Financial manipulation leaves a trail, like tracks in 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 reports 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 that the industry/peer group, the superior performance must be justified. Possible justifications could be either better management (or/and) better products/service quality.
- Compare accounts receivable with revenues over several years: A rising ratio could indicate insufficient allowance for doubtful accounts or even fictitious sales.
- Examine asset turnover: It becomes especially important in the case of a new acquisition. If the company‘s asset turnover is continually declining or lagging the asset turnover of the industry, it may signal for 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 the company breaks the trend, it could be simply 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 that ratio could also suggest inventory obsolesces.
Pay Attention to Capitalization Policies and Deferred Costs
Suppression of expenses is the second most frequent method of financial reports manipulation.
- Examine the company’s accounting policy note for its capitalization policy for long-term assets, including interest costs, and for its processing of other deferred costs: If the company capitalize costs which 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
If the cash flow to earnings is consistently below 1 it might be a signal of heavy use of accrual accounting.
Other Potential Warnings Signs
- Depreciation methods and useful lives: Big difference between the depreciation method and estimated useful life of the company and its industry peers could be a sign of a manipulation attempt.
- Fourth-quarter surprises: As managers try to avoid cooking the books until inevitable (from their point of view), most of the manipulation happens in the results of the fourth quarter. For that reason, an analyst should check closely companies which 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: The 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.”
If a company’s revenue increases at a rate faster 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?
A. The trend of change in accounts receivable
B. The company’s revenue recognition policies
C. Bothe A & B
The correct answer is C.
An increasing trend of accounts receivable might indicate that the company might be lowering its credit issuance restrictions to generate more sales which would affect the ratio of uncollectible debt and result in low earnings quality. The company could also be involved in channel stuffing which would make its revenues seems inflated.
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?
A. The ratio of cash flow from operations to net income is consistently > 1
B. The ratio of cash flow from operations to net income is consistently = 1
C. The ratio of cash flow from operations to net income is consistently < 1
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.
Reading 29 LOS 29i:
Describe accounting warning signs and methods for detecting manipulation of information in financial reports