Beware the accounting scandals

Lately, major accounting scandals have shook the financial world with their little cheating ways. They mess around with the balance sheet and the result is pro forma(in the latin sense meaning as if) profits and balance sheets looking healthy on the outside but is malignant on the inside.

Why would companys want to cheat anyway? They benefit from the good-looking numbers by attracting many new investors who are after their shares. What then happens is the share price rocket with many eager bidders who are after the company's "profits".

Recently in Australia there have been a few scandals such as OneTel and HIH Insurance. The story of OneTel was amazing. This telecommunications company started out small. But soon it attracted lots of customers with their low prices and they grew in prosperity. Their managers soon became ambitious and decided to take on the big guys such as Telstra, Optus and Vodafone, who were the major players in the telco industry at the time. They expanded at a massive rate, year after year, with earnings shooting through the roof alongside their share price. OneTel went public in 2000, but just a short 18 months after, it was declared bancrupt. What had happened to the company who was prosperous and was the envy of all other businesses a mere 18 months later?

The truth was OneTel had never made a profit. Its earnings were largely overstated and balance sheet mugged with to give rise to Assets which were not really Assets at all. What OneTel was doing was bringing forth profit it never actually earned yet. They also capitalised many expenses that should be classified as expenses in the Income Statement. Their balance sheet was full of Assets that were of no value or could not be sold of for money in the event the company goes into liquidation. Liquidation is when a company sells all its assets, repays all its debt, and the remainder is returned to the shareholders.

The story of OneTel was finally revealed not long after and havoc and hell broke loose as investors rush to sell off their shares in OneTel. This is not always an easy task when selling off shares means you have got to find a replacement for your stake in OneTel, and when millions of other sellers are doing the same. Lesson learnt: never invest in a company that do not have earnings, earnings, earnings.

Sometimes managers have incentives to overstate profits or understate profits. Usually in companies, the shareholders set goals for the managers to achieve, and if they do achieve it, the managers are given a bonus. A scenario when a manager would want to understate profits is when they are making a loss for the year. What they will try to do then is to bring forth all the losses from nearing periods. This would try to lump all the losses in one period, but in the next, earnings would dramatically rise. They give the impression that the manager has worked really hard and that they don't deserve to be fired.

The other case is when managers tend to overstate profits. If the goal they have to achieve is to make a profit of a thousand dollars and currently profit is 900 dollars, they might just reduce some expenses, capitalise expenses or try to bring forth earnings which would result in a higher profit.

By now, you should have some idea that accounting is really dodgy. That is because the AASB(Australian Accounting Standards Board) together with the international FASB(Financial Accounting Standards Board) give alot of room for the accountants to wiggle in their space. Mind you, it is not easy for accountants in making their decisions.

Imagine this scenario. You buy a machine for $90000 at cost. Together with this cost includes delivery of $500, installation of $1000 and a 12-month insurance on the machine worth $2400. How would you record the asset on your balance sheet?

The manager calls three people in, an economist, a lawyer and an accountant.
The manager asks them what they think the profit of this year would be,
The economist says "Depends on the economics of the business right now"
The lawyer says "All seems good. The lawsuits are tipping on our side"
But then the accountant replies,
..
..

"What do you want our profit to be?"