Many clients have asked me to help them to invest in stocks. I have thought about it for a very long time and considered all possible business model that I can use to do that (i.e. how am I going to charge clients fee for doing this). Finally, I figured that the best way to advice in stock is to educate my clients on how to do that on their own. Similarly to what I feel in other financial matters, I always think that everyone must educate themselves. Here is an article on clever accounting employed by companies.
When making stock investments, it is important to look out for these clever accounting and manipulation. While not all manipulation can be detected by looking at Income and Balance sheet, many manipulations can be detected through the trained eye. For this article, I will mention about Phantom Profit through the use of LIFO Liquidation.
There are 3 ways of calculating the cost of goods sold for inventory – these are First-in-first-out (FIFO), Last-in-first-out (LIFO) and weighted average. LIFO method is prohibited by the IFRS but permitted under the US GAAP. So this article is only relevant for companies reporting under the US GAAP.
Recall that Gross Profit = Revenue – Cost of Goods Sold (COGS). The value of COGS determines Gross Profit. If COGS can be manipulated lower, Gross Profit will be higher.
One way of manipulating the value of COGS is to deliberately planned inventory purchases so as to allow for LIFO Liquidation. Note that not all LIFO Liquidation is due to accounting manipulation. Before we continue, we need to visit how to calculate the COGS for LIFO inventory method.
The cost of goods sold (COGS) is based on the most recently inventory purchase under LIFO method. Take for instance this example of a trading company and buys and sells chairs. Such a company holds chairs as inventory and it make its purchases and sales as follows:
1 Jan 2009 Balanced carried forward 2,000 chairs at $50/chair
1 June 2009 Purchase 1000 chairs at $55/chair
1 July 2009 Sold 1500 chairs
Under the LIFO method, the COGS for the 1,500 chairs sold on 1 July 2009 is 1000*55 + 500*50 =$80,000.
What will happen if the company delays its 1 June 2009 purchase of 1000 chairs to after 1 July? In this case, the COGS for 1,500 chairs sold on 1 July is 1500*50=$75,000.
Since Gross Profit = Revenue – COGS, by delaying the inventory purchase, the Gross Profit can be inflated. This is what we known as the Phantom Profit. It is Phantom because the increased in Gross Profit is purely due to older inventory being used for calculating the COGS. Such a profit cannot be sustained in the long run because the company does not have unlimited inventory to liquidate.
Another way to calculate Phantom Profit is = Number of units of inventory liquidated x (Replacement Cost – Historical Cost).
In the above example, by delaying the 1 June purchase to after 1 July, the sale of 1 June 2009 will cause a liquidation of 1000 chairs of the existing inventory purely due to the postponement of the 1 June purchases. The historical cost of these 1000 chairs is $50/chair and the replacement cost is $55. Thus the Phantom Profit = 1000*(55-50)= $5,000.
However, do note that LIFO liquidation can happen due to other reasons such as:
- During recessionary period, companies do not wish to hold too much inventory would deliberately reduce their inventory level. This causes LIFO Liquidation to occur and ironically increase profit!
- During declining prices of raw materials, LIFO method makes COGS lower and increase Gross Profit. This is strictly not due to LIFO liquidation but it nevertheless makes the profit looks larger than if the company had employed FIFO method.
When comparing companies prepared under the US GAAP and others prepared under the IFRS, it is important to make adjustments to the financial statements to account for the LIFO and FIFO methods.
Most of people will find it too tedious to check for accounting manipulation such as Phantom Profits. So they end up buying stocks which they hold forever - not because they practice buy and hold but because they just don't have time to monitor. A diversified portfolio is one that has at least 30 stocks holding. How is anybody going to monitor these 30 stocks? Even if you outsource to a financial adviser like me, I don't have time to monitor because investment is only part of the many things I do. Don't forget I have so many clients to deal with.
Personally for me, I find it easier to manage portfolios instead of stocks holdings. Portfolio management is 'scalable ' and has enabled me to manage large amount of assets for large number of clients.
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