While selecting stocks, direct investors always need to be more careful. Besides, looking at quality of management and business, financial accounting of companies is often an area that needs to be understood property. This is because the changes in the accounting policies and the manner in which some entries are made can impact the overall profit.
The investor may not know much about it though they are directly impacted by such changes. As a result, they are caught on the wrong foot. Here are a few common entries in the company's balance sheet they should look out for that would impact their investments.
There are some expenditures that are made by companies that are unique in nature. They are neither creating an asset nor generating revenues. They are also known as deferred revenue in nature.
This kind of expenditure includes, research and development cost or expense incurred on brand building. The way in which these expenses are treated is that they are written-off over time.
This means that a part of the expense is written-off every year in the profit and loss account. However, sometimes companies often take a shortcut and directly write- off the amount against the reserves of the company.
In technical terms, the final impact here is the same because the impact is on the reserves of the company and not on actual revenues. By doing so, the company is able to show a higher profit. An investor should look at such situations carefully because the profit is higher than what it would have been.
There are also several details regarding sales that should be taken into account. For instance, an earlier way of showing rising sales was by including inter-departmental transfers as sales. And unless one took a closer look at the nature of accounting in such cases, it was very difficult to know what was actually leading to rising sales.
Another variation of this route is to make sales to companies within the same group and then show the resulting figure. Once again, there are accounting requirements to show the transactions done with related parties, but there are very few people who look at these details while making investments. All these need careful scrutiny.
Often the excise duty paid on a product is also included along with the sales figure. This, once again, can give a wrong impression to the potential investor. This kind of break-up is essential because a higher excise duty amount can inflate sales but might not translate into profits down the line.
There is also a grave danger of the impact of roll over of debts that might escape the attention of the investor. When times get tough, there is a pressure on the payment of debts against purchases that have taken place. If any company finds it difficult to service these instruments or obligations, there could be a problem of default.
However, since both the lender and borrower do not want to take flak for making a wrong decision, they simply postpone the date of repayment. Investors often have absolutely no idea about the window dressing of the balance sheet.
The postponement is done by rolling over the loan before the end of the financial year. This leads to closure of an old loan and at the same time, opens up a new one. In reality, nothing has really changed at the ground level.
This kind of postponement is also possible with debtors who are unable to pay on time and hence, end up as bad debts. By rolling over the debt, the company is able to show that there is no problem in their books. An investor should carefully scan the balance sheet and look at such anomalies before investing in the company.
The writer is a certified financial planner