A company’s balance sheet and profit & loss (P&L) statement are the key documents that investors look at to decide if it will be a good investment option or not. Company management is also aware of this and that’s why a few unscrupulous companies have come up with different methods that are designed to make their financial situation look better than they actually are. We have already discussed some of these unethical practices in an earlier blog titled Financial shenanigans: How Companies Cook Their Books?
In this blog, we will discuss some more of these unprincipled accounting strategies that companies can use to manipulate their profit numbers and boost their earnings on paper with the intention of duping investors.
Not Accurately Recording Expenses
Businesses use money i.e. expenses to generate their revenue. So, decreasing expenses can help a company increase its profits. One of the simplest ways to hide an expense is to not record it at all. A company can just fail to record an expense and boost their net income which will increase the profits reported by the company in their financial statement.
Another option that some unprincipled companies and vendors can employ to show lower expenses is to record a sham rebate from suppliers. However for this to work, the company and its vendor both need to play along.
For example, suppose a company and a supplier come to an agreement for office supplies of Rs. 10 lakh for the coming year. But in reality, the supplies are actually worth Rs. 9 lakh and both the company as well as the vendor know this. Now in exchange for this order, the company asks the vendor to provide an upfront discount of Rs. 1 lakh. The company can now record this Rs. 1 lakh discount as a reduction in expenses for the current quarter, which will increase the current profit numbers recorded by the company.
If a company gets multiple vendors to participate in this type of unethical activity, the company can end up with crores of rupees in profit on paper. Even though no actual profits have been made. So as an investor, you should beware of such activities and take a close look at any unusual cash flow that a company has received from vendors. After all, cash should flow from a company to its vendors and it is suspicious if this movement of cash is occurring in the opposite direction.
Decreasing Operating Reserves
A reserve is a pool of cash or other liquid assets that a company might set aside for specific requirements at a later date. The main objective of having a reserve is to ensure that a company remains financially stable to meet contingencies, make dividend payments, ensure timely loan repayments, etc. From an accounting perspective, having a reserve is definitely encouraged.
However, keeping the reserve intact is essential so that there is a sufficient amount available when the requirement actually arises. However, some companies engage in the improper practice of reporting a lower reserve in order to show a higher profit in the short term.
For example, a company purchasing an expensive machine would possibly decide to purchase a comprehensive warranty plan to cover future repair/parts replacement costs of the machine. Now if accounting is done correctly, the company will set aside a reserve and record it on their books to cover the cost of purchasing the warranty. Additionally, the company should also set aside an appropriate amount to cover future warranty extension costs.
But, companies have a significant amount of discretion in deciding the amount that they can set aside as a reserve. If they choose too high an amount, the profit numbers will decrease, while choosing a lower reserve amount will give an immediate boost to the company’s profit numbers.
As an investor, you should therefore look for warning signs by watching the quarterly trend of warranty reserves as a percentage of the revenue reported by the company. If you see a declining trend in these numbers, it might be due to the company reporting inflated earnings by reducing the reserve set aside for the company’s warranty obligations. This might lead to financial instability of the company in the long term.
Recording Expenses Incurred As A Capital Asset
Many companies apply a creative accounting technique that can convert an expense into a capital asset on the company’s balance sheet. To understand how this might happen, let’s take an example.
Suppose an insurance company finds itself falling short of its annual targets. So it decides to run an advertising campaign costing Rs. 100 crore during the last quarter of the financial year. Now, if the company’s annual revenue is Rs. 80 crore, this advertising campaign would result in the company reporting an loss of Rs. 20 crore for the financial year.
But instead of following the standard accounting practice, the company can choose to engage in a bit of creative accounting so that it does not have to report a loss. So, the company shows the advertising expenditure as an asset with the justification that the advertising expense will generate long-term benefits for the company over the next 2-4 years. By treating the advertising as an asset on the books, the company can now charge depreciation on the asset. So using the straight line depreciation method over a 4 year amortization period, the company can show that the advertising asset depreciates by Rs. 25 crore every year as shown below:
| Capitalized Advertising Costs | |||
| Profit & Loss Account | Balance Sheet | ||
| Revenue | Expenses | Liabilities | Assets |
| Revenue = ₹80 crore | Depreciation = ₹25 crore (25% of 100 crore) | Gross Block = ₹100 crore
Less depreciation = ₹25 crore |
|
| Profit = ₹55 crore | Brand Asset = ₹75 crore | ||
This technique would enable the company to run its advertising campaign without having to report any decline in its profit numbers.
In fact, capitalizing an expense might even result in healthier EBITDA numbers for the company in the near term. But if the practice is continued in the long term, the company might end up with a large number of depreciating assets on its books, which can impact the long-term profitability of the company.
As an investor, you can look out for some key warning signs that can help you detect if a company is engaged in capitalizing expenses. These include:
- Unexplained improvement of profit margins
- Unexpected decline in operating cash flows
- A sudden increase in capital expenditure that was not mentioned in any earlier guidance by the management
In fact, many companies that are planning an IPO (Initial Public Offering) employ this trick of capitalizing expenses to make their balance sheet look healthier than they actually are. A balance sheet that looks healthy and shows strong earnings can help the company float a successful IPO. So you need to be on the look out for capitalized expenses in the red herring prospectus of an IPO-bound company before you invest.
Creatively Recording Profits Or Losses From One-Time Events
In standard accounting practice, one-off events such as profits/losses resulting from a merger or an acquisition are treated separately as they have no relation to the day-to-day operations of a company.
However, creative accounting techniques can take advantage of these one-time events and help a company inflate its profits. An example of this is how IBM increased the profits recorded in its income statement in 1999. In 1999, IBM was struggling and its costs were increasing faster than its revenue, so the company was expected to show minimal or no growth in annual profits. Instead, the company reported a 28% increase in year on year net profit as shown below:
| Income Statement of IBM (1998 and 1999) | |||
| 1999 ($ million) | 1998 ($ million) | % Change | |
| Revenue | 87,548 | 81,667 | 7.2% |
| Less: Cost of Goods Sold | 55,619 | 50,795 | 9.5% |
| Gross Profit | 31,949 | 30,872 | 4.4% |
| Less: Selling, General & Admin Expenses | 14,729 | 16,662 | -11.6% |
| Less: R&D Expenses | 5273 | 5046 | 4.5% |
| Operating Income | 11,927 | 9,164 | 30.2% |
| Less: Non-Operating Expenses | 170 | 124 | |
| Less: Income Tax | 4,045 | 2,712 | |
| Net Profit | 7,712 | 6,328 | 21.9% |
A closer look at the income statement however reveals an inconsistency in the Selling, General and Admin (SGA) Expenses reported by the company. Typically, SGA expenses increase in line with the growth in revenues and costs of the company. But IBM had reported a 11.6% decline in SGA expenses for 1999 even though its revenues and costs during the same period had increased by 7% and 9% respectively.
It was later discovered that IBM had actually set off a $4 billion one-time gain from the sale of one of its businesses to offset the SGA expenses reported in its income statement. This had effectively allowed IBM to use a non-operating gain into show lower operating expenses for the year, which allowed the company to show a higher operating profit. On including this US$4 billion as part of the SGA expenses of IBM for 1999, the company’s net profit actually shows a decline of 20.2% instead of the 21.9% growth originally reported by the company.
Misleading Classifications That Can Boost Income on Paper
As per standard accounting practice, the profit and loss (P&L) statement of a company contains 2 key sections – operating and non-operating. The operating section includes revenues and the expenses incurred as part of the company’s day-to-day operations.
On the other hand, the non-operating portion includes items like profit/loss from investments, foreign exchange gains/losses, profit or loss from the sale of subsidiaries, etc. These profits or losses are one-time events that are due to the company’s day-to-day operations.
Typically, most investors focus on the operating portion of a company’s P&L statement as operating income and expenses play a key role in determining a company’s financial health. As a result, some companies attempt to shift non-operating gains to the operating section, while others might try to shift operating expenses or losses to the non-operating section of the P&L statement. One common way to do this is to show a portion of operating expenses as a one-time cost in the P&L statement.
While this shifting of income or expenses in the P&L statement does not impact the net profits numbers of the company, it can easily mislead investors.
For example, suppose a company decided to shut down a few of its poorly performing units. Now, this action should ideally be considered as part of a company’s day to operations as opening and closing of units can occur quite often. However, closing an unit might involve a number of additional one-time expenses such as severance payment to employees, penalty payments for premature termination of the office lease agreement, costs involved in shifting equipment, etc. Now, ideally these costs should be included in the operating section of the company’s P&L statement.
However, creative accounting techniques can help the company show these expenses as part of the non-operating part of the P&L statement. One way companies do this is by presenting the closure of units as part of the company’s restructuring plan. This way, the costs can be shown as a one-time cost on the books so that an operating expense becomes a non-operating expense for the company.
Investors should pay careful attention to the footnotes in a company’s financial statements to uncover the existence of this type of activity. This is the only way you can protect yourself from companies that engage in creative accounting to pad their profit numbers.
Shifting Losses to Discontinued Operations
Closure and sale of loss-making units can play a key role in improving the long-term profitability of a company, however, some companies can take undue advantage of this situation.
To understand how this can happen, let’s take an example. Suppose a company has 3 divisions – A, B, and C. Out of these, A and B are profitable with net profits of Rs. 1 crore and Rs. 2.5 crore respectively. Division C on the other hand has incurred losses of Rs. 4 crore. So the consolidated loss for the business is Rs. 50 lakh.
If the company does not want to show visible losses from division C, there is one way to move the Rs. 4 crore loss from the operating section of the P&L statement to the non-operating section. To do this, the company puts Division C up for sale at the beginning of the financial year and accounts for it as discontinued operations.
By doing this, the company can easily move the Rs. 4 crore of operating loss to the non-operating part of the statement. As a result, the company can report a Rs. 3.5 crore operating profit instead of an operating loss of Rs. 50 lakh. So, investors should check the financial statements of companies thoroughly to figure out if there is any type of accounting trickery at play.
Bottom Line
It is a reality that many companies big and small implement creative accounting techniques to paint a rosy picture to investors. While it is easy to get duped by such unscrupulous activities, there are a few ways you can recognize if a company is manipulating its financial statements and dressing up key data like the P/E Ratio, earnings per share, etc. These warning signs include:
- One time events that impact profit numbers
- Conversion of expenses into a capital asset
- Shifting of operating expenses to non-operating
- Routinely recording restructuring costs
- Shifting of losses to discontinued operations,
To prevent yourself from being duped by these types of financial shenanigans, you need to proactively seek out signals that these types of manipulation are occurring. The good part is the evidence of such manipulations are present in the company’s publicly available financial statements. But you need to put in adequate time and have a high degree of patience to identify the inconsistency in these financial documents.
We hope you found this article useful. If you did, please share it with your friends and family and help us reach more people. If you have any questions or you need clarification on what we have written in this blog, do ask us in the comment section below, and we will respond.
