October 2008: A report by a brokerage on Satyam Computers gives an ‘accumulate’ rating, which means it expects the stock to go up. The rating is based on the company’s high cash/market cap ratio. The information technology company had reported a cash balance of Rs 4,500 crore at the end of the 2007-08 financial year. The report gives a one-year price target of Rs 373 for the stock. The stock closes at Rs 273 the day the report is written.

January 2009: The same brokerage releases a hurriedly-compiled report suspending the previous rating. Low market cap, high cash status no longer holds, it says. On 7 January 2009, the founder of Satyam Computers admits to inflating cash and bank balances by Rs 5,040 crore, overstating debtors’ position (money lent) of Rs 2,650 crore as against the actual figure of Rs 490 crore and non-disclosure or understatement of liabilities worth Rs 1,230 crore.

The Satyam accounting scam. one of the biggest in India, left millions of investors in the lurch, as the stock fell from Rs 179 to Rs 23 in one trading session.

The inability of stock analysts to identify the ‘gaps’ in Satyam’s books and ring warning bells proved costly for investors. Had investors known the basics of reading financial statements and techniques used by companies to report false numbers, they would have asked their advisors a few valid questions about Satyam’s finances.

Incentive of committing/abetting a fraud is greater than the disincentive of being caught for companies as well as promoters and other financial service providers.

Arpinder Singh

Partner and National Director, Fraud Investigation & Dispute Services, Ernst & Young India

Some would argue how lay investors could see red flags when experts failed to do so. It’s a valid argument, though we believe that with a little bit of learning you can see what professionals cannot.

We discuss a few common forms of accounting frauds companies indulge in and signs that may alert you to wrongdoing -

FINANCIAL REPORTS

A company’s financial health can be gauged through three statements — balance sheet, profit and loss account and cash flow accounts.

A balance sheet records a company’s assets (land, machinery, inventory, cash balance, investments, loans given), liabilities (loans taken, income tax payable, tax liabilities) and owner’s equity. It is generally prepared annually.

A profit and loss statement (or income statement) records a company’s earnings and expenses. Any company whose shares are traded on exchanges is required to release its income statement every quarter.

A cash flow statement tells us where cash is coming from (inflow) and how it is being used (outflow). There are three types of cash flow-operating cash flow (sale of goods, revenue from services, interest/dividend received, payment for purchases, payment for operating expenses), investing cash flow (sale and purchase of assets, sale and purchase of debt/equity, loans advanced to others) and financial cash flow (issue of equity shares, borrowing, repayment of debt).

INDICATORS OF EARNING QUALITY

1. High debt reserves relative to past loan defaults. A debt reserve is money set aside to account for losses that may arise as a result of defaults on future loans.

2. Minimal use of off-balance sheet techniques. It’s a form of financing in which large capital expenditures are kept off a companys balance sheet through various methods

3. Use of accelerated depreciation. It allows one to deduct far more in the first years after purchase. The straight-line method spreads the cost evenly over the life of the asset

4. Showing shorter useful life of assets. Any changes on this front cause higher or lower depreciation writeoffs

Notes to accounts are important as they detail the accounting policies followed, pension and other post-employment benefits and potential liabilities/losses.

MANIPULATION OF STATEMENTS

There are many items in financial statements for which companies use different policies. These are inventory valuation, investments and fixed assets, conversion of foreign currency and asset depreciation.

Companies often manipulate these to inflate revenue, assets, cash inflow and understate expense, liabilities and cash outflow in financial statements.

INFLATING EARNINGS

1) Lending to customers: Sometimes companies lend money to customers to buy their goods. This way they can report high revenue in the income statement and high receivables (treated as an asset) in the balance sheet.

2) Trade stuffing: Companies use this usually just before the end of a reporting period. They ship goods to customers even though the latter may not need them immediately. This increases sales ahead of the reporting period.

3) Understating provisions: Companies often allow credit sales on generous terms, sometimes even to customers with a poor credit history. Ideally, in such sales, the company should set aside a higher amount for bad debt provisioning. This amount is recorded as a liability. Understating such liabilities is another way of ‘enhancing’ the financial statement.

4) Round-tripping: This means getting into fictitious transactions with related parties to inflate revenue. In round-tripping, a company sells unused assets to a party with the promise of buying back at a later date at the same price.

UNDERSTATING EXPENSES

1) Spreading out expenses: According to accounting norms, if an expense has been made for acquiring an asset whose benefits the company will avail of over a long term, the expense is to be reported in the books in a spread-out manner over that period. The process is called capitalising. Companies often use this to delay recognition of short-term expenses.

2) Cookie jar accounting: Companies put aside money for possible loan defaults. Some companies, during periods of high revenue growth, increase the amount and release the same during periods of poor revenue, offsetting the impact of low sales growth. Among other common forms of financial statement manipulation are revaluation of assets, showing unrealised gains as profits and assigning higher values to fixed assets.

3) Off-balance sheet items: Some assets/liabilities or financing activities are not fully recognised in the balance sheet due to the complexity of transactions involved. These include pension assets and liabilities, assets and liabilities of joint ventures and unconsolidated subsidiaries and lease arrangements. These are recorded in footnotes of financial statements.

Sudden increase in inventory/sales ratio indicates that the company may be fraudulently inflating assets such as inventories.

Many companies resort to off-balance sheet financing by way of entering into joint ventures, research and development partnerships and lease contracts. Floating special purpose entities or subsidiaries to expand business is another off-balance sheet arrangement.

As the liabilities/risk involved in such transactions are not reflected in the balance sheet, one may draw wrong conclusions about a company’s financial health. It is, therefore, necessary to check the footnotes of financial statements.

RED FLAGS

Some manipulations we mentioned earlier are difficult to detect even for finance professionals. Here are some indicators of rot in a company’s financial books.

Continuous high level of cash, cash equivalents and current assets: Satyam Computers showed high cash balance over the years. Later it turned out it had inflated cash and bank balances by as much as Rs 5,040 crore.

Reported earnings consistently higher than cash flow: If cash flow from operating activities of a company is consistently less than the reported net income, it is a warning sign. The investor must ask why operating earnings are not turning into cash.

Sudden increase in inventory/sales ratio: This indicates the company may be inflating assets such as inventories.

Financial ratios not in line with industry peers could be due to inflated earnings, asset valuation or understating of expenses and liabilities.

Spurt in other income: Revenue sources recorded under other income are non-recurring and may include earnings from asset sales and closure of debt or debt restructuring. However, sources of earnings are seldom disclosed under this head. A sudden spurt should raise eyebrows.

Frequent changes in policies: Earnings and assets can be inflated by alternative accounting policies. If one sees frequent changes in these policies, there may be something fishy about the company’s books.

Financial ratios not in line with industry peers: This could be due to inflated earnings, asset valuation or understating of expenses and liabilities.

Too many off-balance sheet transactions: If a company has been expanding by creating special purpose entities and has entered into many lease contracts, it is possible a lot of liabilities are not reflected in its balance sheet.

We have seen in the past that many respected and renowned companies have been charged with manipulation of account books. Therefore, investors must stop treating financial statements issued by companies as gospel truth and scan them carefully to detect possible foul plays.

THE ENRON GAME PLAN

Enron, an energy trading company in the US, used various accounting methods for years to show high revenue and profit and understate debt.

How It Cooked Its Books

Inflated revenues: Enron was supposed to report trading and brokerage fees as revenue. However, it chose to report the entire value of transactions as revenue instead of just the fees.

This led to a huge jump in sales figure. In four years between 1996 and 2000, Enrons revenue jumped from $13 billion to $100 billion, a compounded annual growth rate of 65%.

It also started marking its revenue to the market, something unheard of in a non-financial company. This allowed it to record revenue from long-term contracts by estimating the present value of future cash flow even before it actually made any income from the project.

This method, approved by the US market regulator in 1992, helped Enron show inflated income.