Understand signs of financial statement manipulation Jay Taparia, CFA Inquirer
July 31, 2006
I AM SURE that all of you have several words or phrases to describe financial statements of Corporate America--some that I have heard from all of you include: vague wording and legalese, long and small print, incomplete, too many numbers, hard to understand and the list goes on.
And yes, Corporate America has taken advantage of this within accounting rules enough so that we are forced to read them slowly (and thus, carefully) within our fast-paced world.
But there is some validity in why financial statements are long, written in legalese and hard to understand:
1. How companies are financing themselves has been increasingly complex. There are new financing tools that are hybrid securities, having characteristics of both debt and equity. Additionally, there are new hedging tools (outside of just call and put options) that must also be "accounted" for. The accounting rules and tax rules have lagged these new developments.
2. How companies are structuring themselves has become more complex. Subsidiaries are being used not only to separate businesses, but also to transfer assets for short-term financing (such as in the case of asset-backed securities). Explaining this to the individual investor may end up very vague or too detailed for anyone to read.
3. Hence, why we see terminology and semantics vary from one statement to another. Each company is trying to describe their structure on their own way and not neccessarily with the same words as the next.
We, as individual and institutional investors (and yes, many of you will agree that journalists are included in this as well) have become complacent in reading financial statements in-depth, because of the increased complexity. The process of analyzing financial statements has become a nuisance when you have short deadlines and little time to ask questions (as in the case of the journalist).
In fact, reading financial statements has become even more time-consuming since financial reports have increased in length post-Enron, post-Tyco, post-WorldCom, post-Global Crossing and post-GE.
Get this: New disclosures (not required by the way) have shown up that were never in prior financial reports. However, since we have little comparison to prior data, the new information is difficult to use (in other words, it is useless for now until future quarters pass).
Not necessarily fraud But there are a few simple tricks that can help out--both qualitative and quantitative symptoms--to know when a company might be manipulating their financials. (Keep in mind there is a fine line between using accounting rules to manipulate financials and outright fraud--the former is legal, the latter is not--what we are talking about here is the former--catching where management has exaggerated financials).
1. The company operates in a high growth (expectation) industry--given shareholder perception of high growth, high risk and thus, high return, management is tempted (and typically will implement) aggressive accounting "to make the consensus expectation," especially when the industry has a natural tendency to slow down (i.e. cyclical). We saw this with the Biotech Bubble in the early 90s and the Technology Boom in the late 90s.
2. Management is under fire to show short-term results--this is typical when a new management comes on board of a company and desires to improve profitability quickly (similar to the first 100 days in office of the new president of the United States). Assets are written off, heads are cut and accounting might become more aggressive.
3. Management is highly compensated for strong short-term result--and they get huge personal windfalls for meeting performance targets, usually in the form of stock options, increased salaries and bonuses.
4. Companies are highly dependent on a high share price to maintain their operations-- this is usually the case where companies depend on growth via acquisition. A high stock price goes a long way as a form of currency in the purchase of other companies. Tyco, GE, WorldCom, AOL-Time Warner, Lucent Technologies and Nortel Networks were some of the high-fliers needing a high share price to continue their acquisition spree.
5. And lastly, during a market boom or industry boom, no one wants to be left behind--in fact you will see some companies set up new divisions that focus on that boom, but represent a small portion of total sales, just to mention in their press releases and appear "sexy" to the reader/investor. We saw this with all historical market booms and even more lately, in the currently strong real estate market.
(The author, a lecturer of finance at the University of Chicago in the US, is speaking in a seminar "Accounting Tomfoolery and Financial Statement Manipulations, on Friday, Aug. 4, from 2 to 5 p.m. at the Mandarin Oriental Hotel. The seminar is for anyone involved in interpreting financial statements, reading press releases, or analysts about a specific company or industry.)
