Have you heard of the term cooking the books? Cooking the books is a term used to describe the illegal act of manipulating accounting records and financial statements in order to deceive others. This deception can be done for various reasons, such as hiding losses or inflating profits.
Cooking the books is an illegal activity that can result in serious consequences, including fines, prison time and other legal action by authorities – if caught. But it is unlikely that even if caught, investors can recoup their money. So it is better to stay out of such situations.
But just how can companies ‘cook the books’? There are several ways, but in this article we recap 4 of the most common.
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4 ways cooking the books may occur
1. Timing revenues and expenses
This is the way to ‘cook the books’ that ASX investors need to watch out for most closely. Companies can manipulate the timing of revenue and expenses to make a result look better, especially if it is near results time. They may report revenue from a customer contract as being received in one year even though all that will happen in the applicable year is the contract being signed and the actual revenue won’t come until the following year. This may come back to bite them if the customer, or customers, experience hardship and trouble paying as a consequence.
The same might occur with expenses – a company may delay the reporting of expenses until another year. In doing so, the bottom line will look better than it actually is. In more extreme examples, companies may book lump-sum payments in one year when the payments will be spread out over several years. The intention is the same and the ultimate outcome will be – the company will look stronger than it is. And if the company is caught in the act, there’ll be penalties to pay.
2. Subsidiary balance sheets
Companies can perpetrate accounting fraud through subsidiary balance sheets. Essentially, the company creates a new entity (such as a Special Purpose Vehicle) and moves assets and/or liabilities to that entity’s balance sheet, while still using them.
So what? Well, a company can transfer it for more than it is worth. And if so, it could be recognised as a gain in earnings even though the company is not generating a cent because they are not parting ways with the asset.
This way of cooking the books was exactly what occured at Enron where collateralised debt and impaired assets were moved to SPVs to an extreme extent – in the sense that there was a very complex web. Under accounting laws, companies still need to report assets and liabilities of subsidiaries as if it was their own unless they have no control over it (not just in theory but in practice).
3. Synthetic leases
Companies can cook the books through synthetic leases by taking advantage of the complex accounting rules that govern these transactions. By falsely reporting a lease as an operating lease, companies can hide the liabilities associated with the lease from their balance sheet. This can be done by structuring the transaction in such a way that it falls under certain accounting rules and allows for more lenient reporting. Additionally, they may employ creative and aggressive accounting practices to make it appear that they own certain assets which they do not actually own in order to boost their financial statements.
Companies may also use aforementioned off-balance sheet financing techniques to hide liabilities from their balance sheets or even set up dummy corporations and subsidiaries to obscure ownership of assets or liabilities related to synthetic leases.
4. Buying back shares
Wait, what? Yes, we wrote about stock buybacks just a week ago and noted there were advantages to companies in doing so. But stock buybacks can be a way of cooking the books. Keep in mind that they reduce shares on issue and this may disguise a decline in earnings per share (EPS).
A company with a $10m NPAT will record the same NPAT regardless of shares on issue, but EPS will change. If there are 500m shares on issue, it will be 2c per share but 800m shares on issue will cut this to 1.25c per share.
Now, we’re not saying stock buybacks are instances of ‘cooking the books’. But we think investors need to be wary of the practice generally. Even if there’s no fraud, it may not be the best use of capital. The key is to look for the size of the share buyback and how it is being financed. Is it being financed with free cash flow, or with borrowed money?
Watch out for companies cooking the books
We admit that cooking the books is a rare event, but is one that investors need to look out for. Because if they are caught in this situation, they will likely lose all their money.
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