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How accounting tricks distort the equity market

The World is accelerating. It is clear especially when you look at the amount of bad news we are being fed. Markets react violently – we saw that during Brexit vote. Aside from more remarkable events, the rest is only the white noise of information which makes it harder, not easier, to invest. Despite tough circumstances of the market, there is still a possibility to find companies with healthy fundamentals and good perspectives for growth. Much easier it is to find firms hiding their own problems with accounting tricks.

I will show you on what basis today’s bull market is being built and why experts (pontificating their truths in media) are selling a very poor lie about the good health of economies and representative corporations to convince us to continuously buy overvalued stocks. I will give you examples how corporations can enhance their books only to give their investment indicators (most popular way) the right kind of make-up, in spite of terrible situation of the company itself. This knowledge is a prerequisite you have to acquire and carry on studying not only to financially survive the snowballing crisis ahead of us but to distinguish pearls from the mud among the bankrupted firms when the dust eventually settles down.

Motives behind creative accounting

Creative accounting follows rules and regulations but presents reports and data in a way to improve investing indicators (relied upon by banks and investors) while not showing the true condition of a company. There are few ways you can do it:

- the market capitalisation of a company being included in firm’s own capital - the higher the stock price the more means are available for the company,

- using profitability and financial liquidity indices to calculate the level of interest on debt,

- rewarding managers with stock, more expensive shares equal bigger bonus.

The example of Apple shows how skilful managing of a corporation and its image increases the popularity of both company itself and its products. This translates into higher sales and higher margins pushing the stock price up. The Apple phenomenon is very hard to copy. In today’s circumstances of weak demand for USD and ever higher inventories, to lift, or at least sustain, high share price managers are ready to use creative accounting. Although it is legal – similarly to tax avoidance – it is the way to use loopholes in the system. Usually, it is very hard to hide deficits in firm’s budget for a long time. This is why in practice it is done on a small scale (often around 10% of the balance). The only way to ‘go big’ is to do it for a short period of time and simultaneously with an important event happening - such as a new issue of shares, fiscal year end (FYE) or other important events.

How is it done?

There are many ways to enhance the balance. Normally, everything is based on the right reporting of revenue and losses (from various sources) and adding them to the specific categories. Higher net revenue relative to variable cost and already your P/E, or EBITDA are looking better. You can decrease the number of shares to lift EPS or ROE (return on equity). Dump inventory of your warehouses and push debtors in order to boost quick ratio (QR) – short-term liquidity indicator.

There are more tricks:

a) To show better results, especially when fiscal year is around the corner companies hastily transfer their products to their intermediaries’ stores (shops). Thanks to this, intermediary bears bigger costs but through rebates, sales or competitions a producer helps to sell the surplus. The price of the product is often lower than normally but this also can be hidden because additional costs are going to be calculated only after the report is published. This makes investors unaware of the real situation of the company.

b) In case of company calculating their revenue according to prognosis (e.g. water supply companies), they can easily overstate it to possibly acquire more capital and additionally make money (before the bills come) on interest payments.

c) Firms create reserve funds in case various liabilities materialise, where they put a share of their revenues. Managers can manipulate the size of those reserves through estimation of the sum required and probability of the event against which the fund is created. When it is needed, company can lower the capital savings and artificially increase net profit making economic indicators better.

d) Heads of the company during the incoming FYE collect as much money as possible from their customers but issue invoices for suppliers. Only after the financial statement is printed company pays suppliers and this shows higher earnings compared to costs.

e) The trick used both by countries and companies is pushing debt onto subsidiaries which are not required to account for in your balance (you do not use an acquisition accounting method).

f) The sale of a product booked before it materialises. This repairs your monthly/quarterly balance.

g) Corporations repurchase their shares to reduce their outstanding number. Less equity means better EPS.

h) The last year’s final statement balance published in a new financial statement is falsely underestimated making this year result more attractive.

i) Company to avoid paying income tax can overspend on renovations or investments. Interest from those you can add to your tangible fixed assets (e.g. real estate) thanks to which you bolster net profit. Fixed assets can be depreciated (asset’s cost over its life) improving EBITDA (very important for investors, banks when giving a loan).

Methods explained above are very popular among both medium and big companies. The list is, of course, not exhaustive and the only limit is the standards you adhere to. For example, in the US you can publish Pro Forma financial statement and throw away unwanted elements like restructuring costs. This is done by an increasing number of entities there. After 2011 it was 70% while today it is 90% of NYSE-listed businesses.

Below you can see how much – in just one year – the number of ‘boosted’ books grew. Nearly all NYSE listed corporations enhance their books. The average difference between factual data (GAAP) and ‘refined’ results (non-GAAP, Pro Forma) widened since 2015 by 10 percentage points. Last year the fabricated numbers were around 20% but today it is nearly 30%. The scale is huge because statistics can be overestimated by astounding 1/3!

Source: Mark Faber

This is the reason behind increasing manipulations – see chart below. While in normal circumstances the average earnings per share get additional 0.2 USD, this number can reach even 1 USD during slump as it happened in 2008. We can observe similar levels today. We can imply that the bull market is either nearing the finish line or has already finished.

Source: Mark Faber

This relation is very important as it directly shows a bad condition of businesses. At the end of the day, these accounting methods are used to add some makeup to financial statements and operate on the edge of the law (or accepted practices) not to plainly lie. The more tricks a company have to use the clearer we can see how purchasing power of their clients' drops. Plus, forecasts of a 20-30% increase in sales in the near future is just a bad joke.

The basic rule, when it comes to stability of a company, is the quality of revenue, not its quantity. In the short term, you can easily improve performance on paper through ‘sales’ but the market can quickly get sated and clients could resign from our products making quarterly reporting very hard in the future. This is why it is crucial for a business to build the right base of clients as this will shape financial results during bad years and crisis. The most reliable, but far from ideal, is CAPE or Shiller P/E including data from the last 10 years.

How to easily

The problem with EBITDA (earnings before interest, taxes, depreciation and amortisation) is becoming well-known. EBITDA is used not only by investors but also by banks, indirectly affecting the share price. The higher EBITDA the more attractive a company is, plus it is taken into consideration to calculate the height of interest rate on debt.

Seeing many indicators improving: EBIT (earnings before interest and taxes), liquidity, ROA (net return/assets), ROE (net return/equity) or reduction in fixed costs – firm’s EBITDA is going to rise. You could even say that the company is growing. This is a clear signal to buy equities before the rise of price. Unfortunately, we can take a big hit unless we critically analyse financial statement of the respective business. Look at capital flows. An accountant is able to put in the column of ‘earnings’ the amount of money gained by e.g. selling fixed assets. The entity could be closing its business due to lack of clients, selling production lines and properties only to book this money as net earnings. Moreover, unless the asset was fully depreciated, company during the sale doesn’t incur any costs. EBITDA will jump through the roof, suggesting a good condition of the business. The truth will be shown only when some competent investors check the numbers in the capital flows. Usually, they are hidden in the statement behind a mass of digits and forecasts. The investor has to be patient and determined to deeply analyse data. Bottom line: a company could be selling machines, formerly used to make money, close or significantly reduce its operations and indicators can show the business is growing. Next, the share price can nose dive with 80% loss!

You can see now how depending only on few samples far from being representative e.g.: the value of sales, assets, capital or inventory level, can lie. This is very important fact to keep in mind because it touches all key gauges widely used (EBITDA, P/E, EPS, ROE, ROA, liquidity etc.).

Who present financial statements and how?

One of the most interesting examples of how big of a success a business can achieve thanks to accounting tricks is Twitter. TWTR in the first quarter had 80 million USD losses – 0.12 USD per share. Thanks to enhancing the data and diverging from GAAP they were able to show a profit of 103 million USD and 0.15 USD EPS. I guess ‘miracles’ do happen if you believe hard enough.

Obviously, they are not the only ‘magicians’. General Electric added so much makeup to their statements that they pulled 0.02 USD EPS up to 0.06 USD. Basically, they tripled their earnings! Merck&Co. tuned up their 0.4 USD EPS up to 0.89 USD. Examples are countless.

You can ask – how do I know all of this? I read the financial statements. Companies can publish non-GAAP propaganda but they also have to print their GAAP results. Again, many tactics are utilised not to expose the latter. Today financial statements are ‘sold’ just like any products. What do you see when you buy a chocolate bar? Attractive, shiny packaging, emboldened name to get your attention and pick already known from tv adverts branded product. A snack has to be sweet to make our minds salivate at the thought of eating all the sugar and chemicals inside of it. We can also find ingredients but the font is small, monochromatic and at the end of the day definitely not eye-catching. This is the way financial reports are being made. Everything positive is highlighted and all bad numbers are hidden in the plain sight. If the document is dull, data is adjusted with the use of methods explained above. First pages are really nice and full of colours and quotes with numbers. Then we add forecasts of analysts for the following years, showing how high our earnings will reach. Finally at the end of the booklet, with boring graphics they publish facts that are required to be there but paint quite a different picture. Experts in the media sell the right picture of the business to investors making them susceptible to an imaginary depiction of the firm and already have an emotional base for their decisions. If the propaganda is successful, people heavily invested in shares are not going to sell until the loss will be very hurtful (they wait until the forecasts of experts will come true).

Consequences

The reality always returns to the stock exchange. It does not matter how far accountants pushed their skills to beautify reports – you cannot fool all the people, all the time. The point here is that inexperienced investors allow smart money (hedge funds, investments banks) to lie to them and buy from those entities overvalued stocks at the peak of the boom. Price is always going to nose dive showing the real value of traded companies. Corporations guarding their high share price until the end of the bull market or even after starting stages of the bear market will finally have to adapt their employment structure and operations to the new situation. Despite appearances, it is a very healthy phenomenon which cleans financial system from badly governed companies.

Today’s situation of the advanced bull market is perfectly described by the chart below. Wholesale inventories-to-sales are on the same level as two earlier crises. This directly affects the ability to sell and continues the narrative presented by the previous chart (the gap between Pro Forma and GAAP EPS).

Source: harveyorganblog.com

The problem with selling is visible in the picture below. Sheerness, UK. Thousands of unsold cars landed in huge parking lots and slowly deteriorate.

Source: autonet.ca

For now, corporations thanks to historically low interest rates collect as much debt as they can and use it for buybacks – keeping their share price high. After all, the moment when lies will be exposed and prices will meet reality has to come. For this moment to materialise a catalyst is needed. The last snowflake to start an avalanche. Events of the day after the EU referendum in the UK show how chaotic markets can be and what sort of discounts we can expect then. Brexit was only one incident of many to come before investors will experience a brutal reality check.

Summary

Everyone who buys stocks in developed world has to watch out. Entities that seem to be well capitalised (with growing earnings), may not be a great investment opportunity. With the state of the bull market, businesses advertised by experts or investment funds can lose much of their worth any moment with shareholders taking the biggest hit. This could not be possible without a scapegoat, being the main reason for terrible situation of the financial market. Will it be China, UK or the whole EU collapsing in front of our eyes? Only time will tell.

The long-term chart of Shiller’s P/E for S&P500 is now at 25 with the average of 16. The reason why I give the US situation here – because the US stock market is the trendsetter for other parts of the world. Big falls are still ahead of us.

To make P/E and EPS or EBITDA more real we will have to wait until the slump is going to rob most of inexperienced investors. In my opinion, blind faith in popular indicators is not advisable. What can save you from propaganda promoting investments in the worst possible moments is continuous education. The more you learn and the more sourced you knowledge is the better your chances to prevent big losses when betting on equities.

Independent Trader Team