Raihan Safa probes the practice of the misrepresentation of financial statements through overstatement of cost.
We hear in the news how some companies try to misrepresent their financial statements with higher profits by understating cost or by overstating revenues, and this is often done to impress the investors. However, have you ever heard of cases where companies are intentionally misrepresenting their financial statements by lowering their profits through overstatement of costs? Yes, that’s right, this practice is also surprisingly prevalent across the corporate world.
The companies try to predict their future financial performances through forecasting, and if the management anticipates poor performance in the future they try to take advantage of the good year when they are earning high profits by artificially inflating the costs and redistributing the understated earnings in the bad year when their financial performances are likely to worsen.
Why is it done?
You might wonder, why would any company deliberately misrepresent its financial statements by increasing cost, understating its net earnings and redistributing them in the future? Well, there could be two common reasons, which are:
1. Management performance: as you know, the financial performance of a company is also a reflection of the performance of the top officials such as the CEO and CFO. Therefore, a major decline in financial performance in any particular year or for a number of years could risk their jobs or bonuses. As a result, through the redistribution of the unreported earnings, they would be able to manipulate the financial performance as favourable even though in reality the company’s profit is diminishing.
2. Consistency: most investors would like to invest in companies that are steady and predictable. Investors would lose confidence if the performance of the company is volatile.
Therefore, the management tries to maintain consistent performance throughout the years instead of presenting a fluctuating performance. Imagine, if in one year the company has a growth percentage of 7% and in the next year it has a growth percentage of 2%? This is likely to deter the investor from buying shares as they would perceive it as a high financial risk and this will eventually impact the share price.
How is it done?
There are many ways in which a company can manipulate their cost. However, I have tried to highlight a few common areas that can be examined and reviewed to ensure no manipulation has taken place.
Provisions – Companies can make large provisions against operating expenses and this is often done by booking highly estimated provision figures than the actual probable liability which is likely to incur. Later in the desired year, they are reversed and thus the differences between the higher and actual amount contribute to increased profit.
Depreciation – Some companies can also use unrealistically high depreciation rates for their assets so that the asset life is quickly depreciated within a few years. After some years when the asset life is over, the total depreciation cost will reduce drastically and this will result in increased future profits.
Booking CAPEX as operating expenditure – Some expenses which can be conceptually qualified as CAPEX are treated as Revenue expenses, this enables the company to avoid future depreciation costs. Some of these common types of expenses are Machine
Overhauling costs, License, and Server installations.
Recognising supplies as non-stock items – The modern ERP systems usually allow us to recognise any supplies either as inventory or non-stock items. When supplies are recognised as inventory it is recorded in the balance sheet as current assets and expensed gradually based on the consumption of the supplies.
However, in a good year where the profit is expected to be very high, the management may order supplies in bulk quantities and record them as Non-stock items in the ERP system.
In this way, the entire supplies cost is being booked directly as an expense into the Profit and Loss account although it was not used. As a result, in the future years, these supplies can be consumed as per the operational needs but without any cost impact in the Profit and Loss account.
As professional accountants it is our ethical responsibility and professional duty to try our best in preventing the misrepresentation of the financial reports. This can only be done with in-depth knowledge and awareness of the risk areas which are prone to manipulation.
• Raihan Safa is an ACCA member, financial consultant and senior finance manager working for an international research institute