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Financial Trick # 3 – Leaving Out Liabilities

How does a company make itself look more valuable?

Among the many ways that "creative" accounting can be used, under-stating or leaving out liabilities is an effective way of increasing reported net worth. How does a company simply make their debts disappear? By entering into a sham partnership with an offshore company, some debts can be hidden. The company forms the fake entity and then through a series of journal entries, move liabilities off the balance sheet so they are not reported.

An easier way to under-report liabilities is to simply leave off current accounts payable. These are funds owed to suppliers for current-year expenses. By failing to book the expense, net income is increased; and by not listing the liability, the debts are under-stated and net worth is reported higher than it should be. The same, fairly simple trick can be applied to taxes payable and even to notes and other debts.

Some liabilities are excluded within the accounting rules, and these further distort the truth. For example, contingent liabilities are items that might be owed in the future, but are not booked yet. For example, a company is being sued in a class action suit and if they lose, it could cost millions or even billions. But because a judgment has not been entered, you find these contingent debts listed only in the footnotes. Accounting rules state that when a contingent liability is reasonably expected to materialize in the future, it should be partially or wholly accrued in the current year; but this rule is easily overlooked or ignored, reducing liabilities and again increasing net worth artificially.

A company also will not always report its liability under a long-term lease agreement. By contract, the company is legally obligated to make future payments on the lease, but it is not uncommon for this to be excluded from the list of current and long-term liabilities. Even the footnotes to the statement might not include these items.

All under-reported or manipulated items can be discovered in an audit, but unfortunately the history of independent audits is that they often are far from independent or accurate. It takes forensic investigation of long-term trends in liabilities to spot anything out of order, and for most analysts, it is simply too complex to pursue. But anything manipulated in the liabilities is also going to show up on the income statement. So when you see a sudden and unexpected spike in earnings, it pays to also examine the levels of liabilities over the past few years. This is very basic analysis, but with a nicely detailed research report such as the S&P Stock Reports, you can spot suspicious changes from one year to the next.

The next step: Get in touch with the shareholder relations department of the company and ask for an explanation. If you get no reply or the reply makes no sense, it could mean that something is amiss.

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