Different Ways to Identify Warning Signs in Accounting

6 mins read
by Angel One

While in the preceding blog (Blog 1- Warning Sing In Accounting – Different Ways to Analyze) we had discussed about different possible ways there is a misrepresentation in Cash Flow and revenues), here we are going to understand how a few companies are misrepresenting the Balance Sheet items.

There are ways in which overzealous management (yes zealous management- that are not able to stick to Ethical ways for growth) distort the balance sheet presentations to show a rosy picture to investors.

While there are many ways, we are discussing a few important ones in this blog.

As we stated earlier the revenue growth is a very important parameter and the factors depending on the same are easier to be manipulated. Following are a few of the ways companies misrepresent data points.

Distorting account receivables to hide revenue problems

Every Company wants to showcase consistency at least on the revenue front, especially to ride-through difficult periods. And one example is distorting the receivables. Products are sold and the company shows them in other receivables rather than showing it in account receivables. Further, changing definitions of days of sales outstanding (DSO) or receivables days is also done.

Misrepresenting the financial asset metrics to hide financial impairment issues

This one is specifically applicable to financial institutions, which may use various tricks to hide the actual stress in their loan books. We have seen recently how investors in stocks like DHFL and Yes Bank have suffered. In both cases numbers were misrepresented and hidden. No wonder companies can follow such practices and enjoy benefits for some period. However in the long run it only backfires.

Distorting inventory to hide profitability issues

The inventory methods used by companies also makes an impact on the margins and overall profitability. Like if the company applies last in first out (LIFO) method when the prices of raw material are higher, in such cases the margins would get affected. Similarly to showcase lower or higher profits the inventory methods are accordingly =followed. Further, by classifying certain inventory as noncurrent saying that it will not be used within one year. Using only in-store inventory and excluding warehouse & transit inventory etc. In this scenario the inventory is understated. Hence it is important to read the accounting policies and accounting Standards followed by the company along with footnotes.

Showcasing different parameters to show business growth

Every business has its own critical success factor (CSF, We have discussed the same through blogs in the past).It is important to understand those CSF as one should focus on growth in those parameters that is important. Many times, management creates new parameters to describe their business performance. Like if we discuss the revenue growth in retail business without focusing on the number of new stores opened, it has no meaning. Just to put in simple words, in Telecom it is ARPU, for Hotels it is Occupancy rate, For Aviation it is Revenue per Available Seat, etc. But many companies showcase completely different parameters.

Such parameters are not the standard parameters of profitability or efficiency as described in accounting standards. However, many times, they help investors understand the status of companies of any particular industry in a better fashion. Such creative parameters are essential but due to non-standardization, the management gets an opportunity to change their definitions as per their requirements. Hence it is important to analyze the number in your own way and not take the ratios and numbers at the face value.

As we mentioned earlier, the possibility of misrepresenting the data like “Same-store sales” for retailers, as well restaurants then ARPU for telecom, Broadband and DTH companies is a common practice. Companies or we can say managements have been known to show a high level of reverse engineering skills to create such eligibility criteria to show the desired trend in performance.

I would like to share one example of subscriber additions: Subscriber for media houses. Like many companies take help of mega subscription drives and collects revenues in advance. Now consider one scenario where a company has provided a subscription for next three years at a discounted rate. The revenue recognition has to be according to accounting standards. In a normal scenario the revenue recognition would happen in three parts (three years). As companies have already received the amount this subscriber would be there for the next three years. However, the subscription amount will increase next year. One would take the same rate to come to average revenue per subscriber. While the subscribers are higher the revenue received from old subscribers is lower. Hence one must try to bifurcate the number of subscribers and revenues received from them. Further there is a possibility that few companies may add up subscribers of unconsolidated entities or joint ventures as well.

Order book for status is another parameter that is very tricky. Some companies may not disclose the details about orders, which might contain cancellation clauses, indemnity clauses and club all orders as if they might be firm sources of revenue in future. Further the JV and subsidiaries are clubbed in Case of infrastructure companies. Such numbers should be closely watched, especially the project tenure and other cost escalation clauses.

Using EBITDA rather than PAT for disclosing business performance

One can see a lot of advertisements given in the financial newspapers with focus being given on the important analytical parameters. And one such important figure almost all companies showcase is earnings before interest, tax depreciation and amortization. We agree that such factors are important but not in all sectors. Some companies may act as if key expenses like depreciation, interest etc., are irrelevant for businesses and investors. For instance Power companies or even in such cases higher Capex sector companies have heavy debt on balance sheets. Real Estate and even Infrastructure companies have heavy debt laden balance sheets. Just for example, for like rental cars, depreciation is the real cost of inventory & operations. Looking at EBITDA only for such companies is highly misleading.

Last but not the least, companies also showcase cash earnings (PAT + Depreciation) or EBITDA instead of Cash Flow to investors as better parameters. Some management focuses on cash earnings as if changes in working capital do not matter for businesses. In simple terms companies adopt the accounting standards favorable to them in a particular scenario.

Hence above are accounting related Red Flags one must read before investing in a company. Rest not every company manipulates the numbers. A few make such gimmicks to lure gullible retail investors. Before investing one must check the above red flags with a detailed eye.