Conservative vs Aggressive Accounting Practices

When analysing the financial statements of companies, consider the implications of the methods of accounting that a particular company chooses. Unfortunately, using acceptable accounting practices does not always reflect economic reality. Companies often have the discretion to manipulate their earnings to reflect the reality that they wish the rest of the world to see them in.

Have a look below for some of the signs to look out for in the financial statements of companies you are interested in investing in:

Conservative Accounting Practices:

•    Choosing LIFO as opposed to FIFO accounting for inventory in an inflationary environment (this leads to ending inventory being lower from higher COGS, and lower operating profit)
•    Rapid write-offs of intangibles gained through acquisition
•    Lack of nonrecurring gains (no regularity of weird gains from unusual or infrequent items)
•    Expensing of initial start up costs (should be expensed as opposed to being capitalised)
•    Minimal software capitalization (again should usually be expensed unless it is going to provide an on-going future economic benefit)
•    Minimal capitalization of interest and overheads (again should be expensed)
•    Accelerated depreciation methods (this leads to higher depreciation in early years thus decreasing net income in early yearly and increasing the reliability of the earnings) (this also has the benefit of decreasing taxes payable)
•    Short asset lives – depreciation (using a small useful life leads to a bigger depreciation expense and again a smaller net income)
•    Using the completed contract method for revenue recognition rather than the percentage of completion method (this ensures all revenue has been earned)
•    High bad debt provisions
•    Little use of off-balance sheet finance (eg operating leases or using the equity method to account for associate companies)
•    Clear accounting policy disclosure
•    Net income approximate to CFO (higher earnings quality)

Aggressive Accounting Practices (mostly the opposite of above):

•    Lengthening asset lives (will reduce depreciation charge)
•    Using straight line depreciation (lower depreciation in earlier years)
•    Choosing FIFO as opposed to LIFO accounting for inventory in an inflationary environment (this leads to ending inventory being higher from lower COGS, and higher operating profit)
•    Insufficient acquisition disclosures
•    Capitalisation of operating costs (this can be fraudulent – Anything that doesn’t lead to future economic benefits must be expensed)
•    Recording investment income as revenue (Think: is management masking a decline in sales?)
•    Recording revenue prematurely (percentage of completion incorrectly used, bill and hold)
•    Manipulating discretionary expenses (big bath provisioning so future years look better – this involves taking an extra hit in the bad years so the future years look better)
•    Manipulating reserves (impair an asset one year and reverse in future periods – only available under international accounting standards, not US GAAP, as you can reverse impairments)
•    Adopting new accounting policies early/late depending on the the impact of the policy
•    Frequent changes in auditors (why are management changing auditors, is there something to hide? always a warning sign)
•    Selling assets/investments to generate gains/losses (these are one off gains)
•    Accelerating/decelerating sales activities (incorrectly reporting sales, bringing forward etc)

2 Responses. Add Yours!

Discussion

  1. bruce said:
    Posted March 8, 2010 at 7:48 pm

    I’m generally bullish about the banking sector, we have had 20% retracement of banking stocks in Australia over the last 3 months which makes a good buying opportunity, many are trading around 16pe and have already expecting profits to double on 2008′s drop, which would put them around 12pe, some of the good value banks here in Australia are ANZ trading at only 1.7 times Equity, NAB trading at 1.6 times equity and Suncorp trading at 0.8 times equity, the other banks CBA and Westpac are trading well above equity and are now overpriced – 2.4 and 2.7 times respectively.

  2. gadgets (be/nl) said:
    Posted December 5, 2011 at 8:48 pm

    Greetings from Idaho! I’m bored to tears at work so I decided to browse your blog on my iphone during lunch break. I enjoy the info you present here and can’t wait to take a look when I get home. I’m surprised at how quick your blog loaded on my mobile .. I’m not even using WIFI, just 3G .. Anyhow, good blog!

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