This seems to be a global phenomenon as financial statement manipulation is an ongoing problem in corporate America. Although the Securities and Exchange Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between the independent auditor and the corporate client continues to provide the perfect environment for such activity. Due to these factors, investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in order to mitigate the adverse implications of these problems.
In an article recently published by Investopedia, there are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company’s financial condition in order to meet established performance expectations and bolster their personal compensation. Second, it is relatively easy to manipulate corporate financial statements because the Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude in the accounting provisions that are available to be used by corporate management. For better or worse, these GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.
Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. In the U.S., the Big Four accounting firms and a host of smaller regional accounting firms dominate the corporate auditing environment. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business.
How Financial Statements Are Manipulated
There are two general approaches to manipulating financial statements. The first approach is to inflate current period earnings on the income statement by artificially inflating revenue and gains, or by deflating current period expenses. This approach makes the financial condition of the company look better than it actually is in order to meet established expectations.
The second approach to financial statement manipulation requires the exact opposite tactic, which is to deflate current period earnings on the income statement by deflating revenue or by inflating current period expenses. The reason behind this approach may not be as obvious as in the previous example because it may seem counterintuitive to make the financial condition of a company look worse than it actually is. However, there are many reasons to engage in such activity, such as making a company look bad in order to dissuade potential acquirers, pulling all of the bad financial information surrounding the company into one period so that the company will look stronger going forward, pulling all of the bad financial information into the current period when the poor performance can be attributed to the current macroeconomic environment or to postpone good financial information to a future period when it is more likely to be recognized.
According to Dr. Howard Schilit, in his famous book “Financial Shenanigans” (2002), there are seven primary ways in which corporate management manipulates the financial statements of a company. Let’s look at these seven general categories of financial statement manipulation and the typical accounting processes that facilitate the manipulation.
- Recording Revenue Prematurely or of Questionable Quality
- Recording revenue prior to completing all services
- Recording revenue prior to product shipment
- Recording revenue for products that are not required to be purchased
- Recording Fictitious Revenue
- Recording revenue for sales that did not take place
- Recording investment income as revenue
- Recording proceeds received through a loan as revenue
- Increasing Income with One-Time Gains
- Increasing profits by selling assets and recording the proceeds as revenue
- Increasing profits by classifying investment income or gains as revenue
- Shifting Current Expenses to an Earlier or Later Period
- Amortizing costs too slowly
- Changing accounting standards to foster manipulation
- Capitalizing normal operating costs in order to reduce expenses by moving them from the income statement to the balance sheet
- Failing to write down or write off impaired assets
- Failing to Record or Improperly Reducing Liabilities
- Failing to record expenses and liabilities when future services remain
- Changing accounting assumptions to foster manipulation
- Shifting Current Revenue to a Later Period
- Creating a rainy day reserve as a revenue source to bolster future performance
- Holding back revenue
- Shifting Future Expenses to the Current Period as a Special Charge
- Accelerating expenses into the current period
- Changing accounting standards to foster manipulation, particularly through provisions for depreciation, amortization and depletion