Signals of Creative Accounting
- Reduction of provisions as a long-term liability in the balance sheet
- Increase in inventory value in the balance sheet when company encounters under pressure gross margins
- Very high non-controlling (minority) interest figure in the footer of the income statement
- Growth in receivables greatly exceeds growth in sales
- Increase in bank debt in the balance sheet without an increase in finance costs in Income Statement
- Significant transactions near the year end e.g. Acquisitions / divestments, Reclassification of joint venture to subsidiary or vice versa, Reclassification of associate to subsidiary or vice versa
- High cash balances together with significant debt and high non-controlling (minority) interests in equity
- Large negative adjustment to net profit for “income from associates and joint ventures” in the published cash flow statement
- Reduction in bank debt, increase in finance cost
- Significant related party transactions in consolidated accounts
- Unexpectedly small amount recorded for “investment in associates and joint ventures” on the consolidated balance sheet
- Increase in property, plant and equipment in the balance sheet is greater than purchases of PP&E in the cash flow statement
- Increase in PP&E in balance sheet is not proportional to the increase in depreciation charged
- “Investments in associates and joint ventures” as a percentage of total assets is much higher than “income from associates and joint ventures” as a percentage of EBIT
- Appearance of unusual increase in long term receivables
- Increase in intangibles
Reduction of provisions as a long-term liability in the balance sheet
May be caused by crediting to the income statement provisions which were overstated in prior years. In which case profit margins and balance sheet leverage will be improved. Check historically to see if provisions made appear disproportionately high in good years.
When a company reduces provisions for a long-term liability on its balance sheet, it is indicating that it has re-evaluated the potential cost of the liability and determined that it will likely be less than the amount that had been previously set aside in provisions. This can have a positive impact on the company’s financial statements, as it can increase net income and decrease liabilities. However, it is important to note that the reduction of provisions should be based on a sound analysis and judgement.
Increase in inventory value in the balance sheet when company encounters under pressure gross margins
Inventory might be re-valued at period end for the following reasons:
- This could be through the legitimate reversal of impairments no longer required or incorrectly by inflating inventory values.
- It could also result from slow moving inventory or deliberate increases in inventory to meet future demand.
- there are more stock items in the stores than the actual stock count.
COGS is an expense item computed by subtracting the closing stock from the sum of the opening stock and purchases.
Check for unexplained increase in inventory days. The increase of inventory value will boost current ratio and improve balance sheet leverage.
Besides, an overstated inventory lowers the cost of goods sold. The availability of excess inventory (ending inventory) in the accounting records ultimately translates to more closing stock and less COGS. Overstated inventory will also boost margins.
(Understated inventory increases the cost of goods sold. Recording lower inventory in the accounting records reduces the closing stock, effectively increasing the COGS.) If there has been a large increase in sales after the year end, then the increase in inventory is more likely to be genuine.
Very high non-controlling (minority) interest figure in the footer of the income statement
This indicates that a partially owned subsidiary is contributing significantly to consolidated earnings. The results of the partially owned subsidiary are fully consolidated into all financial statements so particular care needs to be taken when establishing the proportion of group cash flows attributable to the owners of the parent. Good results in the partially owned subsidiary may disguise poor results elsewhere in the group. Establish the exact control and agreement with the minority interest shareholder and look for evidence of poor performing subsidiaries in other parts of the group.
Growth in receivables greatly exceeds growth in sales
The danger is that sales at year end have been inflated by booking future sales (or false sales) into the current year. This boosts both sales and receivables, but receivables by proportionately more. This might then be unwound in the new year with a drop-in sales. More legitimately it may indicate issues with their credit control or that bad debts are not provisioned adequately or that sales have genuinely increased during the last part of the year (look for evidence of this continuing in the new year).
False booking of sales would give the appearance of improved margin, current ratio and balance sheet leverage and inflate both net earnings and increase in receivables in the operating cash flow reconciliation.
It may also indicate that the company is having difficulty collecting payments from its customers. This can put pressure on the company’s cash flow and profitability.
Increase in bank debt in the balance sheet without an increase in finance costs in Income Statement
IFRS requires interest incurred financing the construction of long life assets such as PP&E to be capitalised as part of the PP&E cost, reducing the finance cost in income statement and increasing interest cover. If material, the amounts and rates involved should be disclosed and so can be adjusted for. Places to look include fixed asset notes and comparing interest paid per cash flow statement to interest charged in income statement. On the other hand, it may be that debt has only recently increased near the year end.
Capitalized interest is the cost of the funds used to finance the construction of a long-term asset that an entity constructs for itself. The capitalization of interest is required under the accrual basis of accounting, and results in an increase in the total amount of fixed assets appearing on the balance sheet. An example of such a situation is when an organization builds its own corporate headquarters, using a construction loan to do so.
This interest is added to the cost of the long-term asset, so that the interest is not recognized in the current period as interest expense. Instead, it is now a fixed asset, and is included in the depreciation of the long-term asset. Thus, it initially appears in the balance sheet, and is charged to expense over the useful life of the asset; the expenditure therefore appears on the income statement as depreciation expense, rather than interest expense. For example, in 2016, Karex capitalised finance cost RM607,284 into their properties at 3.99% – 7.85% per annum. In other words, RM607,284 wasn’t charged to Finance Costs in Income Statement, thus this won’t impact earnings.
Significant transactions near the year end e.g. Acquisitions / divestments, Reclassification of joint venture to subsidiary or vice versa, Reclassification of associate to subsidiary or vice versa
Acquisitions of good companies and divestment of bad companies may improve the year end numbers. Selective use of consolidation policies can improve consolidated income statement and balance sheet ratios. Investigate fully the reasons behind the timing of the events and the reasons for change in consolidation accounting policy. Watch out for trends being distorted by the sudden appearance of results from discontinued operations being reported below EBIT and reclassifications of assets and liabilities into held-for-sale categories at lower of cost and realizable value.
High cash balances together with significant debt and high non-controlling (minority) interests in equity
It is possible that the cash and debt are not in the same group companies. The cash may be in a highly performing partially owned subsidiary while the debt is held by wholly owned subsidiaries. If so, the consolidated NET Debt / EBITDA ratio will be misleading from the perspective of lenders and investors of the parent company. Until location of cash is known and whether it is restricted care always needs to be exercised when working with Net Debt or Net Interest figures.
Large negative adjustment to net profit for “income from associates and joint ventures” in the published cash flow statement
The issue is whether group’s share of net earnings from associates and joint ventures is being received by way of cash dividends. To see if this is so, compare net earnings from associates and joint ventures in the income statement to dividends received from associates and joint ventures in the cash flow statement. Expect dividends to be less than net earnings, but if considerably less, investigate how the associate or joint ventures is using the retained funds.
The quality of the income from associates cannot be assessed without direct access to the financial accounts of the associate company.
Reduction in bank debt, increase in finance cost
Check to see if any financial liabilities (on or off balance sheet) have been terminated early lending to high termination costs (which will be reflected in finance costs). The company has paid off or reduced its existing debt, but at a higher cost. This could be due to several reasons such as higher interest rates or fees associated with paying off or refinancing the debt. It could also indicate that the company has replaced existing debt with debt at a higher interest rate.
Reason of early termination of borrowing should be legitimate and justifiable.
Significant related party transactions in consolidated accounts
The danger is that there are significant transactions being conducted between the parent or its subsidiaries and associates, joint ventures or other related parties which may not be on normal commercial terms and may indicate under-recording of consolidated liabilities or losses or over-recording of assets or gains; improving consolidated cash flows, earnings and leverage. Check whether the related party transactions are trade or finance related.
Significant related party transactions in consolidated accounts can raise questions about the fairness and accuracy of the financial statements. A related party transaction is a transaction between a company and another entity that is related to it, such as a subsidiary, affiliate or key management personnel.
Such transactions can create potential conflicts of interest or the appearance of such, and can be used to manipulate financial statements. For example, related party transactions might be used to artificially inflate or deflate revenue or profits, or to move assets or liabilities between entities in a way that is not fully transparent to external parties.
It’s important for the management to disclose the nature, terms and conditions of the related party transactions in the financial statement notes and to ensure that the transactions are conducted at arm’s length, i.e. at a fair market value. Additionally, the management should have a robust related party transaction policy in place, and independent auditors should review the related party transactions to ensure they are in compliance with accounting standards.
Unexpectedly small amount recorded for “investment in associates and joint ventures” on the consolidated balance sheet
To recap, investment in associates and joint ventures (ending of year) is carrying amount of investments in associates and joint ventures (beginning of year), plus the investor’s proportional share of the associate’s income is reported in the income statement, minus dividends from the ownership. In other words, the investment in associates and joint ventures line represents the group’s share of the net assets of its associates and joint ventures.
Value of the investment in associates and joint ventures is reduced if associates and joint ventures are losing money.
Be mindful that when the value is getting very small or zero, a liability will be recognised the investor has incurred legal or constructive obligations or made payments on behalf of the associate.
Therefore, it is important not to ignore this number, even if the number is small, as it could be the net of substantial assets and liabilities of those companies and the group may have obligations to finance those liabilities.
Check whether the relationship with the associate is at arms-length or strategically / commercially important. The group account notes should include summary information about the associates and joint ventures and disclose any obligations that the group must support the companies. Study the financial statements of the associates and joint ventures, if available. For example, SUMATEC received a notice of demand as guarantor, for a sum equivalent to RM144, 953,800.83 by virtue of Judgement obtained against Semado (associate of SUMATEC). In the Balance Sheet of SUMATEC 2016, value of investment in associate companies was ZERO due to full impairment of the investment.
Increase in property, plant and equipment in the balance sheet is greater than purchases of PP&E in the cash flow statement
This may indicate a policy of revaluation of PP&E, possibly significant capitalised interest, purchase of assets on credit (possibly extended credit terms), or an asset swap. Revaluation or capitalised interest may improve balance sheet leverage and capitalised interest may improve profitability. Check notes for details.
Increase in PP&E in balance sheet is not proportional to the increase in depreciation charged
The use of new fixed assets may be delayed, or depreciation policy changed to improve operating profits and balance sheet leverage. Revaluation may also have occurred or PP&E purchased just before year end. Read management discussions which might note any significant purchases close to year end and read the policies and PP&E notes.
“Investments in associates and joint ventures” as a percentage of total assets is much higher than “income from associates and joint ventures” as a percentage of EBIT
[Investments in associates and JV]/[Total Assets] > [Income in associates and JV]/[EBIT]
The danger is that poor performing partially owned subsidiaries are not being consolidated to improve consolidated income statement, balance sheet and cash flow. Is there a good reason why the associates and joint ventures do not bring in proportionally the same profit as other assets? Could transfer pricing (aka transfer cost) be taking place?
Appearance of unusual increase in long term receivables
The situation may be the same as in question 4 or the company could be rescheduling uncollectible receivables. In both cases profitability and balance sheet leverage will be improved without any increase in cash flows. Check whether there is a good underlying transaction behind the long-term receivable and whether any extended credit is being compensated by higher pricing or interest receivable.
Increase in intangibles
The increase could be a result of inappropriately capitalised internal costs which will improve profit, balance sheet leverage and debt service capacity ratios. Investigate the nature of the items being capitalised, whether they result from internal development or acquisition and whether these are likely to result in long-term benefits to the company. Also, investigate their amortisation policy and the results of any impairment reviews.