Creative accounting in financial statements

Being highly dependent on the financial statement to paint a picture of health for the company, we as investors should also be equally updated on what are some of the things creative accounting can do.

(These are summarized from the book, the intelligent investor by Benjamin Graham)

1. Special charges

Special charges are vague expenses the management can make, as long as they have a reason, for costs such as anticipated closing down of division or other future estimated cost. A company might be more tempted to occur them in years that the performance was well, in order to make bad years better (since the charges are already on the books).

2. Income tax benefits delay

A company can choose a bad year to show its delayed tax credits, thus boosting its result. I do not think this may be such a big issue in Singapore as our tax system is fairly straight forward, but I may be wrong.

3. Dilution factor

If everyone already expects the company to have a bad year, the company can choose to write off future loss. The effect to stock price would be contained and minimal, since everyone is already expecting it. When the loss is actually occurred, no further write off is needed.

4. Depreciation

A company can choose to depreciate its assets in a straight line or accelerated manner, subjected to certain conditions. By accelerating its depreciation, it might seem like the company is making less money, and more when it has finish depreciating the asset.

5. R&D cost

A company can choose to charge R&D as they occur, or amortize them over a few years. This can be a huge expense on a company that requires heavy R&D such as pharmaceuticals.

6. Value of inventory

Inventory can be valued based on first in, first out (FIFO) or first in, last out. While a company has to standardize its accounting system internally, it can be hard for investors to make comparison across the board.

All companies want to look good in front of their investors. The unseen pressure can force some companies to take up such creative accounting. These are just a few of the things that can be adjusted in a financial statement, and such changes are usually only visible if you look deep into the annual reports.

Luckily, most of the companies listed are generally honest and SGX has been getting more actively these years in response to querying the companies.

 

 

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