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Failing to write down assets with Impaired value (AS 28 Impairment of assets)
Failure to write off obsolete inventory Increase in inventory levels whether on
account of estimation of increased future sales or due to no market/ slackening
demand for the product . Inventory holding period will signal the problem (case
Coldwater creek, pg 128)
Failing to record expenses for uncollectible receivables and devalued investments
Failing to record Allowance for bad and doubtful debt leads to overstating of earnings
Indicators
Be wary of the change in policy from expensing costs to capitalizing them
and the impact on earnings
Be cautious about large jump in capital expenditure (capex) vis--vis
planned/committed commitments
Prepare common size statement (expense as % of sales), see the trend, find
reason for sudden drop in expenses
Free cash flow (OCF less capex) deteriorating at a much higher rate than
before (as capital expenditure will increase due to capitalization of expense)
New and unusual/unexplained asset account
Stretching out depreciable assets life
Amortizing or depreciating costs too slowly can be checked by comparing
policies followed by the companies in same industry
Study the Auditors complete report
Study the stock and receivables audit report
Surprise visit to the clients premises in suspicious circumstances
Compare budgeted figures (submitted at the time of sanctioning limits) with
actual figures for the quarter/year and find the deviations
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EM-5
Closely monitor the foot notes to see future purchase
agreement that signal heavy burden of the company's
earnings thus negating the lending decision
Case- Columbia Gas Systems CGS signed Take or Pay
agreements to purchase substantial amounts of Natural Gas
at above market price. Gas price plummeted and it could not
sell the gas at a price anywhere near its cost. CGS had to
honor the commitments to its suppliers while its utility
customers were free to purchase gas from cheaper sources.
CGS filed for bankruptcy thereafter
While modeling future periods for a borrower; look critically
at the movement in the prices of products and any such
binding agreements that may lead to questions on
sustainability.
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EM-5
Boosting income by changing pension
assumptions (will be covered in session on
pension liability)
Pension expense is recorded based on certain
assumptions made by the management
True economic cost of post retirement obligation
can be concealed by the company, if estimate of
expected rate of return on plan asset is taken
higher than the reasonable estimate of market
return
Indicator Check for the return rates used by peers
EM-5
Reduce expenses by releasing reserves
from previous charge
Companies indulge into creation of bogus
liability/provision during the period of good
earnings
These provisions can be written back (reserve
for the rainy day!) as a reduction from expense
thus boosting the reported profits
Indicators watch for sudden drop in liabilities
(at times masked as other liabilities) and read
notes to accounts carefully
Case Sunbeam Corporation (pg-155)
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Indicators
Always prepare common-size
statements to find out major
deviations
Study Auditors report
Critically check the write-back of
provisions
Read notes to accounts carefully to
see whether any contingent liability
has a probability of devolvement the
provision for which has not been
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Sources
Financial Shenanigans by Howard M. Schilit and
Jeremy Perler
Accounting Standards issued by ICAI
Research papers from Journal of Accounting
The Serious Fraud Investigation Office (SIFO)
http://www.watchoutinvestors.com - Site formed
by Ministry of Corporate Affairs, Government of
India, Investor protection and education fund and
SEBI
http://www.watchoutinvestors.com/compindex.asp
?findword=A
list of companies alleged on different grounds
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