The valuation process typically does not assess the underlying company accounting policy and procedures. However, it is important for stakeholders to be aware of accounting conventions, and to vet them in any due diligence effort. The following is a discussion of different accounting policies and what risks they might introduce.
Accounting guidelines allow companies discretion in a number of areas, and the latitude built into accepted accounting practice can result in considerable variation in the presentation of financial results. These policies, when applied in an extreme nature are often called ‘creative accounting’. Typically management will have a bias in one direction or another. Conservative policy tends to understate profit and lower the values of inventory and other assets. Aggressive policy tends to do the opposite –inflate earnings and assets values. These approaches are not necessarily unethical or illegal, unless taken to excess. Potential ethical issues don’t usually arise unless management switches back and forth between approaches to deceive the stakeholders.
In addition, the pressure to perform can lead to manipulation of the books for personal or professional gain. Management bonus schemes based on accounting profits are also an opportunity for executives to divert more money their way. Cases of financial manipulation date back over centuries, and recent examples such as Enron, Worldcom, Tyco International and AIG should be a reminder to investors of the this type of investment risk. An additional caveat here is that financial manipulation can be even easier in private companies, where fewer people are usually needed to commit a financial statement fraud. Also, the metrics can be moved quickly in private companies to exploit minority owners.
One of the most prevalent approaches to corporate accounting is to omit the bad and inflate the good. Accountants can adjust a number of subjective figures in any financial report. For example, a company may choose to exclude costs that are not related to its core operations when figuring its operating basis but will still include the revenue from those unrelated ventures when determining their quarterly earnings. Fortunately, companies have to break down their figures, but to find these details requires looking beyond the few main figures in a company’s financials.
The first place to look is at the top of the income statement – revenue. The main issues are the timing and quality of the revenue. Large gains in reported sales or income should have a good explanation. Any unexplained or windfall results could be a sign of manipulation. Any sales that are accelerated into the current period will lower future sales and profit. In general, this is a zero-sum game, unless we have outright fraud.
According to Dr. Howard Schilit, in his book “Financial Shenanigans” (2002), there are seven principal ways in which management manipulates its financial statements. Here are the revenue related practices and the typical accounting actions that produce the manipulation.
A quality of earnings analysis looks to identify artificial profit created by anomalies such as temporary situations, product line mix, accounting practice or inflation. A business with multiple product lines is subject to variation in profit depending on whether higher or lower margin product lines comprise the bulk of its sales. And the monetary phenomenon of inflation boosts earnings without any corresponding operating activity.
One revenue example is presented in the case of franchisors. Some franchisors sell more franchises than they are capable of bringing into operation through training and store opening support. In this case, it is not likely that the company can continue selling franchises at this rate. Essentially, it has pulled forward future sales into the present, and it will take time to bring the sold franchises into service, unless it increases its store opening capability simultaneously. So, whether the accelerated sales of franchisor result in continued future revenue will depend on whether the company is also growing its support capabilities.
In another franchise example, Howard Schilit discussed Papa John’s pizza, which reported $171.8 million of revenue during the first nine months of 1995, of which $78.7 million was equipment sales to franchisees. These sales were considered ‘weak quality sales’, because once a franchisee has an oven it is not likely to need another for a long time. With the size of the equipment sales being a large percentage of the total, investors in Papa John’s were at risk of a sudden slowdown in sales growth if the number of new franchises sold slowed down.
Revenue should be recorded on the basis of the net proceeds received from customers. Intermediaries that sell the products and services of other firms should count only the fees they charge for their own services. For example, consider ebay, which sells third party retail goods. If it sells a widget for $250 and earns $25, is revenue $25 or $250 (with a related $225 cost)? The correct practice is to record the revenue at $25 which represents its fee received from the third party seller. But, the company could inflate its revenue, and show dramatic top-line growth by booking the $250 value (although net income would remain the same).
Sometimes a company will have its shipments subject to their client’s inspection before they can be shipped. This occurs often in the aerospace and military components industry. So, in a way, the company’s performance is out of their control – subject to the performance of a third party. What happens when the company is ready to ship its product, but the customer isn’t available for the inspection? Can the company record the shipment to make its monthly numbers?
In other cases, aerospace component companies have partnered with an aircraft manufacturer and kept title to their product after shipment, through its installation into an aircraft up until the aircraft ships to the airline buyer. When does the company recognize their revenue? When it leaves the factory? Or when it is technically sold upon shipment of the entire aircraft?
These questions characterize some of the decisions inherent to individual accounting policy, and some of the ethical dilemmas that might arise. In the spirit of accrual accounting, which ones are OK? If the transactions are large, and/or are inconsistently applied, they can give rise to deceptive financial reporting.
Carrying on the though process of revenue manipulation, we have expense recognition to consider. Dr. Schilit, presents these expense related categories of financial statement manipulation and the typical accounting processes that facilitate the manipulation.
Like revenue, expenses must be appropriately recorded using the matching principle in accrual accounting in order to accurately present earnings. Here, a quality of earnings analysis would look to identify artificial profit created by anomalies such as the capitalization expenses. Capitalization of expense avoids large expenses hitting the books all at one time and allows management to record the expensed items as an asset and spread the cost out over time. While this is not illegal, capitalizing inappropriate expenses is a manipulation of accounting information.
Conversely, amortizing or depreciating an asset with a useful life that is longer than reality would consistently lower expenses for a period of years, leaving an outsized expense to be taken when the asset is retired – and the executive who made these decisions likely to be retired as well. Other tactics might be to exclude the cost, but report the revenue of an acquisition of another company or the purchase of investments.
The Deep Cleanse
When a company is going to take a loss and has no way to avoid the negativity of the hit, they sometimes take the ‘opportunity’ to write off everything possible in order to enhance the reporting of future financial results. Like a deep cleanse, the company takes any past losses that were not booked, plus any identified unrealized losses from future periods and records them in the same period as the loss.
This sets the stage for the company to report a remarkable turn-around after the poor year. If the write-downs were excessive, such as claiming unsold inventory as a loss when it has a good chance to be sold in the future, then when the inventory sells, the company would have no cost of goods sold for those transactions, reporting tremendous profits.
The acceleration of the losses makes the poor period look worse, but artificially enhances future earnings reports. In this case, there is no actual crime taking place, but it is a deceptive accounting practice, being only one step short of outright income manipulation.
When this pattern appears – a poor period followed by a tremendous rebound – it is hard to identify whether the company is truly rebounding or is just enjoying the benefits of their write-offs. So any company that rebounds quickly from a big loss should be viewed with caution.
Companies can manipulate the value of their assets to present a better or worse value for the items on their balance sheet. Overstating asset values can improve the company’s balance sheet position and create a higher economic value from the manipulated information. Understating asset values may allow companies to write off fictitious decreases in the assets to the income statement. This reduces net income for an accounting period and can be used by the company to avoid high tax liabilities from government agencies.
Closely tied to asset value is depreciation method. Companies use up their assets while producing their goods and services. The resulting decline in assets is reflected in financial statements by depreciation and amortization expense. Depreciation is used with fixed assets, while amortization is used with intangible assets.
Depreciation or amortization, in theory, spreads the cost of the asset over its useful life. This depreciation expense reduces income each year. Although, income and capital gains tax implications often drive the selection of depreciation method, the acceleration or deceleration of this expense can be used to bias earnings.
Misrepresentations in financial statements will appear in both the income statement and the balance sheet as accelerating depreciation will reduce the asset on the balance sheet too quickly, and the opposite happens when depreciation is spread over too long of a useful life.
Companies lease buildings and equipment to use in their business without incurring the upfront cash outlay of buying the items themselves. Operating leases where the intent to purchase the assets isn’t considered, are fair representations of expense.
However, the use of an operating lease for capital assets has an effect on the income statement. It shows a controlled asset as a direct expense, as opposed to being shown on the balance sheet and depreciated. This convention may not be an appropriate representation of the operating expense of the business nor the company’s assets and liabilities, as it actually represents a capital expenditure for fixed assets which may normally be accounted for over a longer period of time.
The relevant issue in lease accounting is that the lease expense under a capital lease may be significantly greater than the depreciation expense had the asset been purchased outright. Companies can use this as a financing method to increase their expenses and not show the entire nature of their assets and liabilities.
Inventory costs provide an opportunity for owners and managers to manipulate financial results. Companies may attempt to minimize allocating production costs to its cost of goods sold, which will result in higher gross margin. Under-costing inventory also decreases the inventory reported on the company’s balance sheet, and presents a better inventory turnover ratio.
The choice of inventory account method – First In First Out (FIFO) or Last In First Out (LIFO) directly affects the gross margin. In an inflationary economy for the input, the cost of the last item will be higher than the first item. Using the last item for cost, inflates COGS and lowers reported earnings, while FIFO does the opposite.
As an operating tactic, companies may try to hide an unsuccessful quarter by pushing unsold merchandise into the market, or into the distributors’ warehouse. This is often called channel stuffing. Forcing the sale of goods to the distribution channel may save a company from a big quarterly loss, but future sales may be depressed as the inventory is sold and the channel clears over time. Or, the unsold goods are returned for credit at some point in the future. Channel stuffing can be detected in two figures: the stated inventory levels and the cash meant to cover bad accounts. If inventory level suddenly drops or the liability for bad accounts is drastically increased, channel stuffing may be taking place.
Hidden reserves provide a nice secret fund to tap when times turn bad, giving a misleading boost to the bottom line. Sometimes when a company is struggling financially, it will dip into financial reserves to improve near term performance at long term expense. The first target is usually the pension plan. Others may include a sinking maintenance fund, or other provision to save for a projectable large, future expense.
Companies will optimistically predict the growth of the pension plan investments or reduce the projected future maintenance costs and cut back on contributions to the fund, improving cash flow and the balance sheet. When the bills come due, however, the company will have to record the plan deficit and fund them from current revenue – potentially creating a financial crisis. Like other short term vs. long term decisions, the management that benefits from changing the present allocation, is not around when the account comes due. The future expense doesn’t go away by changing the financial assumptions.
A contingent liability is potential obligation to a third party that may be incurred depending on the result of a future event. Although a contingent liability is uncertain, the uncertainty will be resolved by a future event. These situations most often involve disputes and potential lawsuits. A contingent liability is recorded in the books of accounts only if the contingency is probable, not just possible, and the amount of the liability can be estimated.
One example is when a company may face a lawsuit from a rival firm for patent infringement. If the company believes that the case against them is strong, the company estimates the damages payable if the rival firm wins the case and books a contingent liability of this amount on its balance sheet. On the other hand, the company believes the lawsuit is frivolous; no contingent liability would be booked. Disclosure of the possibility of the future liability though, is required.
As may be abundantly obvious, booking or un-booking contingent liabilities, and/or estimating their liability are rife for manipulation. Timing of the entry would affect the financial performance of the period under consideration, while omitting the entry would preserve current earnings.
A related-party transaction refers to the transfer of assets or liabilities, or the performance of services, by, to or for a related party irrespective of whether a consideration is given. These transactions can be between companies, a shareholder and the company, or the company and other entities. The two most popular suspects are special purpose entities (SPE) and sister companies.
Enron famously created SPEs to mask their malfeasance and misrepresent their financial condition. SPEs allowed Enron to move massive amounts of debt off its balance sheet and hide the fact that it was teetering at the edge of insolvency.
Sister company transactions present opportunities to set transfer costs and revenue which affect the related companies in opposite ways. A high transfer price to a parent increases the income of the subsidiary while increasing the expenses of the parent. Theoretically, this is a zero sum game, but often an arbitrage opportunity exists. In one case, Motorola and Scientific Atlanta, engaged in creative sale-and-cost transactions with Charter Communications that helped Charter meet its annual operating cash-flow goals.
Sister companies have also been used as a way to spin off expense as new business. For example, a biotech company could create a sister company and hire it to do its research and development (R&D). Instead of doing the R&D itself, the sister company hires back the parent company to do the work. The sister company essentially pays the parent to do its own research – thus the parent company’s biggest expense is now shown as income and no one notices the perpetually loss-ridden sister company.
Payment of expenses, purchase and sale of property and sharing resources may all be related party transactions. Disclosure of these transactions is required. The footnotes of the financial statements list all financing related affiliates and financial partnerships.
Operations of an entire division, subsidiary, or segment of a company where a formal plan exists to eliminate it from the company are considered discontinued operations.
The revenues, gains, expenses, and losses pertaining to the business segment are removed from the company’s continuing operations and are reported separately on the company’s income statement. The amounts that pertain to discontinued operations are reported near the end of the income statement but before the amounts for extraordinary items and the cumulative effect of a change in an accounting principle.
While discontinued operations continue to perform, financial statements have the similar risks to related party condition.
Extraordinary items are one-time events that are the result of unforeseen and atypical circumstances. They are usually accounted for separately so they don’t skew the company’s regular earnings. An example may be the cost to recover from an earthquake that disrupted business for several weeks. These losses might be written down as a one-time charge. Like the ‘Deep Cleanse’, companies may off-load unrelated expenses into the extraordinary item, enhancing future results.
Large write-offs can be legitimate reflections of a plant closure — or an excuse to lower the value of assets so future performance looks even better. Conversely, a company’s management might include a one-time gain in earnings and not identify this as a one-time gain and claim that the amount is not material. Large moves in profitability around an extraordinary event should also be viewed with caution.
Another form of financial manipulation can be found during the merger or acquisition process. A classic approach to this type of manipulation occurs when management tries to convince the parties involved to support a merger or acquisition based primarily on the improvement in the estimated earnings per share of the combined companies. Let’s look at the table below in order to see how this type of manipulation takes place.
Proposed Corporate Acquisition
After Stock Purchase
Market Enterprise Value
Common Stock Price
Earnings Per Share
In this example, the acquirer purchases the target in a stock transaction at its current stock price in a non-dilutive transaction. Since the target is valued at $2.5 million, they issue 25,000 new shares at $100 each to buy out the target company’s shareholders.
Interestingly, the proposed transaction appears to make financial sense because the earnings per share of the acquiring company will increase from $4.50 per share to $5.20 per share. However, this is strictly financial engineering. No value has been added. The earnings per share of the acquiring company increase by a material amount because the target is more profitable than the acquirer. The target company earns 8% return on equity, while the acquirer earns 4.5%.
In some cases, companies desire to benefit from owning a company, but do not want the target to tarnish their financial statements. Suppose a target company has a high debt ratio on the balance sheet. This results in a less favorable credit rating and higher interest rates. The acquiring company’s management, wanting to avoid consolidation of a highly leveraged subsidiary, only purchases 49% of the target. By keeping its ownership below fifty percent, the company then uses the equity method of recognizing the subsidiaries’ operating results, which keeps the target company’s assets and debt off the parent’s books. If the parent owns a majority of a financially undesirable company, they could divest stock to get below the fifty percent threshold.
An increasingly common practice in accounting for acquisitions, especially in technology companies, is to write off in-process research and development. Under this technique, acquirers take large, immediate charges against earnings to reflect R&D underway at the target company at the time of takeover. The write-off is justified under the theory that the research might never find a commercial application and thus is of doubtful value as an asset. Although the real motivation is probably to reduce the amount of goodwill that the acquirer must put on the balance sheet, it also improves future earnings by eliminating part of the goodwill amortization going forward.
Management bonus schemes based on accounting profits are a golden opportunity for executives to divert more money their way.
Abuse of expense accounts, nepotism and other executive perks can all decrease investment return for minority owners. One of the easiest ways to scoop profits out of their hands is to overcharge the company for goods or services supplied by a firm owned wholly by an executive or group of executives.
Minority owners might not receive fair compensation if executives negotiate for excessive non-compete payments or similar golden parachutes. The costs of those perks will simply come off the top before the remainder is disbursed to shareholders. In the case of privately held small companies, the majority owner can divert substantial dividends to themselves by paying above market salaries. Minority shareholders have little leverage.
OPTIMISM and A GOOD ECONOMY
Generally, statements of opinion or intention are not statements of fact in the context of misrepresentation. But if someone has specialist knowledge on the topic discussed, such as company management, it is more likely that an opinion by that party would be treated as a statement of fact. As a statement of fact, it becomes actionable in a lawsuit.
However, most accounting misrepresentations do not rise to the level of fraud. They may be intentional, but that does make them fraudulent. They also may be unintentional, or a result of overconfidence and optimism. By their nature, most forecasts are high, most schedules run late and most budgets are busted. Or, projects can be strategically misrepresented. Strategic misrepresentation involves intentionally under-estimating the effort and resources a project will require in order to get it approved. As the saying goes, ‘It’s easier to ask forgiveness than permission’.
Other issues also drive inaccuracy. The scaling up of an endeavor requires a growing set of resources and complexity, some which are foreseen, and some not. As the company progresses, random events can take it off track and the effect of disruptions may not be linear, and in fact they could cascade into larger problems.
The conclusion to this section is that some error is baked into financial statements, no matter the level of care. One other caution in interpreting financial statements is that a good economy or a good industry often masks underlying problems. It pays to stand back and make an overall assessment of risk in the complexity, scale and economic environment at hand.
Although this is not an exercise in forensic accounting, it is important to note some practices can protect an investor when acting on financial statement information.
First, read the financial reports. Financial statements can be at great odds with what someone has told you about a company. And, of course, after careful analysis you will also find that the financial reports of many companies are often incomplete and sometimes misleading.
Monitoring cash inflows is vital, but financial statements can hide or obscure them.
Understand what makes up the different categories on a company’s financial statement. Watch for dramatic fluctuation in key indicators such as cash flow, accounts receivable, or assets. Ideally, an investor would be comfortable using liquidity and solvency ratios, growth and profitability rates, variable and fixed cost analysis and market multiple analyses in order to gauge rationality.
Businesses are relatively stable. Develop a skeptical attitude; recognizing when something is too good to be true. Question accounting shifts that stem from so-called “changes in strategy”. When one thing changes dramatically, that could be the first sign of trouble — especially if it produces radically improved results.
Using trend analysis will help identify discontinuities, whether it is a spike in sales, a drop in gross margin or profitability. Any sharp change deserves investigation because positive reports may actually be a contrarian indicator of future performance.
Watch out for vague categories that allow companies to fudge the numbers, Dr. Schilit advises. Some of his favorites include “prepaid expenses and other current assets,” “noncash revenue,” or “unbilled receivables.”
If there is no accompanying information to the footnotes regarding related party transactions- disclosing how much the company owes to the affiliates or the contractual obligations, there is good reason to be suspicious.
The Advantages of Dividends
Accounting malfeasance is harder if a large transfer of cash is going to shareholders on a regular basis. This means companies with a dividend yield above 1% per year. When considering dividends, watch dividend coverage. The dividend coverage ratio indicates how well earnings support the dividend. As a general rule, avoid companies with a dividend payout ratio above 50%. Above 50%, the company is not likely to be investing enough capital into the organization. It is critical for any company to reinvest a portion of earnings back into the organization.
Rising dividends show that management and board of directors are reasonably sure the company is performing well and will continue to perform well in the foreseeable future. Plus, it demonstrates the intention of management to return a profit on investment to the shareholders over other interests.
An ounce of prevention is worth a pound of cure. When investigating a stock purchase in a company, you might not be in a position to bargain for changes or better terms upfront, but at least by asking the right questions, you can avoid the worst investment of your life.
Learn the nature of the company, especially its sources of revenue and income, including the countries of origin. Many corporate collapses have involved financial institutions and real estate operations. Financial statements of companies in resource industries can be of limited use because financial accounting doesn’t focus on valuing the assets in the ground.
Recognize that you have a better chance when a company follows U.S. or international accounting rules. Clearly defined accounting methods should be specified in share purchase contracts. Simply agreeing to follow generally accepted accounting principles can leave investors open to abuse. The choices available to management under these rules are simply too broad for comfort.Require forensic investigation rights.
Require a third party equity valuation annually. The cost of a business valuation is minor when compared to being able to identify changes in equity value, and is more easily borne for all investors by the company. GAAP financial statements are made for reporting taxes and book value, not market value and the current value of equity.
Due diligence means scouring the financial statements until you are sure that those main figures are real. The best place to start looking for risky practices is in the footnotes.
Finally, investors should keep in mind that independent auditors may very well have a material conflict of interest that is distorting the true financial picture of the company, and that the information provided to them by corporate management may be disingenuous. Therefore it should be taken with a grain of salt.
The art of forensics, in the valuation context, is to identify and address all the challenges that an opposing side may make, and to dispose of them on your terms, not theirs. These challenges come from government when arguing about taxes, from partners in a business dispute or from investors is a stock transaction, among others. Well executed valuation forensics is a way of turning defense into offense. A forensic accounting analysis, conversely, would address all the issues raised earlier, and reconcile them into an opinion suitable for defense of the accuracy of the financial statements. As an expert, to render this opinion on the truthfulness of a report is one thing, to defend the value opinion when attacked is another.
The goal of a business valuation is not to certify the financial statements or to investigate into the revenue recognition practices of the company, although professional valuators should also be able to complete a quality of earnings report if that task is desired. The valuation objective is to take the information presented and determine a market value for the company. The financial information has assumptions built into it, whether it is management’s presentation of the financial statements, or a forensic accounting of them.
Some valuation practices do safeguard against valuing on a temporary spike in value. One of these efforts is to normalize cash flow by adjusting out extraordinary items and inappropriate managerial compensation. Another is weighting of the cash flow streams in different periods, and a third is trend analysis. The valuator will look for extraordinary events, non-operating assets and other items not reflective of the ongoing company operations and adjust those out. Cash flow and balance sheet will then be evaluated for trend, and peculiar spikes in data can be smoothed out. The smoothing process limits the impact of any misrepresentations.
Although some of the issues such as identifying discontinued operations, lease accounting and other items do come into play and mitigate error, the valuation effort is mainly geared around analysis of the data and making a best fit of the qualitative and quantitative aspects of a business to market transactions in order to determine what a buyer might pay to acquire it. So, not being a forensic accounting investigation, the representations of management in the financial statements form the basis of determining the company’s value. On this standard, if the input is faulty, so will be the result. The quality of the source information is integral to the result.
Barney, Gerald W., (2013) Street-Smart Guide to Valuing Business Investments, ISBN-13: 978-0615806334
Ittleson, T. R. (2009). Financial statements (Rev. and Expanded Ed.). Pompton Plains, NJ: Career Press. ISBN-13: 978-1-60163-023-0
Rosen, Al, (2007) Detecting crookery. Canadian Business, 00083100, 2/12/2007, Vol. 80, Issue 4
Schilit, Howard (2002) Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition, McGraw-Hill, ISBN-13: 978-0-07138-626-5
National Association of Certified Valuators and Analysts (NACVA), Glossary of Terms
About the Author
As a Valuator, Mr. Lisi has performed valuations of over 100 business entities, intellectual property and/or equipment assignments. These companies range from start-ups to low middle-market companies. His general qualifications are:
Certified Valuation Analyst (CVA), National Association of Certified Valuators and Analysts
Masters of Business Administration, University of California, Irvine
Bachelor of Science, Industrial & Operations Engineering, University of Michigan, Ann Arbor
Certificate in Production and Inventory Control Management, American Production and Inventory Control Society