Question

In: Accounting

Evaluating a company’s economic health and stability is just as important as evaluating their performance. Economic...

Evaluating a company’s economic health and stability is just as important as evaluating their performance. Economic health metrics should provide insight into the strength of a company’s Balance Sheet. What metric is distorted to hide revenue problems, and how would a company go about distorting this metric?

Solutions

Expert Solution

Most of the companies attempt to show higher revenue & profits during the current period to meet or exceed market expectations. Higher earnings in the current period act as a strong factor to raise the market price of the company’s shares and increase the wealth of promoters/managers who stand to benefit from their stake/stock options in the company.

However, there have been cases when companies have tried to mask the current good performance and tried to defer revenue/profits to a future period so that they can show sustained performance during upcoming tough times.

Deferring current good earnings for future periods helps the company to show sustained performance during bad times, thereby, giving the impression of a resilient business model to the markets. Stock markets usually assign higher multiples (P/E ratio) to such companies, which show stable performance with low volatility in earnings. Therefore, the management has sufficient incentive to act both ways.

Managements may use the following techniques to inflate their current period earnings:

  • Recording revenue too soon
  • Recording bogus revenue
  • Boosting income by using one time or unsustainable activities
  • Shifting current expenses to a later period
  • Using techniques to hide expenses or losses

Managements may use the following techniques to subdue their current period earnings in an attempt to inflate future period earnings:

  • Shifting current income to a later period
  • Shifting future expenses to an earlier period

All these steps could easily help the management achieve their objectives. However, there are certain checks and balances in place in the system, which often play the spoilsport for such managements:

  • the requirements of disclosures about revenue recognition and other accounting policies and
  • the presence of three financial statements: Balance Sheet, Profit & Loss, and Cash Flow Statement, which talk to each other. If the management tinkers with one of these statements, then there is a very high probability that investors would find signs of unhealthiness in the other two statements.


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