Cooking the Books: Techniques to Puff Up the Income Statement

A.  Improperly increased revenue
B.  Improperly lowered cost or expenses.

A.  Improperly increased revenue

A1.  Sales recorded before completed and final

• A1a.  Goods shipped before sale final
• A1b.  Revenue recorded while future services still due

A2.  Bogus revenue recorded

• A2a.  Supplier refunds recorded as revenue
• A2b.  Revenue recorded from self-dealing
• A2c.  Revenue recorded from asset exchanges.

B.  Improperly lowered costs or expenses

B1.  Current expenses shifted into later periods

• B1a.  Period expenses capitalised onto Balance Sheet
• B1b.  Assets depreciated too slowly.
• B1c.  Probable liabilities not accrued.

B2.  Operating losses masked in discontinued operations

"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.

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• Related:
• Cooking the Books: Why do managers cook the books?
• Cooking the Books: This is very different from "Creative Accounting"
• Cooking the Books: Puffing up the Income Statement
• Cooking the Books: Techniques to Puff Up the Income Statement
• Cooking the Books: Sweetening the Balance Sheet
• Cooking the Books: Techniques to Sweeten the Balance Sheet
• Cooking the Books: The Auditor's Job
• Cooking the Books: Investors, be warned.

Investing In A Bear Market

Investing In A Bear Market

We are in the 6th inning of the residential RE crisis and the 1st inning of the commercial RE crisis. Most of you are trapped in normalized bull market valuation methods (Income Statements and Cash Flow statements) which states "earnings growth and cashflow" are what you should follow. In a bear market you should be focused on the (Balance Sheets and Cash Flow Statements). Notice the switch from income statement to balance sheet. Read some of my first few blogs and you will see before the residential RE crisis started in mass I was focused only on balance sheet items (cash and debt). I was right and the worst balance sheet stocks got killed not the ones with the biggest losses.

If you actually look at how I ranked builder stocks using cash and debt and applied it to other industries you would see the same result. Why? When a bear economy is upon us credit markets tighten, loans do not get renewed, cash flow turns negative, borrowing costs go up, interest burden becomes magnified, asset prices drop, etc.....

Wall Street can't value stocks as easily when the future is uncertain and earnings go negative or are falling. Bear markets are about surviving and the companies that thrive DURING AND AFTER a bear market are the ones with the best balance sheets buying assets on the cheap. They are also the companies that have the cash to continue to invest in future product while their competitors are trying to stay alive vs. thinking and investing in future operational profit.

Be like the best companies. Stop listening to doom and gloomers, raise cash, invest in yourself, work twice as hard, stay focused and push forward doing whatever you have to in order to make money. Invest it wisely. You may not make as much today, but deflation pushed all your consumer good prices down too. Everything is on sale even at the Chicken Ranch.

http://kolkalamar.blogspot.com/2010/01/investing-in-bear-market.html

The Market Price-to-Book and Intrinsic Price-to-Book Ratio

The balance sheet equation corresponds to the value equation. 

 

The value equation can be written as:

 

Value of the firm = Value of equity + Value of debt
or
Value of equity = Value of firm - Value of debt

 

• The value of the firm is the value of the firm's assets and its investments.
•  The value of the debt is the value of the liability claims.

 

The value equation and the balance sheet equation are of the same form but differ in how the assets, liabilities, and equity are measured.

 

The measure of stockholders' equity on the balance sheet,l the book value of equity, typically does not give the intrinsic value of what the equity is worth. 

• Correspondingly, the net assets are not measured at their values. 
• If they were, there would be no analysis to do!  It is because the accountant does not, or cannot, calculate the intrinsic value that fundamental analysis is required.

The diffeence between the intrinsic value of equity and its book value is called the intrinsic premium:

 

Intrinsic premium = Intrinsic value of equity - Book value of equity

 

The difference between the market price of equity and its book value is called the market premium:

 

Market premium = Market price of equity - Book value of equity

 

If these premiums are negative, they are called discounts (from book value).  Premiums sometimes are referred to as unrecorded goodwill because someone purchasing the firm at a price greater than book value could record the premium paid as an asset, purchased goodwill, on the balance sheet; without a purchase of the firm, the premium is unrecorded.

 

Premiums can be calculated for the total equity or on a per-share basis.

 

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Example:
Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

 

Comments: 
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

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The ratio of market price to book value is the price-to-book ratio or the market-to-book ratio.

 

The ratio of intrinsic value to book value is the intrinsic price-to-book ratio. 

 

• Investors talk of buying a firm for a number of times book value, referring to the P/B ratio. 
• The market P/B ratio is the multiple of book value at the current market price. 
• The intrinsic P/B ratio is the multiple of book value that the equation is worth. 
• An investor will spend considerable time estimating intrinsic price-to-book ratios and asking if those intrinsic ratios indicate the the market P/B is mispriced.

Historical Perspective of P/B ratios

 

In asking such questions, it is important to have a sense of history so that any calculation can be judged against what was normal in the past.  The history provides a benchmark for our analysis.  

• P/B ratios in the 1990s were high relative to historical averages, indicating that the stock market was overvalued.  
• The medican P/B ratios (the 50th percentile) for the U.S. listed firms were indeed high in the 1990s - over 2.0 - relative to the 1970s. 
• But they were around 2.0 in the 1960s. 
• The 1970s experienced exceptionally low P/B ratios, with medians below 1.0 in some years.

 

What causes the variation in ratios? 

• Is it due to mispricing in the stock market?
• Is it due to the way accountants calculate book values?

 

The low P/B ratios in the 1970s certainly preceded a long bull market.

• Could this bull market have been forecast in 1974 by an analysis of intrinsic P/B ratios?
• Were market P/B ratios in 1974 too low? 
• Would an analysis of intrinsic P/B ratios in the 1990s find that they were too high?

 

Company A's P/B of 11.0 in 2008 looks high relative to historical averages.

• Was it too high?

 

The fundamental investor sees himself as providing answers to these questions.  He estimates the intrinsic value of equity that is not recorded on the balance sheet. 

 

You can screen for firms with particular levels of P/B ratios using stock screener from links on the Web.

Reading The Balance Sheet

As you can see from the balance sheet above, it is broken into two sides. Assets are on the left side and the right side contains the company’s liabilities and shareholders’ equity. It is also clear that this balance sheet is in balance where the value of the assets equals the combined value of the liabilities and shareholders’ equity.

Another interesting aspect of the balance sheet is how it is organized. The assets and liabilities sections of the balance sheet are organized by how current the account is. So for the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations.

Analyze the Balance Sheet With Ratios
With a greater understanding of the balance sheet and how it is constructed, we can look now at some techniques used to analyze the information contained within the balance sheet. The main way this is done is through financial ratio analysis.

Financial ratio analysis uses formulas to gain insight into the company and its operations. For the balance sheet, using financial ratios (like the debt-to-equity ratio) can show you a better idea of the company’s financial condition along with its operational efficiency. It is important to note that some ratios will need information from more than one financial statement, such as from the balance sheet and the income statement.

The main types of ratios that use information from the balance sheet are financial strength ratios and activity ratios.

• Financial strength ratios, such as the working capital and debt-to-equity ratios, provide information on how well the company can meet its obligations and how they are leveraged. This can give investors an idea of how financially stable the company is and how the company finances itself.
• Activity ratios focus mainly on current accounts to show how well the company manages its operating cycle (which include receivables, inventory and payables). These ratios can provide insight into the company's operational efficiency.

There are a wide range of individual financial ratios that investors use to learn more about a company. (To learn more about ratios and how to use them, see our Ratio Tutorial.)

Conclusion
The balance sheet, along with the income and cash flow statements, is an important tool for investors to gain insight into a company and its operations. The balance sheet is a snapshot at a single point in time of the company’s accounts - covering its assets, liabilities and shareholders’ equity. The purpose of the balance sheet is to give users an idea of the company’s financial position along with displaying what the company owns and owes. It is important that all investors know how to use, analyze and read this document.

by Investopedia Staff, (Contact Author | Biography)

http://www.investopedia.com/articles/04/031004.asp

Reading The Balance Sheet

Reading The Balance Sheet
by Investopedia Staff, (Investopedia.com) (Contact Author | Biography)

A balance sheet, also known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth). The balance sheet, together with the income statement and cash flow statement, make up the cornerstone of any company's financial statements. If you are a shareholder of a company, it is important that you understand how the balance sheet is structured, how to analyze it and how to read it.

How the Balance Sheet Works
The balance sheet is divided into two parts that, based on the following equation, must equal each other, or balance each other out. The main formula behind balance sheets is:

Assets = Liabilities + Shareholders' Equity

To learn more, check out our balance sheet video:



This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.

It is important to note that a balance sheet is a snapshot of the company’s financial position at a single point in time.


Know the Types of Assets


Current Assets
Current assets have a life span of one year or less, meaning they can be converted easily into cash. Such assets classes include cash and cash equivalents, accounts receivable and inventory. Cash, the most fundamental of current assets, also includes non-restricted bank accounts and checks. Cash equivalents are very safe assets that can be readily converted into cash; U.S. Treasuries are one such example. Accounts receivables consist of the short-term obligations owed to the company by its clients. Companies often sell products or services to customers on credit; these obligations are held in the current assets account until they are paid off by the clients. Lastly, inventory represents the raw materials, work-in-progress goods and the company’s finished goods. Depending on the company, the exact makeup of the inventory account will differ. For example, a manufacturing firm will carry a large amount of raw materials, while a retail firm caries none. The makeup of a retailer's inventory typically consists of goods purchased from manufacturers and wholesalers.


Non-Current Assets
Non-current assets are assets that are not turned into cash easily, are expected to be turned into cash within a year and/or have a life-span of more than a year. They can refer to tangible assets such as machinery, computers, buildings and land. Non-current assets also can be intangible assets, such as goodwill, patents or copyright. While these assets are not physical in nature, they are often the resources that can make or break a company - the value of a brand name, for instance, should not be underestimated.

Depreciation is calculated and deducted from most of these assets, which represents the economic cost of the asset over its useful life.

Learn the Different Liabilities
On the other side of the balance sheet are the liabilities. These are the financial obligations a company owes to outside parties. Like assets, they can be both current and long-term. Long-term liabilities are debts and other non-debt financial obligations, which are due after a period of at least one year from the date of the balance sheet. Current liabilities are the company’s liabilities which will come due, or must be paid, within one year. This is includes both shorter term borrowings, such as accounts payables, along with the current portion of longer term borrowing, such as the latest interest payment on a 10-year loan.

Shareholders' Equity
Shareholders' equity is the initial amount of money invested into a business. If, at the end of the fiscal year, a company decides to reinvest its net earnings into the company (after taxes), these retained earnings will be transferred from the income statement onto the balance sheet into the shareholder’s equity account. This account represents a company's total net worth. In order for the balance sheet to balance, total assets on one side have to equal total liabilities plus shareholders' equity on the other.


http://www.investopedia.com/articles/04/031004.asp

How are a company's financial statements connected?

How are a company's financial statements connected?

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When you do research on different companies by looking at their annual reports, you will typically come across two separate financial statements: the balance sheet and the income statement (also known as the statement of profit and loss). These two statements are very significant for companies as they can be used to describe the company's health and effectiveness of management.

Balance Sheet - B/S
The balance sheet gives investors a general overview of a company's financial situation. That is, it tells investors exactly what a company owns (assets) and who it owes (liabilities).

Assets and liabilities are listed in order of liquidity (relative ease of convertibility to cash), from most liquid to least liquid. Assets appear on the left hand side of the balance sheet and liabilities on the right hand side. For simplicity's sake, think of a B/S as an indicator of net worth: that is, how much a company is worth "on the books."

Income Statement – I/S
The income statement tells investors about the company's profits and losses for a specific time period. Expenses are subtracted from income to determine a firm's profit or loss. Unlike the B/S, the I/S doesn't look at the company's financial health (total net worth). Instead, it looks at how much revenue a company is able to create. If you were to think of the B/S as an indicator of net worth, you can think of the I/S as a company's profitability: that is, how much it can make in a given time frame.

These two statements are intertwined and should be looked at by all people who are considering investing their hard earned money in a particular company. You should look at a company's B/S to see exactly how much it is worth (remember, this is a book value representation rather than market capitalization), and look at the I/S to see how profitable the company is. Obviously, if it has a negative net worth (its liabilities are greater than its assets) or if it has a negative income, then the company might not be the best place to invest your money.


http://www.investopedia.com/ask/answers/03/061603.asp

The Importance of Earnings

Business and economic activity are undertaken with the idea of generating a profit.

Profit is simply the gross revenue of an enterprise, minus the cost of producing that income, over a defined period of time. For businesses, it's important to measure the profit and allocate capital resources in such a way as to maximise it.

It is the earnings that make the world go round.

So much is made of earnings and earnings reports. Do you hear much about a company's cash balance, accumulated depreciation, or owner's equity during CNBC and other financial shows?

Does everyone salivate four times a year for "asset season?"

No, but there's a definite "earnings season" at the end of each calendar quarter, giving financial analysts, journalists, and pundits plenty to talk about.

On an ongoing basis, earnings are the driving force and "macro" indicator of a company's success.

• If earnings are growing, the financial press doesn't worry much about the other stuff.
• Conversely, serve up a couple of double faults on the earnings front, and everybody is all over asset impairment, write-offs, debt, weak cash positions, and the other similar "disasters."

In the purest sense, long-term stock price appreciation is based on the growth of a company's asset base and owner's equity in that base. Ultimately, that comes from earnings.

If a company is earning money, and particularly if it earns it at a growing rate, that's a good thing. As Warren Buffett says, "If the business does well, the stock always follows."

Earnings tell us how well a business manages its operations, while the balance sheet tells us how well it manages its resources.

Reading a Balance Sheet

Reading a Balance Sheet

A balance sheet will tell us something about the financial strength of a business on the day that the balance sheet is drawn up.

This action list gives an overview of a balance sheet and looks at a brief selection of the more interesting figures that help with interpretation. It is important to remember that a lot of these figures do not tell you that much in isolation; it is in trend analysis or comparisons between businesses that they talk more lucidly.

What is a balance sheet?

A balance sheet is an accountant's view, the book value of the assets and liabilities of a business at a specific date and on that date alone. By balancing the assets and liabilities and showing how the balance lies, it gives us an idea of the financial health of the business.

What does a balance sheet not do?

A balance sheet is not designed to represent market value of the business. For example, property in the balance asset may be worth a lot more than its book value. Plant and machinery is shown at cost less depreciation, but that may well be different from market value. Stock may turn out to be worth less than its balance sheet value, and so on.

Also, there may be hidden assets, such as goodwill or valuable brands, that do not appear on the balance sheet at all. These would all enhance the value of the business in a sale situation, yet are invisible on a normal balance sheet.

Learn to interpret the balance sheet

Note that the balance sheets differ between one industy and another as regards the range and type of assets and liabilities that exist. For example, a retailer will have little in the way of trade debtors because it sells for cash, while a manufacturer is likely to have a far larger investment in plant than a service business like an advertising agency. So the interpretation must be seen in the light of the actual trade of the business.

Reading a balance sheet can be quite subjective - accountancy is an art, not a science and, although the method of producing a balance sheet is standardized, there may be some items in it that are subjective rather than factual. The way people interprete some of the figures will also vary, depending on what they wish to achieve and how they see certain things as being good or bad.

Look first at the net assets/shareholders' funds

Positive or negative? Positive is good.

If it had negative assets (same thing as net liabilities, this might mean that the business is heading for difficulty unless it is being supported by some party such as a parent company, bank, or other investor. When reading a balance sheet with negative assets, consider where the support will be coming from.

Then examine net current assets

Positive or negative? Positive net current assets (NCA) mean that, theoretically, it should not have any trouble settling short-term liabilities because it has more than enough current assets to do so. Negative net current assets suggest that there possibly could be a problem in settling short-term liabilities.

You can also look at NCA as a ratio of current assets/current liabilities. Here, a figure over one is equivalent to the NCA having a positive absolute figure. The ratio version is more useful in analysing trends of balance sheets over successive periods or comparing two businesses.

A cut-down version of NCA considers only (debtors + cash)/(creditors) thus excluding stock (Quick Ratio). The reasoning here is that this looks at the most liquid of the net current asset constituents. Again a figure over one is the most desirable. This is also a ratio that is more meaningful in trends or comparisons.

Understand the significance of trade debtor payments...

Within current assets, we have trade debtors. It can be useful to consider how many days' worth of sales are tied up in debtors - given by (debtors x 365)/annual sales. This provides an idea of how long the company is waiting to get paid. Too long and it might be something requiring investigation. However, this figure can be misleading where sales do not take place evenly throughout the year. A construction company might be an example of such a business: one big debtor incurred near the year end would skew the ratio.

...and trade creditor payments.

Similar to the above, this looks at (trade creditors x 365)/annual purchases, indicating how long the company is taking in general to pay its suppliers. This is not so easy to calculate, because the purchases for this purpose include not only goods for resale but all the overheads as well.


Recognise what debt means

Important to most businesses, this figure is the total of long and short-term loans. Too much debt might indicate that the company would have trouble, in a downturn, in paying the interest. It's difficult to give an optimum level of debt because there are so many different situations, depending on a huge range of circumstances.

Often, instead of an absolute figure, debt is expressed as a percentage of shareholder's funds and known as 'gearing' or 'leverage'. In a public company, gearing of 100% might be considered pretty high, whereas debt of under 30% may be seen as on the low side.

COMMON MISTAKES

Believing that balance sheet figures represent market value

Don't assume that a balance sheet is a valuation of the business. Its primary purpose is that it forms part of the range of accounting reports used for measuring business performance - along with the other common financial reports like profit and loss accounts and cash-flow statements. Management, shareholders, and others such as banks will use the entire range to assess the health of the business.

Forgetting that the balance sheet is valid only for the date at which it is produced

A short while after a balance sheet is produced, things could be quite different. In practice there frequently may not be any radical changes between the date of the balance sheet and the date when it is being read, but it is entirely possible that something could have happended to the business that would not show. For example, a major debtor could have defaulted unexpectedly. So remember that balance sheet figures are valid only as at the date shown, and are not a permanent picture of the business.

Confusion over whether in fact all assets and liabilities are shown in the balance sheet

Some businesses may have hidden assets, as suggested above. This could be the value of certain brands or trademarks, for example, for which money may not have ever been paid. Yet these could be worth a great deal. Conversely, there may be some substantial legal action pending which could cost the company a lot, yet is not shown fully in the balance sheet.


Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)