Cooking the books can only last 2 years

Interesting article in The Economist "How companies massage their profits to beat market forecasts", some snippets:


Executives have every incentive to match or beat forecasts as the market punishes those that fail to do so. That, in turn, hurts the value of the share options which are the best hope of making the executives rich.

A recent academic paper looks in detail at this process (The Valuation Premium for a String of Positive Earnings Surprises: The Role of Earnings Manipulation by Jenny Chu, Patricia Dechow, Kai Wai Hui and Annika Yu Wang). As the authors point out, it is hard to know whether the ability of the corporate sector to beat forecasts is due to good management, a growing economy or outright manipulation. So they focus on companies that the SEC has identified as indulging in manipulation.

Sure enough they find that 53% of such firms have a record of four straight quarters of beating forecasts, compared with just 43% of all firms. Secondly, they find that firms tend to indulge in earnings manipulation when they already have a high stock market multiple; they are trying to prop up their share price, not inflate it. The average price-earnings ratio during the manipulation period is 35.

Third, they find that 42% of manipulating firms beat profits for eight quarters, compared with 32% of all firms. After that, the difference is not statistically significant. So two years seems to be the limit for cooking the books. And fourth, they find that executives focus more on beating forecasts than on beating last year's numbers.


The link to the research paper can be found here.

Top 8 Ways Companies Cook The Books

From InvestoPedia, edited version, I took away some material that is not so relevant for Malaysia, the original article can be found here:

http://www.investopedia.com/articles/analyst/071502.asp?partner=basics102811#axzz1cojrnmgz

What can you do to protect your investments from Enron-style disasters? You need to learn the basic warning signs of earnings manipulation. While the details are usually hidden - even from the accountants - learning these money-manipulation methods will keep you alert to companies who may be cooking the books:

 

Accelerating Revenues
One way to accelerate revenue is booking lump-sum payment as current sales when services will be provided over a number of years. For example, a software service provider receives upfront payment for a four-year service contract but records the full payment as sales of only the period that the payment is received. The correct, more accurate, way is to amortize the revenue over the life of the service contract. (A recent change in accounting standards lead to a revenue boost for many companies that were required to defer revenue over several years.

A second revenue-acceleration tactic is called "channel stuffing." Here, a manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales; however, the distributor has the right to return any unsold merchandise. Because the goods can be returned and are not guaranteed as a sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.

Delaying Expenses
AOL got in trouble for this in the early 1990s when it capitalized the costs of making and distributing its CDs. AOL viewed this marketing campaign as a long-term investment and capitalized the expense. This transferred the costs from the income statement to the balance sheet where it was going to be expensed over a period of years. The more conservative (and appropriate) treatment is to expense the cost in the period the CDs were shipped.

Accelerating Expenses Preceding an Acquisition

This may sound a little counterintuitive, but before a merger is completed, the company that is being acquired will pay, possibly prepay, as many expenses as possible. Then, after the merger, the EPS growth rate of the combined entity will be easily boosted when compared to past quarters. Furthermore, the company will have already booked the expense in the previous period.

"Non-Recurring" Expenses

By accounting for extraordinary events, these one-time charges were meant to help us better analyze ongoing operating results. It seems, however, that some companies take one of these each year. Then a few quarters later, they "discover" they reserved too much and are able to put something back into income (see next tactic).

Other Income or Expense

This category can house a multitude of sins. Here companies book any "excess" reserves from prior charges (non-recurring or otherwise). This is also the place where companies can hide other expenses by netting them against other newfound income. Sources of other income include selling equipment or investments.

Off-Balance-Sheet Items

A company can create separate legal entities that can house liabilities or incur expenses that the parent company does not want to have on its financial statements. Because the subsidiaries are separate legal entities that are not wholly owned by the parent, they do not have to be recorded on the parent's financial statements and are thus hidden from investors.

Synthetic Leases

A synthetic lease can be used to keep the cost of new building from appearing on a company's balance sheet. The lease is a long-term (five- to 10-year) agreement under which a company will pay a fixed lease expense to be in a new headquarters. At the end of the lease, the company is obligated to buy the building, but because of the nature of the lease, this liability is not included on the balance sheet. (Who said accountants were boring and uncreative?) At the time the lease was made, the company may have been in fine financial shape and the economy may have been booming; however, the ability of the company to meet this huge obligation is hard to determine until shortly before maturity (one to two years).

The Bottom Line
If you tune into the items hidden in a company's financial statements, you may be able to spot some of the warning signs that point to earnings manipulation. This doesn't mean that the company is definitely cooking the books, but if a company makes you suspicious, that's a sure sign that you should dig deeper before making an investment.

In the Malaysian context, warning signals are increasing Sales and Profits, but

• Decreasing Cash
• Increasing Debts (especcially short term is worrisome)
• Increasing Inventory
• Increasing Receivables

Classic accounting fraud cases in Malaysia (post 1997/98) are Megan Media and Transmile, apart from many other smaller cases (especcially on the ACE market).

There are currently a few others that have dubious looking accounts, only time will tell how they will end.