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Asian Financial Statement Analysis: Detecting Financial Irregularities by Howard Schilit, Thomas R. Robinson, ChinHwee Tan

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CHAPTER 3

DETECTING OVERSTATED FINANCIAL POSITION

This chapter takes a look at companies that attempt to make their financial position look stronger than it really is. This practice is commonly associated with the overstatement of assets, although that is not necessarily the case. The company may want to understate both assets and liabilities, which improves profitability ratios (such as return on assets) or debt ratios (by making them look smaller). This chapter provides you with the tools and techniques to detect such activity.

While earnings are typically a focus of investors, and company managers have clear incentives to overstate earnings to benefit their compensation, there are also incentives to overstate the company's current financial position. This entails presenting a stronger balance sheet, also known as the statement of financial condition or statement of financial position. The balance sheet is a common focus of creditors and is also of interest to most investors. In fact, common financial ratios used by investors, such as return on assets and return on equity, require balance sheet information and are often a target of management manipulation. As demonstrated in earlier chapters, our view is that all investors should always examine the balance sheet in conjunction with the income statement, as either statement has a corresponding effect on the other. The balance sheet can be represented by the accounting equation shown in Exhibit 3.1.

Overstating financial position ...

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