3.17 Accounting Manipulations
Clearly the corporation (i.e., management) has an incentive to do whatever it can in order to reduce its cost of capital, including creating the impression via accounting manipulations that its overall riskiness is less than otherwise may be recognized. There are numerous ways in which this may be achieved. Herewith, we shall examine several.
First, the firm can transform liabilities into off-balance sheet items. Doing so will make the balance sheet appear stronger. Think Enron.
Next, it can “smooth” earnings, by engaging in discretionary decisions as to when to book certain revenues and expenses. One of the most common manipulations has to do with the establishment of reserves for possible asset write-offs. In so doing, a company may show relatively larger net assets, at a point in time, than would be the case if it were more conservatively reflecting certain asset accounts. It also helps smooth earnings.
Specifically, the firm might increase (or decrease) its “Balance Sheet Reserves” in good years. Management will reduce its currently reported profits by expensing additional reserves thus increasing “reserves” held on its Balance Sheets. In bad years, it reduces its Balance Sheet Reserves and inflates its currently reported earnings. These actions will enable it to show more stable operating earnings over time, and thus increase its ability to take on more debt and to service it. Further, if the firm is more profitable, its costs of debt and equity will go down.
Not all of these deceptions are detected even by alert analysts. The benefits of such machinations for the corporation are enormous. For example, a reduction in the annual Allowance for Doubtful Accounts of, let’s say, $100,000 in artificially reduced expenses, translates into increased Net Income of: ($100,000) (1 – .30) = $70,000.
At a PE ratio of 20 times earnings, this could mean an increase in total market value of (20) ($70,000) = $1,400,000. If this number does not impress you, let’s be more realistic for the large corporate world, i.e., “big business.” Just add on three zeroes! Now, we’re talking!
Corporate managers, who are not often schooled in business and financial ethics, will feel compelled, out of a fiduciary obligation to shareholders, if not out of self-interest, to take advantage of these “opportunities.” Let us not forget that managers, whose bonuses may be tied to financial metrics, are frequently also shareholders themselves. The result often is that the company is in fact more risky than perceived, to the benefit of the corporation’s managers, and to the detriment of bond and equity investors alike.
It is essential that external credit (i.e., bond) and equity analysts, and sophisticated investors, be well-schooled in Financial Statements Analysis. This is real money we’re talking about!