Each company manipulates its numbers to a certain extent to ensure a balanced budget, executives receive bonuses, and investors continue to provide funding. This kind of creative accounting is nothing new. However, factors such as greed, despair, immorality, and misjudgment may cause some executives to cross the line and fall into outright corporate fraud.
Enron, Adelphia, and WorldCom are extreme examples of companies that claim to have billions of dollars in assets, but these assets simply don’t exist. They are an exception to the rule. Regulations such as the Sarbanes-Oxley Act of 2002 control wayward companies to a large extent. And financial reporting audit procedures to carry out a comprehensive reform of federal laws.
However, investors should still know how to recognize the basic warning signs of false statements. Although details are usually hidden, even to accountants, there are red flags in financial statements that may point to the use of manipulation methods.
Some companies manipulate their accounting practices financially to paint a better picture. The reasons for this include offering higher bonuses to executives or attracting investors.
1. Accelerate revenue
One way to accelerate revenue is to record a one-time payment as current sales when the service has actually been provided for many years. For example, a software service provider may receive an advance payment for a four-year service contract, but record the full payment as the sales during the payment period. The correct and more accurate method is to amortize the revenue during the entire life cycle of the service contract.
The second revenue acceleration strategy is called “channel filling.” Here, the manufacturer makes a large number of shipments to the distributor at the end of a quarter and records the shipment as sales. But the distributor has the right to return any unsold goods. Since the product can be returned and cannot be guaranteed for sale, the manufacturer should classify the product as inventory until the distributor sells the product.
- Most companies implement accounting procedures to best reflect their performance.
- Greed and misjudgment can be a precursor to corporate fraud.
- The Sarbanes-Oxley Act of 2002 introduced reforms that largely controlled capricious companies.
- Financial statements may indicate the use of manipulation methods, such as accelerated revenue; delayed expenses; accelerated pre-consolidation expenses; and use of pension plans, off-balance sheet items, and comprehensive leases.
2. Delay costs
AOL felt guilty for delaying spending when it first distributed its installation CD in the early 1990s. AOL sees this marketing activity as a long-term investment and capitalizes its costs—that is, it transfers costs from the income statement to the balance sheet, where the activity will be spent in a few years. A more conservative (and appropriate) approach is to use the cost during the CD shipment as an expense.
3. Expedited pre-merger expenses
This may seem counterintuitive, but before the merger is completed, the acquired company will pay—perhaps prepaid—as much as possible. Then, after the merger, the earnings per share (EPS) growth rate of the combined entity will be higher than in the past few quarters. In addition, the company will have been included in the previous period’s expenses.
4. Non-recurring expenses
By considering special events, non-recurring expenses are one-time expenses, designed to help investors better analyze continuing business performance. However, some companies use these every year. Then, a few quarters later, they “discovered” that they had retained too much and reinvested part of it in revenue (see next strategy).
5. Other income or expenses
Other income or expenditure is a category that can hide many evils. Here, the company reserves any “excess” reserves from previous expenses (non-recurring or otherwise). Other income or expenses are also places where the company can hide other expenses by netting it with other newly discovered income. Other sources of income include sales of equipment or investment.
6. Pension plan
If the company has a fixed benefit plan, it can use the plan to its advantage. Companies can increase revenue by reducing program costs. If the investment growth rate in the plan exceeds the company’s assumptions, the company can record these gains as income. In the late 1990s, some large companies, some of which were blue chip stocks, adopted this technology.
7. Off-balance sheet items
Companies can create independent subsidiaries to bear liabilities or expenses that the parent company does not want to disclose. If these subsidiaries are established as independent legal entities and are not wholly owned by the parent company, they do not need to be recorded in the parent company’s financial statements, and the company can conceal it from investors.
8. Synthetic lease
For example, comprehensive leases can be used to prevent the cost of new construction from appearing on the company’s balance sheet. In fact, comprehensive leasing allows companies to lease assets to themselves. It works as follows: A special purpose entity established by the parent company purchases assets and then leases them back to the parent company. Therefore, the assets of the special purpose entity are displayed on the balance sheet, the lease is regarded as a capital lease, and depreciation expenses are deducted from its income. However, the asset did not appear on the balance sheet of the parent company. Instead, the parent company treats leases as operating leases and receives tax relief from payments in the income statement. It was also not disclosed that at the end of the lease, the parent company was obliged to purchase the building-a huge liability that was nowhere to be seen on the balance sheet.
Despite a series of reforms and legislation, misconduct by enterprises still occurs from time to time. Hidden items found in the company’s financial statements are warning signs of profit manipulation. This does not mean that the company is definitely doing the accounting, but it may be worthwhile to dig deeper before investing.