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Economic health may be hiding accounting fraud

Economic health may be hiding accounting fraud

BENIGN ECONOMIC conditions globally may be masking accounting frauds, according to a leading ratings agency.Fitch Ratings said that the absence of corporate collapses due to accounting fraud in…

BENIGN ECONOMIC conditions globally may be masking accounting frauds, according to a leading ratings agency.

Fitch Ratings said that the absence of corporate collapses due to accounting fraud in 2004 does not mean that enhanced regulation such as the US Sarbanes Oxley Act is meeting its aims. The most recent corporate collapse brought on by accounting fraud concerned Parmalat in late 2003, and while since there have been issues at Adecco SA and Fannie Mae, they do not appear to be terminal.

“However, it is too early to deem this as a sign that enhanced regulation and scrutiny of corporate governance are kicking in and paying dividends,” Fitch warned in a briefing. “Accounting problems tend to emerge in times of economic adversity for companies and the relatively benign economic environment in recent years may be obscuring such problems.”

Fitch added that risk of misstatement, whether fraudulent or not, tends to be more likely in the more ambiguous and shadowy areas of accounting. “These shadows grow longer in the increasingly complex world of accounting and reporting for derivatives and hedging activities, securitisations, and reinsurance amid emerging issues such as the new revenue recognition model and IFRS convergence,” Fitch said. “More common than outright misstatement is opaque disclosure that may be wholly in line with all applicable accounting rules but adds nothing to investors’ understanding of a company’s business.”

International regulators need to add clarity to the increasingly complex set of accounting rules, Fitch said. But, increased regulation will not help, and a move back to principles-based accounting is needed, the firm added. While the International Accounting Standards Board (IASB) has built a set of principles-based standards, they are being steadily made more prescriptive as more companies in more countries attempt implementation and further guidelines and rules are added.

“By the time these have been translated into a wide variety of languages, the underlying message may be lost.,” Fitch said. The likely end result will be a mix between prescriptive and principles-based rules. “The time until then will be uncomfortable for companies trying to communicate the success of their business to investors, for auditors reporting on whether these companies’ financial statements reflect current best practice in accounting (a moving target), and for investors trying to assess whether restatements tell them if anything relevant to their investments.”

In addition, Fitch said there are several other risks that could drive financial restatement in 2005. The move to International Financial Reporting Standards (IFRS) — a bone of contention for many corporates here - will be an drawn out process, while financial disclosure is also an issue. Enhanced disclosure through IFRS and local initiatives has the potential to change disclosures and this could reveal aspects of transactions that were not properly disclosed in the past and could uncover previously unidentified risks.

Moreover, derivatives — dubbed financial weapons of mass destruction by legendary US investor Warren Buffett — are also an area of concern with the potential for incomplete and inconsistent disclosure.

Stuart Fagg is the Editor of Risk Managementmagazine, Lawyers Weeklys sister publication.

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