The World is accelerating. It is clear especially when you look at the amount of bad news we are being fed. Markets react violently – we saw that during Brexit vote. Aside from more remarkable events, the rest is only the white noise of information which makes it harder, not easier, to invest. Despite tough circumstances of the market, there is still a possibility to find companies with healthy fundamentals and good perspectives for growth. Much easier it is to find firms hiding their own problems with accounting tricks.
I will show you on what basis today’s bull market is being built and why experts (pontificating their truths in media) are selling a very poor lie about the good health of economies and representative corporations to convince us to continuously buy overvalued stocks. I will give you examples how corporations can enhance their books only to give their investment indicators (most popular way) the right kind of make-up, in spite of terrible situation of the company itself. This knowledge is a prerequisite you have to acquire and carry on studying not only to financially survive the snowballing crisis ahead of us but to distinguish pearls from the mud among the bankrupted firms when the dust eventually settles down.
Motives behind creative accounting
Creative accounting follows rules and regulations but presents reports and data in a way to improve investing indicators (relied upon by banks and investors) while not showing the true condition of a company. There are few ways you can do it:
– the market capitalisation of a company being included in firm’s own capital – the higher the stock price the more means are available for the company,
– using profitability and financial liquidity indices to calculate the level of interest on debt,
– rewarding managers with stock, more expensive shares equal bigger bonus.
The example of Apple shows how skilful managing of a corporation and its image increases the popularity of both company itself and its products. This translates into higher sales and higher margins pushing the stock price up. The Apple phenomenon is very hard to copy. In today’s circumstances of weak demand for USD and ever higher inventories, to lift, or at least sustain, high share price managers are ready to use creative accounting. Although it is legal – similarly to tax avoidance – it is the way to use loopholes in the system. Usually, it is very hard to hide deficits in firm’s budget for a long time. This is why in practice it is done on a small scale (often around 10% of the balance). The only way to ‘go big’ is to do it for a short period of time and simultaneously with an important event happening – such as a new issue of shares, fiscal year end (FYE) or other important events.
How is it done?
There are many ways to enhance the balance. Normally, everything is based on the right reporting of revenue and losses (from various sources) and adding them to the specific categories. Higher net revenue relative to variable cost and already your P/E, or EBITDA are looking better. You can decrease the number of shares to lift EPS or ROE (return on equity). Dump inventory of your warehouses and push debtors in order to boost quick ratio (QR) – short-term liquidity indicator.
There are more tricks:
a) To show better results, especially when fiscal year is around the corner companies hastily transfer their products to their intermediaries’ stores (shops). Thanks to this, intermediary bears bigger costs but through rebates, sales or competitions a producer helps to sell the surplus. The price of the product is often lower than normally but this also can be hidden because additional costs are going to be calculated only after the report is published. This makes investors unaware of the real situation of the company.
b) In case of company calculating their revenue according to prognosis (e.g. water supply companies), they can easily overstate it to possibly acquire more capital and additionally make money (before the bills come) on interest payments.
c) Firms create reserve funds in case various liabilities materialise, where they put a share of their revenues. Managers can manipulate the size of those reserves through estimation of the sum required and probability of the event against which the fund is created. When it is needed, company can lower the capital savings and artificially increase net profit making economic indicators better.
d) Heads of the company during the incoming FYE collect as much money as possible from their customers but issue invoices for suppliers. Only after the financial statement is printed company pays suppliers and this shows higher earnings compared to costs.
e) The trick used both by countries and companies is pushing debt onto subsidiaries which are not required to account for in your balance (you do not use an acquisition accounting method).
f) The sale of a product booked before it materialises. This repairs your monthly/quarterly balance.
g) Corporations repurchase their shares to reduce their outstanding number. Less equity means better EPS.
h) The last year’s final statement balance published in a new financial statement is falsely underestimated making this year result more attractive.
i) Company to avoid paying income tax can overspend on renovations or investments. Interest from those you can add to your tangible fixed assets (e.g. real estate) thanks to which you bolster net profit. Fixed assets can be depreciated (asset’s cost over its life) improving EBITDA (very important for investors, banks when giving a loan).
Methods explained above are very popular among both medium and big companies. The list is, of course, not exhaustive and the only limit is the standards you adhere to. For example, in the US you can publish Pro Forma financial statement and throw away unwanted elements like restructuring costs. This is done by an increasing number of entities there. After 2011 it was 70% while today it is 90% of NYSE-listed businesses.
Below you can see how much – in just one year – the number of ‘boosted’ books grew. Nearly all NYSE listed corporations enhance their books. The average difference between factual data (GAAP) and ‘refined’ results (non-GAAP, Pro Forma) widened since 2015 by 10 percentage points. Last year the fabricated numbers were around 20% but today it is nearly 30%. The scale is huge because statistics can be overestimated by astounding 1/3!
Source: Mark Faber
This is the reason behind increasing manipulations – see chart below. While in normal circumstances the average earnings per share get additional 0.2 USD, this number can reach even 1 USD during slump as it happened in 2008. We can observe similar levels today. We can imply that the bull market is either nearing the finish line or has already finished.
Source: Mark Faber
This relation is very important as it directly shows a bad condition of businesses. At the end of the day, these accounting methods are used to add some makeup to financial statements and operate on the edge of the law (or accepted practices) not to plainly lie. The more tricks a company have to use the clearer we can see how purchasing power of their clients’ drops. Plus, forecasts of a 20-30% increase in sales in the near future is just a bad joke.
The basic rule, when it