Detecting profit manipulation - Step 1

Step 1: Net profit and depreciation

You need to know two numbers:
a. profit after tax (before minority interest, if any)
b. depreciation

That’s all for Step 1.

Problems you might encounter:

The quarterly report format approved by Malaysian Accounting Standards Board (“MASB”) took a step backward that the disclosure of depreciation can be avoided. MASB allows CONDENSED Cash Flow Statement that can hide many important breakdowns. It is frustrating considering the importance of depreciation to estimate owner’s earning (as per Warren Buffett’s methodology) and to understand cash flow. However, most decent companies still disclose depreciation voluntarily in their quarterly report announced to Bursa Malaysia.

If the depreciation number is not available in the quarter report, you can estimate the number from their previous financial year annual report. It should not run too far under normal circumstances.

Skip this part if you are familiar with financial reports. For novice only:

If you are reading annual report, the comparing balance sheets are that of the current year end and preceding year end. The profit and depreciation figures are of the current year.

If you are reading quarterly report to find out quarterly performance, the comparing balance sheets are that of the current quarter end and preceding quarter end. The profit and depreciation figures are of the current quarter.

If you are reading quarterly report to find out year-to-date (for instance, three quarters) performance, the comparing balance sheets are that of the quarter end and preceding year end. The profit and depreciation figures are of the year-to-date ended at current quarter end.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Detecting profit manipulation - overview

Authentic profits generate hard cash. Manipulated profits stick in other assets like stocks, debtors, reduced creditors and provisions, etc. To detect profit manipulation we need to find out where these funds (from profit) are reflected in the Balance Sheet.

The rightful places in Balance Sheet for funds (generated from profits) are:

• increased cash and bank balance
• reduced borrowings
• additional fixed assets
• reduced retained profit (due to dividend payments)
• reduced tax provisions or increased tax recoverable (due to tax payments)

The 'wrongful' places for such funds (generated from profits) in Balance Sheet are:

• increased stocks
• increased debtors
• reduced trade creditors
• reduced provisions (due to reversal)

The actual method of detection will be addressed in the Part 4's step-by-step guide.

Balance sheet and cash flow statement are not arranged in the way to facilitate the checking profit authenticity.

(Even as an Accountant I do wonder what on earth these Standards Board members are thinking when they set the format of presentation. The financial presentations required by the Accounting Standard look nice, consistent and comprehensive, though it doesn't serve any purpose for decision making.)

We need to do a slight rearrangement of balance sheet's numbers. The objective is to find out where the funds (generated from profits) are landed or reflected in Balance Sheet. We shall get our hands dirty in the coming step-by-step guide.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

The principle of profit manipulation

Profit manipulation comes in many faces. However, generically or technically there is only one way to do so:

To jack up profit, an accountant must CREDIT (CR) the accounts in Profit and Loss accounts. The beauty of accounting is that inevitably he has no choice but DEBIT (DR) the accounts in Balance Sheet.

Dr Balance Sheet
(Increase assets like stocks, trade debtors, etc. or reduce liabilities like trade creditors, provisions, etc.)

Cr Profit and Loss accounts
(Increase revenue or reduce costs)

The above double entry is the mother of all profit manipulation. There are rare exceptions and we will address them later.

Backed by the above core double entry, these are the common masks of profit manipulation:

• Reduce cost of sales by increase the value of closing stock
• Refuse to provide for uncollectible bad and doubtful debts
• Reverse previously provided provisions for bad and doubtful debts without true sign of debts recovery
• Delaying in charging out expenses
• No accrual was made for known and quantifiable expenses
• Fake cash (less common, more difficult to perform and subject to higher risk of being prosecuted as criminal.)
• Etc.

The way to detect profit manipulation or to ensure the authenticity of profit is first to look at the movement of Balance Sheet! In the case of jacking up profit, beside the increase in retained profit, Balance Sheet will also reflect a significant increase in assets or reduction in liabilities.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Reading financial statements

Knowledge is power. This is particularly true when it comes to investing. Knowing a company's business performance and its industry well enough enables us to buy or sell its stocks confidently and correctly. Knowledge and information improves quality of our investing decisions.

We can gain such knowledge and information of a company predominantly from their financial statements. When we look for a company with strong management, solid financial positions, earning growth, etc. look no further but the company's report card: its financial statements. Searching for a proper valuation of the stock? Let's begin with the financial statements. Analysts from the entire stock investing/ trading profession analyze and comment on the financial statements of listed companies every quarter. Great investors like Benjamin Graham, Warren Buffett, Philip A. Fisher, etc. read financial statements before further facts finding. In fact, all investing fundamentalists read financial statements.

It is suicidal to practice investing characteristics like "being patient", "being quick to response", etc. without the backing of knowledge and information. It is knowledge and information that provide great investors their unweaved beliefs in their decisions, whether it is being patient or being quick to cut loss.

With knowledge and information, we are able to be patient and to hold on to jewels like Wells Fargo, Walmart, Public Bank, OYL, etc. that can (and had) brought fortune to the stockholders. Without knowledge and information, we psyche ourselves up to "be patient" on Enron, Bestcorp, Omega, etc. and to see our life savings evaporated when these companies failed. Both are being patient, the difference lies in what we know about our investments. It comes from reading the financial statements.

(So don't advice other to BE PATIENT or BE DECISIVE in holding on or disposing their investments. Such advice can only come after knowing the true financial performance and status of a stock. BE PATIENT and BE DECISIVE are dirty investing words without the backing of knowledge and information of a particular company.)

But why, in general, layman investors don't read financial statements? One of the main reasons I suspect is that layman investors basically throw in the towel in believing that performance of stock prices has got anything to do with the company’s financial numbers. Reading financial statements is, sometime, a futile effort in knowing the company performance. Profit numbers are unreliable. They are right. Looking back at 1997 Asia financial crisis and 2000 Dot Com Bubble, failed companies unabashedly manipulate their numbers before their demises. Stock prices crashed before showing any sign of losses, or before the reported profits were rediscovered as losses. The unscrupulous managements cheated in their report cards. It is reasonable for investors to believe that it is useless and meaningless to read financial statements. However, this is not true. There are ways to detect profit manipulation. We, as investors, can definitely detect profit manipulations.

We rely on the numbers provided by the management to make our investing decisions. These numbers have to be authentic and we must have confident in relying on them. To confidently relying on numbers in making investing decisions, we must be able to detect profit manipulation. Before we learn how to detect profit manipulation, we first must learn how the accountants manipulate the profit numbers.

In Part 2, you will find how accountants cook their books. In Part 3, we will learn how to detect such manipulation.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview

• Step 1 - Net profit and depreciation
• Step 2 - Net cash or debt movements
• Step 3 - Stocks add trade debtors less trade creditors
• Step 4 - Capital expenditure, goodwill, tax and dividends
• Step 5 - Other debtors and creditors
  
• Concluding Steps

Part 4: Exceptions and limitations

Stocks selection: Warren Buffett's criteria

In his book, The Essential Buffett, Robert G. Hagstrom listed down twelve basic principles that guide Warren Buffett investments decisions.

It can be organized in four areas:
a. Business
b. Management
c. Financial
d. Market

Warrent Buffett's twelve investment principles

On Business

1. He invests only in the businesses that are simple and understandable

Hagstrom wrote, "...he purposely limits his selections to companies that are within his area of financial and intellectual understanding..." because otherwise "...you cannot possibly interpret developments accurately or make wise decisions." and that "...the key (for a business) is to do those ordinary things exceptionally well."

An investor needs to do very few things right as long as he or she avoids big mistakes. - Warren Buffett

2. With consistent operating history

Buffett avoids purchasing companies that are either changing directions due to past failures or going through a difficult time. "...best returns are achieved by companies that have been producing the same product or service for several years. Undergoing major business changes increases the likelihood of committing major business errors."

Severe change and exceptional returns usually don't mix. - Warren Buffett

3. With favourable long-term prospects

Buffett prefers businesses with pricing power. Such pricing power usually comes from products differentiation. To Buffett, commodity businesses, (i.e. oil, gas, chemical, lumber, and even computers, automobiles, airline services, etc.) that has no meaningful product differentiations therefore lacking pricing power, are not worth purchasing.

The companies with pricing power, called "franchise" business, provide products or services that
a. is needed or desired,
b. has no close substitute, and
c. is not regulated.
(i.e. consumer products,

"This pricing flexibility...allows them to earn above average returns on invested capital."

The key question on long term prospect is therefore whether a business has pricing power through product differentiation. "A franchise can survive inept management; a commodity business cannot," Hagstrom wrote base on comments from Buffett.



On Management
(details coming soon...)
4. Is management rational
5. Is management candid with its shareholders?
6. Does management resist the institutional imperative?

On Financial

7. Focus on return on equity, not earnings per share
8. Calculate "owner earnings"
9. With high profit margins
10. Achieve more incomes (will reflect in market value) with less capital (retained profit)

On Market

11. Determine value of the business
12. Buy the business cheap