There are ample of motives for a company to manipulate its financial statements and dupe the investors of their hard earned money. One of the most lucrative motives is an increase in the share price of the company; we investors tend to pay a higher price for companies that communicate higher earning power.
So, is it possible to know before-hand whether a company is engaging in suspicious accounting practices? Are there any red-flags which can help us find such companies and avoid investing in them? The answer is – Yes! Yes, it is possible to identify if a company is engaging in dubious accounting practices!
In the following Shastras, we will take a look at some of the biggest corporate frauds in history; identify the various methods with which a company can manipulate their accounts and how a few red-flags can help us avoid investing in such companies.
‘This is my sales target and I don’t care how we achieve it!’ – a common motto for many marketing managers, branch heads and CEOs just before a quarter or financial year ends. The motive – To show a rosy picture of the company’s financial position so that it can have a positive effect on the company’s stock price. All analysts and investors eagerly await the company’s quarterly results. If the company meets its sales guidance the company is rewarded and the stock price rises; if it fails to meet the guidance, the price is hammered. Very often this motivates the companies to manipulate their sales. Infact, sales or the top line is one of the easiest figures to manipulate with a number of techniques available to the manipulators.
So, what are these techniques? And is it possible to find out such companies through some early signs or red flags? Let’s have a look.
Every now and then when the profits of a company suffer, we hear management talk about the various “cost-cutting measures” that it is implementing. Infact during a downturn, when customer orders are hard to come by and revenue growth slows down, companies have no option but to control costs and sometimes cut them drastically to maintain profits. To do this companies reduce salaries and bonuses, cut down on marketing and advertising costs and lay off people. Infact sometime back we even had a pharma company go as far as cutting down on toilet paper to reduce costs! Unfortunately, some companies adopt a different approach to cut down costs and report higher profits : They simply manipulate their expenses.
So, what are the techniques used by these companies to manipulate their expenses? And what red flags can help us identify these possible manipulations?
The financial statements of a company are usually thought to be too complicated! And of all the numbers given on them, depreciation is perhaps the least understood number. We routinely overlook depreciation as just another item on the Profit and Loss statement and fail to realize its significance. However, this number is perhaps one of the easiest for companies to manipulate.
So, what exactly is depreciation and how do companies manipulate it? And what are the red flags available to investors to identify such companies?
Stock Shastra #39: How do companies manipulate Asset Valuation to project a strong financial health?
The balance sheet, also known as the statement of financial condition, offers a snapshot of the company’s health. It tells us how much a company owns (Assets), and how much it owes (Liabilities). Many analysts and investors look at the assets to judge a company’s financial health, as assets are the economic resources owned by a company and are used to operate its business. Some companies try to manipulate this part of the balance sheet in order to show a better picture of the company’s health.
So, why and how do companies manipulate their assets? And what are the red flags available to us investors to identify these manipulations.
As investors, we often pay more attention to the sales, net profit numbers on the profit and loss statement, while neglecting the balance sheet. After all balance sheet numbers are not as dynamic and interesting as the sales and net profit figures! But think again! The sales and net profit figures never tell us the entire story.
To know whether a company is fundamentally strong we must look at certain numbers on the balance sheet. In the last Stock Shastra we looked at the asset side of a balance sheet. The other side i.e the liabilities on a balance sheet tell us how much a company owes and how leveraged it is. In an attempt to showcase a healthier balance sheet companies often manipulate these liabilities.
So let’s find out what are the liabilities commonly manipulated? And how are these manipulations done?
“The cash flow statement is one of the least manipulated financial statements”. The other two financial statements viz. the Profit & Loss and Balance Sheet, are often subjected to many manipulations. However, while the cash flow statement does render more transparency, it too can be manipulated to a certain degree. And with analysts considering a sustainable cash-flow stream as the primary factor in determining the value of a company, the incentive to manipulate cash flows is greater.
In the last 3 Shastras we saw how the P/L account and Balance Sheet can be manipulated. Now, let’s have a look at how the cash flow statement, which is said to be the least manipulated out of the 3, can actually be tweaked.
Tata Steel acquires 100% stake in Corus Group; Vodafone purchases 67% stake owned by Hutchinson-Essar; Indian major Ranbaxy acquired by Japanese pharmaceutical company Daiichi Sankyo – these were headlines that were splashed across newspapers for days together at their time. Many companies find that the best way to grow is through mergers and acquistions. And investors usually take comfort in the idea that a merger will deliver enhanced market power. But, think again. Sometimes, the real picture might actually be different.
Infact, at times M&As might prove to be dangerous to shareholder value as the real purpose behind them could be to portray a fake picture of the company’s financial health.
So, how do companies manipulate financial statements through mergers/acquisitions? And what are the signs to spot such manipulations?