Chapter 2 Detecting Overstated Earnings

In this resume will explore techniques used by companies to overstate earning and
present some warning signs that may alert you to potential problems. In some cases, companies
will play games that do not overstate bottom-line earnings (net income) but overstate revenues or
some subtotal earnings such as gross margin or operating margin. What motivates a company to
overstate earnings? Because both investors and creditors are interested in the level of profits of a
company. The higher the earnings or profit, the more can be returned to investors and creditors
or invested for the future. If management want to make themselves look better to creditors or
investors, they may be motivated to play accounting games to make earnings appear better than
they actually are, especially if managers compensation is linked to earnings or share price. That
income statement game are aggressive revenue recognition, deferral of expenses, classification
of non-operating income or non-recurring income as revenue and Classification of operating
expenses as non-operating or special.

Aggressive Revenue Recognition

Aggressive revenue recognition is where company overstates revenues and earnings by reporting
revenue on the income statement earlier than the economics of the transaction or in some cases in
the absence of a true transaction-for example, fraudulent reporting of revenue. Generally,
revenue is recognized when the company has delivered goods or services to its customers, which
could be before or after cash is received. As a results, there is a timing difference between the
time when sales transactions are reflected on the income statement and the cash flow statement.
Some companies are more aggressive than others when they report revenues on the income
statement.

Understatement or Deferral of Expenses

Classification of Non-Operating Income

Classification of Non-Operating Expenses

Chapter 3 Detecting Overstated Financial Position

Excluding Both Assets and Liabilities

Understating assets also improves some financial ratios-most importantly return on
assets. Return on assets is a measure of profitability where a higher number is preferable to a
lower number. It is typically computed as net earnings divided by total assets. By understating
assets, the company’s return on assets will be higher. Let’s first address a legitimate way that
companies can get the benefits of the use of assets without having to show the asset and a
corresponding obligation (liability) on the balance sheet. The technique that companies use is
leasing. Currently, under both International Financial Reporting Standards (IFRS) and U.S.
Generally accepted accounting principles (GAAP), companies that engage in operating leases are
not required to put the corresponding asset or liability on the balance sheet.
By leasing the asset using an operating lease, the company gains use of asset without
reflecting it is a liability on the balance sheet. This is effectively an off-balance-sheet financing,
which results in better return on assets and debt-to-equity ratios versus what would be shown if
the asset had been purchased and financed. Even though this is permitted under accounting rules,
analysts should carefully consider the impact of leasing on the balance sheet and both techniques
(leases and sale of receivables) effectively involve off-balance-sheet financing of assets where
the obligation and asset are not recorded.

Other Off-Balance-Sheet Financing/Liabilities

A company may also try to understate liabilities without having an impact on assets. In
this case, in order for the accounting equation to balance, they would also need to overstate
owner’s equity. This could involve failing to record a liability that would also results in an
expense (overstating earnings and owner’s equity). The company might find a creative way of
borrowing funds but reflect these in the financial statements as revenue/earnings rather than as a
liability (also understating liabilities and overstating owner’s equity). A company may have also
footnotes if the liability is a contingent liability.
Overstating Assets
 This category can include overstating the value of an asset or reporting an asset that does not
exist. It might also involve a company’s overstating the value of “assets” that are not currently
reported on the balance sheet. The overall assets of a company are a function of the quantity of
assets controlled and he valuation of those assets. An overstatement can therefore involve
overstating the quantity of assets or overstating the valuation of those assets. Quantity is easier to
verify, so most accounting schemes involve the valuation of assets.
 Overstating Valuation of Assets on the Balance Sheet
In the past, assets were largely recorded at some measure of their adjusted cost-
typically at cost, and then adjusted over time for an estimate of the decline in value due to
use of the assets, called depreciation or amortization. Gains and loses from changes in
value are reported in the income statement unless they are related to securities held for
hedging or where the company has elected to report the gains and loses in other
comprehensive income (available only for equity investment not held for trading). Gains
and loses from changes in fair value over time are reflected in net income and retained
earnings.
 Overstating the Quantity of Assets on the Balance Sheet
Companies may try to overstate their overall assets by claiming to have more
assets than they do. This is particularly true for assets like inventory, where there may be
many items that may be hard to observe. Often, this is associated with an overstatement
of income by understating costs of goods sold. In the case of commodities, companies
may also overstate the value of their inventories, not to understate cost of goods sold, but
simply to appear as though they have more resources that can be used to generate future
revenues.
 Overstating Off-Balance-Sheet Assets
The company may be able to defer expenses by overstating these reserves. Many
expenditures related to discovery and production of these resources are capitalized and
amortized over the productive capacity/quantity of reserves. Different countries have
different conventions about how exploration expenses may be expensed or capitalized.