The difference between fact and fiction, which one encounters in the financial statements, is often further aggravated by what is found – or rather not found – on the ground, during actual visits, inspections. As there is no end to human ingenuity, so there is no limit to the kinds of creative accounting to which our brethren can resort to. Nevertheless, it is quite worthwhile to look at some of the more frequently encountered versions, in the hope that familiarity may make them easier to recognise and deal with.
Many Companies have several operating divisions. Sometimes the division is very clear and along functional lines, e.g. foreign and domestic operations, or on distinct business lines i.e. manufacturing and financial businesses or depending on the scale of operations – even product-wise. Sometimes, different processes in the manufacturing activity are completed in separate divisions of the Company e.g. a component may first be produced in the forging division and then proceed to the machining division for finishing.
The problem arises if the transfer of goods from one division to another, although part of a complete process, is shown separately as sales & purchases of each division and these figures simply totalled up as the total sales & purchases of the Company. The effect of this is that the total sales appear to be higher but there is no impact on profit as sales & purchases of the individual divisions cancel each other out.
It is crucial to remember that an actual sale takes place only when an invoice is issued. You realise the importance of this, when you compute working capital requirements of the unit which are invariably calculated on the basis of the level of sales achieved / projected. If the sales are falsely boosted, the basic premises on which the structure of working capital requirements is built up comes tumbling down.
A different modus operandi is adopted by some units to achieve a similar effect. Sometimes, you find that sales at the end of one financial year / quarter are stepped up (this is more often seen in the last financial quarter). This is followed by a significant amount of sales returns / rejections at the beginning of the subsequent quarter which falls in the next financial year. This has the effect of not only inflating the sales figures but also inflates the profits – both of which are false and both of which impact the assessment of the performance of the unit and its requirement of finance.
Sometimes, companies making capital equipment, sell machines / equipment on hire purchase basis. In such cases, another method used to boost revenues / sales is to recognise the entire hire-purchase transaction, which may be spread over more than one financial year, as part of current year sales, whereas, only the portion of income pertaining to the current year should actually form part of this years’ sales. The effect of this action again is to inflate the current year revenue and profit – perhaps to show a better picture or reduce the visibility of a declining performance.
A recent trend observed in some Corporate statements is to show current liabilities, as deferred liabilities, or worse, as income. For example deposits raised or advance payments received etc. are shown as part of revenue. I even came across an interesting case in which the sales tax deferral loan obtained from the state governments was shown as income on the rather fallacious argument that since it was to be repaid only after twelve years, it was a permanent source of funds.
quite often one comes across write back of previous years’ depreciation / tax provisions or other excess expenditure provided for. It is important to realise that such write-backs, first of all, do not impact the cash profits of the unit and secondly also do not reflect the current year’s performance since they pertain to income of previous year(s) which have now been recomputed due to some error / revision. However, they do lead to a rise in the net profits of the unit and correspondingly, in its net worth. A more dangerous scenario is inadequate provisions for fluctuations in value of assets held in foreign currencies, or disputed liabilities (tax / excise), or for deterioration in value of investment portfolio / bad debts etc.
The net result is of showing an artificial profit for the year or in falsely lowering the loss for the current year and is totally misleading. One has even come across a company not making any provision for depreciation or interest payable on loans during a year due to inadequate profits.
Quite often companies will resort to more than one stratagem to overcome the shortfall in profits and will recognise certain claims / liabilities only as contingent liabilities in the notes to the account and not make any provision for meeting these claims in the Balance Sheet itself. I once came across a Company which declared a guarantee invoked by another commercial bank as quite simply ‘not payable’ and therefore not requiring any provision.
Of course, by far the most common adjustment one finds in most balance sheets is in the variation in valuation and quantity of closing stocks of inventory. So much so that, more often than not, one is hard pressed to get a stock statement as on the closing date of the financial year – normally 31st March! The effect of increasing or decreasing the closing stock is directly felt in an almost proportionate increase or decrease in the profits shown without any increase or decrease in the value of the Company’s assets. And this brings us to another commonly found shenanigan, which is inclusion of obsolete stock / scrap in value of closing stock.
This is frequently done on the pretext that the obsolete stock or scrap generated will eventually be sold and until then funds are blocked therein and should therefore be financed. Just how false this argument is, can be gauged from the fact that if the stock has become obsolete, due to any reason whatsoever, then the value of this stock for the unit has become nil and should be reflected as such in its Financial Statements which are required to present a true and fair picture of the unit’s performance and financial position. The diminution in value of this stock is a loss for the unit and has to be provided for accordingly.
A major issue which the financial analyst encounters pertains to loans given to or taken from associate concerns being shown as advances given / received for supplies. This is very dicey, as it is often a ploy used for diverting funds to associate concerns or even for hiding possible losses or for diverting profits to associates. This becomes even more tricky to detect and deal with, when these transactions are camouflaged with genuine trade transactions between the same associates. Quite often, you find the name of the same associate concern figuring in the list of Sundry Debtors as well as Sundry Creditors.
Desperate situations call for desperate measures. When pushed to the wall, some companies have been known to resort to selling some of their fixed assets to an obliging associate concern and then promptly taking it back on a lease arrangement for its regular operations. The consequent improvement in its financial position is then declared to be a result of profound management strategy.
Why do companies go to such lengths to hide their true position? Motives are as varied as the tools used. Sometimes, profits are understated to avoid taxes or overstated to show better performance to various stakeholders i.e. shareholders, bankers, employees, capital markets etc. Occasionally, the salary of the CEO is linked to increase in sales, or profits and is reason enough for showing better performance.
Seeing the kind of skullduggery which can go on in the financial world, where you have losses masquerading as profits; assets, which are really not there; and reserves created simply on paper, one wonders whether, even after getting some understanding of the variety of skeletons that can tumble out of Balance Sheets, there is still much more below the surface.