While Enron has become the star child of blatant financial statement fraud, other companies are also notorious for rigging their numbers. The income statement is one of the primary financial statements of a business, along with its balance sheet and cash flow statement, and it can be manipulated in several common ways. Investors should watch for red flags related to income and expenses.
The income statement shows what the income (or profit) of a business is by showing all of its income and expenses for a specific period. Analysis of the income statement is an integral part of fundamental analysis. The statement should present an honest and accurate picture of a company’s financial condition so that investors can make informed decisions about buying or selling shares. Because these numbers are so important, they must be reviewed and approved by an independent auditor. Unfortunately, listeners can be fooled by fabricated numbers or even overlook such events (see WorldCom and Global Crossing). This is why investors should be vigilant and skeptical when studying a company’s income statements.
Beware of revenue manipulation
Income is vulnerable to misrepresentation. Common ways of manipulating income include recording income before it is actually earned or simply creating income that does not exist. Companies can do this by making fraudulent sales to accomplice related parties (for example, by selling to a sister company with the immediate intention of rescinding the sale), by recording incomplete sales because they are related to a condition (for example, by recording the full value of an installment sale), recognize the consignment as a completed sale, and modify contracts to increase sales. A business could also delay considering customer feedback to a later quarter, or perhaps ignore it altogether. But how can an investor know if a company is engaging in these income statement manipulations? Look at the company’s income over the past few periods. If it seems to be growing inconsistently, it should be a red flag. Investors should examine the company’s income statements for previous periods, including the last quarter and the last year, to see if there is a sudden and unexplained change in its income that is not explained by its cash flow.
One common way to manipulate expenses is through inventory manipulation. For example, a business might purchase materials and not record the entire expense of the purchase or not record the purchase at all. Businesses can also exaggerate supplier discounts to keep costs down or not write off obsolete, non-salable inventory. Other schemes include overestimating or underestimating inventory to showcase whatever image management wants to paint or create ghost inventory. To get an overview of these practices, take a look at the company’s expenses. If expenses move in a way that is not consistent with previous periods, investors should study the spread. The company’s balance sheet and footnotes could also provide additional information.
Accounting for cookie jars
Many companies operate in industries where the income stream is not constant and therefore the income varies. Regardless of the natural rhythms of an industry, all publicly traded companies must report quarterly profits, and analysts and investors keep track of those profits. Companies are under great pressure to meet their targets and consistently exceed their profits from the previous quarter. Because of this, they can manipulate their income and expenses in different ways to paint a picture of stability and continued growth when in reality the business may be less profitable, or even more profitable, than depicted. For example, some companies will keep reserves of income from past quarters, without explicitly stating so, or use other means to show profitability in future quarters. Other methods of accounting for these cookie jars include moving current expenses to a future period in order to increase current income. Future expenses can also be carried forward to an earlier period. Anything that looks like this sort of manipulation should also be a cause for further investigation. Look for red flags in past period earnings and in management’s discussion of earnings. Also check if the current income is from “other income”. Other income can be a red flag for previous reserves being plugged in to increase current income. Companies that have been involved in cookie jar accounting schemes include Dell and Fannie Mae.
Other red flags
Some transactions do not occur regularly and are called one-time transactions. Such a transaction could include the sale of the company’s head office. It is also worth looking at these kinds of transactions to see if there is anything irregular. These types of items could appear as a “gain on disposal”.
The bottom line
An investor should be vigilant before investigating any item in a company’s income statement that raises a red flag. Income and expenses are vulnerable to manipulation. Company management is often prompted to engage in manipulation and auditors do not always understand. Reading the income statement and management’s presentation of its activity (as well as the balance sheet and footnotes, as well as the cash flow statement) provide clues for vigilant investors.