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Detecting Red Flags Of Financial Statement Manipulation
Education | 17 December 2010
By: jason.liew
Articles (66) Profile

Over the years of bulls and bears, regulators of the financial market constantly sharpen their standards to maintain transparency and protect investors. While new regulations are enacted in this ever-changing market, one problem continues to exist: financial statement manipulation or financial shenanigans. Companies, for many reasons, may be tempted to manipulate or exaggerate their financial figures at any time, regardless of a good or bad economy. No matter how much the governing bodies do to prevent, we see scams and scandals emerging to haunt investors.

In this article, we will discuss some of the common ways a company may use to distort its figures.

Income Statement
Aggressive Revenue Recognition
A company may manipulate the timing of the recognition of revenue or include items unrelated to its business operations as part of revenue. These could be done in an attempt to inflate top line growth or to hide the deterioration of sales.

Listed below are some of the aggressive techniques:
Recording of revenue at the time the contract is signed but the goods or services have yet been delivered

- Recognising revenue before fulfilling all contract terms

- Reporting of gains from non-operating or nonrecurring activities as part of revenue

- Recognition of barter transactions as sales

Classification of expenses or losses as extraordinary or nonrecurring
The nature of nonrecurring items is meant to occur infrequently. Hence, a company that frequently reports nonrecurring losses may attempt to artificially boost its income from continuing operations by moving these items “down” the income statement. Such extraordinary charges that occur frequently are best to be classified as ordinary operating expenses for clearer assessments.

Deferring the recognition of expenses
The motivation of deferring expenses to future years through amortization or other means is to boost current period earnings. Attention should be paid to slow amortization of costs or changing of accounting policies to foster manipulation by determining if this is a common industry practice.

Balance Sheet
Inconsistent Growth in Accounts Receivable
Several items in the balance sheet can be tampered with to create a false appearance of strong financial standing, one of which is the accounts receivable. Investors should monitor if the growth in receivables is in line with growth in revenues. When the balance sheet item is growing faster than revenue, this could indicate the fabrication of sales, and investors may want to investigate further into the adequacy of the provision for doubtful accounts.

Overvaluation of Inventory
Inventory increasing faster than sales or total assets are the tell-tale signs of the overvaluation of inventory which will lead to an understated cost of goods sold, and that will in turn inflate net income. Decreasing inventory turnover may indicate that inventory is too high and may be a sign of obsolescence.

Cash Flow Statement
Stretching Accounts Payable
A temporary mean of increasing operating cash flow is by stretching accounts payble, by delaying payments to the suppliers. This method is not sustainable as suppliers may refuse to extend credit to the company. Stretching accounts payable can be examined by the increases in the number of days in accounts payable.

Securitization of Accounts Receivable
A company can borrow with its receivables as collateral. This securitizing process accelerates operating cash flow into the current period and artificially increases receivables turnover. A gain is generated from the differences between the book value and fair value of the receivables at the time of securitization.

Spot Them Before They Turn Your Portfolio Red
Companies’ press releases are often packaged with the good news while masking the bad. Instead of jumping into an investment decision based on a company’s boasting of its earnings or revenue growth, question its statements. While a company’s earnings growth may indicate superior leadership from its management, investors should check if the increases are in sync with its peers and industry. Make extra efforts in observing the trends of its financial ratios or any sudden changes in reported figures.

Outlined above are some common ways of the manipulation of the financial statement. This topic remains a broad spectrum of financial reporting, and an added advantage for investors is to be familiar with the financial reporting standards. As Benjamin Franklin quoted, “by failing to prepare, you are preparing to fail.” Every serious investor should equip themselves with the fundamental skills in performing investment decisions, at the same time aiming towards a high level of diligence in conducting financial analysis.

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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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