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Financial Trick # 2 – Capitalizing Expenses

Among the tricks used to increase the current year's reported net profit, is a reduction in expenses through capitalizing. This is difficult to spot unless you track long-term expense and earnings trends.

A company capitalizing a long-term asset and depreciates it over time. This process involves setting up the purchase on the balance sheet, and then reducing it every year through depreciation. In this orderly manner, a long-term asset (like machinery, vehicles, or even buildings) is recognized over many years and not just in the year bought. To write it off as a current-year expense would artificially reduce this year's profits. In this procedure, it is correct to set up an asset and gradually reduce it over a specified recovery period.

However, when the same procedure is used improperly, the current year's net profits are inflated, creating a false impression that profits are high. This encourages investors to buy shares based on inaccurate results.

When should current-year expenses be set up as assets? There are a few exceptions to the rule that this should not be done. For example, if a current-year expense applied over several years, it should be set up as a prepaid asset and then amortized. For example, a company pays this year for a 36-month casualty insurance premium. It should be written off not all in this year, but over the next 36 months.

Now consider the deceptive practice of setting up expenses that do belong in the current year, and deferring them until later. If these expenses should be written off, they belong in the expense ledger and not in the list of assets on the balance sheet. It is easy to just make a journal entry transferring current-year expenses to either long-term assets or to "deferred" assets, with plans to quietly reverse these entries in a future year when profits are much higher. This increases the current-year earnings, but deceives investors into believing that the company is much more profitable than it is. This may cause the stock price to rise as more people buy shares based on healthier earnings per share (NYSEARCA:EPS) and artificially modest P/E ratio.

All forms of manipulation betray the confidence the investing public has in the financial statement. If a falsely deferred expense item is included and the books were audited, the entry should have been challenged. However, the past demonstrates that auditing firms often do not challenge their clients or question their false entries. Auditing firms want the business and have been known to allow false reports to be published as part of their process. This is a conflict of interest, of course. However, there is a lesson here for every investor: Do your research.

If you see a trend moving oddly, question it. So in a year when the net earnings suddenly spike higher than the 10-year average, you might also notice an unusually low level of general expenses. Next, look to the balance sheet and read the footnotes. The skilled accountant can easily come up with a reasonable-sounding explanation for deferring expenses and write a confusing footnote to mask the deception.

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