Asian Financial Statement Analysis is a book written by Tan Chin Hwee and Thomas R. Robinson. This is a highly recommended book which lays out proven framework for detecting irregularities in profits, financial positions and cash flow. I wanted to read this book because I found a company listed in HK that has fabulous financial results yet the stock price keeps dropping. As I scrutinize the numbers, they look too good to be true. Therefore, I want to know what are the key things to look out for in financial statements so that I can be better informed before I invest in the company.
There are a few categories for accounting scandals.
1. Overstating Earnings
2. Overstating Operating Cash Flows
3. Overstating Financial Position
4. Corporate Governance/Related Party/ Auditor Issues
Income statement can be manipulated by:
1. Aggressive Revenue Recognition
Most of the cases of aggressive and fraudulent revenue recognition result in large increases in receivables.
2. Understatement or Deferral of Expenses
Understate expenses or losses either by avoiding reporting them altogether or deferring them to a later period.
3. Classification of Non-Operating Income
Inappropriately report non-operating gains as part of operating revenues
4. Classification of Non-Operating Expenses
Another option is to move expenses down the income statement and classify them as a “special” or “extraordinary” loss to make normal operating earnings look larger.
Overstated Financial Position
Excluding both assets and liabilities from balance sheet is the easiest technique to employ and current accounting rules permit some ways of achieving this result. Understating assets also improves some financial ratios – most importantly Return on Asset.
By leasing the asset using an operating lease, the company gains use of the asset without reflecting it as a liability on the balance sheet. This is off-balance-sheet financing, which results in better return on asset and debt to equity ratio versus what would be shown if the asset had been purchased and financed.
Another method of understating both assets and liabilities involves shifting accounts receivables off the balance sheet in a borrowing transaction.
A company may understate liabilities without having an impact on asset.
Overstating Valuation of Assets on the Balance sheet
PP&E are initially recorded at cost upon acquisition. Subsequently, company can choose to measure the asset under cost model or revaluation model. Intangible assets are initially recorded at their acquisition cost. Subsequently, the company may report using cost model or revaluation model.
The most interesting category is agricultural assets – living plants and animals. Generally, these assets are required to be recorded at fair value less expected costs to sell during the growth, production and procreation period. Fair value would increase over time as crops or cattle grow. Gains and losses from changes in fair value over time are reflected in net income and retained earnings For fair value, it is easier to manipulate and you must assess the likelihood that this is happening.
Checklist of Warning Signs and Analysis Techniques for Earnings Management
Allowance for Doubtful Accounts
- Examine the allowance for doubtful accounts and bad debt expense relative to accounts receivable and revenue over time. Look for irregular patterns
- Examine the level of actual bad debts over time relative to the company’s estimate in prior years.
- Look for accounts labeled deferred revenue or unearned revenue.
- Consider whether advance collection is normal? Does deferral make sense?
- Examine the balances from ear to year to determine if their use increased or decreased revenue for the current year.
- What would the company’s revenue and profit have looked like without this deferral?
- Are there significant accrued expenses relative to net income, and do they fluctuate by large amounts?
- Are there any deferred expenses listed as an asset on the balance sheet?
- Are there any unusual assets or unexplained large increases in assets, particularly relative to the increase in revenue?
- Does the company’s net deferred tax impact on net income fluctuate from a positive to a negative impact?
- Does the company have a significant deferred tax assets? Is it plausible that they will be usable in subsequent years?
- Did the company establish a valuation allowance for deferred tax assets, and has it fluctuated in value over time?
Contingencies and Reserves
- Scrutinize disclosures both on the balance sheet and footnotes for
- Contingent loss
- Contingent liabilities
- Derivative liabilities
- Similar terminology
- Consider whether the company appears to be creating a cookie jar reserve.
Typical cashflow games are aimed at increasing either total cash flow or the subtotal for operating cash flow since that is a key indicator of value for a company.
- Aggressive encouragement of customers to pay their balances sooner than required.
- Sale of accounts receivables in a factoring arrangement
- Delaying payments to suppliers, employees and others.