FINANCIAL REPORTS
A company's financial health can be gauged through three statements - balance sheet, profit and loss account and cash flow accounts.
A balance sheet records a company's assets (land, machinery, inventory, cash balance, investments, loans given), liabilities (loans taken, income tax payable, tax liabilities) and owner's equity. It is generally prepared annually.
A profit and loss statement (or income statement) records a company's earnings and expenses. Any company whose shares are traded on exchanges is required to release its income statement every quarter.
A cash flow statement tells us where cash is coming from (inflow) and how it is being used (outflow). There are three types of cash flow-operating cash flow (sale of goods, revenue from services, interest/dividend received, payment for purchases, payment for operating expenses), investing cash flow (sale and purchase of assets, sale and purchase of debt/equity, loans advanced to others) and financial cash flow (issue of equity shares, borrowing, repayment of debt).
Notes to accounts are important as they detail the accounting policies followed, pension and other post-employment benefits and potential liabilities/losses.
MANIPULATION OF STATEMENTS
There are many items in financial statements for which companies use different policies. These are inventory valuation, investments and fixed assets, conversion of foreign currency and asset depreciation.
Companies often manipulate these to inflate revenue, assets, cash inflow and understate expense, liabilities and cash outflow in financial statements.
INFLATING EARNINGS
1) Lending to customers: Sometimes companies lend money to customers to buy their goods. This way they can report high revenue in the income statement and high receivables (treated as an asset) in the balance sheet.
2) Trade stuffing: Companies use this usually just before the end of a reporting period. They ship goods to customers even though the latter may not need them immediately. This increases sales ahead of the reporting period.
3) Understating provisions: Companies often allow credit sales on generous terms, sometimes even to customers with a poor credit history. Ideally, in such sales, the company should set aside a higher amount for bad debt provisioning. This amount is recorded as a liability. Understating such liabilities is another way of 'enhancing' the financial statement.
4) Round-tripping: This means getting into fictitious transactions with related parties to inflate revenue. In round-tripping, a company sells unused assets to a party with the promise of buying back at a later date at the same price.
UNDERSTATING EXPENSES
1) Spreading out expenses: According to accounting norms, if an expense has been made for acquiring an asset whose benefits the company will avail of over a long term, the expense is to be reported in the books in a spread-out manner over that period. The process is called capitalising. Companies often use this to delay recognition of short-term expenses.
2) Cookie jar accounting: Companies put aside money for possible loan defaults. Some companies, during periods of high revenue growth, increase the amount and release the same during periods of poor revenue, offsetting the impact of low sales growth. Among other common forms of financial statement manipulation are revaluation of assets, showing unrealised gains as profits and assigning higher values to fixed assets.
3) Off-balance sheet items: Some assets/liabilities or financing activities are not fully recognised in the balance sheet due to the complexity of transactions involved. These include pension assets and liabilities, assets and liabilities of joint ventures and unconsolidated subsidiaries and lease arrangements. These are recorded in footnotes of financial statements.
Many companies resort to off-balance sheet financing by way of entering into joint ventures, research and development partnerships and lease contracts. Floating special purpose entities or subsidiaries to expand business is another off-balance sheet arrangement.
As the liabilities/risk involved in such transactions are not reflected in the balance sheet, one may draw wrong conclusions about a company's financial health. It is, therefore, necessary to check the footnotes of financial statements.
Continuous high level of cash, cash equivalents and current assets: Satyam Computers showed high cash balance over the years. Later it turned out it had inflated cash and bank balances by as much as Rs 5,040 crore.
Reported earnings consistently higher than cash flow: If cash flow from operating activities of a company is consistently less than the reported net income, it is a warning sign. The investor must ask why operating earnings are not turning into cash.
Sudden increase in inventory/sales ratio: This indicates the company may be inflating assets such as inventories.
Spurt in other income: Revenue sources recorded under other income are non-recurring and may include earnings from asset sales and closure of debt or debt restructuring. However, sources of earnings are seldom disclosed under this head. A sudden spurt should raise eyebrows.
Frequent changes in policies: Earnings and assets can be inflated by alternative accounting policies. If one sees frequent changes in these policies, there may be something fishy about the company's books.
Financial ratios not in line with industry peers: This could be due to inflated earnings, asset valuation or understating of expenses and liabilities.
Too many off-balance sheet transactions: If a company has been expanding by creating special purpose entities and has entered into many lease contracts, it is possible a lot of liabilities are not reflected in its balance sheet.
We have seen in the past that many respected and renowned companies have been charged with manipulation of account books. Therefore, investors must stop treating financial statements issued by companies as gospel truth and scan them carefully to detect possible foul plays
A company's financial health can be gauged through three statements - balance sheet, profit and loss account and cash flow accounts.
A balance sheet records a company's assets (land, machinery, inventory, cash balance, investments, loans given), liabilities (loans taken, income tax payable, tax liabilities) and owner's equity. It is generally prepared annually.
A profit and loss statement (or income statement) records a company's earnings and expenses. Any company whose shares are traded on exchanges is required to release its income statement every quarter.
A cash flow statement tells us where cash is coming from (inflow) and how it is being used (outflow). There are three types of cash flow-operating cash flow (sale of goods, revenue from services, interest/dividend received, payment for purchases, payment for operating expenses), investing cash flow (sale and purchase of assets, sale and purchase of debt/equity, loans advanced to others) and financial cash flow (issue of equity shares, borrowing, repayment of debt).
INDICATORS OF EARNING QUALITY 1. High debt reserves relative to past loan defaults. A debt reserve is money set aside to account for losses that may arise as a result of defaults on future loans. 2. Minimal use of off-balance sheet techniques. It's a form of financing in which large capital expenditures are kept off a companys balance sheet through various methods 3. Use of accelerated depreciation. It allows one to deduct far more in the first years after purchase. The straight-line method spreads the cost evenly over the life of the asset 4. Showing shorter useful life of assets. Any changes on this front cause higher or lower depreciation writeoffs |
MANIPULATION OF STATEMENTS
There are many items in financial statements for which companies use different policies. These are inventory valuation, investments and fixed assets, conversion of foreign currency and asset depreciation.
Companies often manipulate these to inflate revenue, assets, cash inflow and understate expense, liabilities and cash outflow in financial statements.
INFLATING EARNINGS
1) Lending to customers: Sometimes companies lend money to customers to buy their goods. This way they can report high revenue in the income statement and high receivables (treated as an asset) in the balance sheet.
2) Trade stuffing: Companies use this usually just before the end of a reporting period. They ship goods to customers even though the latter may not need them immediately. This increases sales ahead of the reporting period.
3) Understating provisions: Companies often allow credit sales on generous terms, sometimes even to customers with a poor credit history. Ideally, in such sales, the company should set aside a higher amount for bad debt provisioning. This amount is recorded as a liability. Understating such liabilities is another way of 'enhancing' the financial statement.
4) Round-tripping: This means getting into fictitious transactions with related parties to inflate revenue. In round-tripping, a company sells unused assets to a party with the promise of buying back at a later date at the same price.
UNDERSTATING EXPENSES
1) Spreading out expenses: According to accounting norms, if an expense has been made for acquiring an asset whose benefits the company will avail of over a long term, the expense is to be reported in the books in a spread-out manner over that period. The process is called capitalising. Companies often use this to delay recognition of short-term expenses.
2) Cookie jar accounting: Companies put aside money for possible loan defaults. Some companies, during periods of high revenue growth, increase the amount and release the same during periods of poor revenue, offsetting the impact of low sales growth. Among other common forms of financial statement manipulation are revaluation of assets, showing unrealised gains as profits and assigning higher values to fixed assets.
3) Off-balance sheet items: Some assets/liabilities or financing activities are not fully recognised in the balance sheet due to the complexity of transactions involved. These include pension assets and liabilities, assets and liabilities of joint ventures and unconsolidated subsidiaries and lease arrangements. These are recorded in footnotes of financial statements.
Sudden increase in inventory/sales ratio indicates that the company may be fraudulently inflating assets such as inventories.
As the liabilities/risk involved in such transactions are not reflected in the balance sheet, one may draw wrong conclusions about a company's financial health. It is, therefore, necessary to check the footnotes of financial statements.
Continuous high level of cash, cash equivalents and current assets: Satyam Computers showed high cash balance over the years. Later it turned out it had inflated cash and bank balances by as much as Rs 5,040 crore.
Reported earnings consistently higher than cash flow: If cash flow from operating activities of a company is consistently less than the reported net income, it is a warning sign. The investor must ask why operating earnings are not turning into cash.
Sudden increase in inventory/sales ratio: This indicates the company may be inflating assets such as inventories.
Financial ratios not in line with industry peers could be due to inflated earnings, asset valuation or understating of expenses and liabilities.
Frequent changes in policies: Earnings and assets can be inflated by alternative accounting policies. If one sees frequent changes in these policies, there may be something fishy about the company's books.
Financial ratios not in line with industry peers: This could be due to inflated earnings, asset valuation or understating of expenses and liabilities.
Too many off-balance sheet transactions: If a company has been expanding by creating special purpose entities and has entered into many lease contracts, it is possible a lot of liabilities are not reflected in its balance sheet.
We have seen in the past that many respected and renowned companies have been charged with manipulation of account books. Therefore, investors must stop treating financial statements issued by companies as gospel truth and scan them carefully to detect possible foul plays
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