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.
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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!
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