The world of financial statements is not always as it appears. A company manipulates financial statements to mislead investors and shareholders.
Financial statement analysis is an umbrella term for the tools that can be used to detect manipulation. These include horizontal analysis, vertical analysis and running ratios.
Using this deceptive tactic, information and numbers are manipulated to make a company's performance appear to be better than it is.
Understanding how financial statement manipulation works will help investors and stakeholders protect their investments and avoid costly mistakes.
This post will discuss how companies manipulate their financial statements and provide tips on spotting these tricks.
What is financial statement analysis?
Financial statement analysis aims to uncover any potential issues with a company's financial statements by examining their numbers and any accompanying footnotes.
Analysts typically focus on three key areas to complete a financial statement analysis. These include the income statement, balance sheet, and cash flow statement.
Each of these provides information that can be helpful when assessing a company's financial health.
Identifying trends, like increased or decreased sales, can be done with an income statement. It can also provide valuable insight into the company's pricing strategy and margins.
An asset and liability balance sheet provides information about the assets and liabilities of a company. In addition to providing insight into how much debt a company carries, it can also reveal whether or not it can repay its obligations. This can be useful for assessing liquidity and solvency risks.
An organization's cash flow statement shows how much cash it brings and expands over time. In addition to providing insights into a company's investment strategy and cash resources management, it can also help assess short-term liquidity risk.
How are financial statements manipulated?
Misclassifying revenues and expenses, fictitious assets and liabilities, and creative accounting practices are the most common ways financial statements are manipulated.
Increasing revenue through manipulation
An example of revenue manipulation is when a company overstates sales, recognizes revenue too early or records fictitious sales to inflate its income.
Manipulation of expenses
It involves understating expenses to boost profits. This can be done by delaying the recognition of expenses, understating actual expenses, or using creative accounting methods.
Manipulation of assets
Creating fictitious assets or overstating the value of tangible assets in order to inflate income is an example of asset manipulation. It can be done through improper asset valuation, the creation of fictitious assets, or the failure to adequately depreciate impaired assets.
Manipulating liability
A company can manipulate its liabilities by delaying their recognition, understating true liabilities, or using creative accounting techniques to improve its financial ratios.
interpreting financial statements
When interpreting financial statements, there are a few key things to remember. First, remember that businesses often use creative accounting practices to make their numbers look better than they are. This means that you need to be careful about taking the numbers at face value and instead look for any red flags that may indicate manipulation.
Next, remember that businesses report their financial information on an accrual basis, meaning that revenue is recognized when earned, not when it is received.
This can sometimes create a discrepancy between the cash flow and income statements. As such, it is essential to understand how accrual accounting works to interpret financial statements correctly.
Finally, remember that financial statements provide historical information and should be used as a starting point for your analysis, not as the sole source of information.
Be sure to supplement your financial statement analysis with other research, such as industry trends and competitor analysis. Considering all of this will give you a more accurate picture of a business’s financial health.
horizontal and vertical analysis
Financial statement analysis can be accomplished in two primary ways: horizontal and vertical analysis.
The horizontal analysis involves comparing financial information over a sequence of reporting periods, whereas vertical analysis is a proportional approach to analyzing a financial statement with each item listed as a percentage of another.
For instance, line items on the income statement are typically expressed as a fraction of gross sales, while items on the balance sheet are reported as total assets.
Thus, horizontal analysis focuses on the changes between multiple time intervals, while vertical analysis concentrates on the ratios between accounts within one period.
One red flag that can come up during horizontal analysis is if a company's expenses are increasing faster than its revenue. This could be a sign that the company is overspending and may not be able to sustain its current level of operations.
Vertical analysis can also reveal potential problems with a company’s financials. For example, if the ratio of debt to equity is increasing, it could be a sign that the company is taking on too much debt and may be unable to repay it.
Both horizontal and vertical analysis are essential tools for decoding financial statement manipulation. By looking at the big picture and the details, you can get a complete picture of a company’s financial health and identify any potential red flags.
Using Ratios for Financial Statement Analysis
When companies want to manipulate their financial statements, one of the ways they do it is by using ratios. Ratios can be used to make a company look better than it is or to hide existing problems.
For example, a company might want to increase its profits. One way to do this would be to reduce its expenses.
But if the company reports its expenses as a percentage of sales, then reducing expenses will also reduce the reported ratio. This makes the company look like it is doing better than it is.
Alternatively, a company may be trying to hide its losses by reporting them as a one-time event rather than an ongoing problem. This can be done by using ratios such as "earnings before interest and taxes" (EBIT) or "earnings before interest, taxes, depreciation, and amortization" (EBITDA). By excluding some of the costs involved in running the business, these ratios make the company appear to be doing better than it is.
If you're reading a financial statement and you see ratios being used, be sure to ask yourself why they are being used. It could be because the company is trying to hide something from you.
Lessons from examples
Many examples of companies have manipulated their financial statements to deceive investors and other stakeholders.
Enron is perhaps the most well-known example, but there are many others.
The following are some lessons that can be learned from these examples:
1. Companies can use creative accounting techniques to inflate their profits and make themselves look more successful than they are.
2. Sometimes, senior executives at a company may be aware of the financial manipulation taking place and may even be complicit in it.
3. Financial statement manipulation can have severe consequences for a company, including bankruptcy and criminal charges for those involved.
4. investors and other stakeholders need to be aware of the possibility of financial statement manipulation so that they can make informed decisions about whether or not to invest in a company.
Conclusion
Financial statement manipulation is a widespread practice in business that can damage a company's reputation and mislead investors.
Analyzing financial statements using techniques such as horizontal and vertical analysis and running ratios can help detect any such manipulation—professional analysts must be engaged in case of any doubts or red flags.
In addition to understanding how financial statement manipulation works, investors and stakeholders should be aware of the consequences of such practices and use proper judgement when assessing a company’s financial health.
Investors can better protect their investments and avoid costly mistakes by taking these steps.
