Accounting is a tricky business. In the UK we have defined accounting policies. But in the US, there are Generally Accepted Accounting Principles, or GAAP.
In my opinion, accounting shouldn’t be generally accepted. It should be exact. The more discretion that is allowed in accounting, the more opportunity there is for the numbers to be cooked and fiddled with.
But no matter how exact the accounting laws are, there will always be industrious accountants searching for ways to hide things the company doesn’t want its shareholders to see.
Here are two accounting tricks that you should be aware of.
Channel stuffing is the practice of sending retailers more product that the company believes its distribution channel can actually sell. The product is then booked to the profit and loss statement despite the inventory not even being properly sold, which is the “sell-through“.
It could also be that the product is returned to the company, meaning adjustments need to be made to the P&L. Many companies will try to stuff their channels right before the end of their results period, in order to meet its targets. This is not too dissimilar to Tesco‘s accounting scandal in 2014.
While there are no laws against channel stuffing, the procedure is frowned upon and many investors do not take it positively. There can be legitimate reasons for increasing inventory through the distribution channel if the company genuinely expects sales to be higher and wants its distributors to be prepared, but often the process has been abused by management fearful of taking hits to their execution remuneration, which may depend on certain targets being hit.
Another common trick used by corporate accountants is to convert costs that should go on the P&L into an asset on the balance sheet.
For example, let’s say we own a restaurant, and we take in £100,000 of revenue in our first year. Our operational costs are £50,000, meaning we have gross profit of £50,000. However, we also had to spend £20,000 on furnishings and upgrading our restaurant.
Usually, that £20,000 would come under capital expenditure, and so we would book it on the P&L or income statement. That would change our gross profit of £50,000 to £30,000 – after we’ve taken off the £20,000 in capital expenditure.
But some companies might not put the £20,000 in costs through the P&L, but add the £20,000 in capital expenditure to the balance sheet as an ‘asset’. This has two effects:
- The real net profit can be misstated due to a real cost that has not been acknowledged
- The the company’s assets are inflated, which strengthens the balance sheet, despite the cost being a necessary part of doing business
Be aware of oil exploration and mining companies classing exploration or drilling fees as assets. They are not.
By understanding how these two accounting tricks work, you’ll be better prepared and informed when making investment decisions.
Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.