- Income statement or profit and loss statement measures the financial performance of a company for a specific accounting period.
- Simplify investment analysis by understanding how companies can cheat on line items like COGS, R&D and SGA expenses.
- Examples like the Enron fraud show how companies do willful corporate fraud, and how as an investor one can avoid such investments by looking at the income statement for warning signs.
Many investors remember Enron and what they did to the financial markets in late 90's. Very few know how exactly they cheated so many intelligent folks at Wall-street! In this article, we will try and explain how companies in connivance with their auditors
can use the financial reporting and Web disclosure to give misinformation or hide relevant information.
Cheating on Top-line Number
The first line item of an income statement is 'Revenue or Net Sales' commonly known as the top line. This is a number, which is very closely watched by investors to see if a company is growing, or not. There is immense pressure on the top management of every company to report continuously rising revenue. Like everything in life, it is common sense that a company's revenue cannot keep increasing forever, every quarter on quarter. For a company to show increased profits it has to either go on increasing the revenue indefinitely or reduce its expenses. The chances of decreasing expenses aren't much in an established industry where certain expenses must be incurred to generate certain revenue.
That makes the top management of many companies to inflate the revenue, most of them do it being well within the accepted standards of accounting, but some test the boundaries of law.
Revenue & the Receivables
What one would normally think is that 'revenue' is the amount of 'sales' that a company has done and that is the cash the company would have received during the said period. WRONG! Revenue is just booked.
For example a manufacturer of goods can just ship the products to a wholesale dealer and claim the entire value as 'revenue' for that period. This is commonly referred as channel stuffing. This can be done even though the wholesaler or stockist has not paid for the goods received. There is always a chance that the wholesaler will probably not pay if he is not able to sell the goods subsequently to a retailer. So all this amount that the company needs to collect from the wholesaler would appear as 'receivables' in that company’s balance sheet. Hence it is very important to see the receivables of a company, which is reporting higher sales quarter on quarter. Of course there will always be some amount receivable by a company but if the receivables are increasing as a percentage of sales then it is a potential red flag!
Playing with Group Companies, Franchisees revenue accounting
There are other ways of cheating on top-line number. Many companies have very complicated ownership structures where they have subsidiaries and affiliate companies that have common shareholders. Now potentially two affiliate companies can sell large amount of goods to each other inflating the revenue for both of them. There are accounting standards that make companies report such things as 'Intra Group companies sales'. However there are always ingenious ways of reporting higher revenues with the help of subsidiary or affiliate or franchisee companies.
Special Purpose Vehicles, or SPVs, are a legitimate way for a company to create a separate company specific to a large project. This enables companies to raise finances specific to that project. The risks and liabilities are sort of limited within that project. These SPVs were the means Enron used to create those magical top line numbers.
The franchisee route was the innovative way adopted by Boston Chicken Company to inflate its top line and profits. This company was running a franchisee operation. The franchisees were provided with almost 80% of the capital by the company mainly in form of loan. The franchisees in turn paid Boston Chicken Company Royalties and revenue share. This went directly to company’s top line. The franchisees were suffering losses, but were not worried as the capital was provided by Boston Chicken Co. This was a classic case of shareholder's capital coming back as revenue in much smaller measure and in the process hiding the losses incurred by franchisee. Boston chicken Co eventually filed for bankruptcy and investors lost millions of dollars.
Cheating on Cost of Goods Sold and Gross Profits
Cost of Goods Sold (COGS) is typically the raw material, direct labor and other direct costs associated with a company’s revenue. It is sometimes at company’s discretion as to which of the costs get added to COGS. This concept is more relevant to manufacturing industry but how can this apply it to an Internet company? There are certain things left to a bit of discretion and interpretation.
Internet companies do not have any real raw material costs, direct labor costs can be said to be zero as only computers are working to provide the service to end-users. Why would companies want to show low COGS? Simple, they want to show higher Gross Profits and Gross Margins. Always check if the company has been following consistent method for determining COGS.
Cheating on R&D expenses and Selling, General & Administrative Expenses
After Gross Profits are determined, we come to R&D and SGA expenses. Many companies try to report higher R&D expenses to please investors. For an internet or a software company it is easy to argue that every engineer working on the development of software is R&D expenses, but there are many other gray areas like what about the salaries of administrative staff for an R&D unit? It would be interpretation dependent. So Internet companies have certain leeway as to how to report an expense as R&D or SGA. Subtracting both R&D and SGA expenses from gross profits we arrive at net Operating Income. This is a good measure of companies operations and should be used rather than the final ‘Net Income’ reported by the company or the gross profit reported. As we will see, ‘Other Income’ and ‘One Time Income’ can be used inflate Net Income.
The big write-off by HP on Autonomy deal
Hewlett Packard (HPQ) had acquired British business software maker Autonomy in summer 2011 for 11 billion dollars. Recently, HP announced a huge write off of 8.8 billion dollar related to this acquisition.
HP has alleged fraudulent accounting practices by Autonomy as the reason for this write-down. In effect HP is saying that it had paid the high price because of improper accounting that is the reason it needs to take this charge on its income statement.
Depreciation, Depletion & Amortization
These are what are known as ‘Non-cash’ expenses. Depreciation is a way of reporting the fact that a company’s plant and machinery is being subjected to wear and tear or technology obsolescence. Here again it is left to the company’s discretion as to at what ‘rate’ it needs to report wear and tear. Take for example a five-year-old computer; does it have any realistic value in today’s world? However a company could potentially show this asset depleting at the rate of say office equipment, say over a period of 10 years.
There are guidelines about the rate and method to be applied for reporting depreciation, however they are open to interpretation. Companies can report lesser depreciation to inflate the ‘pre-tax’ profits.
Other Income, Income from Discontinued Operations
Lets take an example of a person who earned 80K $ as salary and made 250K $ additional profits from the sale of his house for 600K which he had bought for 350K.
Now he goes to a bank for buying a new house worth 1.2 M $ claiming his last year total income as 330K. Banks promptly will deduct the 250k $ one-time income and will probably refuse to grant such a huge loan.
This type of other income is typically a way for companies to reach the ‘target’ final profits and earnings per share. If a company is not able to meet or beat the market expected net profit, they can decide on engaging in speculative activities with their cash reserve or sell some of the assets to increase the Other Income, which adds to the final net profit reported by a company. It is not uncommon for companies to report higher Other Income for the quarters when their Operating Income is lower than the market expectations.
Difference Between EPS Basic and EPS Diluted
EPS stands for Earnings Per Share and is a very key number for an investor to determine the fair price of a stock.
A diluted EPS gives what the EPS of a company would be if all convertible bonds, convertible warrants convertible preference shares and stock options outstanding on the company’s books are converted into shares. Convertible bonds and warrants are loans raised by the company with a promise to convert the loan into shares of the company if the lender chooses to do so. Stock options have hurt investors during Dotcom bubble when companies did not fully disclose the fact that large number of outstanding stock options when converted will result into serious drop in earning per share for existing investors.
Moral of the Story
These are various means by which companies can fool unsuspecting investors. The SEC (Securities and Exchanges Commission) is always coming up with newer laws and regulations to govern such misconduct by publicly listed companies. However it is a difficult compromise between making the laws easy for majority of companies that do not want to engage in such fraudulent means as opposed to a few that want to do so!
Let’s not even think that Enron, Boston Chicken, Lehmann Brothers are examples from long gone past. Let’s not forget that Greed is considered a virtue on Wall-street!