Off Balance Sheet accounting

As an investor we would be looking for information that is from various sources like annual report, news, analysis etc. But truly there are times when we are not sure about how the company is making money. Though one may think of spending more time in knowing exactly what the company is doing. But that may not be true, as managers may choose not to disclose those to the public. Hence there is always a cap on the information available to the public when there is no ceiling set by any governing body.

This is the major reason why stock market are inefficient!. Let us look more closely at specific accounting malfeasance. This will help us see what is the information that we should be looking more closely when evaluating a company? The biggest corporate scandal in U.S happened in the starting of this decade including Enron, WorldCom.

Although Enron was involved in more than one accounting scandals, the important one was the off balance sheet accounting. It is just pure number jugglery. Towards the end of a financial year if Enron notices that there is $3, 00,000 bad debts, it will simply create a Special Purpose Entity to get this huge debt off the record and create revenue! Now you might wonder what this SPE – Special Purpose Entity is? It is another entity set up by the Enron. Now how would this SPE raise money? They would finance it through banks. Isn’t surprising to know which bank would lend money for such bad debts. But much to our surprise it is all the globally reputed banks. Now the real motivation for the banks to lend money is the coveted stocks of Enron which was consistently increasing in value. That is surprising to see, how the market will evaluate a company with such an accounting practice.

The story doesn’t end here as the equivalent stock which was pledged for this bad debt should also have an accounting entry. This is where the Enron were smart in using the loop holes in accounting standards. They booked them under the issue of stock against promise to pay- notes receivable. Although there is a long standing accounting rule that says Notes Receivable created for the issue of stock should not be treated as an asset but as a contra equity- deductions from owners’ equity. But Enron actually treated as an asset. This is the multibillion dollar “mistake” that Enron did. Without any genuine earnings they were able to bloat their balance sheet!
WorldCom story was a little different. It overstated cash flows by booking $3.8 billion in operating expenses as capital expenses. For an exhaustive list of accounting scandals refer to the link below
http://www.forbes.com/2002/07/25/accountingtracker.html

There is a separate area called the forensic accounting which provides report on the insights into this number jugglery. Now as an investor what are the word of caution?
1. Income from unspecified source, that are not revealed or from special purpose entities
2. Loading of inventories to a sister company
3. Income from asset sales or financial transactions
4. Frequent accounting restatements
5. Accrual earnings that run ahead of cash earnings consistently
Although the list is not exhaustive these are the learning from the past. But the most essential thing for any successful investment as Warren Buffet says is to invest in something where you really know and like the business! It is strange though to see the herd mentality.