A balance sheet of a company is divided into two parts, that as the name suggests, must balance each other out. The formula behind balance sheets is:
In the last Stock Shastra, we saw what are the assets of a company and how are they manipulated by various companies. It’s now time to look at how companies indulge in undervaluing liabilities. An undervalued liability is one that is reported at an amount less than the true value of the underlying obligation. These amounts might be undervalued until true amounts owed are acknowledged and recorded on the balance sheet. Undervaluing liabilities can show a better picture of the company’s financial position.
So, let’s find out what are the techniques used for liability management? And what are the red flags that will enable investors to identify these?
So what are the liabilities commonly manipulated by companies?
Liabilities that you should look out for are the ones arising from operations viz. accounts payable, accrued expenses payable, tax-related obligations, and contingent liabilities. This is because their effect on earnings is more direct and their amounts are more subject to manipulation. The table below shows how liabilities are placed on a balance sheet:
Let’s see what are the methods used for undervaluation of liabilities?
All of us have bills to pay at the end of the month; credit cards, mobile, electricity, milkman, laundry…the list is endless. We use these products and services during the month and hence owe them a certain amount at the end of the month. Similarly, companies buy raw materials for the products they manufacture , usually on credit, and hence owe their suppliers money for the raw materials. This money that a company owes to its suppliers is nothing but accounts payable. But sometimes companies may decide to tone down the amount they owe to vendors especially if they are having a bad year. Have a look at the table below to see how their accounts would look in this case.
As can be seen, even when revenue and inventory purchases grew in FY 10, accounts payable decreased by 12.5%. Though such a situation does not necessarily indicate an account manipulation, it definitely warrants further scrutiny on the part of investors.
Let’s see what are the warning signals available to investors to identify accounts payable fraud?
A contingent liability is a potential cash outflow that is dependent on the occurrence of some event. Suppose Mr. A whom we met in the previous Stock Shastras does not use upgraded technology in his bakery. As a result his bakery lets out a lot of smoke through the chimney, polluting the air in the vicinity. A resident of the area notices this and lodges a complaint against him. The result is that Mr. A now has a court case pending against him for environmental damages. Accounting standards state that Mr. A should provide for the possible damages he may have to pay. However, if he does not record this, it would lead to an understatement of a liability.
Investors should also be particularly wary if the amount shown under contingent liabilities is very high. Such a situation would demand a thorough investigation of the footnotes of the company pertaining to contingent liabilities.
So what are the red flags that will help investors identify these contingent liabilities?
Concluding, it is necessary that we investors shortlist a few companies we would like to invests in. And before investing in these companies analyse their annual reports and notes to accounts to be sure of the company’s business and dealings. Given below is a checklist that summarizes all the warnings available to investors that suggest that a company may be involved in undervaluation of liabilities.