Saturday, June 16, 2012

Accounting games companies play

In The Edge Financial Daily Today 2012
Written by Goola Warden of The Edge Singapore
Thursday, 14 June 2012

Key article highlights:
  • It is possible for investors to identify the "accounting games" companies play by reconciling their revenues and earnings with their cash flow statement and balance sheet.
  • Reported revenue and earnings albeit easily manipulated, impacts figures on balance sheets.
  • Legitimate sales and real earnings booked results in increased cash on the balance sheet; unreal revenues and earnings however, inflates the accounts receivable figure.
  • An annual 10% revenue growth accompanied with 20% to 30% accounts receivable growth poses a big problem because the company will never get the cash.
  • This manipulation technique is likely to be used by companies whose business have a significant time lag between signing contracts and actual delivery of the product or service.
  • Companies with an unexpected surge in sales towards the end of a financial year should be looked out for.
  • 'Bill and hold' sales allowed Sunbeam to meet revenue and earnings expectations but was essentially fraudulent as their inventory of barbeque grills stockpiled.
  • Investors should read every line of a company's financial statements, check all the footnotes and try to understand the company's policy for recognising revenues, earnings, depreciation and accruals.
  • Artificially lowering reported expenses to achieve revenue boost results in telltale balance sheets.
  • America Online's floppy disks to get signups, an advertising expense that should have been in the income statement, ended up as deferred customer acquisition cost on the balance sheet.
  • Inventory consistently growing faster than sales could be a sign that the cost of goods sold on the income statement is understated thereby boosting reported earnings.
  • Investors ought to have a healthy skepticism of any move by a company to revalue assets on its balance sheet, especially commodity and agricultural companies.
  • Bre-X, a mining company, kept increasing the estimates of the size of its supposedly Indonesian gold deposit. Eventually, it met with a share collapse when earlier ore samples from its mine had been found salted with gold dust.
  • Ordinarily, cash should be coming from the operation of the business and going to investments for the future and repaying debt, that is, investing cash and financing cash flow.
  • Cash flow classification tricks, however, overstates the operating cash flow instead of the investing or financing cash flow (e.g. classifying tax expense as capital expenditure).
  • WorldCom's payment for use of third-party satellites expense was classified as an asset under property, plant and equipment on the balance sheet (instead of an expense in the income statement) and cash outflow as a result of investing activities (instead of operating cash outflow in the cash flow statement) resulted in overstated earnings, overstated operating cash flow and an increase in assets.
My view - an investor is essentially risking his money when buying any company's shares. While there is potential capital growth and cash flow from dividends, adequate pre-investment due diligence and post-investment monitoring must be conducted. Periodic review of financial statements can serve as a means to uncover any irregularities on the company's operating state of affairs.

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