The financial statements of companies can sometimes be manipulated to present a misleading picture of their performance. While regulations such as the Sarbanes-Oxley Act of 2002 have helped curb fraudulent practices, investors should still be aware of red flags that indicate the use of manipulating methods. Here are eight common ways companies cook the books:
- Accelerating Revenues:
- Lump-sum payments for long-term contracts are recorded as immediate sales instead of being amortized over the contract’s duration.
- “Channel stuffing” involves shipping excess products to distributors at the end of a quarter and recording them as sales, even though the products can be returned.
- Delaying Expenses:
- Companies postpone recording expenses to future periods, artificially inflating current profits.
- AOL’s delayed expenses for CD distribution in the 1990s is an example of this practice.
- Accelerating Pre-Merger Expenses:
- Before a merger, the acquiring company may pay or prepay expenses to boost the post-merger earnings per share (EPS) growth rate.
- This tactic allows the company to already record expenses in the previous period.
- Non-Recurring Expenses:
- Non-recurring or extraordinary charges are one-time expenses used to analyze ongoing operating results.
- Some companies misuse this category by artificially creating non-recurring expenses to manipulate earnings.
- Other Income or Expense:
- Companies use the “other income or expense” category to manipulate financial statements.
- Excess reserves from prior charges may be added back to income, while expenses can be netted against newfound income.
- Pension Plans:
- Companies with defined benefit plans can adjust plan expenses to improve earnings.
- Gains resulting from investments exceeding assumptions can be recorded as revenue.
- Off-Balance-Sheet Items:
- Separate subsidiaries are created to hold liabilities or expenses that the parent company wishes to conceal.
- These subsidiaries, if not wholly owned, can be kept off the parent company’s financial statements, hiding them from investors.
- Synthetic Leases:
- Synthetic leases are used to keep certain costs off the balance sheet.
- Companies establish special purpose entities to purchase assets and lease them back, avoiding disclosure of the asset or related liabilities.
The Role of the Sarbanes-Oxley Act: The Sarbanes-Oxley Act of 2002 was enacted to reform financial practices in publicly held corporations. While it has significantly curbed fraudulent practices, companies may still attempt to manipulate financial statements. Investors should remain vigilant and look for warning signs of earnings manipulation when analyzing a company’s financial statements.
Key Takeaways:
- Corporate misdeeds can still occur despite reform legislation.
- Identifying hidden items in financial statements can be a warning sign of potential earnings manipulation.
- Conducting further investigation before making investment decisions is prudent when red flags are present.
Websites and Online Resources:
- U.S. Congress. “H.R. 3763—Sarbanes-Oxley Act of 2002.” – This official document provides the full text of the Sarbanes-Oxley Act, offering detailed information on the comprehensive reforms introduced to combat financial fraud and improve corporate governance. Read more
- U.S. Securities and Exchange Commission. “Securities Exchange Act of 1934 Release No. 42781.” – This SEC release provides insights into regulations and guidelines related to financial reporting and disclosure requirements, offering valuable information for investors and companies alike. Read more
Books:
- “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports” by Howard M. Schilit – This book provides a comprehensive guide to identifying and analyzing deceptive accounting practices, equipping readers with the knowledge to uncover financial manipulations. Amazon link
- “Creative Accounting, Fraud, and International Accounting Scandals” by Michael Jones – This book explores notable accounting scandals and fraud cases, offering in-depth analysis of the tactics employed and the consequences faced by companies involved. Amazon link
Academic Journals and Research Papers:
- “Earnings Manipulation and Corporate Governance: A Comprehensive Review” by Naohiko Matsuo – This academic paper discusses the relationship between earnings manipulation and corporate governance, providing insights into the factors that contribute to financial statement fraud. Read more
- “The Detection and Deterrence of Financial Statement Fraud: Implications for Future Research” by James A. DiGabriele and D. Larry Crumbley – This research paper explores methods for detecting and deterring financial statement fraud, highlighting the importance of internal controls and the role of auditors in uncovering manipulations. Read more
Reports and Studies:
- “The Financial Cost of Fraud 2020” by the Association of Certified Fraud Examiners (ACFE) – This report provides insights into the financial impact of fraud, including financial statement fraud, on organizations worldwide. It offers valuable statistics and case studies for understanding the prevalence and consequences of manipulation. Read more
- “Global Forensic Data Analytics Survey 2020” by Ernst & Young (EY) – This survey report explores the use of forensic data analytics in detecting and preventing financial statement fraud. It highlights key challenges and trends in this field, providing useful information for professionals and researchers. Read more
Professional Organizations and Associations:
- Association of Certified Fraud Examiners (ACFE) – ACFE is a professional organization dedicated to fighting fraud and providing resources for fraud examiners. Their website offers