IS A FINANCIAL STATEMENT MANIPULATED?
How can an investor - or an average person- tell if a financial statement is manipulated or not? Here are some of the subtle signs.
Abusing the Elder
In times of financial difficulties, firms begin dipping into reserves, hoping no executive or employee will notice. Pension plan is their favorite target. For example, companies will optimistically project the growth of a pension plan investments, and then reduce contributions, cutting costs as a result. However, when the pensions start coming due, the firm will be forced to top off the plans from current revenue.
Call a Friend
Firms can find several accomplices to any accounting crime, but the two most common confederate are sister companies and special purpose entities. Sister firms are being used to spin off debt as new entity. For example, a pharmaceutical company could establish a sister company and tap it to take charge of their research and development. Instead of doing the work, the sister firm hires the parent firm to do their own research. Conversely, SPEs enable a company to transfer hefty amounts of debt off its balance sheet and hide the fact it is at the brink of insolvency. No investor can notice such discrepancies unless they read the footnotes, which list down all financing related affiliates and partnerships.
This is one of the most prevailing deceptions in a financial statement. It is as simple as removing the bad and exaggerating the good. Accountants can alter numerous figures in any financial report, such as excluding expenses unrelated to its core operations when determining the operating cash basis. Companies need to list down each cost, making smoke and mirrors easier.
Ditch the Body
Also known as channel stuffing, companies hyperbolize its sales and earnings data by pushing unsold items into the market or the distributors’ storage rooms. Yes, it may save a corporation from a huge quarterly loss, but the products will return unsold, anyway. Investors can discover this act in two ways: the indicated inventory levels and the money meant to cover bad accounts. So, if inventory level suddenly slumps or the cash for bad accounts increased drastically, channel stuffing may be happening.
Big bath is a fraudulent act of manipulating a corporation’s income statement to make poor earnings worse and enhancing the following earnings report. In case a company is going to take a loss, they will go on a spring cleaning by writing off any item they can. Although it is not considered a criminal act, it is a deceptive accounting practice.
American and Canadian companies are so intertwined firm trading on their exchanges can choose the country’s accounting standards to employ. If you observe a certain company changes from the historical accounting norms for that corporation, there should be a better justification. While the two systems are the same, both account income in different ways, allowing an affected company to conceal its losings by switching sides. Any modification in accounting standards is an obvious red flag any investor must not ignore.
Read between the lines. If a corporation overstates the positive and understates the negative, dig deeper into these remarks immediately. For example, if a company casually admits to a "going concern", it may actually be confiding they are two steps from bankruptcy.
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