A Close Look at Accounting Changes

The various accounting methods often require an observer to make accounting changes in effort to compare different companies and make those comparisons meaningful. Management discretion can be vast, and two otherwise identical firms may report significant differences. The most common differences usually arise in net income, operating expenses, reported sales and balance sheet values. Understanding how different accounting methods affect income statement and balance sheet values is also vital because it helps detect red flags and gives warning signs of poor internal management, and in some cases fraud. 

Various Meanings of Alternate Accounting Practices

Variations in accounting procedures may be justified and are often related to the cost structure and management techniques of a firm. However, firms in financial distress may also use this flexibility to distort figures and present the company’s financial health in a more favorable light. A description of the accounting practices used by past companies involved in some of the most egregious scandals in history is a good starting point for understanding how various accounting practices can be abused, and for avoiding investment in firms engaging in questionable practices.

Aggressive Revenue Recognition

The most common form of earnings manipulation is recognizing revenue too soon. This includes practices such as holding the accounting period open past year-end and recognizing revenue before goods are shipped. It can also be before fulfilling all of the terms and conditions of a sale. Aggressive revenue recognition results in higher reported profits. A firm engages in such practices in order to remain in compliance with debt covenants, or to support its stock price. This is a recipe for disaster. There are other forms of manipulation including:

  • boosting revenue with nonrecurring gains
  • delaying expense recognition
  • abnormal uses of operating leases
  • hiding expenses by classifying them as extraordinary or nonrecurring
  • LIFO liquidations
  • extending the useful lives of long-term asset
  • year-end surprises that cannot be explained by seasonality

A Brief Look at Enron

A brief overview of how Enron manipulated its statements to conceal its financial condition is a good lesson in how to spot warnings signs in the future. Enron had external pressures to support its stock price and debt ratings. The company’s lenders required additional collateral if debt ratings dropped below investment grade. This led the way for aggressive revenue recognition practices, such as valuing revenues using mark-to-market accounting. Enron grossly overestimated the value of contracts that had no established market prices, and reporting third and fourth quarter revenues that were disproportionate to seasonal trends from previous years. Another added incentive to distort was that senior management’s compensation was based mostly on bonuses and stock awards, which created internal pressures to report good-looking financial statements.

Identifying High Quality Earnings

In general, when evaluating a company’s financial statements, you should only consider recurring profits when calculating earnings and forecasting earnings growth and profit margins. Gains on asset sales, foreign currency gains or losses, and disproportionate single-period write offs may all serve to present net income in a more favorable light, but since these are one-time events, it is common for analysts to omit these events in order to boost the “quality” of earnings.  

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