Earnings Manipulation

By Bob Ross

While most small to mid-sized companies have generally clean financials, it is important to be aware of earnings manipulations that can be hidden.  Rick Wayman, author of numerous investor valuation articles, has listed the following techniques that can be used to create earnings to achieve premium pricing or management bonuses.

Accelerating Revenues: Booking as current sales a lump-sum for services to be provided over a number of years.

Channel Stuffing: A manufacturer makes a large shipment at the end of a fiscal period and records the shipment as sales even though the distributor can return any unsold merchandise.  Because goods can be returned and are not a guaranteed sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.

Delaying Expenses: If managers view an expense as a long-term investment it is possible to transfer the cost from the income statement to the balance sheet by capitalizing it.  In many cases it is more appropriate to book the expenses at the time they occur.

Accelerating  Expenses:  If the owner is being paid in part by a earn out agreement, it is possible to accelerate or pre-pay expenses prior to an acquisition.  After the sale, the earnings per share will be easily boosted when compared to previous quarters.

Non-Recurring Expenses: It is important to see if a company takes Non-Recurring expenses periodically and if these are in fact extraordinary events.  When valuing small to mid-sized businesses, it is a common practice to add back non-recurring expenses to arrive at the base cash flow on which the company’s value is determined.  If not truly a onetime expense, this could inflate the value of the company.

Other Income or Expenses: It is rare to see a small or mid-sized business with more than minimal amounts on this line of the income statement, usually from cash investments or the sale of assets.  Beware  that companies are not hiding expenses by netting them against newfound earnings.

Conclusion: When in doubt an acquisition specialist is a good individual to have on your side.