Most public companies play to the tune of short-term results. Driven by compensation incentives, management is expected to create a company performance that will meet the praise of investors. Earnings that meet or exceed expectations give way to a rising stock price, and who doesn't like a rising stock price? It is the pressure (or incentive) of short-term results that often lead management to actions of unethical tactics. In this post, we will explore ways management can artificially boost earnings through the manipulation of liabilities and expenses.
How To Detect Manipulation: Footnotes
The first place to begin your search for questionable tactics is analyzing what accounting assumptions management is using and how it compares to the norm. There are a few red flags that can immediately alert you to suspicious activity.
For starters, always read the footnotes and disclosures a company puts forth in their financial statements. Legally this covers managements obligation to shareholders, ethically, it’s an entirely different question. If you see something out of the ordinary in a footnote, ask the question, “why was this necessary?” Sometimes management is making a sound business decision that works well strategically down the road. Other times, management is simply deploying tactics that appease what numerical results shareholders are expecting. If you see a footnote around “date changes” and “extended reporting periods,” this can be a big red flag. Shifting reporting periods backwards or forwards can manipulate when expenses are accounted for. A tactic of this measure gives the illusion that expenses were reduced (as they compare to revenue), when in fact they were just shifted to the past or future reporting periods.
Another topic within the footnotes that is worth monitoring is how management is treating future commitments and contingencies. Depending on the structure, a commitment can be a light financial expense in the present but a heavy obligation in the future. Management should be recording these items accurately under liabilities on the balance sheet. Understanding these commitments can be challenging to analyze and offer a perfect hiding ground for questionable tactics. Sound leadership will overtly go out of the way to maximize transparency and provide a true explanation of how these commitments play out down the road. Anything less than full transparency should alert you to the possibility of more to the story. When evaluating commitments and liabilities ask how these impact the core business model. Commitments and liabilities that are driving short-term results should warrant even harder questions during your analysis. It wouldn’t be the first time management has backloaded a future obligation to create short-term results.
How To Detect Manipulation: Pension Obligations
Pension plans can be a fantastic tool to motivate and reward employees of a business. They also can be a lever used by management to manipulate the current performance of a business. Pension plans work in a way that provides flexibility in decision making and accounting for management. Companies that provide a pension plan must account for expenses associated with this plan. It would make the life of an investor a lot easier if this was a separate line item on the Statement of Income, but typically it is not. Companies usually elect to group this expense with other employee salary costs. Depending on what industry, that expense can be grouped into costs of goods sold (COGS) or selling, general and administrative (SG&A). Here’s where it gets dicey… management has full discretion in calculating that expense. Accounting rules allow for calculating pension expense by taking a smoothed expected return minus the cost of running the pension. It’s important to emphasize that this is an "expected return" and not an actual return that is being documented. If management chooses to use an overly optimistic expected return, the cost associated with running the pension would be less and less.
Understanding the accounting rules of pension obligations gives you a few things to look out for. Management discloses accounting assumptions for pension plans in the footnotes. Be alert for any assumption around a pension plan that expresses an overly optimistic expected return. A reasonable expected rate of return will require your best judgment but remember most pension obligations are invested in safe, conservative instruments.
Another pension plan footnote worth looking out for is the mention of a negative pension expense. A negative pension expense occurs when a pension fund has income that exceeds overall cost associated with running the pension. Good right? Well not always… Since most companies choose not to breakdown pension expense and income, the surplus can be camouflage for overall operating income. Management can paint a rosy situation where overall operations of the business did not do so well, but the pension investments created fantastic income. The pension investment income creates a negative expense and boosts the overall company performance. This situation typically occurs in companies that have very large pension plan assets.
How To Detect Manipulation: Unusual Cash Flow
A typical business operation consists of businesses paying vendors thus creating a standard expense. However, what isn’t so typical is when a vendor pays a customer cash. This act of smoke and mirrors requires management to find a party that will play along. In an attempt to reduce expenses, management can overpay a supplier on the condition that an immediate cash rebate is given. For example, let’s say management agrees to pay a willing supplier $1.25 for a cost that is just $1, and they commit to doing so for the next five years. The only condition is the supplier has to issue a one time upfront rebate of $1. That rebate immediately lowers expenses and thus increases income. If management reports this as a financing activity, all is well and reported as such. However, if management incorrectly classifies this as an operating expense, cash from operations will be more favorably reported. Anytime a company mentions a rebate or a cash receipt from a vendor, be sure to investigate.
How To Detect Manipulation: Manipulating Reserves
Reserves are a healthy way for businesses to account for future obligations. However, reserves can also offer management an enticing playground of manipulative accounting tricks. Let’s begin by looking at a common type of reserve, the warranty. Warranties are common and offer a company a method of increasing the value for customers. Bundling an expensive warranty with a product helps protect the customer in the event the product malfunctions. When a company issues a warranty, it is typically done at the time of purchase and carried as an expense for expected future costs. This actually is a great thing because although the warranty is seen as an expense the cash never leaves the business. It actually creates an opportunity for “float.”
However, where companies run into problems is when management plays with this lever too much. If management creates a low expense on present-day warranties, profits shoot up in the present reporting period. The present-day benefits but at the sacrifice of not having enough cash to cover obligations of the future. If management chooses to overstate the expense of warranties, the present day profit will be held back and the future will show a distorted view of profit. Overall be on the lookout for warranty expense declining in relation to revenue. Look closely and make sure management is not sacrificing long-term health for short-term gains.
Seeing as warranties are very much a form of insurance, it shouldn’t come as a surprise that the other area worth monitoring is, in fact, self-insurance accounts. Self-insurance is a common business practice and can be taken out as an alternative to various types of insurance policies. A company will self-insure by setting aside a portion of funds that they believe sufficient to pay against claims. The amount they set aside is an expense. Just like with warranties, if a company “estimates” claims cost to be less, then less expense is needed to be set aside. A decrease in expense creates an increase in earnings. While some companies can adopt internal policies and procedures that lower accidents and reduce insurance claims, be cautious of companies with overzealous assumptions to insurance liability.
Wouldn’t it be convenient for management to have a justified event that shareholders support and create's a nice cushion for their incentives going forward? This scenario is precisely what happens in some restructuring cases. To understand this let’s walk through an example.
Let’s say a company has been in a slump. Management decides what is needed is a restructuring plan. They announce the plan to restructure and mention the need for layoffs and assets to be sold. In consequence, expenses will go up in the short term, but the overall performance of the company will improve in the long run. Management lays out its plan and creates a reserve for expenses that will occur from the restructuring. Months go by and the restructuring is complete. However, not as many layoffs were needed, and fewer assets were sold off than projected. In consequence, the expenses were not quite as high as projected. Management can now reduce these expenses, thus boosting income. The end result is a successful reorganizing with improvements in income already taking shape! To keep an eye out for this tactic, monitor current liabilities and accrued expense accounts. If these accounts drop in value in relation to revenue, you will need to decipher if it was an operational performance that created improved income or just sleight of hand.
Overall, it can be a challenge to sort out what is true company performance and what is simply managements accounting tricks. Focus on places where issues are likely to reveal themselves. Footnotes are always worth reading and can detail more of the story than simply looking over financial statements. Also, find companies with good management that have a track record of being fully transparent. A management team that goes out of their way to explain typically has less to hide. Another good rule of thumb is to track expenses as they relate to sales. Earnings can be easy to manipulate; sales are a lot harder. Monitoring expense ratios to sales will alert you to places that deserve digging.
If you found this article helpful, check out my Six Checks To Spot Cash Flow Manipulation post.
Sources;
McKee, T. E. (2005). Earnings management: an executive perspective. Australia: Thomson.
SCHILIT, H. (2018). FINANCIAL SHENANIGANS: how to detect accounting gimmicks & fraud in financial reports. S.l.: MCGRAW-HILL EDUCATION.
Author: Carter Johnson
Expertise: Entrepreneurship and business strategy
Carter is the founder of United Business Leaders which invests in private companies with strong operating histories. He has a passion for investing and helping businesses with strategic initiatives.
Connect with Carter on LinkedIn.
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