Wednesday, 21 September 2011

Twelve Tricks in Financial Statements and How to Detect Them

Last post we listed a dozen general warning signs that company management may be up to no good and be trying to conceal outright illegal fraud or painting a rosier-than-justified but still legal picture of the financial condition of the company. This week we look at some of tricks of the managers and a few ways to detect the manipulation.

Deceptions on the Balance Sheet

1) Liability provision for Product Warranties in excess of what's needed to cover actual costs. This reduces current earnings and creates a "cookie jar", as Al and Mark Rosen describe in their book Swindlers, that can be used later on to boost earnings by simply reversing the excess provision. The obvious sign: the provision rises significantly and out of line with sales.

2) Excessive restructuring charges upon a reorganization or cutbacks, often after poor results. Erring on the high side gives management the opportunity to look good by using this form of the cookie jar to boost earnings in subsequent quarters and try to deceive investors that a quick turn-around has taken place.

3) Resource companies can use, and often have used, asset writedowns to lower earnings initially and then raise them later by reversing the writedown. Similarly reserves for claims are a key variable in life insurance companies, or loan loss provisions in banks and it is very difficult for an investor to figure out what such values should be, even at times company management is trying its best to be forthright.

4) Expenses booked as an increase to Assets - capitalized expenses - instead of including the amounts in operating expenses. This results in higher immediate earnings. One way to uncover this subterfuge is to to compare the choice of methods used to capitalize expenses in other similar companies, as explained in notes to financial statements. It also helps to compare the depreciation and amortization expense amounts with the average asset balance. If either depreciation expense as a percentage of fixed assets or amortization expense as a percentage of intangible assets is much lower than in prior years, this might indicate the fraudulent classification of operating expenditures as capital expenditures. (from What's Your Fraud IQ? in the Journal of Accountancy)

5) Hidden asset impairments that should trigger a reduction in earnings through writedowns but don't because hidden. Such impairments might consist of obsolete equipment and facilities in industries like manufacturing, technology, media and communications. At an extreme of impact, we note the example of toxic mortgage and related derivatives assets on bank balance sheets which played a central role in the credit crisis. Often the problem is hidden in a manner that is quite within accounting accounting rules but which effectively masks economic reality by choosing a favourable valuation technique. The way to discover the ruse is to read the notes to financial statements regarding accounting assumptions and then to compare with other companies in the same sector.

6) Significant liabilities off the balance sheet. Items such as leases and contractual obligations and pension liabilities can hide a weak financial situation. Tracking them down involves going through various sections of quarterly and annual reports such as the notes and the management's discussion and analysis, the company's annual information form and the proxy circular.

7) Omitted or down-played contingent liabilities. The best example is the possible impact of lawsuits, which companies are wont to under-emphasize, if only to not publicly admit culpability before a case is settled. There may not be a hard and fast answer until actual resolution of a lawsuit but the investor may be able to develop a sense of where things are heading by reading up on what is said in the media, for which Internet search tools are a wonderful help.

Trickery in the Income Statement

8) Lower credit standards, allowing more people or firms to buy products, who otherwise would not be accepted. This raises sales in the near term but results in higher future write-offs for uncollectible bills.

9) Premature recognition of revenue in multi-year contracts, such as construction and projects, through overstating progress towards completion, again in order to enhance immediate earnings.

10) Fictitious sales are outright illegal fraud. In one variation, a company ships product to an outside warehouse, books the revenue to meet a year-end goal, and then returns the goods to its own inventory. A clue is that a large proportion of reported revenue is uncollected - the Swindlers book warns that when accounts receivable represent 80%+ of a quarter's sales, danger lurks. Another indicator is a reversal to accounts receivable in later periods. A third sign is a big sudden increase in the Quick Ratio, of which receivables is a key part.

11) Big discounts or extended payment terms to customers to bring forward sales into the current period to boost earnings. One sign is that the Gross Margin (Sales - Cost of Goods Sold) will decline.

Cash Flow Manipulation

12) Operating cash flow juiced up by a whole menu of possible tactics such as: sale of receivables, separate sales companies, stock option compensation instead of pay, prepaid maintenance, substituting property ownership for leasing, buying R&D instead of doing it in-house, paying consulting fees to related parties with shares and other techniques, as described by RetailInvestor.org in Cash Truths that Aren't.

The Beneish M Score - A good way to start investigating a particular company would be to apply the system of financial ratio tests developed by Indiana University professor Messod Beneish to detect earnings manipulation. The test uses eight different financial ratios and produces a single number that in Beneish's testing successfully identified about three quarters of manipulators, though it also wrongly labelled 18% of non-manipulators (see David Bricknell's short and readable summary on iStockAnalyst of the various ratios and what they mean).

That kind of result reminds us too that detection of fraud or manipulation is not always possible. Therefore we might not be sure about what a company is doing and how much that should affect the value of its stock. However, investigation directed at typical trouble spots can be a real boon for the investor contemplating purchasing a particular company's stock.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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