A company's profits can be artificially inflated. Watch out for these tricks!
Using a range of accounting tricks, ranging from the subtle to downright fraudulent, companies have often manipulated their published accounts to help support the share price and attract finance, customers and investors.
This is such an important area for all investors that many books have been written about it. One of the best is Terry Smith's "Accounting for Growth", which explains how Report and Accounts are manipulated to boost company profits. Although first written in 1992, it will open your eyes to the shenanigans of reputable companies and the failure of many analysts to spot them. (A revised version was written in 1996 but I believe both editions are out of print now, although second hand copies are no doubt available.)
Although Financial Reporting Standards have changed, accounting tricks are still with us today and the most common include the following:
Aggressive revenue recognition
There is a lot of pressure on companies to increase revenues and sometimes this produces
aggressive revenue reporting policies. For example, revenues should not be recognised when a contract is signed and before delivery of the goods or services. It sounds logical but cases abound where companies have been pulled up for overstating revenues.
Liberal use of accruals (estimates of future cash flows and expenses that impact current revenues) should be a warning sign that the company may have lax internal controls and be overstating revenues.
The notes to the accounts should explain the revenue recognition policy, which should alert investors to any potential over-optimism. It's also useful to compare a company's policy with its competitors.
Frequent exceptionals
Special or exceptional items are supposed to be one-off costs or profits that need to be disclosed. Examples of special items include profits on disposals, restructuring costs and other unusual profits or losses.
However, there is scope here for manipulation as it may be tempting to try to bury bad news in this pot year after year in an effort to boost the profits before exceptionals. The question here is are the costs really exceptional, and therefore eligible, or have they occurred as part of the ordinary activities of the business.
Capitalising ineligible operating expenses is how WorldCom deferred the payment of costs from the current reporting period in order to boost year-end profits.
Underestimating liabilities
It is hard to prove that underestimating liabilities is deliberate although it certainly indicates poor risk assessment.
Frequently companies understate their liabilities, leading to problems further down the line. The best example of this comes from the banking sector, which dramatically failed to anticipate, or even understand, the risks it was running regarding subprime mortgages and CDOs.
Pensions
Pension liabilities are another area that needs to be carefully scrutinised in a report and accounts. Depending on how the liabilities are measured, it can make a huge difference to the deficit a company faces. For example, many FTSE 100 companies have been valuing their pension liabilities using the yield on AA bonds. Since the credit crisis the yield on these bonds has soared reducing the deficits. But any alteration in accounting standards or a reduction in the yields will hit these companies hard.
Read the notes
Quite often the most interesting and damaging information on a companies performance is hidden towards the back of its annual report in the 'Notes' section, where it may disclose problems such as:
- The progress of lawsuits relating to copyright infringements
- Losses due to inadequate or inappropriate hedging
- Other embarrassing mistakes that have cost the company money
Other warning signs
There are also other warning signs that indicate financial difficulties:
- If a company changes its auditors this may perhaps be a sign that the previous auditors were unhappy at its internal accounting methods.
- A change of financial director may also be the prelude to the discovery of some accounting irregularity.
- Late filing may also indicate some financial problems; at the very least it indicates poor management accounting.
It's also important not to jump too readily to conclusions but let your analysis of the figures and further research dictate your view of what is behind unusual figures or mysterious board level resignations.
More from Chris Menon:
