There are risks associated with investing but at the very least you should expect to be able to trust a company’s audited accounts.

Most people remember what happened to Enron. In 2001, the company was the seventh largest in the US and had profits approaching $1bn. Then due to some ‘creative’ accounting which turned out to be fraudulent, not only did the company go bankrupt it brought down one of the world’s largest accountancy firms, Arthur Andersen.

Shareholders saw Enron’s value collapse from over $90 a share to under $1.

You’d hope that lessons would be learned on both sides of the Atlantic but events show that investors still have cause to be wary of some company accounts.

Focus on accounting firms

The Financial Reporting Council (FRC), the body in charge of enforcing accounting and auditing standards, tends to focus on the accountancy firms when it comes to reprimands.

In reality, only a handful of companies are sanctioned for filing dodgy accounts. But if analysts voice their concerns, they may well need a thick skin. When Matthew Earl, a former analyst at Matrix, issued bearish reports on UK outsourcer Connaught way before the rest of the market, he was attacked by the company’s head, Mark Tincknell. Tincknell even described Earl’s work as ‘a masterful feat of incompetence’.

Less than a year later, Connaught had gone the way of Enron, collapsing into administration.

Michael Donnelly, an analyst at Panmure Gordon and one-time colleague of Earl tells Shares that when looking at balance sheets, he’s rarely looking for fraud as it’s extremely rare. Donnelly is looking for imprudent and aggressive accounting.

If a company is recognising revenue too early and deferring costs well into the future this should ring alarm bells. These aggressive accounting techniques suggest a company is trying to manipulate its earnings. Donnelly put a ‘sell’ recommendation on Utilitywise (UTW) two years ago due to its accounting methods.

Private investor and highly respected blogger Paul Scott says he can easily spot dodgy accounts, even when the auditor gives a clean sign off.

‘You just have to look for things that don’t look right - e.g. excessive debtors, excessive capitalising into intangibles, weird other debits sitting on the balance sheet where they wouldn’t normally exist,’ says Scott.

Connelly likes to look at balance sheets every six months to see if there’s anything amiss and Scott checks the movement over several years on the balance sheet to make sure that the changes in balance sheet values match up.

It's not easy to spot

If a chief financial officer (CFO) or finance director really wants to try and fool an auditing firm, there’s not much the firm can do about it. Richard Murphy, a chartered accountant and political economist, says if a CFO is really ‘crooked’ they can hide transactions for some time if they really want to.

Auditors should resign if they think that risk exists as KPMG did at Lycamobile recently but the lack of resignations in general suggests not enough caution is shown in Murphy’s opinion.

Scott agrees, saying that a determined and clever CFO can easily pull the wool over the eyes of auditors. However, he says that auditors should act as whistleblowers if they suspect fraud and not just resign.

It is the auditors though who more often than not face the wrath of the FRC although there are many who don’t think the organisation is set up correctly.

Jason Yardley, a partner at law firm Jenner & Block says the FRC has an odd set-up. It is an industry funded body acting as judge and jury over its own members behaving as if it’s a court but without the rigour of a court.

Tim Bush, head of governance and financial analysis at the Public Interest Research Centre (PIRC) is also no fan of the FRC. Bush says the FRC breaks the normal rules on the separation of powers.

Another source who didn’t want to be named said that the FRC was set up under the recommendation of the so-called ‘Big Four’ accountancy firms (PWC, Deloitte, EY and KPMG). They say it’s like a prison camp being set up by the prisoners and once in a while they ask the guards to beat them up so it looks a lot tougher than it really is.

What can be done?

With the current system, there’s a huge conflict of interest as the management of a company appoints the auditors and determines their fee. Yet the auditor is supposed to be independently checking management figures. There are ways to resolve this.

• Let the shareholders appoint the auditors and the director that deals with them without interference from the company.

• Have the fee approved by shareholders.

• Have the auditor appointed by a third party, combine the task with tax inspection and have a government approved panel of auditors paid for by a levy on all companies as part of a registration fee for owning a company.

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