How can financial statements be manipulated

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Journal of Accounting and Business Research , 30, Perry, S. Earnings management preceding management buyout offers. This type of income manipulation makes it hard to tell whether the company is actually rebounding or is merely enjoying the benefits of the items they "erroneously wrote off.

One of the most prevalent approaches to corporate accounting is to omit the bad and exaggerate the good. There are a number of subjective figures in any financial report that accountants can tweak. For example, a company may choose to exclude costs unrelated to its core operations when figuring its operating cash basis—say, an acquisition of another company or purchasing investments—but will still include the revenue from the unrelated ventures when calculating their quarterly earnings.

Fortunately, companies have to break down the figures, thus dispersing the smoke and mirrors, but if you don't look beyond a few main figures in a company's financials you won't catch it. There can be a number of accomplices to any accounting crime, but two popular suspects are special purpose entities SPE and sister companies. SPEs allowed Enron to move massive amounts of debt off its balance sheet and hide the fact that it was teetering at the edge of insolvency.

Sister companies have also been used as a way to spin off debt as new business. Nobody, that is, except those who read the footnotes. The footnotes list all financing-related affiliates and financial partnerships. If there is no accompanying information disclosing how much the company owes to the affiliates or what contractual obligations there are, you have plenty of good reasons to be suspicious.

Sometimes when a company is struggling, it starts dipping into financial reserves that it hopes no one will notice. Target No. Companies will optimistically predict the growth of the pension plan investments and cut back on contributions as a result, thereby cutting expenses. When the pensions start coming due, however, the company will have to top off the plans from current revenue, making it clear that putting off expenses doesn't make them go away. A healthy company pension plan has become critical as baby boomers near retirement.

Companies may try to hide an unsuccessful quarter by pushing unsold merchandise into the market, or into the distributors' storage rooms. This is usually called channel stuffing. This may save a company from a big quarterly loss, but the goods will return unsold eventually. Channel stuffing can be detected in two figures: the stated inventory levels and the cash meant to cover bad accounts. If inventory level suddenly drops or the money for bad accounts is drastically increased, channel stuffing may be taking place.

Because the Canadian and American markets are so intertwined, companies that trade on both exchanges can choose which country's accounting standards to use. If a company changes from the historical accounting standards for that firm, there had better be a good explanation. The two systems, while generally similar, account for income in different ways that may allow a wounded company to hide its weakness by switching sides.

Any change in accounting standards is a huge red flag that should prompt investors to go over the books with a fine-toothed comb. Damning statements are often casually mentioned in a company's financials. For example, a "going concern" note in the financials means that you should get out your magnifying glass and pay close attention to the following lines.

This regulation has prompted some software companies to write contracts that carve out and separately price upgrades and other hard-to-value services. In doing so, the companies solve an accounting problem—but compromise their ability to adopt a conceivably more attractive bundling strategy. The shortcomings of revenue-recognition practices have also caused companies to increasingly use unofficial measures to report financial performance, especially for businesses operating in the virtual space.

Unsurprisingly, these companies soon began to adopt alternative ways to report on earnings. The new rules will allow companies that bundle future goods and services into contracts to recognize revenue in the year it is earned by using estimates of future costs and revenues. How will this work? Current GAAP rules would have the business recognize no revenue for the upgrades until the end of year five, when full cost information is available.

But under the new rules and under current IFRS rules , the company may estimate the cost of delivering those upgrades to allow it to recognize revenue. But the change will not completely eliminate problems. After all, estimating costs requires managers to exercise judgment, introducing yet another opportunity to make good-faith errors or to deliberately tilt estimates in such a way that the resulting revenues are closer to meeting financial targets.

Therefore, as these new revenue-recognition standards are adopted and implemented under GAAP and IFRS, investors will need to examine closely the assumptions and methods used to estimate costs and report revenues.

Although unofficial measures of revenue are relatively new for many companies, all types of businesses have been employing non-GAAP and non-IFRS measures of earnings for a long time. Today, Sarbanes-Oxley requires companies on U. In addition, the SEC requires that management be able to support the reasoning behind including an alternative measure in its financial disclosures.

For example, a company might justify the use of a non-GAAP measure by noting that it is required by one of its bond covenants. The alternative measure yielded a relatively modest price-to-earnings ratio of , rather than the mind-boggling 1, This suggests that unofficial measures may be a better representation of earnings. The danger, however, is that alternative measures are usually idiosyncratic. Investors and analysts should continue to exercise great caution in interpreting unofficial earnings measures and should look closely at corporate explanations that might depend on the use or abuse of managerial judgment.

Some 25 years ago, before the rise of the internet, corporate financial statements relied on the former, which has the important virtue of being easily verifiable. Today, however, companies use fair value for a growing number of asset classes in the hope that an examination of balance sheets will yield a truer picture of current economic reality.

As the financial crisis took hold in , a myriad of adjustments to the methods of applying fair value were adopted by the U. The goal was to guide auditors on how to verify fair value, but the result has been more confusion, not less. The measurement process has proved difficult, often highly subjective, and controversial. Consider the accounting treatment of Greek bonds by European banks in , during one of a seemingly endless stream of crises involving government debt in Greece.

On that basis, RBS noted that market prices had dipped by just over half the price paid for those bonds when they were issued. If such difficulties arise with tradable securities, imagine how difficult it is to apply fair value principles consistently to intangibles such as goodwill, patents, earn-out agreements, and research and development projects. Making matters worse, disclosures about how intangible assets are valued must offer only basic information about the assumptions that generated the estimates.

Key Takeaways The manipulation of financial statements to commit fraud against investors or skirt regulation is a real and ongoing problem, costing billions of dollars each year. Because generally accepted accounting standards can be flexible and open for interpretation by a company's management, fudging numbers can be difficult to detect.

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How Aggressive Accounting Works Aggressive accounting refers to accounting practices designed to overstate a company's financial performance, whether legally or illegally. Financial Shenanigans Financial shenanigans are actions designed to misrepresent the true financial performance or financial position of a company or entity. Investopedia is part of the Dotdash publishing family.

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