TOP 1000/ACCOUNTING:THERE ARE numerous ways in which companies can legitimately massage their numbers in order to cast themselves in the best possible light, but events of the last year have highlighted the dangers of pushing creative accounting – as it's euphemistically known – too far.

Although it’s possible to temporarily bury a problem by “window dressing” results, in the longer run it’s unsustainable. As disgraced Nasdaq nonexecutive chairman Bernie Madoff and former Anglo Irish Bank chairman Sean FitzPatrick have both learned, the truth will out.

In Ireland, directors are required to prepare accounts that give a true and fair view of their company’s position and must abide by certain accounting standards. However, when preparing accounts, management have to use their own discretion and judgment.

This means that there’s plenty of wriggle room to manipulate results without technically breaking any rules or regulations. “The job of company management is to look after the best interests of their company, and in doing that they will present a set of accounts that shows the best possible picture of their company,” explains Prof Niamh Brennan, academic director of the Centre for Corporate Governance at UCD.

A number of accounting manoeuvres are commonly employed to this end. For instance, retail organisations often select January 31st as their year end because cash is likely to be at its highest level after the Christmas sales.

“That is a perfectly legitimate tactic to adopt,” says Brennan. Companies might also choose to delay paying creditors until a week or two after the year end in order to keep their bank balance artificially high, or they might make a push to collect as much money as possible from debtors before the year end. It’s also not uncommon for companies to allow some “looseness” around the precise year-end date, she says.

For instance, if their year end is December 31st, a company might leave its books open for a couple of days after this, so if a customer were to make a large payment on January 2nd, this would be booked on December 31st. It may not be strictly kosher, but in the grand scheme of things it’s a pretty minor issue.

Companies will sometimes window dress their results by simply taking an overly-optimistic view on the recoverability of their debtors, goodwill and stock. For example, clothing retailers with stock left over from the previous season will realistically have to discount that stock in order to sell it. But the company could choose not to write down the stock, in order to present a healthier picture at year end, even though this will come back to bite them when the clothes inevitably fail to sell.

The valuation of assets such as property is an area fraught with difficulty at the moment. Management must take a pragmatic approach and make realistic estimates, biting the bullet and booking impairments where necessary, or else these valuations could be wildly unrealistic, as has been made abundantly clear in the banking sector of late.

“The markets will hammer people who are not taking a robust view of the world,” one industry expert commented. “They get found out eventually.” If this all sounds like a grey area, that’s because it is. In fact, most accounting is “very grey”, Brennan says. “Because everything is expressed in precise numbers, people reading accounts think they are very precise, whereas in fact they are extremely imprecise,” she says.

Therefore, when investors read a set of accounts, they should bear in mind how “flawed” accounting is as a process, she advises, and how prone it is to subjective judgment. Take off the rose-tinted glasses  and look at it with some element of scepticism, and take into account that it is management putting the best foot forward,” she advises.

“We have seen in the Irish market recently how much, on occasion, that can be stretched, so some companies will be putting their best foot forward in a fairly acceptable and prudent way. Others might be going to extremes.” One of the most serious forms of window dressing involves collusion with a third party, for example when a company enters into circular transactions with another company, with the sole objective of misrepresenting their financial situation. This was perfectly illustrated by one of the many scandals at Anglo Irish Bank.

It emerged last year that former chairman FitzPatrick hid borrowings that at times exceeded €87 million through a “warehousing” arrangement with Irish Nationwide Building Society.

This arrangement went on over an eight-year period and unbeknownst to the bank’s auditors and shareholders.

An examination of major corporate scandals of recent years reveals that the accounting practices used to create a false picture of growth and profitability, or to cover up problems, seem complex on the surface but generally boil down to three simple tactics: overstating assets, understating liabilities and manipulating the company’s cash position.

Shareholders and other stakeholders could be forgiven for expecting fraudulent accounting tricks of this nature to be detected by a company’s external auditors, but as cases such as WorldCom, Parmalat and more recently Satyam have proved, auditors don’t always sound the alarm.

“Investors should not put as much reliance on external auditors as they do,” Brennan warns.

“I think that an external audit is a very worthwhile and valuable process, but it is not the absolute perfection that some investors think it is. The auditors are exercising a certain amount of oversight, but the oversight is limited.”

Auditors don’t examine every single transaction of the company being audited; instead they look at a selection of transactions chosen with reference to what is known as the “materiality level” set at the outset. The higher the materiality level, the fewer transactions are audited.

“If this level of materiality was disclosed in the auditors’ report, investors would have a much clearer understanding of how imprecise auditing is,” she says.

So how can investors avoid being deceived by company results that have been tweaked and tailored to look their best? It’s a case of being more proactive.

“Do your own due diligence, do your own checks and balances. Read the accounts. It’s amazing how often issues are revealed in the accounts if you carefully read them,” she advises.

According to Pat Burke, head of the privately-held business (PHB) division at Grant Thornton, good corporate governance and an internal audit committee with strong financial competencies can act as an “antidote to the potential to mis-state results”.

Burke gives his clients two key pieces of advice in relation to preparing and communicating financial information about their business: “Facts are friendly” and “think straight, talk straight”. Whether a business is dealing with bankers or the investment community, what people want are facts and they must believe in the integrity of management, he says.

“Ignoring problems or presenting numbers in a certain way in order to bury a problem doesn’t solve anything,” he continues. “It just pushes it out in front of you.”

Businesses that mis-state or distort results will eventually be caught out. “It’s not sustainable and, in the current climate, it’s totally the wrong thing to do. No matter how bad the problem is, there is always some sort of solution,” he adds. “Denying reality is not it.”