About ‘Fake’ Financial Statements...

Based on my experience every time I spoke on investment training, one of the most frequently asked questions by the participants is, how do we know whether a company's financial statements present the actual figures (revenues, net income, etc.) or not? Or in other words, what if the company falsified the statements? Well, since this might be a question of many, then here we will discuss it comprehensively. Here we go!

One of the concerns of the investors is related to accuracy of the information/numbers presented by the company's financial statements. For example, in the second quarter of 2014, the financial statements of PT Astra International, Tbk (ASII) showed that the company posted a net profit of Rp11.8 trillion (about US$ 1 billion) during the period January – June 2014. The question is, how do we know that ASII actually posted such profit? What if ASII’ profit wasn’t Rp11.8 trillion but smaller than that, or maybe larger?

Writing this, I remember with a friend of mine who is the owner of one of the largest private companies in Indonesia (not listed on the stock exchange), where we had a chat about this financial report issue (if I mentioned the name of the company you would know it, but he objected such disclosure). He told me that, as the owner of a large company that has many subsidiaries, it is not an easy task to recapitalize the data of revenue, net income, etc., of the subsidiaries, then consolidate it to its parent. As a result, even he himself could not guarantee that the data presented in the financial statements are accurate, and it's not because they (the management) deliberately manipulate it, but because the difficulties in consolidating a comprehensive data. Now imagine: If you are the owner of a small car rental company, it is relatively easy to calculate the net income: Earned income during a period minus the costs of fuel, driver salaries, depreciations, and so on until the tax. Then you may find the value of net profit. But if you are the owner of a business group engaged in the production and distribution of cars, oil palm plantations, heavy equipments and coal mining, banking and financial services, until information technology (such as ASII), then how to calculate the consolidated net income? Of course, it could still be calculated. But the greater the number, the greater the likelihood of difference between the actual and presented results of calculation, because the calculation must fit the standard of accounting.

That’s why Warren Buffet once said this: ‘Because of accounting limitations, our actual performance may not presented on the  financial statements of Berkshire Hathaway.’

When the management met with the independent auditor, there are often disputes about which numbers are correct, because of the difference earlier. For example, the management claimed that based on their internal calculations, the company posted net profit of Rp100 billion. However, after conducting an audit, the auditor stated that the company could not present sufficient evidence that its net profit reached Rp100 billion, but only Rp70 billion. If both parties (management and auditors) are equally adamant with the results of their respective calculation, the middle ground is taken. As a result, in the company's audited financial statements, the net income is not Rp70 or 100 billion, but maybe Rp85 billion.

Then, is the profit of the company actually Rp85 billion? Once again, not necessarily. In fact, no one can know exactly, what is the actual value of the net profit.

Note: When auditing, the auditor does not recalculate the value of revenue, net income, etc., but only evaluate the financial transactions of the company (by sampling), to find out that the company was actually conduct the transactions or not. For example, if the company claims to have spent US$ 1 million for the cost of  hotel, where it is recorded as an expense in its financial statements, then the auditor will ask for hotel receipts as proof of the transaction, a sample receipt is enough (not necessary all of them).

So, the task of the auditor is not to making 'an alternative financial statement', but, once again, only evaluates the figures presented in financial statements. If the company can not submit sufficient evidence related to the numbers they stated, then the auditor will probably give the opinion that the financial report is 'qualified'. The best opinion that can be given is 'unqualified', and to obtain such opinion, the companies often have to correct its financial statements several times in line with the evidence that can be submitted to the auditor, and at this point the 'middle ground' may be an option. Afterwards, the financial statements will be published, including the statement of opinion from the auditor.

The audit process takes an average of almost two months after the making of financial statements is completed (but not yet published because it was not obtained the auditor's opinion). That's why for the full year audited financial statements, the date of release is around March 31, or three months after the date of the financial statements (December 31). While for other quarters, the unaudited financial statements will be published one month after the date of the financial statements. For the first quarter ended March 31, for example, the financial statements will be published on April 30, or a few days earlier.

So, if you notice, in English, the financial statements referred not as a financial report, but financial statements. Various data and figures related to the value of assets, liabilities, equity, revenue, operating profit, and net profit of the company, it's all nothing more than a statement of one party, ie the management company, and is not a report that precisely describe the circumstances and the facts on the ground. For example, when XXX Corporation mentioned in its financial statements that the value of equity or net assets (after deducting all liabilities) was US$ 1 billion, then when the company was liquidated (in case of bankruptcy or others) in which such assets are sold and then some of the money used to pay off all debts/obligations, then the value of the remaining cash will not necessarily be exactly the US$ 1 billion as well, but could be less or more, depending on many factors (if the sale conducted quickly, it is likely that selling price of the assets will fall, so that the collected money would be less than Rp1 trillion).

That is why, to confirm all the figures in the financial statements, the company would require an additional statement from a third party, in this case the independent auditors, in which the statement is not a 'second financial statements', but simply to express an opinion that the financial statements are fairly stated or not.

The Indonesia Stock Exchange as the stock exchange authority requires the companies to appoint auditors to audit their financial statements at least once a year (quarterly financial statements may not be audited, but the annual financial statements must be audited). However, even the presence of the auditor still does not guarantee that the financial statements of the company will be 100% correct, or at least in my opinion, because of the things we’ve discussed above: The middle ground when difference occured.

Logo of PWC, one of the most prominent auditor firm in the world

But, are you saying that the financial statements of the public companies are all fake? Well, not fake, only that the accuracy can not be guaranteed, and once again it is not because the company deliberately manipulated the figures (although the possibility of such manipulation will always be there), but because of the difference that may occur when calculating the value of net profit, etc.

But in my experience so far, it does not actually matter. Whether the financial statements are correctly or not, it is obviously that all investors look at the same financial statements, because there are never ‘alternative financial statements’ or the like. For example, when ASII stated in its financial report that their net profit until second quarter of 2014 was Rp11.8 trillion, we may never figure out if it is true or not, but you cannot find other data (or other versions of the financial statements) which states that the profit was not Rp11.8 trillion, but only (for example) Rp10 trillion.

And when certain information can only be obtained from a single source, then you do not have to worry that you will get it wrong, because other people also obtain the same information. When you read that the net profit of ASII was Rp11.8 trillion, then the fund manager at Schroders also read the same numbers. As a result, whether it is an actual number or not, but everyone agrees that the net profit of ASII was actually Rp11.8 trillion.

Here’s the analogy. When the Central Bureau of Statistics (Badan Pusat Statistik/BPS) states that the rate of economic growth in Indonesia in second quarter of 2014 was 5.1% (year on year basis), you may ask, is it correct? Whether it is or not, but it is used as a reference by all the people, or in other words is considered correct by everyone, because there is no alternative data.

But when a political polling organization stated that according to their poll, a particular party will win the elections, then people would not immediately believe the data, because there are several other organizations that also present their own data, which is different from each other. In the case of the data presented in the financial statements, this does not happen because for any company, there is only one financial statements for a certain period, and there is no 'second financial statements'.

And if the financial statements of a company did show encouraging results, while on the other hand the shares price are still low, then it will also rise. Simple example: At the beginning of 2013 and then, property stocks had increased significantly because of its outstanding book performance in 2013. In this year the property stocks are not able to climb back up, then it was because in 2014 the net profit of most of property companies are down. Another example, the shares of coal and oil palm plantations company were somewhat slumped during 2012 - 2013 for their sag financial performance, but this year the stocks in the two sector started to move up, and it's because of some of coal and oil palm plantation companies (although not all of them) began to post an increase in income and profit.

If you are curious, you might ask: 1. Is it true that the profit of property companies rose a lot in 2013, and 2. Is it true that the profit later down in 2014? Well, even if you doubt those two facts, but everybody only sees the same data and numbers, so they execute the buy and sell of stocks based on these data. And that's why most shares in the property sector gained a lot in the 2013 because people were buying it (because of good financial statements of property companies). But after a mini-crash in the end of 2013 and then, they apparently do not rebound (while the stocks of construction companies, although it were also down substantially at the end of 2013, but they quickly climbed back because their performance is so far still good).

And the last example, if you read the financial statements of Bakrie Group companies, then you could easily see that their performance are very, very messy: Equities are constantly dropped (even up to negative), a mountain of debts, and heavy losses. Even if you assume that their performance might actually not as bad as it looks, but other investors also look to the same financial statements, so they avoid the shares. As a result, the fate of Bakrie stocks, you can see it for yourself.

Tips in reading the financial statements

However, as already mentioned above, the possibility of deliberate manipulation of the financial statements will always be there. In addition, the biggest problem that is often experienced by an investor is because he did not read and analyze financial statements in details, that lead to misunderstandings. For example, I often receive complaints, 'Dear Sir, do you know why the A stock is falling? I don’t understand, because I saw that its profit rose.' And that's when I have to explain once again that just because a company posted an increased net profit, it does not mean that we can directly conclude that its financial performance is good, because there are still some other things that also need to be considered in its financial statements, not including share valuation. So if an investor suffered a loss because of this, then it was not because the company manipulated its financial statements, but because he cannot read the financial statements in details.

And the tips that can hopefully help you to discern the financial statements of quality (read: present the data and numbers that are likely to be actual) and the financial statements that is ‘suspected fake’, is as follows: You should choose a stock/company that presents ‘clean’ financial statements, which is presented in a simple, neat, without weird accounts. For example Unilever Indonesia (UNVR), where in the profit and loss statements you can find the accounts of sales, that is after deducting of the cost of goods sold, marketing expenses, general expenses, financial income/expenses, and taxes, the value of net income is obtained.

Meanwhile, if you look at the financial statements of Benakat Integra (BIPI), in its profit and loss statements, there are several accounts that are a little bit complicated, such as other profits/losses (if written 'other', it usually has nothing to do with the company's operations, or in other words, the account is not supposed to be there), gains/losses arising from the translation of the financial statements, and the increase/decrease in fair value of financial assets that are available for sle. The more complicated the accounts, the greater the likelihood that the numbers have been ‘enginereed’.

The most famous case in this regard is when Enron, a giant oil company in the United States, have been caught manipulating its financial statements and finally declared bankrupt in 2011. At the time, the stock analysts of Wall Street also claimed to be confused when they studying the financial statements of Enron, which is filled with accounts of 'transactions by related parties', ‘derivative transactions', 'losses of impairment of investments’, and the like (Enron's auditor, Arthur Andersen, also eventually went bankrupt after they recklessly continued to provide opinion of 'unqualified' for Enron’s financial statements).

In addition, be careful with companies that are often late in releasing its financial statements, or companies which appoint auditors who are not-too-credible to audit its financial statements. Some of the business groups that have high credibility like the Astra Group, no matter how good or bad their financial performances are, they always released its financial statements on time in the last five years, and they always use the services of PriceWaterhouseCoopers (PWC), one of the big four of world-class auditors, to audit their financial statements.

Then, to read the financial statements carefully, you should not read the financial statements only at glance, but must since the beginning (the section of current assets) to the end (cash flows), including the explanation points (in the 'notes'). By that way, you will obtain a more comprehensive information than just 'the company’s profit has grew significantly'. If the company posted a skyrocketed net profit, you must check the origin of the increase, whether from the sale of assets or actually from operations. Another case that frequently occured is when the value of equity/net assets of the company increased significantly, so the valuation (the PBV) was low, but it turns out that the increase came from the additional paid-in capital, revaluation of assets, etc., and not because of a real increase in retained earnings. And so on.

Hufftt, okay, I think that's pretty enough. Actually, if I remember again, I've wrote a similar article a few years ago, also in this thpartner.com website (try searching the article in the article archives on the right), but it seems that most of this website’ visitors only read recent articles. That's why, that last tips I can give on this occasion: After you finish reading this article, do not immediately move to other websites, but please read and read again other articles (from 2010 till now, a total of about 200 article). Trust me, it will worth your while!