Graphical sleight of hand: how can auditors spot altered exhibits that appear in annual reports?(financial graphs in corporate reports)

EXECUTIVE SUMMARY

* GRAPHS IN CORPORATE ANNUAL REPORTS may have an altered vertical scale and often report a more favorable picture than warranted by the underlying financial information. Auditors can perform a real service for their clients by pointing out the existence of graphical alterations in financial statements and helping companies avoid potential "earnings management" problems.

* AUDITORS ARE NOT REQUIRED to corroborate or test additional financial information reported in corporate annual reports, such as data in ratios and graphs. However, auditors should consider whether such information is materially inconsistent with the financial statements.

* A PROPERLY CONSTRUCTED GRAPH that begins with a vertical scale of zero has no disparity between the picture and the numbers. There are high-tech and low-tech solutions auditors can use to detect vertical scale alterations less obvious to the eye.

* ASSESSING MATERIAL INCONSISTENCIES involves auditor judgment. Auditors should consider the materiality guidance outlined in the SEC's SAB no. 99 in preparing financial statements and performing audits of them.

* PRACTITIONERS ENGAGED TO EXAMINE MD&A should explore the materiality implications of graphical alterations and to what extent they lack reliability or representational faithfulness. Intentionally altered graphs mask trends and the real-life events they purport to convey.

At least one in 10 graphs in corporate annual reports has an altered vertical scale that depicts a more positive picture than the underlying financial information warrants. The vertical scale modifications can change readers' judgments, alter trends and may be deemed intentional by regulators if they seem to magnify favorable information. Auditors can perform a real service for their clients by pointing out the existence of graphical alterations in financial statements and helping companies avoid potential "earnings management" problems with the SEC and investors.

Evidence of altered graphs in corporate annual reports spans more than a decade. Vertical scale alterations are reported around the world. According to a 1997 study of 300 annual reports from six countries by the Institute of Chartered Accountants in England and Wales, the design and construction of graphs in annual reports are often poor. Measurement distortions, including vertical scale alterations, were the worst in annual reports from France, the United Kingdom and the United States.

WHAT ARE AUDITORS LOOKING AT?