You can’t trust the numbers because the data in accounting can have bias in the assumptions and estimates. When financial results are concerned, bias means only that the numbers might be skewed in one direction or another.
1. Example a way to skew the finances is to determine whether a given cost is a capital expenditure or operating expense. Operating expenses are the costs that are required to keep the business going day to day. These include salaries, benefits and insurance costs. Capital expenses is the purchase of an item that is considered a long term investment such as computer systems and equipment. So example, there is the temptation say you take all the office supply purchases and call them capital expenses, then the profit can be increased accordingly.
Financial intelligence means understanding where the numbers are “hard” (that is well supported and relatively uncontroversial) and where are “soft” (that is highly dependent on judgement calls)
2. Use of depreciation can also be used in creative accounting. Example a company buys some expensive machinery or vehicles that it expect to use for several years. Accountants will spread the cost out over the equipment’s useful life. Example some years back, airlines realized that their planes were lasting longer than anticipated. So the accountants changed their depreciation schedules to reflect that longer life. As a result, they subtracted less depreciation from revenue each month. And guess what, the industry’s profits rose significantly. This is a resulting upward bias in the profit numbers, but there are implications example investors decide to buy more stocks, airline executives figure out they could afford to give out better raises etc…. no change in profit actually but creative accounting of the length of depreciation was done.
3. When to recognize revenue from sale
Suppose we change how the revenue is recognized? Suppose we recognize 75% up front instead of 50%? The logic might be that a sale in this business takes a lot of initial work, so the company should recognize the cost and effort of making the sale as well as the cost of providing the product and delivering the service. When the way the revenue is recognized is changed, then suddenly earnings per share are nudged up.
Bill-and-hold is essentially a way of accommodating retailers who want to buy large quantities of products for sale in the future but pay off paying for them until the products are actually being sold. Example Sunbeam is a company which makes lots of products geared towards summer such as gas grills. Sunbeam went to major retailers such as Wal-Mart and Kmart and offered to guarantee that they’d have all the grills they wanted for the following summer provided they did their buying in the middle of winter. They’d be billed immediately, but they wouldn’t have to pay until spring, when they actually put the goods in the stores. The retailers were cool to the idea. They didn’t have anywhere to keep all that stuff, nor did they want to bear the cost of storing the inventory through winter. Sunbeam said no problem, they will take care of the storage space and cost. The retailers agree and Sunbeam went ahead and reported an additional $36 million in sales based on the bill-and-hold deals it had initiated. The scam worked well enough to fool most analysts, investors and even Sunbeam’s board of directors.
4. One time charges : A yellow flag
There is one line that often turns up after cost of goods sold and operating expenses (it is sometimes included under operating expenses), called “one time charge”. Most often, one time charges occur when a new CEO takes over a company and wants to restructure, reorganize, close plants and maybe layoff people. It’s the CEO’s attempts to right or wrong, improve the company based on his assessment. Normally such a restructuring entails a lot of costs – paying off leases, offering severance packages, disposing of facilities, selling off equipment etc. This is a yellow flag, because how do you really estimate the cost of restructuring?
If estimate is too high, if actual costs are lower than expected, then part of that one time charge has to be reversed. A reversed charge actually adds to profit in the new time period, so profits in that new period wind up higher than expected – all this because an accounting estimate in the previous period was inaccurate.
If a company takes extraordinary one-time restructuring charges for several years in a row, it should really be a red flag.
5. Gross Profit
To gauge your company’s gross profit, you can compare it with industry standards, particularly for companies of a similar size in the industry. If gross profit is going down, you can ask whether production costs are rising or is your company discounting its sales? But there are possible bias in the numbers.
Gross Profit can be greatly affected by decisions about when to recognize revenue and by decisions what to include in cost of goods sold. Suppose you look at the numbers and appears that service costs have gone up. So you begin anticipating cuts in service costs, perhaps even including some layoffs. But when you do some digging you find that that the salaries that there were previously in operating expenses have been moved into the cost of goods sold. So service cost did not go up, and laying off people would be a mistake. But why did the people in accounting move those salaries? If those salaries are to remain as cost of goods sold, then maybe the firm’s gross profit targets need to be reduced. But nothing else need to change.
6. Operating Profit
Operating profit is a good gauge of how well a company is managed. A healthy and growing operating profit suggests that employees are going to be able to keep their jobs, maybe with opportunities for advancement. HR may need to shift its focus to employee development, recruitment and so on. A declining operating profit will require a different focus. However there are potential bias in the numbers, example some tricks in the depreciation column can be altered to affect profits one way or another.
7. Net Profit
There are usually 3 fixes to net profit
a. Company can increase profitable sales. This solution requires a great deal of time, need to find new markets or new prospects, work through sales cycle etc.
b. Company can figure out how to lower production costs and run more efficiently. This takes time too as you need to study the production process, find the inefficiencies and implement the changes.
c. Cut operating expenses which often mean reduce headcount. This is usually the only short term solution available. That’s why so many CEOs who take over troubled companies start by cutting the payroll in the overhead expense areas. It makes profit look better fast.
Goodwill is found on the balance sheets of companies that have acquired other companies. It is the difference between the price paid for the acquired company and the net assets the acquirer actually got. In the past, goodwill could be amortized over a maximum of 40 years or the estimated useful life of its acquired business. Now they decided that if goodwill consist of the reputation, the customer base, and so on, all those assets don’t lose value over time. They may become more valuable over time.
With this new ruling, you now have even more of an incentive to look for companies without much in the way of physical assets and even more of an incentive to undervalue those assets. Example Tyco was accused of taking advantage of this rule. It was buying companies at breakneck speed – more than 600 in those 2 years alone. Tyco would regularly undervalue the assets of those companies. Doing so would increase the goodwill included in the acquisitions and lower the depreciation Tyco had to take each year. This in turn would make profit higher and drive up Tyco’s share price.