Saturday, December 12, 2015

Common Clues Of Financial Statement Manipulation


Courtesy : Investopedia

Law enforcement has crime scene investigators to tell them the significance of a bloody fingerprint or a half-smoked cigarette, but investors are often left to their own devices when it comes to trying to figure out whether an accounting crime has taken place and where the fingerprint might be. Now more than ever, investors have to become forensic accountants themselves if they want to avoid being burned by unscrupulous accounting in a company's financials. In this article we will look at some common signs, both obvious and subtle, that a company is struggling and trying to hide it.

Exaggerating the Facts.


With all the big baths that companies take, it's tempting to believe that Wall Street is the cleanest place on earth. The big bath refers to the swelling of corporate write-downs in the wake of poor quarters. When a company is going to take a loss anyway, they sometimes take the opportunity to write off everything they possibly can. This is often compared to spring cleaning; the company realizes losses from future periods and/or losses that were kept off the books in previous quarters. This makes poor results look even worse and artificially enhances the next earnings report. In this case, there is no actual crime taking place, but it is a deceptive accounting practice. However, the biggest problem with this practice is that once a company has taken a big bath, income manipulation is a step away. 


A company taking a big bath isn't difficult to evaluate in comparison with other companies in its sector that haven't used deceptive accounting practices. Generally, the company has a very bad year followed by a "remarkable" rebound in which it begins to report profits again. The danger comes when companies make an excessive write down, such as claiming unsold inventory as a loss when it is probable that it will be sold in the future. In this case, when the inventory moves, the company would add the profits to their operational earnings. This type of income manipulation makes it hard to tell whether the company is actually rebounding or is merely enjoying the benefits of the items they "erroneously wrote off". This type of write off is similar to the difference between spring cleaning and burning down your house for the insurance money, so any company that rebounds quickly from a big bath should be viewed with suspicion. 

Smoke and Mirrors.

One of the most prevalent approaches to corporate accounting is to omit the bad and exaggerate the good. There are a number of subjective figures in any financial report that accountants can tweak. For example, a company may choose to exclude costs unrelated to its core operations when figuring its operating cash basis - say an acquisition of another company or purchasing investments - but will still include the revenue from the unrelated ventures when calculating their quarterly earnings. Fortunately, companies have to break down the figures, thus dispersing the smoke and mirrors, but if you don't look beyond a few main figures in a company's financials you won't catch it.


Finding the Accomplice

There can be a number of accomplices to any accounting crime, but two popular suspects are special purpose entities (SPE) and sister companies. SPEs allowed Enron to move massive amounts of debt off its balance sheet and hide the fact that it was teetering at the edge of insolvency. Sister companies have also been used as a way to spin off debt as new business. For example, a pharmaceutical company could create a sister company and hire it to do its research and development (R&D) (pharmaceuticals' biggest expense). Instead of doing the work, the sister company hires the parent company to do their own R&D - thus the parent company's biggest expense is now in the income earned column and no one notices the perpetually debt-ridden sister company. Nobody, that is, except those who read the footnotes.

The footnotes list all financing related affiliates and financial partnerships. If there is no accompanying information disclosing how much the company owes to the affiliates or what contractual obligations there are, you have plenty of good reasons to be suspicious. 

Elder Abuse

Sometimes when a company is struggling, it starts dipping into financial reserves that it hopes no one will notice. Target No.1 is usually the pension plan. Companies will optimistically predict the growth of the pension plan investments and cut back on contributions as a result, thereby cutting expenses. When the pensions start coming due, however, the company will have to top off the plans from current revenue - making it clear that putting off expenses doesn't make them go away. A healthy company pension plan has become critical as baby boomers near retirement. 


Getting Rid of the BodyCompanies may try to hide an unsuccessful quarter by pushing unsold merchandise into the market, or into the distributors' storage rooms. This is usually called channel stuffing. This may save a company from a big quarterly loss, but the goods will return unsold eventually. Channel stuffing can be detected in two figures: the stated inventory levels and the cash meant to cover bad accounts. If inventory level suddenly drops or the money for bad accounts is drastically increased, channel stuffing may be taking place. 

Fleeing Town

Because the Canadian and American markets are so intertwined, companies that trade on both exchanges can choose which country's accounting standards to use. If a company changes from the historical accounting standards for that firm, there had better be a good explanation. The two systems, while generally similar, account for income in different ways that may allow a wounded company to hide its weakness by switching sides. Any change in accounting standards is a huge red flag that should prompt investors to go over the books with a fine-toothed comb. 


Guilty Tongues Slip.

Damning statements are often casually mentioned in a company's financials. For example, a "going concern" note in the financials means that you should get out your magnifying glass and pay close attention to the following lines. With the practice of overstating the positive and understating the negative, a company admitting to a "going concern" may actually be confiding that they are two steps from bankruptcy. Unexpectedly switching auditors or issuing a notice that the CEO is resigning to pursue "other interests" (most likely in the Cayman Islands) are also causes for concern.


Conclusion

Although there are many interesting numbers in a company's financials that allow you to make a quick decision about a company's health, you can't get the full story that way. Due diligence means rolling up your sleeves and scouring the sheets until you are sure that those main figures are real. The best place to start looking for bloody fingerprints is in the footnotes. Reading the footnotes will provide you with the clues you'll need to track down the truth.

27 comments :

  1. One thing that is reported in US financial statements is "goodwill" which can be a hiding spot for uncertain expenditures. There are rules as to how goodwill is to be reported, but the specifics of the things reported aren't known. Goodwill could be something like the value of "reputation" of a new acquisition.

    Something worth considering.

    ReplyDelete
  2. Good morning sir,,,do u track stone india? Is this a right time to buy stone india

    ReplyDelete
  3. Thank you for such great articles Sir. They go a long way in educating us. Hopefully, these gloomy times in the market shall pass away soon and long term investors holding on with patience will reap benefits :)

    ReplyDelete
    Replies
    1. These are part of market .Macro factors will come and go , try to find out companies cable to weather-the-storm , invest in such companies and show patience.

      Delete
  4. Nice article sir..

    Sir pls provide your valuable views on SHARP INDIA if possible..

    Regards


    Abhijeet

    ReplyDelete
  5. Dear VP Sir,

    Please share your view on Narayana Hrudayalaya IPO. Price band of 245-250, Can we subscribe of this IPO.

    thanks,
    ram

    ReplyDelete
    Replies
    1. As a human I like it ( Quality healthcare at affordable rate ) .As an investor , expecting comparatively lower margins ,but still believe there is chance for reasonable gain.

      Delete
  6. Hi sir
    your views on mafatlal industries.

    ReplyDelete
  7. Sir, what is your take on MIC and Indovation tech new tie up?
    One more thing i have noticed in AR2015 of Indovation tech that they have got some loan from MIC and that transaction could not be traced in MIC AR2015. I have to talked to CS office and they have told so many improvements ongoing projects in Rajasthan, Kerala, AP and Nashik. One more thing sir that its competitor EON has bagged a project of worht 50 crore in ALigarh and Jodhpur which they said have been completed but our Nashik project is still in process company told some times back that they would complete it in June Quarter but it is still on. Now we have to track two company MIC and Indovation. What is you thought on this topic? Please post something regarding MIC i would be thankful to you for more deep thoughs on it.

    ReplyDelete
  8. Sir Your View On Fortis Malar Hospital Ltd

    ReplyDelete
  9. Dear vp sir I really thank you for the articles you post, its such a learning experience, is SUBEX a good buy for medium term as the scrip just not able to sustain the higher price band and is becoming very predictable for the traders as I being an invester too get confused whether to stay unvested or play as others do

    ReplyDelete
    Replies
    1. More than once I explained about Subex here . What I mentioned earlier is that Subex may be a turn around candidate and still I believe in it . Price is a function of supply and demand in market and we can't predict it especially when floating stock is high.

      Delete
  10. Sir ji.. Pls advise on one of your old recommendations.. IDFC. Price has fallen substantially of late. Can one add more of the bank shares now?

    ReplyDelete
    Replies
    1. Fall in price mainly due to de-merger of IDFC Bank from itself . Not tracking it after the de-merger

      Delete
  11. Sir plz do share ur view on Intellect Design

    Thanx

    ReplyDelete
  12. Sir,seems like promoters of syncom formulations are exiting,many small Investors are trapped into this share,please give your views about future prospects of the company.

    ReplyDelete
    Replies
    1. In a market like this many small and micro caps are moving without any reason .Many people running behind such companies to make quick bucks without thinking the quality of their investment .True color will be visible only when the euphoria ends .As warren buffett said " "only when the tide goes out do you discover who's been swimming naked"

      Delete
  13. Very good insight into corporate book keeping. Thanks for sharing Sir. I found the financials of Lycos Internet Ltd very attractive. Can you please share your views on this stock and is this a good investment opportunity ?

    ReplyDelete
  14. Expressed my detailed opinion on Lycos at least five times in the past and no change in it.

    ReplyDelete
  15. Dear Sir I have a doubt about valuepick on the mmb. are you same person on the http://mmb.moneycontrol.com/india/messageboardblog/boarders/76616c75657069636b

    Thanks with regards

    ReplyDelete

Followers

Tweet TopOfBlogs