete. Ultimately, the issuer and its advisers are responsible for the accuracy of the information they provide to Fitch and to the market in offering documents and other reports. In issuing its ratings Fitch must rely on the work of experts, including independent auditors with respect to financial statements and attorneys with respect to legal and tax matters. Further, ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts. As a result, despite any verification of current facts, ratings can be affected by future events or conditions that were not anticipated at the time a rating was issued or affirmed. The information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. This opinion is based on established criteria and methodologies that Fitch is continuously evaluating and updating. Therefore, ratings are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for a rating. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. All Fitch reports have shared authorship. Individuals identified in a Fitch report were involved in, but are not solely responsible for, the opinions stated therein. The individuals are named for contact purposes only. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guaran tor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.

Accounting Manipulation February 2012

13