The Most Ignored Investing Aspect by Investors

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” — Mark Twain

Photo by Katie Harp on Unsplash

Everyone wants to be a successful investor but very few actually become one. Have you wondered why? The answer is accounting. Yes, the lack of accounting knowledge is one of the main reasons behind the failure of many people.

Ask anyone who invests in individual stocks whether they understand accounting & you will get a resounding yes. But ask some basic accounting questions related to their portfolio companies and they will have a blank face. For them, accounting is just looking at profit & loss statements released by the company & looking at the final number.

If that number is great, they are happy, but if not, they are sad. They do not realize, results are being manipulated & when the scam is finally revealed they are left holding the bag losing their hard-earned money in the process.

In this post, I will explain how accounting statements are created in-depth and also show possible ways by which earnings can be manipulated.

To keep it relatable, I will take the example of a freelance programmer (Akash) & create his accounting statements.

What are the financial statements:

There are 3 financial statements (well there is a fourth one as well, but the first 3 statements themselves are sufficient):

• Balance sheet
• Profit & Loss statement
• Cash flow statement

The Balance sheet tells us at any point in time, what assets we own & how we have funded them (our liabilities).
The Profit & Loss statement tells us, by combining various transactions, what is the accrual profit or loss during a given period.
The Cash flow statement tells us how cash has moved during the period.

How Akash’s life looks like:

1. Has 2 school going kids with fees to be paid in equal amounts every month
2. Owns a house (with a mortgage), 2 bikes & a car, owns some stocks/ mutual funds, some money in his salary account & few long-term bank deposits.
3. Owns typical home furniture like sofa, beds, TV, etc. He also has a monthly subscription for cable, Netflix & other utilities like milk, etc.
4. Charges a variable fee depending on the gigs. Currently, he is working on 2 client projects (say A & B).
5. He owes some money to his friend Rajat for a recent trip & also is owed some money from his friend Garvit for a recent dinner outing.

Having looked at Akash, let’s begin creating his financial statements.

Balance Sheet:

Assets: (all valued at a minimum of(buying price, current market price) ):

#Non-Current Assets: assets which will not be converted into cash within a year:

• property, plant & equipment: House, car, bikes & other house furniture
• non-current investments: long term bank deposits

#Current Assets: cash/assets which will be converted into cash within a year

• cash & cash equivalents: money in bank accounts & stock/mutual funds portfolio
• prepaid expenses: utility subscriptions which are already paid
• accounts receivable: money owed from other people, here it will be:
  1. Money owed from Garvit
  2. Amount owed from A & B for the work he has already done for them.

— — — — — — — -

Liabilities:

# Non-current liabilities: long term liabilities

• long term loans: the house mortgage

# Current liabilities:

• interest payable: interest portion of the mortgage to be paid this year
• accrued expenses: school fees, subscription amounts
• the amount payable: money owed to Rajat

— — — — — — — -

Shareholder Equity:

Book value or Net worth: what one owns if one subtracts all of his liabilities from all of his assets.

Assets = Equity + Liabilities

Profit & Loss statement:

P & L statement over a period between September 2019- September 2020.

Revenue:

• The amount he should receive from all of his client projects over the entire year
• other income: dividends he should receive from stocks/ mutual funds portfolio & interest accrued on long term bank deposits.

Expenses:

• The mortgage amount, school fees, overall subscription costs he has to pay over the year
• Any expenses incurred because of vacation traveling, food, outings, etc.
• Depreciation: decrease in value of his assets like vehicles & other house furniture (& due to the current fall in real estate because of the COVID-19 situation, his house also)
• Taxes: government taxes

Other profits/losses: None

Profit: (revenue — expenses)+ other profits/losses

At the end of the period, net profit/loss will get added to the existing shareholder equity in the balance sheet leading to an increase/decrease in his net worth.

Cash Flow Statement:

#cash flow from operations:

• (+ve) the actual amount he received from his clients
• (-ve) the actual amount he paid for school fees, subscription
• (-ve) the actual amount paid for vacation, food, etc.
• (-ve) the amount of taxes actually paid

#cash flow from investments:

• (+ve) dividends he received from his stock/mutual fund portfolio
• (-ve) the amount he used to buy more stocks/mutual funds

#cash flow from financing:

• (-ve) the actual amount he paid for mortgage

At the end of the period, net cash flow will be added to last year’s cash amount in the balance sheet.

Understanding how a transaction would get reflected:

Suppose for an outing, suppose Akash has to pay 1000 Rs, he has paid Rs. 600 & owes Rajat 400 Rs. (on top of what he owes from earlier), it will reflect in financial statements like this:

• The profit & loss statements: we will mark 1000 Rs as expenses in the profit & loss statement.
• The cash flow statement: we will mark (-ve) 600 Rs.
• Balance sheet: we will deduct 600 Rs. from cash assets, add 400 Rs. to the existing liability of amount payable to Rajat, reduce the shareholder equity by Rs. 1000

Accrual Accounting:

This above process is called accrual accounting.

Every transaction/event should get recorded in the financial statements irrespective of whether any cash is transferred or not.

It helps us smoothen expenses & revenues over a time period rather than a lumpy system when cash is actually transferred.

For example, consider the bikes Akash owns.

• When they were initially bought for cash,
  in the balance sheet, cash was decreased & a bike asset of equal value was created.
  No entry is made in the profit & loss statement.
  In the cash flow statement, it was marked in -ve cash flow from investment entry.
• As time progresses,
  it is depreciated in the profit & loss statement.
  Similarly, the value is marked down in the balance sheet.
  No entry is made in the cash flow statement.
• In effect, we are dividing the bike expenses over its useful life rather than considering it fully in 1 year & nothing in other years.

One Important Note:

In the balance sheet, assets are never adjusted upwards but only downwards.

For example, suppose the buying price of Akash’s home is Rs. 1 Crore & after 10 years, it is valued at 2.5 Crores in the market.

• Unless Akash sells the house, the value of his home will be marked at only 1 Crore on the balance sheet & when he sells the house at 2.5 Crore, in the profit & loss statement, the additional 1.5 Crore will reflect in other profits.
• But assets whose value decreases every year, ex. vehicles, home furniture, etc. they are decreased by the depreciation amount every year in the balance sheet.
• This seemingly illogical convention is to make sure that companies will always have a conservative view of their assets’ worth & if in the future they face any issue, this conservative nature will act as cushioning.

Inter-company investments:

Many times, companies invest in other companies, their subsidies, ex. Bajaj Holdings has a stake in some of its listed subsidiaries like Bajaj Auto, Bajaj Finserv & Bajaj Finance.

It is important to understand how these inter-company investments reflect in the financial statements of the parent company.

The investments are categorized into 3 types based on ownership stake:

• investment in financial assets (when ownership is < 20%)
• investment in associates (when ownership is between 20% to 50%)
• business combinations (when ownership is > 50%)

Let’s look at how each is treated in some details by again taking our Akash’s example.

Investment in financial assets:

Our Akash owns some stocks of a global tech company, although theoretically, he is an owner. But for all practical purposes he has no control over company operations. So,

• his investment is marked at current market value in his balance sheet
• any realized gain/dividend he receives is treated as income
• any unrealized capital appreciation/depreciation is directly handled in the assets column without affecting profit & loss (via something called other comprehensive income which is generally written below the profit & loss statement.)

Investment in associates:

Suppose our Akash had bought a 25% stake in his friend’s startup X & X gets really huge & gets listed (that is the ultimate dream right !).

Now Akash has some influence on how operations can be run at X (not complete but much more than the earlier case). In this case,

• book value of X proportional to ownership stake is added to Akash’s assets list
• any additional amount Akash paid on top of book value is treated as goodwill & stored as an asset
• the net profit of X proportional to ownership is added to the Akash’s 1st asset
• any dividends he receives from X are added as income & the above asset is reduced by the same

Note there is just a single line about X in Akash’s balance sheet & profit & loss statement, the financial characteristics of X (what % of assets are non-current assets, how are those assets funded, etc.) don’t mix with Akash’s financial characteristics.

Business combinations:

Inspired by his friend’s successful startup. Our Akash also decides to start his own business Y, along with a minority partner B, while continuing his freelance work.
His own stake is 70%. Now Akash has complete control of operations at Y will be run. In this case,

• The entire balance sheet of Y is added to Akash’s balance sheet. To account for B’s share in Y, a separate asset called minority interest is created in Akash’s balance sheet.
• All of Y’s profit & loss entries are added to Akash’s profit & loss statement with deducting B’s profit share in a single entry.
• Same way with cash flow statement

Notice how Akash’s own financial statements have gotten completely mixed with Y’s financial statements. If a novice tries to understand Akash’s financial statements, he will be completely misled.

Ex. Akash is not responsible for paying business loans Y may have taken. In this case, even though the loan shows up on Akash’s own balance sheet, he himself has no obligation to pay it & in a sense, it is not a true liability for him.

Manipulations & how to detect them:

Having understood how financial statements are created, let’s come to the interesting part of how they can be manipulated & how to detect such manipulations!
For this, let’s now think Akash Inc. is our company owned by Akash.

Profit is nothing but (Revenue-Expenses). Manipulation of any of these two leads to profit manipulation.

Manipulating Revenue:

Companies often have leeway on when to recognize sales. Some companies recognize revenue when they get an order from their customer.

Ex. Suppose Akash goes to his friend Rishabh & asks for a freelance project. Rishabh gives him an order, which will take 2–3 years for Akash to complete. Since Akash has received the order, he marks the entire revenue, which he will get from Rishabh in the future in the current period itself.

How it can be detected:

In cases where revenue is being aggressively recognized (like above), one can often see:

• Inventory & the amount receivable assets building up in the balance sheet.
• The cash received will be very less compared to the actual revenue.

One can look at the trend of following over past years:

• Inventory days (cost of average inventory/ cost of goods sold): it represents how much days inventory is lying around before it is processed & sold off.
• Days receivable or debtor days (debtors/ avg. daily revenue): it represents how much time debtors take to pay back their debt.

If any of these two are increasing/ much more than peers, there is a high chance of accounts manipulation.

Manipulating Expenses:

There are many components in expenses, each of them can be manipulated.

Depreciation:
It is the yearly charge over an asset’s useful life. Companies have leeway on deciding the useful life of an asset. When they increase that, the depreciation charge reduces.
Ex. Generally, computer & IT equipment are given a 3-year useful life, but some companies assume a 5 year or even a 10 year life period, thus significantly reducing depreciation expense.

Capitalizing Expenses:

Many times, companies capitalize (create an asset) something which is clearly an expense. Doing this leads to a reduction in the current year expenses.

Ex. The salaries of company employees working in the research department are clearly an expense to the company. But some companies, instead of marking the expense, try to portray this cash outlay as the creation of a research asset, thus not needing to show it as an expense.

How it can be detected:

• Companies, by law, have to share all of their assumptions, for example, what is the useful life of the assets, how employee research is treated.
• One can compare it with its peers to find any discrepancy.
• One can also check if cash outflow from the cash flow segment is much more than the expenses shown in the profit & loss statement.

Closing Note

In this article, I discussed financial statements, how they are created & how they can be manipulated.

There are still some aspects of accounting that I have skipped. For example, handling foreign currency transactions, company stock options, pension treatment, etc. The first reason being the length of this article & the second being they are not required for the majority of the companies one may generally look at.

We also talked about how profits can be manipulated. Although there are many other ways in which profits can be manipulated, I have tried to explain the most commonly used ways, which should help investors weed out 80% cases, if not more. Discussing all the ways of account manipulations is nearly impossible, and at-least warrants a separate book.

If you are interested to learn more about accounting manipulations, you should definitely check out “Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports” by Howard Schilit. It is one of the best books I have ever found on this subject.

Financial Shenanigans, Fourth Edition: How to Detect Accounting Gimmicks and Fraud in Financial…

Full disclosure, I will receive affiliate fees from the above link. But the primary purpose of sharing it is to share this book with you.

I hope you liked this article. Follow me for more such articles in the future!
Bye!