Fundamental investors want to be able to base their financial decision on balance sheets and earnings reports, but accounting standards in foreign markets aren’t necessarily the same as the U.S. or Europe. Regulations may be lax, or less stringently enforced, and the different cultural context of financial reporting can also impact the information that investors get. Even in cases where there is no outright fraud, firms might manage numbers either to appear more attractive to investors or just to hit targets in their compensation package. Sensing growing concern about Asian reporting standards, Matthews Asia research analyst Sudarshan Murthy explains how the most common tactics work.
Detecting accounting fraud
Assuming there is no outright fraud, which Murthy says is “typically extremely hard to detect” regardless of where you are, most methods of managing numbers falls into one of two categories: moving revenues across time periods or moving costs across time periods. Pushing revenues back to a future reporting period or realizing costs earlier than is necessary are relatively safe means of managing numbers since they opt for short-term pain for strategic reasons, such as stabilizing earnings over time.
What’s more worrying is when companies kick costs down the road or realize earning earlier than might be appropriate, even though it’s possible to justify either one in certain situations.
Murthy gives the example of a company that has bid $100 million on a five-year project, with anticipated costs of $60 million. If costs are spread out evenly, the company could realize $20 million as revenue and $8 million in profits after the first year. But if there is a cost overrun to $18 million in the first year the company could post $12 million in profits, claiming that the project budget as a whole remains valid. So increased costs would show up in financial reports as an additional $4 million in profit.
Similarly, a company might incentivize a third-party to move its purchasing schedule forward to increase revenues today, with the understanding that this will decrease revenues in the future, what Murthy calls channel stuffing. “Related party transactions are a particular cause for concern in Asia, given that traditional values encourage intermingling of family ties and business interests,” he writes.
Deciding whether to capitalize a cost is another common example that isn’t fraudulent, but could cause an investor to misunderstand a firm’s financial position if he or she doesn’t dig deep enough. “Given that each business is unique in many respects, generally accepted accounting standards offer management teams numerous accounting choices. An ethical management has to choose between multiple options,” says Murthy. The challenge is knowing what choices have been made and what they tell you about a given company.
“More than any material discrepancy, understanding management’s application of accounting choices helps us glean how it prioritizes long-term benefit versus short-term pain. We tend to like companies that invest for the long term.”