THINKING ALOUD (BusinessLaw) Financial Statements: Unaccountable Accounting
You can measure a man’s character by the choices he makes under pressure— Sir Winston Churchill
The writer makes no warranty of any kind with respect to the subject matter included herein or the completeness or accuracy of this article which is merely an expression of his own opinion. The writer is not responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this article and in no event shall be liable for any damages resulting from reliance on or use of this information. Without limiting the above the writer shall have no responsibility for any act or omission on his part. Readers should take specific advice from qualified professionals when dealing with specific situations.
Chén Róng’s Little English-Chinese Dictionary
- cooking their books = cuàn gǎi gōng sī zhàng běn
- wiggle room = yú dì
- off the record = méi yǒu rù zhàng
- in the red = chì zì
- As long as the green mountains are there, one need not worry about firewood = liú dé qīng shān zài， bù pà méi chái shāo
COMPANY’s FINANCIAL STATEMENTS
Writer: Chén Róng
Outright fraud aside, big and small companies may be cornered into adopting unaccountable accounting technique or, metaphorically speaking, cooking their books at times, but for different reasons. Nevertheless, unforeseen and unfortunate circumstances may be, they should not be used as excuses for keeping two or more sets of books. THINKING-ALOUD articles, as usual, have the small businesses in mind as they may not have the financial prowess and professional expertise big firms had in their employ. Small businesses should think again; cooking the books may return to hit them like a boomerang - although they may brush aside discussions on business ethics as child’s talks when faced with economic reality. Hopefully, they do not fall into the trap of short-term gains.
- Why do firms cook their books?
Big companies have larger global footprints - so to speak – because of their ability to benefit from economic growth of big countries like China and India. The fate of small businesses is bound inextricably to the health of the domestic economy. If the local economy experiences weak growth, it weighs down heavily on small companies; and many of them may not survive the slowing down of the economic engine. Compounding their woes are tax and regulatory issues which some authorities are slow in providing the needed reliefs to take these off the shoulders of small companies. Take shortage of labour as an example. Medium-sized and big companies may move part of their production facilities to a neighbouring country; or they may purchase machinery to work in place of manual labour and write-off such investment in space and hardware from their tax liability. Small companies do not have similar wiggle room and, therefore, they are unable to manoeuvre themselves out of their predicament.
Yet, even when times are good, small companies face challenges. Not least are tax and regulatory requirements imposed by their own governments which relegate their small business structures to secondary importance for economic growth of a less developed country. Bigger firms may get a tax break. In one Asian country, for instance, listed multinational firms get to pay tax at 25% and the majority of companies – the small businesses – pay corporate tax at 30%. The bigger firms also get to enjoy tax incentives from the Board of Investment; and the tax they pay, as a percentage of revenue, is close to one per cent. This policy is unfair to small companies. In retaliation, small firms cook their books by preparing a set of Financial Statements of inaccurate revenue figures for tax purposes.
That is not all. A barrage of regulatory requirements from government agencies, oftentimes, suffocates the smooth running of small businesses barely able to cope with just a few employees each. They have few options but pay bribes to free themselves off official harassments; those frequent inspections from regulators are added cost of running the business. Even during these good times, small business owners are already keeping things lean and mean to stay to survive; at times face challenges such as meeting expenses and payroll, maintain customers, and making longer range plans. The alternative to defraying such regulatory costs is the cooking of books – the financial statements. Big companies generally overstated revenue using dubious sales tactics. They doctored their capital expenditures and offer growth stories full of pleasant fantasies for the foreign investors who want to buy their stocks. Not surprising some such companies actually keep two sets of books, a secret one for people who run the company knowing full well what goes on; and a public one for investors and the regulatory authority and financial institutions.
However, the problem of unaccountable accounting is not necessarily limited to multinational companies. Small firms regard some accounting items as malleable. They understate receivables and overstate discretionary expenses - such as rentals. A company inflates expenses to set-off against profits to reduce its tax liability. Overstating of inventory is another ploy used to make the business look more profitable than it actually is, in an attempt to hoodwink creditors and lenders. Claiming to have paid more than the actual price for stocks, business itself or its factory premises often results in a smaller profit being reported when selling of the subject matter. As a result the company pays a lower tax on that profit.
- Business becomes a Black Box. Banks and Investors uninterested.
One important reason that improper accounting is detrimental to a small business is the potential for growth through cash rich investors. If the small business owner is looking for growth and seeks funding, the investors will want to see past performance of the business. One performance indicator is the numbers that have been reported on the tax returns. While investors and their bankers may be impressed with what they see from an on-site visit to the business; but when financial statements appear to have been fudged brings the integrity and honesty of the owner into question. This causes the bankers and investors to question the character of the owner and makes lending to the owner or investing in the business a greater potential risk.
The primary aim of financial statements is to show the underlying financial performance of a business. The balance sheet gives a snapshot - a moment in time - of its assets, liabilities and capital; and the income statement (or profit-and-loss account) shows the difference between total revenues and total expenses.
Banks generally review the financial statements of a business to decide if they will lend the company money; and at what interest rate should they agree to lend. The other problem with an illegal book-cooking strategy is that it can compromise a company's ability to obtain financing for future projects or expansions even during good times when credit is in abundance. Many small business owners have turned to the bank to finance capital expenditures only to be turned down due to having opaque financial statements. The bank uses previous tax returns to gauge a firm’s business growth and cash flow. If the business continuously shows losses or moribund on the tax returns, the bank will require a greater amount of collateral or a larger capital injection from the owner before approving a loan. If the owner or his close business associate has personal assets, the lender may want a personal guarantee.
Borrowing money from a bank has never been easy for small businesses than in recent years because central banks are printing money in their billions and such ‘hot money’ is always looking for a place to park for earnings growth. The challenges encountered are, at best, cyclical with banks less willing to lend when money market liquidity is low during an economic downturn or when the printing machinery slows down. Unaccountable accounting by a firm will only add a more challenging dimension to the scale of difficulties. Besides, people already established in business may not wish to put up their homes as collateral; nor would they want to provide personal guarantees, if at all possible, for short term loans. Every businessman strives to be self-sufficient and self-financing for business expansion, if possible. This may not always be possible. During an economic crisis, businesses may need bank facilities for working capital when customers do not pay on time; and they also demand harsh payment terms for their purchase contracts.
Fortunately for some companies, governments in the developing world take the initiative to lend money to banks cheaply so that this may be passed down on to businesses. With such initiatives, the government guarantees some 75% of the loan facilities extended to borrowers who pay interest at 2% of the loans guaranteed. Thank heavens for some owners. For others who continue to show losses in the business, they may fail to qualify for such government funding. A bank cannot justify the lending of large amounts without the owner showing the ability to make re- payments. Owners may also find refinancing of existing debt difficult to obtain without a secondary source of repayment.
The moral of the story: Always craft a pristine set of financial statements.
- Business for Sale. Owner retiring.
Just Asia alone, there must be some millions of family-owned businesses, mostly employing fewer than 20 staff-members each. Many such entrepreneurs started their businesses during their heydays but their children, unfortunately, are not keen on taking over the reins because they prefer working for others, especially big multi-nationals enticing them with financial perks and other non-monetary incentives.
In most instances, business owners are too busy trying to build their trades or services to think about selling their companies. For some reason when that moment does arrive, being unprepared – happening at an inopportune time. There will be trepidation. If these business owners have exaggerated profits to secure their bank loans or inflated expenses to deceive tax authorities, their financial statements are less than pristine and they will find due diligence experience with their potential buyers most harrowing experience.
Preparatory work need be started some years ago. Every business owner should start building his business as if he might sell it some five years down the road. When preparing his financial statements he may bend the rules a little within the bounds of acceptable accounting practices; but he should never take the fact-fudging too far out of greed, desperation, immorality and bad judgment. A better grooming exercise is through looking at his firm’s competitive advantage, and put to heart the terms of existing contracts. There may also be a need to fortifying his management team around the profile list of existing customers. The next thing is to have a good look at the business model as a whole for probable reforms in areas that could improve on his asking price a little. In financial jargon that would mean pumping up the multiple of EBITDA – earnings before interest, tax, depreciation and amortization – if that is the formula he prefers in putting forward a price tag in engaging potential buyers.
Nevertheless, business owner will need to understand how potential buyers value his business; methods which may not be what he employed in formulating the sale price, for instance, EBITDA. The evaluation by a potential buyer is usually done using the financial statements supplied by the seller’s accountant. On top of these financial evaluations he would put in such intangible factors as the number of competitors, the company's years in business, its customer list, the demand for its products and the location of its stores.
An intelligent buyer examines the books and records thoroughly, carefully combing over three years of financial data is not unusual. He might want to see that revenues collected were done in verifiable way such that sales were supported by export sales, VAT invoices and custom documents from the relevant authorities. In the case of a retail company, noting if fees from franchisees were collected at a single point, rather than from a string of wholly owned stores.
The next category of document a potential buyer will ask for is the adjusted net income - the total amount of cash generated by the target business – for the past three years. A seller must stand ready in explaining his firm’s history of earnings; cohesively backing up his story lines with documentation. Financial statements are to include earnings and expenses showing owner's salary and all cash-related perks. Some of which are: the use of a company car; company paid insurances on health, life and vehicle; personal expenditures for travel and entertainment; subscriptions to golf clubs and all other similar business expenses. Interest payments on funds borrowed by the firm may be added back to adjusted net income along with accounting entries such as depreciation and amortization. These items can get diverted to the owner's pockets and never got recorded in the financial statements. All these are going against the owner’s case for a sale discussion based on EBITDA.
For reason best known to him, if a business owner is aware of cash income that never got recorded in the financial statements of the company, and he now wants credit for these sums in discussing the sale price. In the calculation of values on an open and above-board sales negotiation any statement made about the business has to be supported by evidence in the form of accounting records and other reliable sources. By admitting that he is running part of his business ‘off the record’ (meaning, not included in the financial statements), it will expose the owner to problem with the tax authority. It also puts him in a poor light with prospects who – if they show interest in his business – must be able to see that all practices and record-keeping are beyond reproach.
- Shadow Banking
The unfortunate outcome for firms that cannot meet official criteria for securing bank loans, they can only turn to informal lending institutions or so-called shadow banking that offers borrowers loans at interest rates for as high as 40% on average. These funding sources are not necessarily die-hard loan sharks that some governments are out to nab them; they are family members or friends of family members lending on more flexible terms and could have longer repayment periods. This practice is prevalent in China because banks give loans overwhelmingly to state-owned businesses, officials and politically connected, who then re-lend the money at much higher interest rates to small businesses. One cannot blame the government. It is a big country and many things can go wrong. So long as there is an honest government in place, it should be given a fair chance to overhaul the system. China is taking substantive steps at reforming its financial sector. Recently, the People’s Bank of China (the country’s central bank) announced it would no longer set minimum lending rates for corporate loans – a major step in liberalisation of interest rates. Lending rate reforms will allow banks to lower rates and compete more fiercely for customers. The main beneficiaries are the privately owned small businesses.
Meantime, every small business should avoid borrowing money at exorbitant interest rates. In a competitive world of business, there is no way any firm can profitably market goods and services with borrowed funds running at double-digit interest rates, when profits at single-digits are hard to come by. We cannot help but feel a sense of helplessness for them. For those others who are not in similar circumstances, they should run their business on purely ethical ground and not fudge their books to entice shadow lenders. Although business owners may bend the rules a little because of exceptional circumstances – the medium to long term benefit will come with sticking to an ethical accounting regime. The IFRS (International Financial Accounting Standards) for small companies, as practised in over 100 countries worldwide, does make the job of preparing the financial statements much easier for small business owners. They should use the plus points of the Accounting Standards to highlight the selling points of the business in their effort to find potential buyers.
A prospective buyer may still pay an above market price for a company with a less glowing set of financial statements but prepared on ‘accountable accounting’ procedure. There may be extraneous circumstances that affect the owner but offer investment opportunity to a prospective buyer with a totally different background and business models. The renowned Washing Post newspaper had its revenues declined seven straights years and still operating deeply in the red, yet the founder of Amazon paid a hefty US$250 for its acquisition – a price tag that amazed many analysts. But the online news mogul will bring his background to bear – so to speak – by transforming the traditional print business into a digital one. The buyer could have paid less so how could we explain for the maths that called for the higher price paid? The answer may not lie with valuation metrics in the financial statements. The new owner has his own ideas when taking the company private. A profit or loss making enterprise is the least of his concerns – for now.
As for the sellers of businesses, the suggestion is: Just take the money on the table and get into some other things they can do better with their current set of circumstances. It is a better option than dying a slow, expensive and painful death with funds borrowed at exorbitant double-digit interest rates. And yet, death (bankruptcy) of the business entity is not the end of it all; not if the owner and his family are bolt down by old debt. “As long as the green mountains are there, one need not worry about firewood” so the Chinese proverb goes. Life goes on.
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Hubpages do not support words written in the Chinese Language. Readers can get a free online English-Chinese translation from GOOGLE TRANSLATE OR TRANSLATED.net
I have also included ChénRóng’s Little English-Chinese Dictionary for a more precise translation of select English phrases from the article.