Different Ways to Analyze – Warning Signs in Accounting

6 mins read
by Angel One

Different Ways to Analyze – Warning Signs in Accounting

When it comes to investing – there are quantitative parameters and there are a few qualitative parameters. Ability to analyze qualitative parameters like business quality and promoter quality comes only along with experience. However the quantitative parameters (mainly financial performance) have got a certain set of processes and rules. It is important to follow such steps and keep a close watch on accounting standards followed by the company.

In a current fast growing world – everyone tries to keep up with the pace. Especially in the world of business there is cut throat competition and no one wants to feel Left out. While most of the companies follow the accounting standards stringently – there are few resorting to malpractices or some manipulation. It is not that only small companies follow such a path. In the past we had examples of Satyam Computers – where management had accepted that there were fraudulent activities carried out. No wonder the investors were quick to reckon the same gave a cold shoulder to Satyam (Now merged with Tech Mahindra). Such instances if caught make a dent on the share price eventually eroding the investor’s wealth. Unfortunately such investors can hardly make up for the loss made in such investments. Rather many such investors move away from markets and never return. It is True that SEBI as a watchdog is doing a fabulous job and investor interest is taken care for. However, as they say – “Prevention is better than the cure”. It is better to understand such accounting gimmicks followed by the company by analyzing the financials in detail. Let’s take a few of the examples one by one.

Misrepresentation of Earnings

When someone wants to show growth – it is the Topline (revenues) everyone focuses on and as result most of the companies attempt to show higher revenue & profits during the current period to meet or exceed market expectations.

Superior earnings in the current fiscal act as a strong factor to raise the market price of company’s shares and increase the wealth of investors (eventually the promoters and in many cases professional managers) who stand to benefit from their stake in the company.

While showcasing higher revenues and profits is one way of manipulating the revenues. There have been cases when companies have tried to mask the current good performance (showcasing slower growth in the current period) and tried to defer revenue as well as profits to a future period. Simple reason being, the same company can showcase a sustained performance during upcoming tough times. To put it in a simpler manner, deferring the current strong set of numbers for future periods eventually helps the company to show sustained performance during bad times, thereby giving the impression of a resilient business model to the markets. And consistency is highly rewarded on the bourses. So there have been cases in the past where the companies under report the numbers and the consistency is maintained. All in all, this clearly indicates that the management has sufficient incentive to act both ways. Hence it is to be cautious ahead of investing and rightfully find such accounting gimmicks.

Let’s take a look at few of the accounting gimmicks followed by the companies to inflate their current period earnings:

  • Recording revenue too soon
  • Recording bogus revenue – (May be through subsidiary companies)
  • Boosting income by using one time or unsustainable activities (companies sell-off assets and such revenues are accounted for)
  • Shifting current expenses to a later period (deferred expenses)
  • Using techniques to hide expenses or losses

Managements may use the following techniques to subdue their current period earnings in an attempt to inflate future period earnings:

  • Shifting current income to a later period
  • Shifting future expenses to an earlier period

All these steps could easily help the management achieve their objectives. However, there are certain checks and balances in place in the system, which often play the spoilsport for such managements:

The requirements of disclosures about revenue recognition and other accounting policies and the presence of three financial statements: Balance Sheet, Profit & Loss and Cash Flow Statement, which talk to each other. And any discrepancy in matching those numbers would mean it is important to dig further for analysis.

We had carried a series of blogs – Playing with Numbers. We had categorically stated how to analyze such numbers.

Blog 1 – How to Find Out Companies Playing Financial Numbers (Expenses Side) – Part 1

Blog 2 –How to Find Out Companies Playing Financial Numbers (Expenses Side) – Part 2

If the management tinkers with one of these statements, then there is a very high probability that investors would find signs of unhealthiness in the other two statements.

Tinkering with Cash Flow

While the revenues are important for growth the Cash Flows are also important for sustainability. Many companies earlier only focused on the revenue manipulation and were caught as upon analysis of cash flows, it could easily be deciphered that the earnings were not backed by cash flows.  In our next blog we would be focusing on how to catch such cash flow gimmicks. Cash flow from operations (CFO) has now become the key parameter to analyze companies.

Cash Flow manipulation techniques are mainly focused on either shifting investing and financing inflow to the operating section or shifting operating outflow to the investing section. There is a very good book “Financial Shenanigan” that classifies such attempts. It can be broadly segregated in following parts

  • Showing financing cash inflow as operating inflow
  • Showing operating cash outflow as investing outflow
  • Using acquisitions or disposals to boost operating cash flow
  • Boosting operating cash flow by using unsustainable activities

In case of cash flows, the reconciliation requires that all the entries of cash inflow or outflow have to be in the cash flow statement and the management can only change their classification from one head to another. Therefore, if an investor uses certain adjustments in her analysis of cash flows then one can easily detect such shenanigans and improve her stock analysis to reflect the true economic reality.

While we have just introduced the – Accounting Red Flag Chapter, we would explain the same in detail in our next blog focusing on Cash Flow Analysis.