Financial Shenanigans: Be Cautious!

Published on 20th December 2006

Every corporate body wishes to get recommendations that beat the industry peers.  Recently, PriceWaterHouse Coopers (PWC) sponsored East Africa’s Most Respected Company of the Year. To most companies, especially those that are publicly listed, it is always a great honor for the shareholders to put the management under the microscope.  Most are left questioning, “are the guys we appointed to the board doing anything that makes us proud?”

It is at such events that companies showcase how well they have tried to stay on track as far as company goals are concerned and prove that they truly beat their peers.

The bigger issue always remains whether you take that at face value or the analyst in you sees a cover up.  Take into addition massive advertising and excessive giveaways.  We can’t always argue that companies preach what they eat. It gets even complicated when one thinks of the extreme example of Enron or Uchumi Supermarkets. 

With regulation, one can argue that company heads are very keen on ethics in the corporate set up.  The truth is, managers always report what they want the public to see, or what they deem the minority shareholders expect.   

What do you pick out when a sitting board member decides to take up the Chief Executive Officer’s seat?  Or a firm starts acquiring firms that are larger than its own (in assets)? Even worse, a firm’s quarterly earnings always match up to the analysts expectations with each major expense bearing the same percentage relationship with sales in the previous quarter. 

If such signs start striking you, then you had better consult your financial analyst. The possibility at which companies misreport their earnings for the sole objective of pleasing shareholders may not often be evident and usually comes to light when it has happened. 

If a company starts booking a lump-sum payment as current sales even when services will be provided over a period of years, then there is need to worry.  This is because such revenues will inflate the income statement which will lead the public to perceive the company as doing very well while in actual sense, it should have amortized the revenue over the life of the contract.

Another tactic that a manufacturing company can use is that of channel stuffing.  Typically, a manufacturer should supply goods and only realize sales once all unsold merchandise is returned.  This is because goods supplied are not guaranteed for sale until they have been fully sold.  A similar trait to this will occur if a financial institution, say a bank, books income from loans as earned upon issue. A client could decide to repay the amount before the stipulated time forcing the bank to forgo the income or forfeit payment leading to greater losses.  This gives an impression that a company is doing well, a trait that does not usually hold in the long term.

A company can also decide to delay its expenses.  This is typically done by capitalizing costs to make then accounted for in future and at the same time transferring them to the balance sheet.  Driven by reduced expenses, profits are usually inflated in the short term. 

Expense acceleration is a common trait that occurs mostly before mergers.  Typically, the firm being acquired will pay as many expenses as possible.  This has an overall effect on the post merger.  Usually, the combined entity will have its Earnings Per Share (EPS) boosted as compared to the previous periods.  This is because expenses of the merged banks will appear as having been booked in the previous periods.

The use of non recurring expenses is even more common. A company will typically book excess reserves from prior charges and at times hide expenses against other newfound income. According to Ricky Wayman, a financial analyst, other sources of such income could include selling equipment or investments. 

Off-balance sheet items can also be a source of the greater ill.  Companies create separate legal entities that can harbor liabilities and other expenses that can negatively impact on a company’s books.  In doing so, an investor will be compelled to treat them as non related items or those owned by subsidiaries.   

Financial gimmicks come in many forms.  As much as it is hard for the ordinary investor to read through a company’s financial statements, it is important to be wary of gimmicks in the financial cycle.  It will not just take an analyst to predict the signs but continuous monitoring.  It always pays to consult before investing. Perhaps 75 per cent of the Wall Street analysts did not see the downfall of Enron coming.

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