Art of Managing Balance Sheet

How balance sheets are made beautiful

Art of Managing Balance Sheet

IFRS is considered as one of the greatest innovation in modern accounting, developed by the accountant themselves and also promoted and ranked as best themselves. I am just giving few insights into how companies are using IFRS to show how good they are. How healthy and beautiful they are.

· Associate Company

This is very important class of assets, it is 20% and above companies are called associate companies, but if company can prove through board presentation or with any other evidence to their auditors even lower stake can be considered as associate companies.

o These associate companies are carried out on balance sheet on book value or acquisition cost/ it is at management’s discretion to decide which method to follow.

§ (Companies are using this gimmick to keep the companies at acquisition cost even though their present value/ market value is lower than acquisition cost.) – This is the area where much due diligence is required while analyzing the balance sheet of the company.

· Mark to Market – AFS – Risk discloser

This is second important grey area for playing. When there is nothing to mark against then and even if there is something companies need to convince their auditors there nothing and no risk involved and it can be kept at acquired value/ book value. How nice it is, the bond, the treasury and junk all in one basket nothing to mark.

o The value of non traded securities of all kind is kept at acquisition cost conveniently even if they are junk. Equity, bond’s treasuries and everything are valued at convenience of holder and not at price market is willing to pay.

o What about derivatives swaps and covers companies has bought. They are not mentioned or even if they are mentioned in risk it is non quantified in small letters.

o Few Examples who lost millions in such transactions.

§ Harvard University

§ Gulf Bank

§ Wokhardt Pharmaceutical India

Municipalities

§ Italian Municipality

§ Australian Rail Road

§ (Still today these transactions are not quantified and not mentioned, no one in this world really knows how much each sovereign state has on its books which can take them to bankruptcy, and Greece is only tip of iceberg.)

· Work in Progress

Work in another interesting area, when assets are constructed or developed or physically acquired they are work in progress till completed. The stalled projects, completed but yet not sold out and also those which has no hopes of completion are all work in progress carried at a value which best suits the company. Companies are using this term to hide their losses and also putting expenditure as capital expenditure so there is no trace of what really going on in the company.

o Few examples of managing work in progress

§ A project which is stalled for last three years, not completed and there is little or no hope of completion in near future is valued every year upside. The hardware and software which are three years old by this time outdated are still at acquired cost as part of capital work in progress. And also equipment which arrived but cannot be used is all at their acquired price.

§ There are many more such examples, commercial complex ready for possession two years ago not yet occupied is work in progress and the company is not even able to pay interest taken to the project, is capitalizing the interest and work in progress is increasing. Even though the fair value of the project is substantial down.

· Intangible assets, goodwill ,brand value and IP’s ( Intellectual Property )

When companies has problems defining and valuing what can be seen and felt, what do you think they will do with intangible which cannot be seen and felt. There is transaction for the same and cannot be explained, can only be believed. These all class of the assets are always for the benefit of the company; in real life it will never create losses on balance sheet of company. They may have been gone long time ago but legacy of it will not go from the balance sheet.

o Few examples from few balance sheets

§ A company which acquired and agency along with product line, but most of these product are no more sold and legacy cannot be sold any more, the overall sale is in decline still the good will paid is there in the balance sheet.

§ When company is acquired along with customer and product, the acquirer has paid separately for the customer and I never been able to understand, what it is really mean and even though company is no more making profit the paid cost for customer is there as intangible assets.

· Receivables

Here I am not talking of receivables of banks or the investment companies, here my only discussion is operating companies who sales services and products. The companies in the year end to achieve results dump the product in the market and show the sales and create receivables against it. This is one common practice, but the real problem is when these receivables become old and non collectible and still remains in the balance sheet. There must be provisioning for the old receivables and write off for non collectibles. These policies must be clearly mentioned in the documents and policies.

o Few examples of receivables management

§ When I look at performance of one of big travel company which is ranked among first few, sales is increasing every year at least 20% and so is profit. Management and everyone are very happy to see it. General Manager has got bonuses for this fantastic performance. When I started digging little bit, the loan has increased at least 40% every year. Liquidity is real problem, when I asked for ageing report for the company, I am surprised to see there are receivables which are more than 3 years old, nothing has been collected and there are many clients who never paid for their bills. This all was big enough to wipe out all equity and still company owes banks more than enough. When I wrote this report, no one was happy and I have been divested of the portfolio of the company.

§ In one instance one company is showing substantial receivables from one shop which has been closed long time ago and this receivable no more collectible. This company has many such clients, in real term they are in mess but management do not want to accept they created a mess.

· Inventory

Inventory should be carried out at lower of acquisition cost, or realizable price at which it can be sold. This is basic principle of inventory. But this is one of the area where lot of input is required, last month a product is selling at 220 KD, the company ordered 1000 pieces and got it. In the mean time the prices are gone down to 185 KD a piece. The company must book a price which it can realized while selling the product. This is wired world. Commodities and products are traded day and night and prices are moving under this circumstances valuation of inventory become very critical. It become more critical when it comes to Food and Pharmaceutical products or any such product which has expiry.

o Few examples of inventory management

§ A pharmaceutical distributor is showing substantial inventory in its books, when we went for due diligence 30% of that is expired and almost 30% is due to expire in next 3 month, and another 20% within six months. This means he has inventory 20% only what he is showing. When we ask him due you have contract for replacement of these expired goods but there is nothing like that. Company says they gets replacement for this, but there is no proof which can show this will be replaced by manufacturer. This shows whole inventory is wrong.

An Asset Called Inventory

An Asset Called Inventory

Inventory is a very important class of assets. This asset is also most important to look at and has many hazy areas where companies take advantage of accounting rules.

There are different methods how the inventory should be valued, LIFO – Last in First Out, FIFO – First in First Out, and in general IFRs says the inventory should be carried at the value at which it can be sold. This definition is vague; this is perception and not reality.

The companies selling technology product, where the competition is very fierce and value of the asset goes down very fast. The changes in the technology make many products just absolute or new and advance products make previous version out of market. The life span of such products is very small, and they are written down in two to three years’ time. The companies selling software and technology product must take this into consideration while valuing the inventory. Such inventory must be valued at the price it can be sold in the market. (Old product – full provision should be taken thereof.)

The companies selling equipment where demonstration is essential or companies providing servicing where back up assets is essential, this asset is really a capital asset and depreciated over the period of its life. The backup and demo equipment are not inventory but are capital assets and should be depreciated over the life of it.

Any inventory which is lying over the period or for long time or is slow moving or has very short remaining life ( expiry is 3 to 6 months or less for Food and Pharmaceutical and similar products), provision should be taken in the balance sheet.

The INVENTORY TURNOVER RATIO is very important indicator of efficiency of the company in managing business and generating profits. If there is high turnover then business is efficient, if it is low then money is locked into it without enough profits.

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