The Southbourne Tax Group Edit Title

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Accounting For Half-Truths

A report by a brokerage on Satyam Computers gives an 'accumulate' rating, which means it expects the stock to go up. The rating is based on the company's high cash/market cap ratio. The information technology company had reported a cash balance of Rs 4,500 crore at the end of the 2007-08 financial year. The report gives a one-year price target of Rs 373 for the stock. The stock closes at Rs 273 the day the report is written.

January 2009: The same brokerage releases a hurriedly-compiled report suspending the previous rating. "Low market cap, high cash status no longer holds," it says. On 7 January 2009, the founder of Satyam Computers admits to inflating cash and bank balances by Rs 5,040 crore, overstating debtors' position (money lent) of Rs 2,650 crore as against the actual figure of Rs 490 crore and non-disclosure or understatement of liabilities worth Rs 1,230 crore.

The Satyam accounting scam, one of the biggest in India, left millions of investors in the lurch, as the stock fell from Rs 179 to Rs 23 in one trading session.

The inability of stock analysts to identify the 'gaps' in Satyam's books and ring warning bells proved costly for investors. Had investors known the basics of reading financial statements and techniques used by companies to report false numbers, they would have asked their advisors a few valid questions about Satyam's finances.

Some would argue how lay investors could see red flags when experts failed to do so. It's a valid argument, though we believe that with a little bit of learning you can see what professionals cannot.

We discuss a few common forms of accounting frauds companies indulge in and signs that may alert you to wrongdoing -

FINANCIAL REPORTS

A company's financial health can be gauged through three statements - balance sheet, profit and loss account and cash flow accounts.

A balance sheet records a company's assets (land, machinery, inventory, cash balance, investments, loans given), liabilities (loans taken, income tax payable, tax liabilities) and owner's equity. It is generally prepared annually.

A profit and loss statement (or income statement) records a company's earnings and expenses. Any company whose shares are traded on exchanges is required to release its income statement every quarter.

A cash flow statement tells us where cash is coming from (inflow) and how it is being used (outflow). There are three types of cash flow-operating cash flow (sale of goods, revenue from services, interest/dividend received, payment for purchases, payment for operating expenses), investing cash flow (sale and purchase of assets, sale and purchase of debt/equity, loans advanced to others) and financial cash flow (issue of equity shares, borrowing, repayment of debt).

Notes to accounts are important as they detail the accounting policies followed, pension and other post-employment benefits and potential liabilities/losses.

MANIPULATION OF STATEMENTS

There are many items in financial statements for which companies use different policies. These are inventory valuation, investments and fixed assets, conversion of foreign currency and asset depreciation.

Companies often manipulate these to inflate revenue, assets, cash inflow and understate expense, liabilities and cash outflow in financial statements.

INFLATING EARNINGS

1) Lending to customers: Sometimes companies lend money to customers to buy their goods. This way they can report high revenue in the income statement and high receivables (treated as an asset) in the balance sheet.

2) Trade stuffing: Companies use this usually just before the end of a reporting period. They ship goods to customers even though the latter may not need them immediately. This increases sales ahead of the reporting period.

3) Understating provisions:Companies often allow credit sales on generous terms, sometimes even to customers with a poor credit history. Ideally, in such sales, the company should set aside a higher amount for bad debt provisioning. This amount is recorded as a liability. Understating such liabilities is another way of 'enhancing' the financial statement.

4) Round-tripping: This means getting into fictitious transactions with related parties to inflate revenue. In round-tripping, a company sells unused assets to a party with the promise of buying back at a later date at the same price.

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