Manipulation and Analysis of Financial Statements

The world of financial statements isn't always what it seems. Companies manipulate financial statements to mislead investors and shareholders.

Financial statement analysis is an umbrella term for tools used to detect manipulation. These include horizontal analysis, vertical analysis, and ratio analysis.

Using this deceptive tactic, companies manipulate information and numbers to make their performance appear better than it is.

What is financial statement analysis?

Financial statement analysis aims to uncover potential issues in a company's financial statements by examining its 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 provides information that can help assess a company's financial health.

• An income statement can show trends, such as increasing or decreasing sales. It can also provide valuable insight into the company's pricing strategy and margins.

• An asset and liability balance sheet provides information about a company's assets and liabilities. 

• In addition to showing how much debt a company carries, it can also reveal whether it can repay its obligations. This can help assess liquidity and solvency risks.

An organisation's cash flow statement shows how much cash it brings in and uses 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, recognises 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 expense recognition, 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. This can happen through improper asset valuation, creating fictitious assets, or failing 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 you need to be careful not to take the numbers at face value and instead look for red flags that may indicate manipulation.

Next, remember that businesses report financial information on an accrual basis, meaning revenue is recognised when earned, not when it is received.

This can sometimes create a discrepancy between the cash flow and income statements. As such, understanding how accrual accounting works is essential to interpret financial statements correctly.

Finally, remember that financial statements provide historical information and should serve as a starting point for your analysis, not the sole source of information.

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.

Horizontal analysis compares financial information over a sequence of reporting periods, whereas vertical analysis is a proportional approach that expresses each item 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 a percentage of total assets.

Thus, horizontal analysis focuses on changes across multiple time intervals, while vertical analysis concentrates on ratios within one period.

One red flag in horizontal analysis is when a company's expenses increase faster than its revenue. This could signal 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 debt-to-equity ratio is increasing, it could signal 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 way they do it is by using ratios. Ratios can make a company look better than it is or 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 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 best-known example, but many others exist.

The following are some lessons that can be learned from these examples:

• Companies can use creative accounting techniques to inflate their profits and make themselves look more successful than they are.

• Sometimes, senior executives may be aware of the financial manipulation and even be complicit in it.

• Financial statement manipulation can have severe consequences for a company, including bankruptcy and criminal charges for those involved.

• Investors and other stakeholders need to be aware of the possibility of financial statement manipulation so they can make informed decisions about whether to invest in a company.

Conclusion

Financial statement manipulation is a widespread business practice that can damage a company's reputation and mislead investors.

Analysing financial statements using techniques such as horizontal and vertical analysis and ratios can help detect such manipulation—professional analysts should be engaged if there are doubts or red flags.

Beyond understanding how financial statement manipulation works, investors and stakeholders should know the consequences of such practices and use sound judgement when assessing a company’s financial health.

By taking these steps, investors can better protect their investments and avoid costly mistakes.