TOOL E3
This tool helps you to identify the early warning signal when a client uses accounting policies to disguise adverse financial trends and delay reporting of negative non-financial events. Usually this is achieved by overstating earnings, and/or reducing reported leverage, including inadequate disclosure of off-balance sheet items.
Overstating Earnings
Inflating Income
• Is there aggressive revenue recognition? Are we sure we understand when the client recognises earnings? Have they inflated yearend sales (check receivables)?
• What inventory valuation methods are used? How accurate are they?
• Has there been historic over provisioning to allow provision release?
• What is “other operational income” and is it really sustainable?
• Is the client maximising negative adjustment to make future years look better?
• Is there large minority interest share of profit after EBIT suggesting over statement of sales growth and profitability?
• Is associate income cash / non cash and what is its quality and sustainability?
• Is there transfer pricing with non-consolidated related parties Improving EBIT?
• Have changes in deferred tax asset and liabilities distorted profit after tax figures?
• Increased reliance on financial/treasury income?
• Is clients electing different average foreign exchange
Understating Expenses
• What is the bad debt policy? Is it estimated on historical performance? Does it fluctuate significantly from year to year?
• How realistic are the depreciation, amortisation and impairment expenses?
•Have provisions been understated
• How closely linked are “non-recurring” items to operations and are they truly one off?
•Are the assumptions on expected rate of return, discount rate and actuarial issues in defined benefit pension plans realistic? Are pension costs too low?
• How are option pay packages accounted for in the income statement?
• What is the real value of purchased in-process intangibles such as R&D?
• Which costs are capitalised? Check intangibles, fixed assets and interest paid.
Be aware that in some cases these activities will also improve reported cash flow.
Reducing Leverage
Reducing Reported Debt
• Is subordinated debt deeply or lightly subordinated?
• What is the relative debt priority position of minority shareholders?
• Full consolidation of low leveraged partially owned subsidiary.
• High year end creditors/cash balances.
• Is restricted cash included in reported net debt?
Off-Balance Sheet Debt
• Operating Leases
• Unconsolidated related parties and associates
• Proportional consolidation
• Take or pay contracts
• Receivable sales/Sale lease back
• Defined Benefit pension plans
• High risk guarantees and other events not provisioned
• Pending litigation
Inflating Net Worth
• What is the impact of overstating earnings (see above)?
• Do minority shareholders have a poison pill arrangement with major shareholders?
• Are low quality assets fully impaired?
• What is the impact of parking reserves(i.e.Translation, cash flow hedges, held for sale, revaluation) on the volatility of Net Worth?
• Will hybrid instruments display equity characteristics in the stress scenario?
• Is there sufficient period to carry forward tax losses? If not deferred tax assets should be deducted from Net Worth.
• Has under provisioning on pensions, deferred tax and restructuring etc. Inflated Net Worth?
Be aware that clients may seek to suppress profit in a particular year through reducing income or accelerating costs
