Let's have a look at the risks associated with estimated numbers in financial statements. Although accounting rules try to ensure that company profits provide a robust way to assess a company's performance, there are a number of areas where profits are reliant on management estimates and which are therefore of particular interest when we're conducting our forensic accounting analysis. Now here we identify the four most common areas where companies tend to manipulate their estimates. The first is contract revenue and profit recognition. Now, this applies to companies which have contracts which run for many years, and the risk here is how the revenues and the profits are recognized each year during the contract. This is an issue that is particularly relevant for service businesses and also for construction companies.
The next issue is inventory valuation, particularly in relation to the absorption of fixed costs and inventory. Now, clearly this is relevant for any company that has a large amount of inventory on their balance sheets, and so particularly applies to industrial companies, component manufacturers, chemical companies, food, and also beverage.
The next issue is provisions, and these are a major risk area for companies because they can use provisions for profit smoothing, and as provisions are relevant for all industries, this is something we will always want to keep an eye out for when we're conducting our analysis. The final risk area for estimates in accounting is for m and a. And although M&A accounting is quite a complex topic, there are two aspects which we'll focus on in relation to the use of estimates. These are how companies fair value, the targets, balance sheets, and how they value contingent consideration. And clearly this topic is relevant for any companies which have recently acquired another business, and particularly where companies have a strategy of regular bolt-on M&A These four areas are highly subjective areas of accounting, so it could be affected by management bias and are always something we want to focus on when we're conducting our forensic analysis.
