Every month we hear news of a new scam breaking out. One of the most widely used methods used to commit these scams has been through the manipulation of financial statements. In the financial world, the manipulation of these financial statements is known as earnings management.
As retail investors, it is very important to know how these financial statements have been manipulated. This helps us to specifically identify the red flags and avoid the potential losses these stocks bring with them. In this article, we cover the motives why companies manipulate and we also look into the means used by them to manage earnings. Keep reading to find out!
What are the Motives Behind Companies Manipulating Financial Statements?
It may come as a surprise but companies manipulate their accounts for various other reasons than just making a quick profit. Following are some of the top reasons why:
1. Unrealistic Expectation & Pressure
To be fair to the management of the companies it is extremely difficult for a company to grow sales and earnings constantly quarter over quarter and across years.
In the real world scenario, with interest rates, technology, human behaviour, and taste & preferences changing on a continuous basis, It has become increasingly difficult for companies to grow profits on a consistent basis.
Managers or the top management’s incentive is tied to stock price through the means of stock options or through various schemes linked to bonuses and commissions or through a share of the company profits.
This alignment was done in companies to motivate the senior management and link their performance to the rewards.
However, the people running the companies use this as an opportunity to satisfy their greed by overstating earnings to boost stock prices and thereby getting higher salaries and bonuses.
2. Manipulation of Financial Statements to Inflate the Share Price
Here the company is induced to manipulate and manage earnings to appease the financial world, investors and analysts. The management does this by manipulating accounts to show results better than the forecasts and estimates. This also helps it stand out when being compared to peer companies.
Growth in earnings is a key metric in the financial world. Generally, companies that consistently show earnings/profit growth quarter on quarter are shown in the positive limelight and praised by the investors. These stocks are in turn rewarded by the means of a stock price increase.
On the flip side, companies showing flat sales and degrowth in earnings are looked down upon. Their managers & top management are blamed and thus penalized by shareholders through a drop in share prices.
3. To Raise Capital at a Lower Cost
Increased earnings offer the company several advantages. These include a higher credit rating from rating agencies like CRISIL, S&P etc which in turn translates into lower borrowing costs along allowing them to raise more funds by allotting shares at a higher price in the Follow on public offerings(FPO) and preferential allotment. These are some of the prominent reasons behind the distortion of financial statements.
4. Large Cap V/S Mid & Small Cap
One common aspect which was observed and is prevalent in the Indian markets is that due to higher disclosure norms and wider public interest along with a tighter corporate governance structure large-cap companies usually have a lower probability of indulging in financial statement manipulation than mid and small companies.
One more reason for this variance in earning manipulation between large-cap and small-cap companies is the theory that small-cap companies being small in size have higher return expectations than large caps due to it being perceived as riskier.
Now since we have got a basic understanding of the reasons why companies do manipulation of financial statements, let’s take a look at some of the most common techniques used by companies to manipulate financial statements.
What are the Common Techniques Used to Manipulate Financial Statements?
There are various ways in which a company indulges in accounting malpractices. This is primarily observed through the means of using the flexibility provided by different accounting standards in deciding the accounting method and the application of the standard in that particular scenario.
We have stated some of the most common techniques used to manipulate financial statements below:
1. Misusing the Flexibility Given for Creating Provisions & Reserves
The most common way of fudging financial statements is by creating provisions and reserves. Here the companies take advantage of the flexibility given by the accounting standards. The standards allow management to estimate and make assumptions for future bad debts, receivables, and other accrued income. But instead, some manipulators use this to their advantage to distort earnings.
Personally, we feel that this practice is very common in the case of Banking, Housing loans, and financial companies in India.
In the case of banks, the senior management has full flexibility to make assumptions about non-performing assets (NPA). Higher provisioning done in one quarter can lead to lower profits in that quarter and vice versa. Thereby whenever the bank wants to improve its earnings it can delay the recognition of bad debts. This is done by creating fewer provisions in that financial year/quarter and thereby tweaking its earnings.
2. Overstating Earnings
The other common method of manipulating statements is through overstating earnings by showing fictitious sales and advance revenues. This strategy is very common in manufacturing companies.
Companies do this by showing inflated sales, advanced sales without an actual sale of goods, or recognizing revenue in one go instead of actually breaking it up for the duration of the project or period of sale.
This practice is commonly used by real estate companies to manipulate sales.
3. Related Party Transactions
Companies indulge in related party transactions to divert company funds. These diverted funds are sent to offshore accounts through dummy companies. These accounts are operated by relatives or close family members of the promoter.
An e.g. of this is a company granting loans to relatives of promoters. The company then claims them as bad debts thereby removing company funds belonging to shareholders.
Another common tactic used is selling items at higher prices to related parties to inflate sales. These parties are then given a share of the differential amount.
Therefore as an investor one should take a good look at the related party transactions of the company as disclosed in the annual report.
4. Underreporting Costs and Expenses or Delaying it
Companies also shift current expenses to a later period. This delays expense recognition and therefore pushes the earnings on an upward trajectory.
Companies capitalizing normal operational costs which should directly appear in the P/L statement. This is done to reduce costs. These costs are then shifted to the balance sheet.This is also a usual way for companies to alter their financial statements.
5. Toying Around with Depreciation
Depreciation is a key item in the income statement. There is a lot of leeway in terms of accounting flexibility and standards given to companies while calculating depreciation.
To begin with, there are 3- 4 different methods of calculating depreciation, with a straight line and written down value methods being the most commonly used ones.
The rate of depreciation & the useful life of the item varies from asset to asset. This allows the companies a lot of flexibility in terms of preparing their depreciation schedule thus managing costs.
Companies charge lower depreciation on assets, increase the lifespan of assets, alter the method of depreciation midway during the lifespan of an asset resulting in extraordinary gains.
Another malpractice used by companies to manipulate depreciation is by keeping assets in the balance sheet which are not in use anymore. Companies also do this by revaluing assets selectively.
Quality of Corporate Governance questions arise frequently in Indian Companies. This is due to the general perception of promoters and managers practising earnings manipulation. This is one of the primary reasons why investors are willing to pay a premium price for high corporate governance companies.
Let’s take a look at Private banking stocks in India like Kotak & HDFC Bank. These trade at higher P/E, P/B and other multiples in comparison to the government banks simply due to the better quality of corporate governance and lower earnings manipulation.
In recent years, SEBI has brought in many rules and regulations in an attempt to curb financial manipulation. In addition, there have been many modifications in the companies act to improve the earnings quality of companies and reduce the chances of any manipulation in financial statements.
Unfortunately, as noticed in previous scams in India there is a time lag in catching the perpetrators of the fraud. Take the case of Satyam where it took 6-7 years for the auditors and SEBI authorities to find out about the scam since it started in the Company.
SEBI has introduced various compliance requirements. These range from making independent audits compulsory to levying strict penalties on auditors who have been involved with promoters in manipulating accounts.
In addition to this SEBI is still slowly introducing steps in improving the quality of governance in Indian Companies. But despite this, we still have a long way to go. Let us know what you think about the steps taken so far and the possible regulations which can be implemented in the comments below. Happy and Safe Investing!