Wednesday, November 16, 2005

Limitation and exception

This method of detecting profit manipulation is particularly effective for manufacturing and trading companies. It is also useful for the industries like service, infrastructure, construction, property development, information technology, mining, etc. Understanding of the principles behind the practice is useful in applying the method.

However, it may rule out most construction or property development companies as badly managed due to the industries' huge stock piles and uncollectible debts. (It is also a good reason for us not to invest in the companies of such industries.) For infrastructure companies, we have to accept its high gearing ratio as reasonable since the income is contractual.

It is not applicable for financial services companies like banks, stockbroking, insurance, etc. While the principles of managing company are the same, they are reflected differently in the Balance Sheet. There are more rooms for such companies to manipulate their profit without reflecting such manipulation in the Balance Sheet. For instance, how do you know their marketable securities are valued correctly (market price for illiquid stock are not indicative as real disposable value), how can we be sure that they have declared or provided for non-performing loans, how can we be sure within the reporting period they wasn'’t any off balance sheet items took place, how much is the company's foreign exchange risks, etc). The transactions in financial services companies are much more complicated than the companies in other industries.

Historical performance is the key to understand their real performance other than merely checking their Balance Sheet'’s movements. For instance, growth story behind a dismal historical performance is unreliable.

Enron is an odd case. It will escape our attempt to detect profit manipulation, simply because it didn'’t consolidate the results of all the companies within the Group. Enron created certain corporate structure that, under U.S. accounting standards, allowed it not to consolidate these loss making companies into the Group accounts. Luckily such loop hole is only available in United States. Malaysia adopts International Accounting Standards, a principle-based Standards just like U.K., Singapore, Hong Kong, etc.

Enron used off balance items in constructing their profitability. To overcome such deception, we must look at the Notes to the Accounts for such off balance sheet items like corporate guarantees, capital commitments, contracts, options written, etc.

Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
Part 4: Exceptions and limitations