Examples of Biased Accounting Choices
Biased accounting choices refer to decisions taken by a company’s management to improve the reported financial results of a company. In particular, management tries to sell a story to investors that is not accurate. We discuss some examples of biased accounting choices and their related warning signs on this page.
We discuss many specific biased accounting choices that analysts should be able to identify and correct for when analyzing a company.
Mechanisms to mistate profitability
The following mechanisms to misstate profitability are often used by company management:
- aggressive revenue recognition, including so-called channel stuffing (aggressively selling products to distributors on generous terms such as lax return policies), bill and hold sales (where economic title to goods may not truly pass to customers), and outright fake sales.
- Lessor use of finance lease classification
- Classifying non-operating revenue/income as operating, and operating expenses as non-operating
- channeling gains through net income and losses through OCI
Clear warning signs of misstated profitability that an analyst should look out for:
- Revenue growth higher than peers’
- Aggressive accounting assumptions (e.g., high estimated useful lives)
- High rate of customer returns
- High proportion of revenue is received in final quarter
- Unexplained boost to operating margin
- Operating cash flow lower than operating income
- Executive compensation primarily tied to financial results
- Inconsistency in operating versus non-operating classification over time
- Receivable”s growth higher than revenue growth
Mechanisms to misstate assets/liabilities
Next, there are a number of mechanisms that can be used to misstate asset/liabilities:
- over- or understating allowances and reserves
- Choosing inappropriate models and/or model inputs and thus affecting estimated values of financial statement elements
- Understating identifiable assets (and overstating goodwill) in acquisition method accounting for business combinations.
Warning signs of misstated assets/liabilities one should look out for:
- Use of special purpose entities (SPEs)
- Inconsistency in model inputs for valuation of assets versus valuation of liabilities
- Typical current assets (e.g. inventory, receivables) being classified as non-current
- High goodwill relative to total assets
- Allowances and reserves differ from those of peers and fluctuate over time
- Large off-balance-sheet liabilities
- Large fluctuations in deferred tax assets/liabilities
Mechanisms to overstate operating cash flows
Even cash flows can be manipulated by the management. Mechanisms to overstate operating cash flows:
- Managing activities to affect cash flow from operations (e.g., stretching payables)
- Misclassifying investing cash flows as cash flow from operations
Warning signs of overstated operating cash flows:
- increase in payables combined with decreases in inventory and receivables
- Capitalized expenditures (which flow through investing activities)
- increases in bak overdraft.
We discussed mechanisms to overstate operating cash flows, to misstate assets/liabilities and to misstate profitability.