Warning Signs and Methods for Detecting Manipulations

Financial manipulation leaves a trail, like tracks on sand or snow. The manipulation could be time-related or location-related. An example of time-related manipulations is expenses capitalization, which would decrease the expenses of the current period and distribute the cost over several upcoming periods. Location-related manipulations could be made through misallocation of losses i.e. by deducting them from other comprehensive income or even by deducting them directly from equity rather than net income.

Pay Attention to Revenue

Revenue is the most frequently manipulated financial report item. Here are ways to examine revenue quality.

• Examine the accounting policies note for a company’s revenue recognition policies: search for “bill and hold” transactions and early recognition of sales. Discern contracts with multiple deliverables to make sure that the recognition of revenue of each deliverable is matched with the recognition of the costs incurred to make that deliverable.

• Look at revenue relationships: compare a company’s revenue growth with its primary competitors or its industry peer group. If the growth of the company’s revenues is faster than the industry/peer group, then, the superior performance must be justified. Possible justifications could either be better management or/and better products/service quality.

• Compare accounts receivable with revenues over several years: a rising ratio could indicate insufficient allowance for questionable accounts or even fictitious sales.

• Examine asset turnover: it becomes especially important in the case of a new acquisition. If a company‘s asset turnover is continually declining or lagging behind the asset turnover of the industry, then, this could signal possible future asset write-downs, particularly in the area of goodwill balances for acquiring companies.

Pay Attention to Signals from Inventories

• Compare growth in inventories with competitors and industry benchmarks: if a company breaks the trend, it could simply be a matter of bad inventory management or an indication of inventory obsolescence. The latter could mean that both of the company’s assets and profits are over-estimated.

• Calculate the inventory turnover ratio: a slowdown in the inventory turnover ratio could suggest inventory obsolescence.

Pay Attention to Capitalization Policies and Deferred Costs

Suppression of expenses is the second most frequent method of financial report manipulation.

• Examine a company’s accounting policy note for its capitalization policy for long-term assets, including interest costs, and its processing of other deferred costs: if a company capitalize costs that are expensed in most of its industry peer group, the difference should be adjusted to reflect a lower asset value and lower earnings for that company.

Pay Attention to the Relationship Between Cash Flow and Net Income

A cash flow to earnings that is consistently below 1 might be a signal of heavy use of accrual accounting.

Other Potential Warnings Signs

• Depreciation methods and useful lives: a big difference between the depreciation method and the estimated useful life of a company and its industry peers could be a sign of a manipulation attempt.

• Fourth-quarter surprises: as managers try to avoid cooking the books unless it is inevitable (from their point of view), most of the manipulation happens in the results of the fourth quarter. For that reason, an analyst should closely check companies that repeatedly achieve out of expectations’ consensus results in the fourth quarter, assuming that the company’s business doesn’t have any seasonality.

• Non-operating income or one-time sales included in revenue: a company can add the sale of an asset to revenue to hide a decline in the revenue generated from its core activities. A similar scheme could be made to decrease the company’s losses by classifying some of the company’s expenses as “non-recurring.”

Question 1

If a company’s revenue increases at a faster rate than the industry growth rate, even though the company’s product quality has been decreasing and the product price has been increasing relative to the competitors’ product prices, which of the following should an analyst most likely examine?

1. The trend of change in accounts receivable.
2. The company’s revenue recognition policies.
3. Both the trend of change in accounts receivable and company’s revenue recognition policies.

Solution

The correct answer is C.

An increasing trend of accounts receivable could indicate that a company might be lowering its credit issuance restrictions to generate more sales. This, unfortunately, could affect the ratio of uncollectible debt and result in low earnings quality. Still, the company could also be involved in channel stuffing which would make its revenues seem inflated.

Question 2

Which of the following most likely indicates that a company is taking advantage of accrual accounting policies in order to shift current expenses to later periods?

1. The ratio of cash flow from operations to net income is consistently > 1.
2. The ratio of cash flow from operations to net income is consistently = 1.
3. The ratio of cash flow from operations to net income is consistently < 1.

Solution

The correct answer is C.

A ratio that is consistently less than 1 signals that a company may be using aggressive accounting policies to shift current expenses to later periods in order to make its current financial position look attractive.

Options A and B would not signal any sort of accounting manipulation.