How Financial Report Readers Can Detect Problems in Undervalued Liabilities - dummies

How Financial Report Readers Can Detect Problems in Undervalued Liabilities

By Lita Epstein

Undervaluing liabilities can certainly make a company look healthier to financial report readers, but this deception is likely to lead the company down the path to bankruptcy. Games played by misstating liabilities frequently involve large numbers and hide significant money problems.

Accounts payable

Most times, an increase in accounts payable is directly related to the fact that the company is delaying payments for inventory. To test for a problem, you need to calculate the accounts payable ratio. If you find a trend indicating that the number of days the company takes to pay its accounts payable is steadily increasing, test the number of days in inventory.

If the company fails both tests, investigate further. Even though the company may not be playing games with its numbers, take these signs as an indication of a worsening problem. With the trends you’re noticing, definitely call investor relations and ask for explanations about why the company has been paying its bills more slowly or why the inventory has been sitting on the shelves for longer periods of time.

If investor relations doesn’t answer the questions to your satisfaction, don’t buy the stock. If you already do own the stock, you may want to consider selling it if you believe the company is hiding the truth.

Accrued expenses payable

Any expenses that a company hasn’t paid by the end of an accounting period are accrued (posted to the accounts before cash is paid out) in the current period, so these expenses can be matched to current period earnings. This amount is added to the liability side of the balance sheet.

Unpaid expenses can include just about any expense for which the company gets a bill and has a number of days to pay, such as these expenses:

  • Administrative expenses

  • Benefits

  • Insurance

  • Salaries

  • Selling costs

  • Utilities

If the bill arrives during the last week before a company closes its books, the company most likely will accrue it rather than pay it. Most firms cut off paying bills several days before they close their books so the staff can concentrate on closing the books for the period.

If a firm needs to improve its net income, it can manage its numbers by not accruing bills and instead paying them in the next accounting period. The problem with this strategy is that the next accounting period has more expenses charged to it than the company actually incurred during that accounting period. The expenses will be higher and the net income will be lower in the next reporting period.

You can test for this particular game by watching the trend for accrued expenses payable. Check to see whether accrued expenses payable is going up or down from accounting period to accounting period. Usually, accrued expenses payable stay pretty level. If you see a steady decline, the company may be doing some creative accounting, or maybe the company’s decrease in expenses is simply due to discontinued operations or other changes.

If you see a declining trend, look deeper into the numbers to see whether you can find an explanation. If not, call investor relations to find out why the trend for accrued payables shifts from accounting period to accounting period.

Contingent liabilities

Contingent liabilities are liabilities that a company should accrue when it determines that an event is likely to happen. For example, if the company is party to a lawsuit that it lost and the winner was awarded damages, the company should accrue the liability as a contingent liability.

A company must determine two factors before it can list a contingent liability on its balance sheet. Factor one: The company deems it probable that it will be held liable. Factor two: The company can reasonably estimate the costs that it will incur.

If the company hasn’t determined these two issues, you’ll probably find a note about the contingency in the notes to the financial statements. Read the notes about contingencies and research further any items you think the company may not be fully disclosing. You can do so by reading analysts’ reports on the company or by calling the investor relations department to ask questions.

Pay-down liabilities

Another way that the firms involved in the scandals of the past three years played with their numbers was by indicating that they paid down their liabilities when they actually didn’t. To make its balance sheet look better, a company may transfer debt to another entity owned by the company, its directors, or its executives to hide its true financial status.

You probably won’t have any way of knowing whether this is happening until a company insider decides to expose the practice or the SEC catches the company.