What are the best practices for detecting and adjusting for accounting distortions?

1 Sources of accounting distortions

Accounting distortions can arise from various sources, such as management incentives and biases, accounting standards and policies, and business complexity and uncertainty. Managers may attempt to manipulate accounting numbers to meet earnings targets, boost stock prices, hide problems, or influence compensation or contracts. Different methods or estimates may be required for measuring and reporting certain items, such as revenue recognition, depreciation, inventory valuation, or goodwill impairment. Additionally, complex or uncertain business activities and transactions may affect the accounting treatment and disclosure of financial information, such as those involving mergers and acquisitions, derivatives, leases, pensions, or contingencies.

2 Types of accounting distortions

Accounting distortions can be divided into two categories based on their effects on financial statements. Income-increasing distortions, such as accelerating revenue recognition or understating liabilities, inflate reported net income or earnings per share (EPS). Conversely, income-decreasing distortions, such as delaying revenue recognition or overstating liabilities, deflate reported net income or EPS.

3 Indicators of accounting distortions

Accounting distortions can be detected by using various indicators, such as financial ratios and trends, red flags and warning signs, and quality of earnings and accruals. Comparing a company's financial ratios and trends with its peers, industry, or historical performance can reveal anomalies or inconsistencies that suggest accounting distortions. Additionally, identifying and investigating the red flags and warning signs of accounting distortions can help uncover potential issues or risks. Furthermore, evaluating the quality of earnings and accruals of a company can assess the sustainability and reliability of its reported income. All these indicators can help detect accounting distortions.

4 Tools and techniques for adjusting for accounting distortions

Accounting distortions can be adjusted through the use of various tools and techniques, such as restatements and normalizations, adjusted earnings and multiples, and cash flow analysis and valuation. Restating and normalizing financial statements can help make them more comparable and consistent, while adjusting earnings and multiples can help reflect a company's true economic performance and value. Analyzing and valuing the cash flows of a company can also help avoid the pitfalls of accounting distortions, allowing for more robust estimates of the company's value and expected returns.

5 Here’s what else to consider

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