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July 7, 2022

Bending The Numbers

Deceptive Accounting Practices

With earnings season coming around four times a year, and the balance sheets of many companies always under heavy scrutiny by analysts and investors, it pays to know some of the accounting tricks that some companies use.  Two of these tricks, one-time charges and investment gains, pop up regularly on financial statements.  But while both are legitimate accounting practices, they can be deceptive about how the company is truly faring.

The vast majority of publicly traded companies use the Generally Accepted Accounting Principles (GAAP) as a method of keeping their books.  While the GAAP is a standard, formalized method that does a good job of making all companies tally their balance sheets in the same way, it does allow for a little give and take with some figures.  Most notably, the methods used to tally a company's total worth can vary slightly.

One-Time Charges

One-time charges are probably the most frequent balance sheet loophole exploited by large companies.  Of course, this isn't to say a company taking a one-time charge is doing anything wrong or even trying to deceive anyone.  One-time charges are perfectly legitimate and are actually a necessity in certain accounting situations.  But some companies do seem to take advantage of one-time charges far more often than they should, and that abuse can mislead investors.

A one-time charge is an expense that a company has incurred due to a its own mistake, merger, bad debt, major purchase, etc.  The charge is one that should occur only once as an isolated event outside of the business's normal operations, and not every quarter or year -- hence the ‘one-time.' 

Rather than put these charges in the main quarterly income statement, they are given a separate designation.  This allows the company to demonstrate its normal earnings growth to investors, without the one-time charge adversely affecting the all-important growth figures, or damaging the long-term earnings projections of the company. 

There are obvious reasons why so many companies would take advantage of the one-time charge.  Any loss that can be removed from the income statement and assigned as a one-time charge allows the company's overall earnings to appear to improve.  Of course, not just any loss can be written off.  It truly has to be a one-time event to qualify for the designation.

Unfortunately, some companies try to take advantage of this method.  Businesses that somehow seem to take one-time charges year after year are probably covering up fundamental problems within the company.  Because there is some gray area concerning what constitutes a one-time charge and what does not, some companies stretch the truth in order to make their balance sheets look better.

Anytime a one-time charge is taken by a business it should be greeted with skepticism.  If it is a legitimate charge, it will truly only occur one time.  If a company has a history of one-time charges on its record, chances are that something is amiss.  Investors should be wary of these balance sheets that don't always tell the full story.

Investment Gains

The other way some companies misrepresent their real value on the balance sheets is through investment gains.  While most companies of any significant size use part their wealth to invest in other companies, the outcome of these investments is no more assured than for any other investor.  During the dot.com boom of early last year, many companies were able to significantly raise their overall returns on the balance sheet due to lucrative investments.

Of course, the folly of projecting future earnings with the income derived from investment gains became apparent when the Nasdaq plunged more than 60% last year.  Many companies had invested heavily in technology and were hurt even worse than the main indices.  Just because a company has a good management team or a best-selling product doesn't mean it will be able to beat the Street.  Investors should look carefully to see how much of a company's earnings are derived from inconsistent investment gains.

Unfortunately, some companies have even used investment gains as a sort of last-ditch effort at improving their bottom line.  A recent trend has seen some businesses use speculative investing to try to meet earnings projections or make up for failing units of their business. 

While some of these companies do succeed in making big returns by using this method, it is a particularly foolish practice in that it puts capital needlessly at risk.  Even if a company does succeed in covering some losses with a successful speculative investment, it is still misleading investors by essentially masking a lucky streak in the guise of sustainable income. 

The investment gain section of a financial statement should be read with care, and an investor should not expect an unusually good return to be duplicated in the future.  Diversified investments are a good way for a company to derive solid, steady income, but wild speculation puts the company's money at risk and calls the ability of the management into question. 

Keep an eye out for balance sheets that seem too good to be true.  Oftentimes they are.  By checking for both one-time charges and investment gains, an investor can significantly reduce the chances of being burned by shady accounting practices.

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