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3 Ways to Spot Aggressive Accounting

Before I had learnt anything about accounting, I have always thought that accounting is a “black and white” system, where all issues have a non-fuzzy definition. How wrong can I be?

Billionaire investor Warren Buffett calls accounting “the language of business and it’s an imperfect language.”Accounting standards are full of assumptions that are usually made under the discretion of management. Sometimes, these assumptions can be aggressive in nature, such that they might legally mask the true economic characteristics of a business.

How then, can we spot aggressive account methods being used by a company’s management? Let us look at some places in a company’s financial statements that we can start with.

Non-Recurring Expenses

Non-recurring expenses are typically expenses that are supposed to be one-off in nature. Thus, when management presents their company’s operational performance, they might exclude these non-recurring expenses.

However, there are cases where companies go on to record non-recurring expenses regularly. In such an instance, it could be telling us that those expenses might not really be non-recurring in nature and that we should take a cold, hard look at those expenses.

Delayed Expenses

There are cases where a company can actually capitalize some of its expenses – in other words, turning the expenses into capital expenditures – if it can show that the expenses incurred have a long-term lifespan.

When expenses are capitalized, the asset base of the company gets larger while its operating income gets a boost at the same time. This butters up a company’s income statement and makes its profits look better than it actually is.

Therefore, management who pursues aggressive accounting methods might want to deem more expenses to be part of the company’s capital expenditure program as compared to more conservative peers.

Off-Balance Sheet Liabilities a.k.a. Hidden Liabilities

Operating leases is one method a company’s management might utilize to keep some liabilities off its balance sheet as these leases are generally only stated in the footnotes of financial statements.

These operating leases, despite not being recorded as liabilities on the balance sheet, would still require a company to make regular (sometimes obligatory) payments for use of whatever property and equipment that’s classified under an operating lease.

Airline companies, for example, have been infamous for having large operating leases as they try to keep large costs involved with the acquisition of expensive airplanes off their balance sheet.

On the other hand, the casino and resort operator Genting Singapore (SGX: G13) – part of the 30 components of the Straits Times Index (SGX: ^STI)  – only has about S$ 6.3 million worth of operating leases that are reported in the footnotes of its last annual report.

In comparison, the company has S$ 11.5 billion worth of assets on its balance sheet and so, investors can feel safer knowing that there are no huge hidden liabilities lurking somewhere.

Foolish Bottom Line

To be certain, we are not talking about having the ability to catch extreme fraud cases like Enron or WorldCom.

However, most large frauds start from a very small level. The ways described above can give investors hints on whether a company’s management is more aggressive in how they deal with their accounting. If we are able to avoid such situations when it’s a smaller issue like legal-but-aggressive accounting, we might not get affected when the small issue snowballs into something much bigger, like outright fraud.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.