Investing: Calling their bluff

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Updated: April 3, 2015 12:02:33 PM

With accounting frauds by companies on the rise, investors would do well to heed early warning signs...

money, investment, ipo india, ipo news, capital market, nse, bse, stock exchange, stock, mumbai stock, company stock, stock investment, investment news, companies, money newsCompanies may show higher earnings in a particular period to meet analyst earning expectations, to meet debt covenants, or to improve incentive compensation. (Thinkstock)

In recent years, we have seen many an accounting scandal — some having resulted in bankruptcies, while others causing the sudden demise of a major accounting company.

Unfortunately, these scandals are not a new phenomena. Looking back, we see that scandals such as these have occurred from time to time, particularly when there is a downturn in the economy and managers have felt the pressure to meet earning expectations or debt covenants or to maintain or increase their personal wealth.

By examining these scandals, we can learn more about warning signs and the techniques used to manipulate reported financial results.

Financial reporting quality

Financial reporting quality goes beyond the traditional view of conservatism and earnings quality. The principal concern of users, especially investors, is whether the earnings have been overstated in financial statements. Companies may be motivated to increase earnings in a particular period to meet analyst earning expectations, to meet debt covenants, or to improve incentive compensation.

The management may also have reasons to lower reported earnings during a particular period. For example, it may want lower earnings reported to obtain trade relief, negotiate lower payments to other counter-parties from a prior business transaction, or negotiate concessions from unions or others.

Customer financing

Sometimes, companies lend money to customers to buy their goods. This might happen towards the end of the accounting year to boost sales. This way, they can report higher sales in the income statement and also show higher receivables (which is a current asset) in the balance sheet.

Understating provisions

Sometimes, to enhance the sale figure, companies may supply goods to customers with a poor credit history. In such cases, they should set aside a higher amount as provision for bad and doubtful debts, which is a liability in the balance sheet. But this amount is understated. Understating such liabilities is another trick to ‘enhance’ the financial statement.

Off-balance-sheet items

Some financing activities, such as lease agreements, assets and liabilities and joint ventures and pension assets and liabilities, are not fully recorded and recognised in the balance sheet due to legal complexities. However, these items are recorded in the footnotes of financial statements. Since the liabilities and related risk involved in those transactions are not reflected in the balance sheet, one might draw wrong conclusions about a company’s financial performance.

Warning signs

A simultaneous examination of all financial statements is a useful tool in detecting financial irregularities. For instance, a combination of increasing earnings and decreasing operating cash flow may indicate aggressive reporting of earnings. Similarly, fraudulent activities to inflate sales and understate expenses generally lead to a buildup in assets on the balance sheet (often assets, such as receivables and inventory, can involve long-lived assets). The auditing literature can help investors, creditors and analysts identify red flags.

Here are some indicators that investors need to pay attention to while looking at the financial statement of a company:

Financial ratios: Key financial ratios, which measure liquidity, profitability, solvency, etc., may not be in line with industry peers. It could be due to the inflated earnings, asset valuation or understating of expenses and liabilities. For instance, when there is a sudden increase in inventory-to-sales ratio, the company might be inflating the value of inventory.

Cash flows: If the cash-flow operation of a company is consistently less than that of the reported operating profit, it is a clear warning sign. Investors need to examine the financial statement with the objective of finding out why the operating profit is not converted into cash. Similarly, continuous (more than three to four years) high level of holding cash and cash equivalent (comparing to its peers) is a warning sign.

Depreciation method: A company might select a depreciation method that results in higher earnings than the economic depreciation of the assets warrants. For instance, when a company follows the written-down method of depreciation, it allows it to deduct a higher amount as depreciation in the first few years of purchase than is the case with the straight-line method, where the amount of depreciation is equally deducted during the life of the asset.

Dodge this

Some of the techniques used by companies to manipulate financial results:

* Companies may show higher earnings in a particular period to meet analyst earning expectations, to meet debt covenants, or to improve incentive compensation.

* They may also lower reported earnings during a particular period to obtain trade relief, negotiate lower payments to other counter-parties from a prior business transaction, or negotiate concessions from unions.

* Companies may lend money to customers to buy their goods. This might happen towards the end of the accounting year to boost sales. This way, they can report higher sales in the income statement and also show higher receivables (which is a current asset) in the balance sheet.

* To enhance sales figure, companies may supply goods to customers with a poor credit history. In such cases, they they should set aside a higher amount as provision for bad and doubtful debts, which is a liability in the balance sheet. But this amount may be understated.

* Some financing activities, such as lease agreements, assets and liabilities and joint ventures and pension assets and liabilities, may not be fully recorded and recognised in the balance sheet.

The writer is associate professor of finance & accounting in IIM, Shillong

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