How to spot accounting gimmickry: R&D expensing

How to spot accounting gimmickry: R&D Expensing

We all know how valuable an intangible asset to a company like patents, trademark, and copyrights so there must be some way to truthfully report them in the balance sheet. It would have been easy to do this if your company bought an intangible asset from another company wherein you can have solid and concrete numbers to start your basis in a balance sheet. Unfortunately as is often the case, the intangible asset is oftentimes developed internally instead of being purchased from another company.

The expenses that arose from the creation of these valuable intangibles like patents for a new drug are hard to ascertain because the expenses related to this have already been expensed and future benefits from this intangible asset are almost impossible to quantify. Because of this the recorded amount in the balance sheet for the value of the intangible asset is decidedly far below than its actual value.

The FASB has decided to expense all R&D even if this will cause an obvious distortion of the financial picture that the balance sheet will show. Their reason is firstly, future benefits from this R&D cost are very uncertain since it might turn out to be a flop after all. Second, there is no solid evidence in terms of hard numbers that there is a relationship between R&D expenses and future income. Lastly, if ever the research proves to create a valuable intangible asset, the amount of gain from this can not be measured in fixed numbers, or in any logical manner.

You might ask after all this background on why it can’t be recorded in predictable figures how to manipulate the earnings and other balance sheet ratios crucial for analysis. It is quite simple; the management would simply have to cut-back on their expenses in R&D and most possibly in advertising too thus creating an artificial rise in their earnings. While this may look good for the bottom line in a short term focus, this will undoubtedly be detrimental to the business in the long term because sooner or later competitors will come up with new and innovative products and steal your company’s market share. This might benefit the management who are simply concerned with their paychecks and bonuses which they don’t deserve but will ruin the poor investor who is unwary of the possible aggressive accounting gimmicks engaged by unscrupulous executives.

Therefore, even if you know that the real value of an intangible asset is not fully reflected in the balance sheet, you can appreciate the value that good management creates by continually pouring resources to create value that customers will seek and make the investor the happy sums he deserves.

  

How to spot accounting gimmickry: write-offs of receivables

How to spot accounting gimmickry: Write-offs of receivables

Author: Y. Woo

Receivables are defined as the amount owed to the company by other business entity whether it’s individual or corporate. Some receivables coming from credit sales never get collected that’s why they are such a painful thing for any entrepreneur to deal with. Also, receivables can be used to borrow as collateral, thus creating further ambiguities for any potential investor and any financial statement reader in determining whether the receivable is indeed a sale or a loan.

You might ask why companies engage in selling their receivables; this is because some companies prefer not to wait for customers to pay because they are under pressure to produce a profit so that they can use it for their daily operations. That is why they might opt to sell their receivables to a bank or a financing company.

The thing that complicates this is that sometimes companies mistakenly treat a sale as borrowing and vice versa.

Usually the condition wherein the transaction of the receivable ownership used are clear as to what it is, whether it was an actual sale or used as a collateral for a loan. Thus, the FASB has created a standard basis on how to determine its classification. They defined a real sale as transferring the control over the receivables to the new owner. However if this condition is not met, then the transaction is considered as a collateralized borrowing.

A good example of this is the banks usual practice of transferring a group of mortgages they consider to be receivables to other business organization but retains the right to service the mortgages, like collecting the mortgage payments.

As an investor there are two serious implications this thing has in store for you. This is one of the signs how to spot accounting gimmickry.

First, if the transaction is actually a borrowing but for some reason treated as sale, then both asset and liabilities are understated. Even finance analysts would have a distorted picture of the company’s financial situation since ratios like debt to equity and ROA are also seriously warped by the understatements. If the unscrupulous executive plans to hide a loss, they can just mislabel the receivable as sale and not as actual debt.

Lastly, if the deal was actually a sale and was erroneously treated as borrowing then you wouldn’t see a gain or loss effect in the balance sheet in effect seriously misrepresenting the company’s net assets. That’s why when you see a receivable as a write-off, this should give you an early warning sign.

How to spot accounting gimmickry: LIFO liquidation

How to detect accounting gimmickry: LIFO liquidation

Management can exploit the LIFO accounting structure to artificially inflate their earnings by liquidating old LIFO layers. This is because the older and presumably lower costs in the LIFO layers are matched against sales amount that are stated at higher current prices. This results in an artificial rise in the profit margin. Below is an example of how it happens exactly.

Company XYZ had the following years in its LIFO inventory of at January 1, 2006,

At which time the cost of the inventory was $700 per unit.

Year LIFO                          Unit        Total           LIFO Reserve

Layer Added      Units       Cost                            as of 1/1/06

2003                     10           $400      $4000        ($700-400) x 10 = $ 3000

2004                     20             500      10000        ($700-500) x 20 = $ 4000

2005                     30             600      18000        ($700-600) x 30 = $ 3000

                             60                        $32000                                     $10000

  

Company XYZ sets its selling price by adding a $300 per unit markup to replacement cost at the time of sale. As of January 1, 2006 the replacement cost was $700; this cost level remained the same throughout 2006. During 2006 the company purchased 50 units at a cost of $700 per unit, and it sold 90 units at a price of $1000 per unit. Pre-tax LIFO income for 2006 is:

Sales revenue, 90 @ $1000                                                         $90,000

Cost of goods sold:

  2006 purchases, 50 @ $700        $35,000

  2005 purchases, 30 @ $600          18,000

  2004 purchases, 10 @ $500           5,000                                     58,000

LIFO Gross margin                                                                       $32,000

Because the number of units sold (90) exceeded the number of units purchased in 2006 which is 50, the company was forced to liquidate its entire 2005 LIFO layer (30 in this case) and 10 units from its 2004 layer. If this happens, the matching advantages of LIFO in income statements will not take effect. As you can see, there is a mismatching that occurs since the reported LIFO margin is $32,000 / 90 = 355.56. This obviously overstates the true current cost operating margin of $300 per unit as stated previously. The excess $155.56 dollars in overstatement of the margin results because the cost of 2005 and 2004 inventories are being paired with the 2006 revenues.

In short, the $355.56 reported LIFO margin overstates the real margin used for pricing purposes which is $ 300 in this case. This increase is what any finance auditor would tag as unsustainable and misleading earnings number. It was just the result of an increase in inventory prices over time.

    

Let’s see the 2006 current cost operating margin:

Sales revenue 90 x 1000                                              $90,000

Replacement cost of goods sold 90 x 700                  63,000

Current cost operating margin    90 x 300                   27,000

  

The 2006 LIFO income of $32,000 exceeds the 2006 current cost margin of $27,000. The excess $5,000 dollars is the result of the mismatching as I have explained. This is an example how LIFO dipping can be used for accounting gimmickry.

Loopholes in management compensation plans

Loopholes in management compensation plans

If you’re part of the board of directors that determine the salary of the management team of your company, then maybe you should be aware of possible loopholes that executives can manipulate just to achieve undeserved compensation. With these loopholes, they can attain financial bonuses for performance that they haven’t actually achieved. This knowledge would be very helpful to you if you are a descendant of the founder of the corporation that employs this easy-to-manipulate incentive scheme or even if you are a small business owner you would still be wise to understand this little bit of finance topic.

First, let’s take a look at how executives are paid in a usual corporate setting.

Executives are paid in three packages usually in three forms namely, base salary, annual incentive and a long-term incentive. The base salary is obviously a fixed amount of salary dictated by the usual rate within the specific industry and the depth of the executives experience and skill. Second of this is the annual incentives wherein the performance of the executive is deemed to be tied up to their performance by giving them a bonus amount of money if they meet certain goals like a 10 percent increase in sales and so on. This is done to make sure that the executive is pushed to achieve the desired short term goal of the company. Third is the long term incentive usually in the form of stocks wherein the management team is rewarded for long-term performance.

So you ask me how we can manipulate the bonus incentives illegally.

It’s quite simple. If the committee just sets a specified bonus money to reach a certain level of sale, (can be any number) the management can simply go on acquisition spree or invest in a new venture, this will have the desired effect of creating more earnings per share and the usual metrics like sales volume. Notice that an increase in sales volume does not necessarily mean better performance by the management. The report would look like you have an increase in performance but in reality you don’t because increases in metrics like these is not compared to its possible downside like the sales increasing with the account receivable since the sales on credit is not a good sign for any business owner. In short, this does not create value for the poor ignorant shareholder.

If you are the business owner, you wouldn’t want an increase in sales just to wait for eternity to get customers to pay.

A nice way of doing this illegally and unobtrusively would be to manipulate the ROA. Since the computation is return divided by the asset amount, the resulting depreciation of the asset amount would make the calculation look like it has an increase in the ROA figure.

Great scam huh??  Also, inflation would exacerbate the problem and those without this knowledge can easily be duped by the “supposedly” great ROA figure. If you are the shareholder, I’m sure you wouldn’t want paying your managers for performance that they have no actual contribution into.

Also, if the option plan ties the bonus to metrics like the earnings per share of a stock, say, once the number goes beyond 10 dollars per share then the bonus program is activated. You might be surprised at how negative this can have an effect to your business.

In case of a favorable condition, the executive will be inclined to defer inventories in the fourth quarter to reduce the earnings per share amount. They do this because the incentive program doesn’t give them an extra bonus if they go beyond the limit for the current year. Why show an overly impressive performance when you can have your bonus at the exact number that your earnings per share shows, save it for the next year if the market condition will reverse so that you can always hit the bonus target no matter what the economic condition will be.

 This is the case if the executive believes the company will have a good time in the current economic condition. Thus they are actually saving the extra points when the business condition will be unfavorable.

If the market condition is unfavorable, the executive can simply just do the senseless asset acquisition spree described above. This is quite a nasty event wherein the executive pushes up the earnings number in unfavorable times and deliberately pushes down the earnings number in favorable times. It’s good for them, but it’s not good of you are the grandson of the deceased founder of the company.

In short, the executive will tone down the earnings if the conditions are good and still get their bonus, on the other hand if the market conditions are unfavorable, they will use the deferred increase in earnings plus an increase in asset acquisition.