Financial statements are one of the widely relied upon tool to analyze a business. However, there are many ways in which companies cook their books and create a false impression of the company’s financial health using accounting gimmicks and financial shenanigans. In this post, we are going to look at how companies cook books and how you can identify such financial shenanigans using accounting red flags.
If you look into the past, you will find that cooking books is not a recent phenomenon, but has existed for a long time. We all know one or the other company which has resorted to accounting gimmicks to dupe investors into believing that the company is doing well. Each market has its own share of such “gutsy” companies which, instead of genuinely improving the business, resorts to cooking books to show improved performance.
Why Companies Cook Books?
The question is, why do companies need to cook books? Why does the management resort to such gimmicks instead of being honest with their investors? Well, cooking books is not just about looking great on paper, some of the common reasons why companies do so are explained below:
1. To meet or exceed market expectations:
Let’s honestly admit one thing, the world is a fiercely competitive place and everyone wants to be on the top of their game. Miss the mark by a few points, and the company’s stock price gets hammered badly by the market.
With ever intensifying competition and “Go big or go home” thinking, the management of every company is pressed to either beat or at least meet the growth expected by the market.
With such mounting pressure to perform, companies that fail to deliver as per expectations, often get involved in cooking books and create a false image of healthy growth.
2. Vested Interests of the Management:
The second reason why companies cook books is because the management has its own vested interest behind it. Nowadays, many companies offer share price linked incentives to their managers.
Such schemes are offered to align the interests of the shareholders to that of management so that both can benefit from the good performance of the business.
Incentives linked to the share price motivates the managers of the company to work harder and deliver a good performance.
When the times are tough, and business struggles to perform, top managers, driven by greed of incentives and fear of being penalized for poor performance start window dressing the accounts to paint a rosy picture of company’s performance.
3. To show a consistent growth rate by under-reporting current spurt of growth:
This is something that does not happen pretty often, but there are times when companies do under-report their financial performance. Why? Let me explain.
Investors love companies with strong consistent performance and growth, and company managers know this very well. There are some companies that have a seasonal business, where they perform well when times are favorable and do poorly otherwise.
Such companies during good times minimize the current earnings by under-reporting the revenues or by inflating current period expenses by postponing good financial information for the future period when the company is more likely to underperform.
This again creates an illusion for investors that the company has performed well compared to its peers even during tough times.
As a result, such companies command higher valuations which they do not actually deserve.
How Companies cook books?
Management of the companies may have different reasons behind cooking books, but the way it is achieved has hardly ever changed.
The only way management of the companies can manipulate books is by concealing information, in other words, by hiding it in places where it is difficult to detect easily.
So how do companies cook books? Well, as I said earlier, it’s all about hiding crucial information about the company within the financial statements so that they are not easily traceable.
There are only three ways a company can manipulate earnings, by manipulating earnings, profit, and cash flow.
1. Earnings Manipulation:
Earnings manipulation occurs when companies try to inflate (or in some cases, hide) their earnings such as revenue. There are two ways companies manipulate their earnings.
— Recording Revenue prematurely: Booking revenues in advance is one of the most commonly used financial shenanigan by the companies. It includes booking revenues even before the goods are sold or a project is completed.
An example of such premature recording of revenue was seen in Sobha Developers in 2008-09. In Q1 of 2008-09, Sobha Developers decided to recognize the revenue earlier during a project cycle. This led to a 20% jump in the company’s profits before tax.
— Recording income from investment as revenue: The second most common way to manipulating earnings is by recording revenue from other sources as operating revenue.
If proceeds from the sale of an asset (such as land, building, plant, and machinery) or income from an investment (such as maturity of a bond or proceeds from the sale of shares) is recorded as revenue, it will boost the total revenue of the company.
Since these are a one-time phenomenon, and cannot be repeated in the future, recording such one-time sources of revenue gives a false impression of improved financial performance.
2. Profit Manipulation:
Profit is considered to be the blood of a business, something which is necessary for the survival and prosperity of a business. Just like revenue, even profits can be manipulated in many ways.
From hiding expenses to making a simple change in the way in which depreciation is calculated, there are numerous ways a company can manipulate its profits numbers. Some of the most common ways companies cook books in terms of profit are as follows:
— Making expenses look like earnings: A simple change in accounting policy can have a significant impact on the way profits are presented. Many companies use this approach to manipulate Net Profits.
For example, a simple change in the way depreciation is calculated can change the entire picture, helping company management boost profits.
For Example, a small change in depreciation policy in case of Jet Airways created profits out of thin air. In the Q2 of 2008-09, Jet airways changed its depreciation policy from written down value method to straight-line value method, as a result of which, Jet Airways was able to write back ₹920 crores to its Profit and Loss account.
— Hiding Expenses as Capital Expenditure: Another way to boost profits is by treating expenses as capital expenditure; that is instead of treating it as expenses during the current financial year, it is treated as investment made to expand the business.
One such incident can be found in the USA, wherein the years 1990, AOL was found guilty of delaying expense.
AOL was distributing installation CDs as a part of its marketing campaign, but instead of treating it as an advertising expense, AOL decided to view it as capital expenditure. As a result of this, the entire amount was transferred from profit and loss statement to balance sheet of the company where the campaign would be expended over a period of years.
Because of AOL’s treatment of expenses as Capital Expenditure, the entire amount was written off the P&L Statement, which resulted in boosted profits.
3. Cash Flow Manipulation:
Cash flow is considered to be the most reliable source of the true financial health of the company for the simple reason that cash is difficult to manipulate. Investors like Warren Buffett rely heavily on numbers like free cash flow to assess the financial health of the business.
Since companies know this well, they have devised new ways where it is possible to manipulate the cash flow of a company using accounting gimmicks.
Detecting such tricks can be quiet challenging for an amateur investor who does not have a deep understanding of accounting and finance or does not have free time to go through the books of the company.
Some of the most common cash flow related financial shenanigans are explained below:
— Showing financing cash flow as operating cash flow: There are two ways a company can generate cash for itself, first, from its own business, where profits earned by the business get converted to cash, and second by borrowing cash from an external source in the form of loan by issuing bonds or bank loan.
The cash received from business operations is called Cash Flow from Operating Activity, and cash received from an external source is treated as cash flow from financing activity.
Many companies try to boost their operating cash flow by treating financing cash flows as operating one, which leads to a wrongful impression that the company is generating a lot of operating cash flow from its business.
— Using acquisitions as a boost to operating cash flow:
Cash flows can also be manipulated using mergers and acquisitions, especially if the target company is rich in cash.
Management often tries to win support from its shareholders by convincing the shareholders that a particular acquisition will be highly beneficial for the company.
As soon as the merger takes place, all the cash that belonged to the target company, now becomes a part of the parent company, thus boosting overall cash flow statements.
Investors must always be wary of the financial history of the target company and its business and find out if the merger is really going to benefit the business.
If an acquisition is happening just because it will boost the EPS or the cash flows of the parent company, with no meaningful benefit to the business, then such acquisitions must be avoided at all costs.
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Some Additional ways companies cook books:
Cooking books is not limited to manipulating earnings or hiding crucial details about the weak performance of the company, management of companies go beyond the books and create their own parameters of measuring the growth and performance of a company.
Such parameters, though necessary in certain industries, are still non-standard as per the accounting standards. Because of such creative parameters, managements get an opportunity to change their definition of performance as per their requirements, allowing them to use creative methods to put encouraging but false performance numbers in front of investors.
Some of the examples of such no-standard parameters are explained below:
— Same Store Sales (Used In Retail Stores and Restaurants):
Same store sales is a parameter to measure the performance of retail stores. It gives information about how much sales revenue a store is generating during a fiscal year or more.
Same store sales also give investors an idea of how much revenue a company is generating from its existing stores and how much is contributed by new stores. If the percentage of sales revenue from new store sales is rising, it’s strong evidence that new stores are performing well, sounds rational, right?
This is where companies get a chance to manipulate with numbers without getting noticed. The management of the company may alter the criteria of eligible stores to be used in the metric.
For example, in one financial year, a company may use only those stores older than 3 years to show the same store sales performance while in the next year, if the performance of the stores older than 3 years deteriorates, the management may change the criteria and use only those stores that are older than 5 years.
Companies may keep changing their eligibility criteria as per their suitability to present the desired picture.
— ARPU (Average Revenue Per User):
ARPU stands for Average Revenue Per User and is a performance metric generally used by Telecom companies or DTH service providers. Just like same store sales, ARPU can also be used for manipulating earnings of a company.
Most telecom companies, especially in this age of smartphones, not only generate revenue from selling data, but also by selling ad space, and this is where the manipulation begins.
The right way to calculate ARPU is by calculating total revenue generated from data services provided divided by the total number of subscribers.
However, some companies, to show encouraging revenue growth add advertising revenue to the revenue from subscription, thereby falsely boosting the total ARPU.
How to detect if a company is cooking books?
So far we have seen why and how companies cook books, but the biggest question is, is it possible to detect these financial shenanigans? How would you know that a company is cooking books?
While detecting some of these financial shenanigans requires a degree in finance, most of them can be traced pretty easily if you just observe carefully.
— Improved Revenue with an absence of Cash Flow:
If the complicated accounting terms are giving you nightmares, and you have no clue what to do, here is something very simple and logical thing you can do. Just Watch out for cash flow.
Increase in revenue of the company should be reflected with an increase in cash flow of the company. If you see operating cash flow declining or stagnant even if the revenue is marching upwards, or if cash flow is much slower than the revenue generated, it usually means that the company is generating revenue but is unable to collect cash, or even worse, the revenue numbers are simply fake and bogus.
— If Q1+Q2+Q3+Q4 is not equal to FY:
In an ideal situation, if the financial results are audited, the annual sales and profits should simply be a sum of all the four quarterly sales and profit numbers, except for minor variations.
If there is a significant variation between annual sales and profit numbers and sum of all quarterly numbers, you can say that the books have been manipulated at least to some extent.
— If a company is on an acquisition spree:
Companies make acquisitions as it helps the acquirers grow inorganically while making an acquisition, companies make sure that the interests of both the companies are aligned and that the resources that an acquiring company needs are available with the company that is being acquired, at a bargain price.
In simple words, any acquisition should add value to the company more than what is being paid for it. There are many instances when companies are on an acquisition spree. Firms that make numerous acquisitions can get into trouble, their financials get restated and complicated to understand.
Aside from complicating things, acquisitions usually increase the risk of cooking books and bury the evidence under many layers of financial statements. So if a company is a serial acquirer, but does not show significant improvement in its financial performance, there is a good chance that the acquisitions were made simply to manipulate the numbers.
— If the company has bulging Trade Payables:
Many companies, especially in a competitive, customer-centric market loosen their credit terms, attracting more customers to buy goods and services now and pay later. While this is a great move that helps boost sales revenue, it may create a liquidity crisis in a company.
Longer credit duration means that company has to wait longer for the revenue to be converted into cash, but since a company has to meet its daily expenses in cash form, longer credit means company may run out of cash and may have to either borrow to meet its operational expenses or shut down its operations completely.
The best way to cross-check if the company’s revenue is simply because of loose credit terms is to check if there is a change in days receivables in the past few financial years.
If a company has increased the receivable days, it shows that all the revenue is just on paper and the cash is yet to be realized. Such practice is pretty common in infrastructure companies.
— If the CFO and auditors resign or get fired:
This is by far one of the most vital signs that a company is cooking books. There is an old saying in Latin “Who Watches the Watchmen?” when it comes to financial reporting, the watchmen are the Chief Financial Officer (CFO), and the corporate auditor.
If you find a company that is involved in some of the suspicious accounting activities as mentioned above, and you see the CFO of the company quitting abruptly for no valid or logical reasons, its time to stand guard and find out if there is something going on within the company that has not met your eyes yet.
The same rule applies to corporate auditors. IF a company frequently changes its auditors or fires them after some accounting issues come to light, be watchful and look for warning signs.
There have been many recent examples of auditors resigning after altercation from the company owners, which later revealed that company was involved in dressing up numbers to make things look good on the surface while it was really bad inside.
In the month of May 2018, Deloitte, corporate auditor of Manpasand beverages quit a few days before the declaration of annual result as the company was unable to share crucial data regarding capital expenditure and revenue. As a result, the stock price of Manpasand beverages tanked 20% within a day. You can read the news by clicking here
Another such incident happened recently where PWC (Price Waterhouse Coopers LLP) statutory auditor of Reliance Capital and Reliance Home Finance, quit just before the declaration of FY19 results.
In its resignation letter, PWC stated that as part of the ongoing audit for FY19, it noted certain observations and transactions, which, in its assessment, if not resolved satisfactorily, might be significant or material to the financial statements. You can read the new by clicking here
If you are looking for a great investment, look for great businesses. The best way to understand if a business id great or not is by analyzing the financial statements of the company.
Since every investor relies on financial statements for his analysis, it’s important that companies remain honest and transparent and give only authentic information.
However, with the ever-mounting competition, and a race to perform better than peers puts a lot of pressure on the management to perform, because of which they often resort to unethical ways to manipulate the number so that the business “appears” healthy.
There is an Old Russian Proverb which means “Trust, but Verify”, taking things at face value can be dangerous and thus it is important that investors, even if they trust the management with the numbers, should always be vigilant and keep checking the authenticity before making an investment decision, after all, it’s your hard-earned money at risk, don’t take anyone else’s word for it.
About the Author:
This article is a guest post by Ankit Shrivastava, a SEBI Registered Research Analyst. Ankit has been investing in stocks since 2004 and writes about fundamental analysis of companies, principles of investing, investment strategies and a lot more on his blog: