Detecting creative accounting 101
In fundamental investing, one needs to look at the financial statements of the listed companies intending to invest or has already invested. Cases of Enron and Worldcom, and now all the famous investment banks shows that audited financial statements do not necessarily mean that every single figure is really correct.
If one waits until “creative accounting” is detected by relevant authorities, then it will be like Enron case, too late already if one is still holding on to the stocks.
“Accounting is the language of business.”
I know that most of us came across above verse from Rich Dad Poor Dad but it is Warren Buffett who said it first.
1. Cash
Cash most probably cannot be faked in an audited financial statement but in the event of liquidation, it won’t be enough for stock holders. In addition, the stacking of large amount of cash in bank is considered inefficient in today’s business world.
2. Land and properties
Of all the assets in balance sheet, land and properties are most probably the best. Most probably only got this type of asset that can appreciate in value, the issue is, it is hard to determine how much a company has as land is usually lumped together with plant and equipment.
Another issue is of course the subprime situation now, when there is credit crisis and recession, most cannot afford land and properties, actual value that can be cashed out is much lower than that reported in balance sheets more than one year ago.
3. Plant and equipment
All the machines are only worth their scrap values only and not capital investment minus accumulated depreciation.
4. Inventories
The actual value of inventories depends on specific businesses and industries. For example, in the case of clothing companies, with value of clothes that are in fashion last year, may have a significant value lesser one year later due to changes in fashion.
Difference in reported inventories values is especially true for firms selling computers like Acer, Hewlett Packard as computers depreciated in value rapidly over time. This is true for electronics also.
5. Receivables
Depending on who owned the receivables, in the event of liquidation, elusive debtors disappear and if receivables are not concentrated in a few hands, liquidators do not have the time and motivation to retrieve those bad debts.
6. Investments
This item is the least to be trusted of all items on balance sheet. “Investments” can literally mean anything, in addition to stocks of other publicly listed companies. Unless they are fully declared and explained, one should be cautious.
7. Intangible assets
These basically include recipes, patents, trademarks, software programs and design, all the intellectual property. They are not totally worthless but when there is liquidation, they most probably fetch far less than their values.
8. Goodwill
It is hard to access the true monetary value of goodwill, though most of the time; it is the key competitive advantage of a business. What is stated on the balance sheet is most probably not their true value; you have to access it yourself.
9. All other liabilities
Unfortunately for equity investors, all the stated liabilities owned to tax office and banks are the most real figures that one sees on a balance sheet. These are figures that one no need to doubt.
Image Credits: Public Domain
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