Part
1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
Part 1 - Reading financial statements
Knowledge is power. This is particularly true when it comes to investing. Knowing a company's business performance and its industry well enough enables us to buy or sell its stocks confidently and correctly. Knowledge and information improves quality of our investing decisions.
We can gain such knowledge and information of a company predominantly from their financial statements. When we look for a company with strong management, solid financial positions, earning growth, etc. look no further but the company's report card: its financial statements. Searching for a proper valuation of the stock? Let's begin with the financial statements. Analysts from the entire stock investing/ trading profession analyze and comment on the financial statements of listed companies every quarter. Great investors like Benjamin Graham, Warren Buffett, Philip A. Fisher, etc. read financial statements before further facts finding. In fact, all investing fundamentalists read financial statements.
It is suicidal to practice investing characteristics like "being patient", "being quick to response", etc. without the backing of knowledge and information. It is knowledge and information that provide great investors their unweaved beliefs in their decisions, whether it is being patient or being quick to cut loss.
With knowledge and information, we are able to be patient and to hold on to jewels like Wells Fargo, Walmart, Public Bank, OYL, etc. that can (and had) brought fortune to the stockholders. Without knowledge and information, we psyche ourselves up to "be patient" on Enron, Bestcorp, Omega, etc. and to see our life savings evaporated when these companies failed. Both are being patient, the difference lies in what we know about our investments. It comes from reading the financial statements.
(So don't advice other to BE PATIENT or BE DECISIVE in holding on or disposing their investments. Such advice can only come after knowing the true financial performance and status of a stock. BE PATIENT and BE DECISIVE are dirty investing words without the backing of knowledge and information of a particular company.)
But why, in general, layman investors don't read financial statements? One of the main reasons I suspect is that layman investors basically throw in the towel in believing that performance of stock prices has got anything to do with the company’s financial numbers. Reading financial statements is, sometime, a futile effort in knowing the company performance. Profit numbers are unreliable. They are right. Looking back at 1997 Asia financial crisis and 2000 Dot Com Bubble, failed companies unabashedly manipulate their numbers before their demises. Stock prices crashed before showing any sign of losses, or before the reported profits were rediscovered as losses. The unscrupulous managements cheated in their report cards. It is reasonable for investors to believe that it is useless and meaningless to read financial statements. However, this is not true. There are ways to detect profit manipulation. We, as investors, can definitely detect profit manipulations.
We rely on the numbers provided by the management to make our investing decisions. These numbers have to be authentic and we must have confident in relying on them. To confidently relying on numbers in making investing decisions, we must be able to detect profit manipulation. Before we learn how to detect profit manipulation, we first must learn how the accountants manipulate the profit numbers.
In Part 2, you will find how accountants cook their books. In Part 3, we will learn how to detect such manipulation.
Part 2 - The principle of profit manipulation
Profit manipulation comes in many faces. However, generically or technically there is only one way to do so:
To jack up profit, an accountant must CREDIT (CR) the accounts in Profit and Loss accounts. The beauty of accounting is that inevitably he has no choice but DEBIT (DR) the accounts in Balance Sheet.
Dr Balance Sheet
(Increase assets like stocks, trade debtors, etc. or reduce liabilities like trade creditors, provisions, etc.)
Cr Profit and Loss accounts
(Increase revenue or reduce costs)
The above double entry is the mother of all profit manipulation. There are rare exceptions and we will address them later.
Backed by the above core double entry, these are the common masks of profit manipulation:
- Reduce cost of sales by increase the value of closing stock
- Refuse to provide for uncollectible bad and doubtful debts
- Reverse previously provided provisions for bad and doubtful debts without true sign of debts recovery
- Delaying in charging out expenses
- No accrual was made for known and quantifiable expenses
- Fake cash (less common, more difficult to perform and subject to higher risk of being prosecuted as criminal.)
- Etc.
The way to detect profit manipulation or to ensure the authenticity of profit is first to look at the movement of Balance Sheet! In the case of jacking up profit, beside the increase in retained profit, Balance Sheet will also reflect a significant increase in assets or reduction in liabilities.
Part 3 - Detecting profit manipulation - overview
Authentic profits generate hard cash. Manipulated profits stick in other assets like stocks, debtors, reduced creditors and provisions, etc. To detect profit manipulation we need to find out where these funds (from profit) are reflected in the Balance Sheet.
The rightful places in Balance Sheet for funds (generated from profits) are:
- increased cash and bank balance
- reduced borrowings
- additional fixed assets
- reduced retained profit (due to dividend payments)
- reduced tax provisions or increased tax recoverable (due to tax payments)
- The 'wrongful' places for such funds (generated from profits) in Balance Sheet are:
- increased stocks
- increased debtors
- reduced trade creditors
- reduced provisions (due to reversal)
Balance sheet and cash flow statement are not arranged in the way to facilitate the checking profit authenticity.
(Even as an Accountant I do wonder what on earth these Standards Board members are thinking when they set the format of presentation. The financial presentations required by the Accounting Standard look nice, consistent and comprehensive, though it doesn't serve any purpose for decision making.)
We need to do a slight rearrangement of balance sheet's numbers. The objective is to find out where the funds (generated from profits) are landed or reflected in Balance Sheet. We shall get our hands dirty in the coming step-by-step guide.
Detecting profit manipulation - Step 1
Step 1: Net profit and depreciation
You need to know two numbers:
a. profit after tax (before minority interest, if any)
b. depreciation
That’s all for Step 1.
Problems you might encounter:
The quarterly report format approved by Malaysian Accounting Standards Board (“MASB”) took a step backward that the disclosure of depreciation can be avoided. MASB allows CONDENSED Cash Flow Statement that can hide many important breakdowns. It is frustrating considering the importance of depreciation to estimate owner’s earning (as per Warren Buffett’s methodology) and to understand cash flow. However, most decent companies still disclose depreciation voluntarily in their quarterly report announced to Bursa Malaysia.
If the depreciation number is not available in the quarter report, you can estimate the number from their previous financial year annual report. It should not run too far under normal circumstances.
Skip this part if you are familiar with financial reports. For novice only:
If you are reading annual report, the comparing balance sheets are that of the current year end and preceding year end. The profit and depreciation figures are of the current year.
If you are reading quarterly report to find out quarterly performance, the comparing balance sheets are that of the current quarter end and preceding quarter end. The profit and depreciation figures are of the current quarter.
If you are reading quarterly report to find out year-to-date (for instance, three quarters) performance, the comparing balance sheets are that of the quarter end and preceding year end. The profit and depreciation figures are of the year-to-date ended at current quarter end.
Detecting profit manipulation - Step 2
Step 2: Net cash/ debts movement
The first question to answer is, “Does the profit bring in real cash?”
In order to know whether there is improvement in a company’s financial position, it is useless to look at cash and bank balances only. We must see the NET of Cash, Bank Balances and TOTAL Borrowings, in order to know whether the profits bring in real cash.
Calculate the change of net cash/(debts) between two Balance Sheet dates. We need to know the movement of net cash/(debts).
Net Cash/(Debts) = Total Cash & Bank Balances – Short Term Borrowings – Long Term Borrowings. The company is EITHER in a net cash position OR net debt position. We calculate the movement of net cash OR net debt.
Get the movement amount out and compare it with Step 1’s Net Profit Add Depreciation. We also need to find out more of other movements in Balance Sheet to know the whole picture.
This is all for Step 2.
Positive movement, i.e. increase of net cash or reduction of net debt, that match Net Profit Add Depreciation indicates possibility of true profit, though we cannot conclude it before looking at other movements in the Balance Sheet.
We have to worry about negative movement. What makes a profitable company to have deteriorating cash or financing position? It can be due to capital expenditure, it can be due to dividend and/or tax payments. It can be due to deterioration of operating efficiency or profit manipulation that cook up the stock and debtors level. We will need to find out.
Cash flow statement is not very helpful in detecting accounting manipulation because it split out the changes in cash and bank balances from the changes in borrowings.
Detecting profit manipulation - Step 3
Step 3: Inventories, trade debtors and trade creditors movements
First test:
If trade debtors amount in Balance Sheet is bulky, with collection period exceeding three months, drop every analysis. Save your breath for a better company.
It is the same for inventories/ stocks. If stocks amount in Balance Sheet is bulky, with stocks turnover period exceeding three months, drop every analysis. Save your breath for a better company.
Generally, a company with long collections period and inventories turnover is either operationally badly managed or having problem in generating sales. Either way, we should not waste our time and money to invest in such company.
Second test:
First, let’s calculate the net total of Stocks Add Trade Debtors Less Trade Creditors (S+TD-TC). Second, we calculate the movement of S+TD-TC of two Balance Sheets period.
If S+TD-TC movement increases, we have to worry. If S+TD-TC movement decreases, we are relief. If the increase of S+TD-TC is almost the same as Net Profit add Depreciation, we are quite sure that the company has not made a single sen of real profit yet. There is no hard cash from the profit.
However, if the revenue increase proportionately, not less, such increase in S+TD-TC is acceptable. Should S+TD-TC increases for two quarters or more without the proportionate increase in revenue, dump the shares.
This is all about Step 3. A company that does not pass the screening test is either badly managed or manipulating their numbers. We cannot differentiate the two, but either way we should not invest in such company.
Click here for further explanations.
Detecting profit manipulation - Step 4
Step 4 Capital expenditure, goodwill, tax payment and dividend
Sometimes, despite showing net profit, there is no significant change in net cash/debts and/or S+TD-TC. We must then look elsewhere to find out where were the funds gone (for real profit) or where were the profits juggled from (for fake profit).
The items listed below are usually NOT “alarming” items in detection of profit manipulation. There are more of “assuring” items on providing us a full understanding of where had the money gone. The judgments on “whether those are good management decisions” are business calls.
Capital expenditure
Movement of fixed assets shows capital expenditure.
Fixed assets as at current period end = Fixed assets as at preceding period end + capital expenditure - depreciation
Company may acquire fixed assets like plants and machineries, vehicles, lands, office equipments, computers, etc. Accountants may hide losses by charging repair and maintenance expenses to fixed assets as capital expenditure. However, as fixed assets are important items for taxation, they are subjected to careful scrutiny by auditors and tax agents. Accountants will usually avoid using fixed assets as a way to manipulate profit.
For the purpose of detecting profit manipulation, there is nothing alarming should the funds from profit were used for capital expenditure. Whether such capital expenditure is good or acceptable to the investors is the matter of business judgment.
Goodwill
Goodwill increases when the company acquires subsidiaries with a price more than the subsidiaries’ book value.
Tax payment
The increase of tax recoverable or reduction in tax provision in Balance Sheet is, sometimes, due to cash payment to IRD. However, we should double check income statement’s taxation row (below profit before tax, above profit after tax).
Sometimes the accountant may decide to reverse tax provided which would jacked up profit after tax. Do a quick check by dividing tax over profit before tax. A range between 20% and 35% is acceptable depending on industry.
Dividend payment
Dividend payment would reduce net cash or increase net debt.
Retained profit as at current period end = Retained profit as at preceding period end + profit – net dividend
At this point, most likely you have got a rough picture on whether the profit generates cash or on how the company utilized its profit.
Detecting profit manipulation – Step 5
Step 5 - Other creditors and debtors
If ultimately the movements in Balance Sheet that match the funds from profit are the movements in other creditors and other debtors, we must know the reasons of such movements. Such information is usually not available in quarterly report and sometimes not even available in annual report.
The way to deal with such movements is to wait for next quarter’s Balance Sheet. Such increase in other debtors or other creditors should be of temporary. It should be alarming if the amount keep increasing in Balance Sheet for two quarters.
It can be due to something as simple as payment or repayment of rental deposits, down payments of agreement, etc. Therefore it should be either of something one off or short term.
Part 4 - Detecting profit manipulation - Concluding Steps
The question to be answered for the entire 5-step-exercise is that "Does the profit generate real cash?"
If the entire profit is almost equal to the net movement of S+TD-TC, the answer is NO. In such a case, the company is either
a. Operationally badly managed
b. Manipulating profit numbers, or
c. In the phase of growth
We cannot differentiate a. and b., but it doesn't matter. Both reasons are good enough for us to avoid investing in such company. Other steps provide us information how the company uses its profit.
The checking begins with Step 2 - movement of cash and bank balances. What if the Cash and Bank Balance is faked?
Faking profit through cash and bank balance is the last thing that accountant or management wants to do. It leaves trail in bank reconciliation or cheques books. In corporate world, the best lie is the lie that can be justified professionally due to subjectivity. For instance, there are various methods for stock valuation that lead to different numbers; performing and non-performing loans can be subjective; timing of billing can be arguable, particularly for construction and IT companies; vendors can be blamed for late billings and that accrual was not done due to staff omissions. These are the grey (and safe) areas that accountant and management want to exploit.
Only in a desperate situation, where all means of profit manipulation were exploited, the management will take the risk of creating fake cash for profit. In such a case, Step 3 would have revealed such badly managed company. We would have avoided investing in it right at the beginning.
Nobody wants their company to be badly managed, including those who manage it. It depends on the management integrity in reporting the truth. However, if the management chooses the evil path of deceiving, the first step of evil path (or selling soul) is always the easiest (or the seemingly harmless) step, i.e. S+TD-TC. (Step 3)
Limitation and exception
Limitation
This method of detecting profit manipulation is particularly effective for manufacturing and trading companies. It is also useful for the industries like service, infrastructure, construction, property development, information technology, mining, etc. Understanding of the principles behind the practice is useful in applying the method.
However, it may rule out most construction or property development companies as badly managed due to the industries' huge stock piles and uncollectible debts. (It is also a good reason for us not to invest in the companies of such industries.) For infrastructure companies, we have to accept its high gearing ratio as reasonable since the income is contractual.
It is not applicable for financial services companies like banks, stockbroking, insurance, etc. While the principles of managing company are the same, they are reflected differently in the Balance Sheet. There are more rooms for such companies to manipulate their profit without reflecting such manipulation in the Balance Sheet. For instance, how do you know their marketable securities are valued correctly (market price for illiquid stock are not indicative as real disposable value), how can we be sure that they have declared or provided for non-performing loans, how can we be sure within the reporting period they wasn'’t any off balance sheet items took place, how much is the company's foreign exchange risks, etc). The transactions in financial services companies are much more complicated than the companies in other industries.
Historical performance is the key to understand their real performance other than merely checking their Balance Sheet'’s movements. For instance, growth story behind a dismal historical performance is unreliable.
Exception
Enron is an odd case. It will escape our attempt to detect profit manipulation, simply because it didn'’t consolidate the results of all the companies within the Group. Enron created certain corporate structure that, under U.S. accounting standards, allowed it not to consolidate these loss making companies into the Group accounts. Luckily such loop hole is only available in United States. Malaysia adopts International Accounting Standards, a principle-based Standards just like U.K., Singapore, Hong Kong, etc.
Enron used off balance items in constructing their profitability. To overcome such deception, we must look at the Notes to the Accounts for such off balance sheet items like corporate guarantees, capital commitments, contracts, options written, etc.
Credit : http://stockinvesting.financialplanningmalaysia.com/2005/10/reading-financial-statements.php
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