Monday, October 31, 2005

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
Part 4: Exceptions and limitations