Deferral Of Financial Statement Release -Things An Investor Should Watch Out For

Deferment of release of a financial statement is a strong indication that something is wrong with a company. There are two strong possibilities; either something is wrong with the accounting setup of the company and the company is trying to fix the same to arrive at a clearer picture, or it is deliberately trying to window dress its books so that investors may be made to believe that the company is performing satisfactorily. The Financial Conduct Authority (FCA) of the United Kingdom had allowed listed companies in the country to delay their financial reporting by anywhere between four months and six months from the financial year-end on account of lockdown conditions prevailing in the country due to the coronavirus pandemic. Dwelling on the reasons for the decision, the authority sighted the decreased manpower in the accounting profession in the country at the moment, which would be hard-pressed to deliver outside of its time and capacity constraints. Investors should, however, beware of the fact that some companies may use this opportunity to deliberately engage in some accounting manipulation so that they may hide the true financial position of the company from the investors and regulatory authorities. Today, we look at five such factors investors should look out for when the companies come out with their financial statements to make sure that those exhibit the materially correct financial position of the company.

1. Fast-tracking revenues – one of the most common enticements of the management of the company is to report higher revenue numbers so that it would appear to be performing well. There are several ways a company may do that. One way is to show advance payments as revenues when goods or services are to be delivered in a future financial period. Another method is to record revenues of multiple periods as revenues of a single period. For example, a company may receive a shipbuilding contract which is to be executed over four years. It is for the shipbuilder to recognize the revenue over four years. Should the company somehow receive some advance payment for the project and recognize it before the year it is due it would amount to window dressing.
2. Similarly, a company may dispatch a large order to a distributor at the end of a year or a quarter and show it as a sale. Since a distributor is not a customer, unless he sells it to a customer, it cannot be recognized as a sale in the books of a company. There are several other such tactics adopted by unscrupulous companies to appease shareholders and ensure that the stocks of such companies perform better on the stock exchange despite a materially weaker revenue position.

3. Delaying and capitalizing revenue expenditure – It is also a common practice to show a reduced expenditure in a year so that profits may be inflated so that a rosy picture may be painted. It may so happen that a company might ask a vendor for allowing a delay in payment, to be made in a subsequent financial period. This will have the effect of higher revenues and higher profitability being shown in the books of the company. Other than that, some companies also adopt the practice of capitalizing certain revenue expenditures which should be recognized in a year to be amortized over multiple years. This is also a mischievous practice as it gives a wrong material picture of the company. In accounting, the correct practice is to charge the revenue expenditure of a period to that period only. Delayed actual payment should not have any material impact on how it is presented in the books of accounts. There have been instances when companies have tried to capitalize heavy marketing expenditures incurred during the launch of a product to be amortized over a period. Taxation and reporting authorities have taken a negative view on this have on several occasions and have reprimanded companies for doing this.
4. Extraordinary non-operating income – Sometimes if in a particular year a company has not performed well, in that year it might engage in some non-operating transaction, i.e. a transaction not related to the core business of the enterprise. This may be done to represent that the company has been executing its business profitably. For example, the company might be holding property in a prominent place in a city, and due to poor financial performance in a year, it might sell that property in that part of town and move to a less popular corner of the town. It is quite possible that selling a high-end property and buying a property in a less popular locality will result in a substantial capital gain for the company. The company may try to show this gain in the operating profit for the year and try to impress upon the investors that the company is executing well. This is the reason why EBITDA is often considered a better measure of company performance than PAT. An investor should be extremely mindful of the sources of revenue of a company before judging its performance for a particular financial period.

5. Pre-merger expenses recorded in a previous period – It is an obvious intention of the company to show to the shareholders that a particular Merger & Acquisition transaction has been beneficial for a company. In achieving that objective the company may tray to prepone certain pre-merger expenses into the accounts of the prior year so that the profits are shown to be lower for that year, and after the merger or acquisition has taken place the profit margin or EPS is shown to be higher for the subsequent year. This is a particularly notorious practice as it amounts to impressing upon the shareholders the benefits of large M&A transactions. It might be possible that the transactions that have been executed could have long-term profitability and viability consequences for the company.

6. Synthetic Deals – Otherwise known as dealing with oneself. It could so happen that a company could open several subsidiaries and transfer parts of its assets or its liabilities to these subsidiaries so that some accounting impact can be lessened from the books of the main company. For example, a company might have taken a large building on a long-term lease. To reduce the burden of lease rentals on its books, it might sublease a part of the building to its subsidiary, whose primary objective is to help the parent company shield some of its expenditures. The company will be able to offset some portion of the lease rental expenses by the lease rent receivable from the subsidiary company. This is a common form of accounting manipulation in practice.

There are several other such means by which a company might try to appease investors into believing that things are going well with the company, but in reality, it may be in financial distress. Investors should always be very careful while reading these statements and if possible, take the help of professionals to interpret the same.