Accounting practices in the United States have improved over the years, but there are still plenty of ways that companies can manipulate their financial results. And not just in the usual ways - the balance sheet can even be used to "store earnings" for future periods! Evidence of these practices can be seen in restated earnings that can be devastating to the stock price. (For an introduction to the balance sheet, refer to our article: Reading The Balance Sheet.)
We'll explore why and how companies utilize creative accounting to overstate a company's assets or understate its liabilities. The result can be a misleading gauge of earnings power and financial condition. This article will explore simple ways that investors can uncover problems by simply looking at the company's financial statements and disclosures.
Why Boost the Balance Sheet?
Companies that manipulate their balance sheet are often seeking to increase their earnings power in future periods (or the current period) or create the appearance of a strong financial condition. After all, financially-sound companies can more easily obtain lines of credit at low interest rates, as well as more easily issue debt financing or issue bonds on better terms.
Provision for Doubtful Accounts
Accounts receivables play a key role in detecting premature or fabricated revenues, but they can also be used to inflate earnings on their own by way of the provision for doubtful accounts. Of course, the reserve for doubtful accounts will prove to be inadequate in the future if adversely modified, but accounts receivable will receive a temporary boost in the short term.
Investors can detect when the reserves for doubtful accounts are inadequate by comparing accounts receivable to net income and revenue. When the balance sheet item is growing at a faster pace than the income statement item, then investors may want to look into whether or not the provision for doubtful accounts is adequate by further investigating.
Inventory represents the value of goods that were manufactured but not yet sold. When these goods are sold, the value is transferred over to the income statement as cost of goods sold. As a result, overstating inventory value will lead to an understated of cost of goods sold, and therefore an artificially higher net income, assuming actual inventory and sales levels remain constant.
One example of manipulated inventory was Laribee Wire Manufacturing Co., which recorded phantom inventory and carried other inventory at bloated values. This helped the company borrow some $130 million from six banks by using the inventory as collateral. Meanwhile, the company reported $3 million in net income for the period, when it really lost $6.5 million.
Investors can detect overvalued inventory by looking for telling trends, such as inventory increasing faster than sales, decreases in inventory turnover, inventory rising faster than total assets and falling cost of sales as a percentage of sales. Any unusual variations in these figures can be indicative of potential inventory accounting fraud.
Subsidiaries and Joint Ventures
When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the equity method depending on their ability to control the subsidiary. Unfortunately, this leaves the door open to companies that want to conceal and manipulate the true performance of their subsidiaries or joint ventures.
Under the equity method, the investment is recorded at cost and is subsequently adjusted to reflect the share of net profit or loss and dividends received. While this is reported on the balance sheet and income statement, the method does limit the information available for investors. For example, a company could overstate interest coverage in order to change the leverage ratios of the subsidiary.
Investors should be cautious - and perhaps take a look at the auditor's reliability - when companies utilize the equity method for accounting in situations where they appear to control the subsidiary. For example, a U.S.-based company operating in China through various subsidiaries in which it appears to exert control could create an environment ripe for manipulation.
Pension obligations are ripe for manipulation by public companies, since the liabilities occur in the future and company-generated estimations need to be used to account for them. Companies can make aggressive estimations in order to improve both short-term earnings as well as to create the illusion of a stronger financial position.
Companies can make themselves appear in a stronger financial position by changing a few assumptions to reduce the pension obligation. Because the pension benefit obligation is the present value of future payments earned by employees, these accounts can be effectively controlled via the discount rate. Increasing the discount rate can significantly reduce the pension obligation depending on the size of the obligation.
Meanwhile, companies can also use pension accounting in order to manipulate short-term earnings by artificially changing the net benefit cost, or the expected return on pension plan assets, on the income statement. While the estimate should be roughly the same as the discount rate, companies can make aggressive estimates that will then affect the income statement. An increase in the expected return on plan assets will reduce the pension expense in the income statement and boost net income. (For additional information, take a look at Analyzing Pension Risk.)
Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee or the date payable. For example, warranty obligations or anticipated litigation loss may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating their materiality.
Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income or shareholders' equity. Investors can avoid these problems by carefully reading a company's footnotes, which contain information about these obligations.
The Bottom Line
Companies can manipulate their balance sheets in many different ways, ranging from inventory accounting to contingent liabilities. However, investors can detect these practices by simply reading the financial statements a little more closely. (For related reading, check out 5 Tricks Companies Use During Earnings Season.)