- creative accounting
- creative-accounting.jpeg (118.92 KiB) Viewed 58 times
Creative accounting occurs when a company's accounts are presented in a way that makes the company look better than it is in reality. You must do a thorough research before investing in the shares or bonds of any company. The financial statements or accounts will provide you with useful information about the underlying company. However, sometimes, the management attempts to cover a lot of things by "pumping up" the company. Consequently, the company appears better than they are in reality, going by the excellent results it declares. As an investor, how do you know the company's accounts have been cooked? You should take note of the following red flags when analysing a company's account for the purpose of buying its shares or bonds.
1. Declining cash flow but rising profit
Something is wrong if a company keeps declaring huge profits but cash flow, as shown in the cash flow statement, is decreasing. The cash flow is more difficult to manipulate than profit. And at the end of the day it is the cash that is generated that matters most to investors. It is from it dividends will be paid and business is expanded.
2. Profit smoothing
They try to make yearly results comparable by removing fluctuations. They may reduce some provisions when the year is bad or increase them during a good year. These provisions do not involve any cash movement, e.g. providing for depreciation or bad debts. This is because the stock market tends to penalise the company when the results are below the expectations of investors.
3. Pulling back revenue of subsequent periods
In a bid to increase reported sales figures, a company may pull back sales that should have been reported in subsequent period. Usually, it takes a few months after the year end before financial statements are published. This presents the management with the opportunity to inflate revenue figure by adding sales made in a new year to the previous period's revenue.
4. Phony assets
The company may use non-existing overseas subsidiaries to inflate the company's assets.