As promised, we return to confront an argument consistent with the central theme of this blog. Nevertheless recommend you to read the latest articles on asset allocation, as the stock will be for the majority
Today, as the title suggests, we will deal with the main “shenanigans” in the financial statements and the red flags that we can use to try to identify them before they impact heavily on performance.
The accounting and the preparation of financial statements are much more subjective than you might think and the degree of freedom left to the CFO of a company in respect of the various items of the budget estimates and manipulation of these is quite high. However, most of the practices used by the company are perfectly legal, so many CFOs may try to “hide” by some “reserve” to beautify the budget in times of trouble / need, or simply to get to the estimations of the various analysts and not to disappoint the market. In extreme situations, however, there may be bad faith or outright fraud and bells d ‘alarm that we will see can help us to identify these situation (though obviously ex-post is much easier).
The main actions taken to try to beautify the budget include: a policy rather aggressive in recognizing revenue; policy “misleading” in recognizing the costs (overestimate depreciation / amortization to pay less tax without having a real output of cash, or the capitalization or overestimate the cost of inventories), and their failure to report to the relevant budget items (this often happens for example with the lease, when you record them as a financial vs. operating). The main reason (but not the only) for which it is possible to perform these actions stems from the difference between the cash vs. accrual-based accounting.
These are the main methods to try to identify possible shenanigans.
As for the aggressive policy to recognize revenues should keep an eye on:
1) Changes in policy for revenue recognition, recognition of non-recurring revenues and generally try to figure out if sales are recorded without actually having delivered / performed the goods / service and then received the payment (or until it has had a “risk, reward and control transfer”). “Simple” methods to control such aspects are: the operating cash flow and generally misaligned lower net income (because there is not really an entry of cash) that leads to the accumulation of so-called “accruals” and then an abnormal growth of receivables (trade receivables) compared to revenues, because in fact the apparent growth in revenue does not match a stream of incoming cash.
2) Have a company that appears to produce very useful and a lot of cash, but that parallel increases steadily the debt unless there are special reasons .
3) Frequent changes concerning the treatment of debt. The debt in fact can be measured through the ‘”amortized cost” or through the “fair value accounting” (granted for the so-called “Debt Valuation Adjustment-DVA). In the second case, the changes in its value are reported in the income statement, which means if the debt loses value (that is sold and the interest rate rises in what is perceived as more risky) there is a profit in the income statement (which is exactly what the banks have done in the last 2/3 years). In any case, when the debt regains value you make the “reversal” and the income statement there is a loss (also at maturity is always repaid the face value, then it does not mean that a loss in the value of debt results in a lower figure to be repaid at maturity). All these changes are designed simply to beautify budgets in difficult times and should therefore be substantially ignored.
Regarding costs
1) A sharp increase in “inventory days” or in general inventories (inventory) that increase in a completely unrelated with revenues. This may be due to the fact that you are trying to inflate the gross profit or net profit (since in this way it reduces your cost of goods sold).
2) Use at your own favor and overestimate the so-called “capitalized expenses”. As for the cost is the so-called “matching principle”, ie a cost is entered in the balance sheet only when the related revenue is recorded, shall be granted to companies to record the expenditure as an asset (prepaid expenses / prepayments) and recognize in the income statement only later when the related revenue is received (this may in fact reduce costs in a given year). However, this can obviously be dangerous and businesses can take advantage of it, see the WorldCom case (also remember that the R & D costs can not be capitalized, because it does not carry a definite advantage). To find out whether the company is trying to go this route, you should generally compare it with peers in terms of this policy and to compare revenue growth with that of these “deferred assets”
Finally, as regards the excessive use of off-balance
1) Excessive use of so-called “operating leases”. The future payments related to operating leases end up off-balance-sheet and consequently may underestimate the leverage of the company. As a result you have to check in the notes if the company has significant operating leases and possibly convert future payments into debt and to sum it up what you see on the balance sheet.
