It is that time of the year when companies go all out to present a pretty picture of their performance to shareholders by manipulating financial statements. According to a recent KPMG report on corporate frauds, a majority of the cases involve accounting tactics designed to decieve investors and auditors. Some of these may not be illegal but are definitely meant to mislead. Here are a few common ploys:
Off-balance sheet financing: The company tries to keep its gearing ratios low by transferring debt to another firm (even a subsidiary). It avoids listing part of its capital expenditure in the balance sheet and hides its true solvency position. Excluding debt from the balance sheet results in a favourable debt to equity ratio, making a high geared company appear low geared. This technique helped Lehman Brothers to disguise $50 billion in debt and remove liabilities from the balance sheet when the results were due, hiding the extent of its debt.
Unreasonable value of inventory: Closing inventory is the stock left over at the end of the accounting year and its value is often used to enhance profits. An increase in its value automatically improves the profit by the same amount as it reduces the cost of sales. The notes to financial statements point out significant facts relating to this value. Investors must ensure it is valued at its cost or net realisable value, whichever is lower.
Creating false sales: This can be done in several ways. A company may consider goods that have been ordered but not shipped as part of its sales revenue. It could also gross up its sales revenue. So a sales agent may charge a 10 per cent commission, but the firm may include 100 per cent of sales as revenue. Among other methods is including interest income as operating income or considering income from the sale of a current asset as operating revenue.
Overstating accounts receivables: Accounts receivables, or debtors, are customers who buy goods on credit and appear on the asset side in the balance sheet. By overstating debtors, companies try to report that they have additional cash that is receivable in the future, which enhances their financial position. A company overstates debtors by creating fictitious credit sales or by reducing allowance for bad and doubtful debts. For instance, in the first quarter of 2009, Tata Motors changed its methodology for calculating provisions for doubtful recievables, which resulted in a higher reported Ebitda of Rs 50.7 crore.
Deferring expenditure: The unpaid expenses of the current year are accrued and shown as liabilities in the balance sheet. By excluding such expenses, a firm can reduce its liabilities. Accrued expenses tend to remain constant over a period of time, so this malpractice can be detected by checking for variations. A consistent decline in accrued expenses is also cause for concern.
Capitalisation of expenses: Current year expenses should be charged to the income statement. Instead, some firms capitalise (spread out) and amortise these over a period of time. This reduces the current year expenses, thereby boosting profits and earnings.
Violation of materiality principle: The accounting principle of materiality requires that an item be reported if it is likely to influence the investment decision of a stakeholder. However, companies manipulate earnings by including a one-time gain in earnings and showing it as an income earned in the normal course of business.
Depreciation policy: Though depreciation is a non-cash expense, it is deducted from a company's profits, reducing the net income. A company can inflate its net income by charging less depreciation on the assets. Arbitrarily increasing the life span of an asset or a change in the method of calculation can alter earnings and profits. For instance, Jet Airways changed its depreciation policy and wrote back Rs 920 crore into its profit and loss account, which helped it report profits during the first quarter of 2009.
Capitalisation of losses: Companies raise funds from abroad in the form of foreign currency convertible bonds (FCCBs). Investors have the option to convert these into equity after a stipulated period. FCCBs are treated as debt in balance sheets till these are converted into equities. These bonds are structured to allow a borrower to pay total interest and principal on maturity. If the value of rupee falls (vis a vis the other currency), the losses on such foreign exchange transactions go up. Companies understate their liabilities by not accounting for such losses in their income statements and including them in the balance sheet instead. In the first quarter of 2009, Reliance Communications did not include Rs 399 crore of losses on FCCBs.
Restructuring: Companies restructure businesses by combining or merging divisions (group companies). Another way is to demerge the main company. Merging different divisions allows firms to set swap ratios that enable them to write off previous unreported losses. In a demerger, they transfer some debt and liabilities to the demerged entities.
