Ways They Cook Books - What You See May Not Be What You Are Buying

Posted on October 13, 2008

The business news over recent months has done much more than report the steep slide of the Stock Market. Overall, confidence in business people, distrust of the financial establishment, and a new mind set for the terms CEO and CFO are the byproducts that will linger long after the stock market rebounds with normal cycles.

The long aspired-for titles of CEO and CFO have taken on an aura of shady dealing and distrust. As Watergate did to politics; what has been revealed about Enron, WorldCom and others yet to surface, will redefine our thinking for some time.

Should we be surprised? Probably not. Since the beginning of time and the first \"transaction\" between cave dwellers, \"creative accounting\" has been a tool to mask weakness and inflate value. The process and game is not limited to FORTUNE 1000 enterprises. In reality, it is easier for a $1Million Message Center or Call Center to \"creatively\" position themselves, due to the fact that the numbers of most small businesses are not audited.

Small businesses normally engage accounting firms to \"compile\" their numbers. A compilation is merely the correct presentation of the numbers given an accountant. A \"review\" is a spot check of accuracy and an \"audit\" is certification of accuracy and consistency. Audits are expensive and most small businesses do not make the investment and merely meet the need for end of year reporting with a Compilation.

The message center industry is ripe for consolidation due to:

  • \r The Capital Investment & Scale Required for Emerging Technology
  • \r The Average Size of Firms in the Industry
  • \r The Opportunity for efficiencies with consolidation and overhead reduction.

The above suggests there will be an increase in transactions going forward. If you plan to enter the playing field be forewarned: You are entering a field filled with mines and potential expense.

BUYER BEWARE

We have not been surprised by the news of accounting irregularities. Over the years we have encountered scores of \"creative\" techniques by business people hoping to look better for courtship and even for their banker. This is not new news and will more than likely remain a fact until the extinction of the cockroach.

Below is a smorgasbord list we created in a brain storming session presenting a sampling of techniques and \"creative\" adjustments to numbers that you should watch for when evaluating a business.

TIMING

  • \r Deferring current expenses to another accounting period.
  • \r Accelerating discretionary expenses to the current period.
  • \r Keeping cash-received records open after the end of a period; closing disbursements records early.
  • \r Depreciating or amortizing at different rates.
  • \r Writing off future depreciation or amortization in the present accounting period.
  • \r Liquidating reserves against anticipated returns to shift sales revenue to a later period.
  • \r Recognizing revenue before it\'s fully earned or while significant contingencies exist.
  • \r Delaying publication of financial results.
  • \r Making unusual entries at or near the end of an accounting period

INTERPRETATION

  • \r Not writing off bad loans or worthless assets.
  • \r Over or under valuing investments, intangibles, and other assets, especially difficult ones like excess inventory, private-placement securities, and contract rights.
  • \r Ignoring liabilities such as long-term commitments, significant contingencies, or post-retirement liability.
  • \r Not making adequate provision for depreciation.
  • \r Overestimating the collectability of accounts receivable.
  • \r Ignoring the obsolescence of fixed assets.
  • \r Making bogus estimates, especially on interim financials.

INVENTORY

  • \r Misstating inventory by counting empty boxes, altering documents, or adding in inventory that\'s not salable, for example.
  • \r Valuing inventory at market price rather than cost.

SALES

  • \r Counting revenue based on goods shipped before a sale is final or based on merchandise shipped but not ordered.
  • \r Considering sales on consignment complete sales.
  • \r Ignoring buyers\' rights to return merchandise.
  • \r Recording sales to buyers who are not likely to make payments because they don\'t have financing.
  • \r Recording phony charges to customers.

COMBINATIONS

  • \r Mixing operating and non-operating accounts.
  • \r Folding a subsidiary\'s results into the parent company\'s financials.
  • \r Paying debts out of the owner\'s pocket to inflate the price of a company before a sale.
  • \r Retaining the main asset of the business in the owner\'s name.
  • \r Borrowing through subsidiaries.
  • \r Failing to separate unusual, non-recurring gain or loss from recurring gain or loss; \"restructuring\" charges.
  • \r Using equity or loans to fund dividend payments.

MISREPRESENTATIONS

  • \r Using inflation to hide asset revaluation.
  • \r Reporting quick gains from the sale of undervalued assets or from retiring debt.
  • \r Burying losses under non-continuing operations.
  • \r Improperly capitalizing research and development, start-up costs, advertising, interest charges, repairs, and the like.
  • \r Exchanging similar assets and counting what\'s received at fair market value.
  • \r Keeping debt off the books.

MORE BAD STUFF

  • \r Intentionally misapplying accounting methods to actual transactions.
  • \r Taking aggressive positions on unsettled, difficult, or controversial accounting issues.
  • \r Treating refunds as revenue.
  • \r Entering phony or bogus transactions.
  • \r Recording income on the exchange of similar assets.
  • \r Failing to identify related-party transactions.

LACK OF AUDITED/CERTIFIED STATEMENTS

Many business opportunities involve smaller companies where certified statements are simply not available. Consider examining the outfit\'s books, ledgers, bills, invoices, bank statements, checks, and other supporting documentation thoroughly, with your own eyes

Paul J. DelFino is a principal of the consulting firm Opportunity Inc. For nearly 15 years, he has assisted entrepreneurs within service and contracting businesses to increase their return on investment. Visit http://www.opportunity-inc.com to contact them or learn more about their services

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