So, you start reading the annual reports of a company and tabulating the numbers. While you punch in those numbers and believe this is a great company?
But what if I told you that you might feel great because the accountant wants you to feel that way? So, just like as an analyst, you seek to be right in understanding a company. Similarly, an accountant’s job is to make you feel good about the numbers. An accountant is not even remotely interested in whether your business is good, bad or ugly.
Accounting audits ensure the following of accounting principles, not investing principles.
The Rozy Pictures in Accounting
When you invite someone to your home to sell the house, what do you do? Do you go and show him every problem you faced in that house? Also, maybe you also tell him how obnoxious your neighbour’s dogs are, as they constantly bark at night?
Now, you don’t do that, and I don’t think no one in this world will do that. However, ask yourself why? Because it hurts sales.
Then, how do you expect a company, no matter how good they are, can you expect them to give you an accurate picture?
Let me give you some statistics here.
Financial statement fraud is the most costly form of occupational fraud, causing a median loss of $1,000,000;
Gettry Marcus’ Certified Fraud Examiners
Now, there you go; it’s the most common fraud that can be done because it’s so easy.
Limitation Number 1- Revenue Manipulation
The number one place and the most frequent place to manipulate financial statements is revenue. Let me show you how a company and its accountants can do that.
- Booking Revenue Ahead
So, how does this work? E.g., You run a company, and the customer pays you for a monthly subscription, but you show an invoice for an annual plan. According to the principle, there is nothing wrong in this, but it bloats the revenue more than it should.
“They (Byju’s) have had to move parts of their revenue for it to be approved as per Indian Accounting Standard (Ind-AS) 115 rules… For example, revenue projected in one financial year for a multi-year fee can’t be used as that year’s revenue alone,” said an industry executive who spoke to ET recently.
Economic Times Article
In the above case, Byju was overbooking the revenue as per the information provided by Deloitte, its auditing firm.
- Other Income
You might be fooled into believing that a company has a fantastic profit after tax, but the devil is in the details. The company might have bought and sold private companies, showing huge gains.
Limitation Number 2- Exceptional Items
An easy and often overlooked place, exceptional items are not so exceptional these days with companies. So, the crux is, put; nothing doesn’t have an explanation for extraordinary items. However, these entries can be red flags if they are often too often.
Limitation Number 3- Inventory Valuation Gimmicks
There are a lot of scopes to manipulate the costs if you can’t manipulate the revenue. Moreover, giving the impression that the margins are increasing. For example;
Company ABC is the in the business of manufacturing sugar, and it buys sugar cane in advance. In the market, sugar cane costs are rising, leading to lower margins in the profit and loss statement. The CFO came up with the idea that we could stop buying new sugar cane and use the FIFO inventory valuation method.
So, the result is that in the income statement, older inventories are cheaper, leading to higher margins in the books. However, in reality, nothing has changed.
Limitation Number 4: Employee Kickbacks
There is no way to identify if all the transactions done with employees and senior managers are legitimate. There might be many such kickbacks in the form of marketing, travelling expenses or even consulting income. Which is nothing but the management of costs.
Also, in the same category, I would like to point out another method where accounting can be used very creatively.
Suppose you have an interest expense, which could lower your profitability in the books. So a simple method to manipulate that is to create a capitalised asset in the balance sheet and depreciate it after a couple of years.
Limitation Number 5: Mergers and Acquisitions
Amid all the seriousness of a merger and acquisition activity, I could also charge ” Merger Expenses”. In other words, although I might acquire another company for, let’s say, X, but I pay in the books X+ 20%. However, you will never know who got that X+20%, and it can also be paid in the form of stock issued to the other party.
Conclusion
Always trust no one when analysing companies. The reality of a business’s financials is reflected in the popularity of its products and happy customers. More insights are generated by looking at companies, customer feedback and reliability. Hence move out of the financial statements and also correlate whether the same feedback is received in the product’s market, as is shown in the financial statements.