Sekou Crawford | Guarding against accounting shenanigans
There is an old industry joke that if you ask an accountant what is four plus four, he will tell you it's whatever you want it to be.
Bookkeepers will even tell you that profit is really just an opinion as it is subject to much estimation, and sometimes manipulation, by management.
The motivation for such unethical practices is oftentimes driven by management's compensation, as well as the need to look good in the eyes of various users of financial information, including investors.
Being aware of the importance of reporting impressive results, companies are incentivised to make their bottom line look as sexy as possible.
Of note, there are cases in which financial statements are misunderstood, not as a result of management's intention to mislead, but due to users' incorrect interpretation of the results and little or no knowledge about how allowances provided by accounting standards can affect results.
Users should therefore be on the lookout for certain line items, including how one-off gains are classified, expense recognition, and revenue recognition practices.
Income from extraordinary activities can lead to a lift in net profit performance. For example, a company may have sold a business unit and realised a significant gain on this transaction, which may act as a major boost to net profit in one particular year.
Depending on how this appears on the income statement, this uptick may come across as a routine transaction and could result in investors thinking that this will be par for the course going forward.
However, if selling business units or assets are not part of the company's normal business operations, then this upsurge is unlikely to recur the following year.
One way to identify this flaw is to carefully examine both the revenue and expense lines in the income statement to see if an uptick in revenues is supported by a commen-surate lift in expenses.
Classification of a one-off gain as revenues will result in a bump in sales, without the associated increase in the cost of goods sold or selling, general and administrative expenses. Where one-off gains are reported and/or classified incorrectly, investors should normalise earnings by removing the effects of the gain in doing their assessment.
DELAYING EXPENSES TO LATER PERIOD
Another accounting tactic for management is to delay
the recognition of expenses. Typically, accounting standards stipulate that expenses should be recognised in the periods that they are incurred.
Delaying recognition reduces expenses and inflates earnings. Companies can delay recog-nising expenses by depreciating or amortising that is, writing down the value of an asset too slowly.
An aggressive amortisation policy will reduce the periodic payments over the life of the asset. For example, software is an asset that is carried on the balance sheet of a company when it is acquired; the related expense is usually recognised in increments on the income statement over the expected useful life of the asset.
Management may employ an aggressive amortisation policy by expensing it over 10 years, thereby reducing the periodic expense on the income statement, when the true useful life is only three years.
You can know if a company is employing aggressive policies by examining the notes to the financial statements and comparing the depreciation and amortisation and bad debt recognition policies to similar companies.
Investors should also be on the lookout for companies that fail to recognise bad debt. Companies routinely sell goods on credit to customers and give them time to pay. However, if the collectability of monies owed becomes doubtful, accounting rules require that companies record a bad debt expense.
Management may fail to do this, given that it would result in higher expenses and reduced net income. Investors should be aware that if the time to collect on receivables is getting longer and longer while the economic climate is good, or that other companies have no issues in converting receivables to cash, it may suggest that they are impaired.
AGGRESSIVE REVENUE RECOGNITION
Companies may also choose to account for revenues sooner than they should so as to boost performance. This typically occurs when companies record revenue before completing their work, or when they record revenue when the customer's payment is uncertain.
The major indicator of the use of these shenanigans is an unusually large increase in receivables. If you suspect this is being done, compare the receivable balances quarter-over-quarter for any unusual changes.
Be particularly vigilant in the final quarter, as management may be motivated to catch up on their targets as the year end is approaching.
Manipulation of financial statements is unethical and can even be illegal and is aggressively discouraged by regulators and end users of financial information. While an auditors' opinion is usually relied on for comfort in a set of financial statements, auditors give only reasonable and not absolute assurance that they are true and fair.
Therefore, investors, lenders and other users of financial information ultimately have to satisfy themselves that the accounts are true in form and substance, given that their decisions are largely influenced by these numbers.
Employing an attitude of professional scepticism and common sense in doing analyses is the starting point to protecting your money. In addition, getting assistance from professionals who are trained in analysing financial statements is always recommended.
- Sekou Crawford is research & structured products analyst at NCB Capital Markets Limited. Email firstname.lastname@example.org.