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Assessing
Accounting Risk
Applied Financial Analysis

ACCT 411 Fall 2020

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Business Analysis-How?

Business Environment -economic & industry circumstances (Industry

analysis – Porter? SWOT? Strategy Analysis -responses to its
environment) Subramanyam, K. R, Financial Statement Analysis, 11th Edition.
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Assessing Accounting Risk

Accounting risk is the risk that financial statement data

contain material misstatements.
Accounting risk is inherent, to some degree, in all financial statements. Hence, financial
analysis requires an assessment of the risk of material misstatement due to accounting
improprieties.
Accounting improprieties can be either improper accounting entries or disclosures.
Causes of financial statement misstatements can range from unintentional accounting
errors to fraud. Since financial analysts do not have access to company records, it is
unlikely that a financial analyst would identify specific accounting misstatements.

Assessing Accounting Risk-David F. Hawkins

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Accounting Risk Framework

The accounting risk assessment framework consists of six assessments, each focusing on
answering a particular question. These are:

• Institutional Context- Is the institutional context in which the company operates one that
would discourage accounting misstatements by management?
• Opportunity- If management chose to do so, what opportunities in the company’s financial
statements are there for management to engage in improper accounting?
• Incentives- Are there any management incentives that under certain conditions might
motivate or pressure management to engage in improper accounting?
• Behaviour-Has management displayed any behaviour that is similar to the behaviour of
those managers who in the past have misstated financial statements?
• Evidence - Are there any signs that suggest misstatements might be present?
• Likelihood- Based on the entity’s potential for misstatement and the identified evidence that
accounting misstatements may be present, what in the analyst’s judgment is the likelihood
that accounting misstatements are present?
 z Institutional Context
§ An institutional context that is likely to facilitate accounting misstatements is one with some of these
characteristics:

§ Weak security markets regulations and regulators.

§ An auditing profession that is not independent, not professional, and/or has a low level of auditing
skills.

§ A financial press that is not independent and aggressive in pursuing potential accounting
misstatement stories.

§ A security analyst community that is not independent and/or competent.

§ Laws and courts that are lenient towards management and companies alleged to have engaged in
accounting misstatements.

§ Corruption is an accepted or at least tolerated business practice.

§ There is little incentive for potential whistle blowers to reveal accounting misstatements.

§ Financial statements relative to personal relationships play a small role in business transactions.
 z Opportunity

The focus of the analysis is on the potential for material improprieties, not on whether
they are present.
An assessment of a company’s potential for accounting improprieties requires the
analyst to examine the company’s
§ Business model

§ Economics

§ Accounting and business transactions

 z Incentives

Incentive-related risk factors might include the following:

§ A significant portion of management compensation is based on achieving aggressive
operating, financial position, or cash flow targets.

§ A significant portion of management wealth is dependent on the company’s stock

price behaviour.

§ Management reputation is dependent on achieving aggressive operating, financial

position, or cash flow targets.

§ Management targets are short-run targets, such as the next quarter’s earnings.

§ The securities market has reacted in a significant adverse manner toward the
securities of

§ firms similar to the reporting company that have not met their earnings targets.
 z Behaviour
Behavioural risk factors include the following:

§ An excessive management interest in the company’s stock price.

§ Management commits to achieving unduly aggressive targets.

§ Management tolerates internal control weaknesses.

§ Domination of management by a single person or close-knit group of people.

§ High turnover of senior management and board members.

§ Poor relations with former auditing firms.

§ Claims alleging management has engaged in improper accounting, regulatory violations,

or unlawful behaviour.

§ Senior management sets unrealistic targets for operating managers.

§ Management releases opaque or unclear financial statements.

§ Management gives vague or implausible responses to analyst conference-call questions.

§ Management operates in a weak governance environment.

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Initial Assessment

Based on the four assessment criteria already reviewed

take a step back and make an initial assessment of the
POTENTIAL for accounting improprieties.
The next step is to look for actual EVIDENCE of this
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Evidence
Evidence will be circumstantial in nature……

Examples of risk factors that individually or in combination raise suspicion that accounting
improprieties may be present include:

§ Net income is significantly larger than cash flow from operations.

§ EBITDA is significantly larger than free cash flow.

§ The reporting company’s financial results are significantly better than the industry
conditions would suggest.

§ The company’s financial performance is significantly better than its direct competitors.

§ The management prefers its performance to be judged by EBITDA and similar non-GAAP
performance metrics, rather than by GAAP net income.

§ Accounting improprieties have been revealed recently at companies with operations

similar to the reporting company.

§ Frequent restatements of past earnings figures.

 z Evidence continued…
§ The company continues to perform well despite a “broken” business model.

§ A critical pending business opportunity is in danger of being lost due to poor financial
results.

§ There is a threat of imminent bankruptcy, foreclosure, or hostile takeover.

§ Debt covenants are increasingly difficult to maintain.

§ Earnings growth is a smooth progression despite earnings volatility in the general

economy.

§ Earnings consistently beat analysts’ consensus.

§ The company is increasingly vulnerable to changes in the economy, such as interest

rates, availability of capital, industry trends, price levels, and tax codes.

§ The company’s cost structure portrayed in its financial statements does not reflect the
nature of its business and current industry conditions.

§ The company has delayed filing its financial results with the SEC.
 z Evidence continued….

§ There are significant questionable movements in provisions.

§ Material changes in accruals.

§ The accounts receivable days collection period has increased significantly.

§ The company has changed auditors recently.

§ On a relative basis, the company’s audit fees are significantly out-of-line with its
competitors.

§ The company’s financial rates profile is not consistent with its industry financial rates
profile.
 z Likelihood

The analyst must now exercise personal judgement and ‘weigh’

the evidence they have collected. This requires exercising
professional skepticism but the analyst must be careful not to see
a potential for misstatement where none exists.
Also, it is not just the likelihood of misstatement that will have
consequences for analysis, but also the materiality of the
misstatement.