Methods of falsifying financial statements of companies (cost reduction)
Good financial performance of a company is not a reason to immediately buy up its shares. It is possible that they are artificially inflated. What for? You will read about this in the previous part of the review. In this part, we continue to look at methods of falsifying accounts by reducing costs.
Falsification of reporting by reducing costs. Profit lowering methods
- Concealment of expenses… Accounting is interesting in that the same figure in different articles affects the final result in different ways – the financial one. To reduce costs, some of the transactions can be conducted through linked structures. Or even simpler – the costs are attributed to accounts receivable, which, by “coincidence” at the right time, may be overdue and irrecoverable.
- WorldCom increased revenue by $ 3.8 billion in 2001-2002 by simply not recognizing its costs. How they were veiled in the balance sheet due to capital flows is another story.
The technique of understating costs when reporting falsification is most often used in long-term projects. Reason: Expenses are volatile and variable and may be posted in different periods. When a project is phased, an estimate of the percentage of work completed is required. The higher the percentage, the more profit can be “drawn” in the reporting, especially when the prepayment has already been received. This model was used by the 3Net System, which overestimated the percentage of readiness of a software development project. It is logical that the smallest amount of profit will fall out for the last period. But who thinks about it when the result is needed now?
- Profit reduction methods… The main goal here is to minimize the tax base. Considering the risk, this technique is used more often by small companies, while large ones, on the contrary, overestimate the financial result.
3.1. Overstating costs… Conclusion of fictitious contracts with overpriced services. For example, overpriced property rentals, overpriced payments for goods, etc.
3.2. Understatement of revenue… Provision of services without a contract with cash payment, settlements without the participation of a bank current account, etc.
Both of these options are in violation of the law in almost all countries of the world. Legal ways of understating profits in Russia include covering past losses and leasing. If you buy fixed assets with 100% payment and putting on the balance. Then only depreciation will be taken into account in expenses. In case of leasing, the entire amount under the contract is included in the expenses.
The company prepares text transcripts of balance sheet items for full financial statements, which can also be formulated in two ways. Falsification of reporting can be neatly disguised. For instance:
- During the reporting period, there are many lawsuits – either there is an overstatement of receivables, or customers are unhappy with the product / service.
- Third party guarantees and sureties – the company has associated structures through which it can conduct fictitious transactions.
- Most transactions with related entities – there is a possibility of misstatement of certain items of the reporting.
- Lack of information about accounting policies – there is a possibility of legal falsification of statements. For example, different methods of valuation and revaluation of fixed assets can radically affect the final financial result (profit or loss).
In 2005 a pharmaceutical company After an audit, Elan was forced to admit that commissions and royalties were included in revenue for several reporting periods. This was in line with accounting policies, but inflated revenue. Since the accounting policies were not disclosed, investors thought that revenue growth was related to sales growth.
Report falsification tool – fictitious contracts and financial transactions. If sometimes even the audit does not notice them, then it is even more difficult for investors to determine the fact of fraud.
If you are going to invest in companies of the 2nd and 3rd tier – pay attention to the following points:
- Unnatural growth in revenue compared to similar companies in the same industry, not supported by arguments.
- Growth in revenue without growth in cash receipts.
- A sharp unreasoned increase in accounts receivable, the value of fixed assets, etc.
Such changes are not always indicative of falsified reporting. But it still makes sense to pay attention to them. If you have any questions, ask in the comments!