I have received a few google alerts recently about companies that are being accused of using their accounting and financial statements to deceive readers. It is sadly a far too common occurrence. For readers of financial statements – like those who are owners in a homeowners or condominium association – knowing what to look for can help you determine if the information could be incorrect and maybe even fictitious.
First up on the balance sheet is cash. While it is difficult to determine if the amount of cash is bogus there are things to look for, especially in associations. If the financial statements show lots of cash but you are receiving messages from the board saying that they are worried about having to increase assessments – ask how that can possibly be. There could be a logical explanation but every once in a while something is just flat our wrong.
Accounts receivable is one of the places where potential problems may really lurk. Accounts receivable are sales that have not been collected – i.e. an IOU from the buyer. For most businesses, one month’s sales in receivable would be expected, but watch out. I once worked on an engagement for a hotel chain where the accounts receivable kept increasing and was approaching almost 10 days of revenue. The a/r was used to hide the theft of cash sales and the controller didn’t catch it. Ask yourself, if you owned a business like that, would you let someone promise to pay you later?
Inventory is another big area where accounting irregularities can show up. Ask yourself, does the inventory seem excessive? An easy way to tell is to divide the cost of goods sold by 12 and then compare that number to the amount reported as inventory. Is it close to or less than 1:1? That would mean that inventory is turning every 30 days. If it is over 1.5:1, or more than 45 days, be careful. Inventory goes obsolete quickly these days so lots of inventory may mean lots of write-offs coming soon.
Fixed assets, or property, plant and equipment can be gimmicked as well. WorldCom tried to pull off this method of lying to their investors. This is one of those areas that is harder to tell if something is wrong but the best thing to do is look at how fast the investment in fixed assets grow. If sales have grown on average 3% over the last 5 years and fixed assets grew 12% this year, it may be worth questioning. It is definitely worth looking at when fixed assets grows consistently at 12% year over year and sales isn’t going anywhere. That is a sign of trouble. We performed a review this past year where we required management to write down their asset value because we felt that the fixed assets were overstated.
Keep in mind that most entities that want to fool you will want you to focus on their profits – which means that revenues exceed expenses. The easiest way to do that is to move expenses to the balance sheet; the receivables, the inventory, the fixed assets. Look at expense trends and if you see an expense, like cost of goods sold, drop as a percentage, and then check if inventory went down that same percentage. If it went up, it could be a sign something is wrong.
The vast majority of financial statement issuers are above board and honest. To help keep them that way, remember to read the statement critically and be willing to ask questions, especially if you have a financial interest in the issuer.
Have a great day.