Every company maneuvers the numbers to a certain extent to achieve budgets and get bonuses. This is nothing new. But sometimes companies take the fact-fudging too far. Factors such as greed, desperation, immorality and bad judgment drive some executives to corporate fraud.
TUTORIAL: Fundamental Analysis
Enron, Aldelphia and WorldCom are extreme examples of companies who cooked the books. They are the few bad apples that get all the headlines. Most companies are run by ethical people. They may bend the rules, but few take the process to the extremes of Enron or WorldCom - companies that claimed billions in assets but promptly went bankrupt when their false claims were exposed. If every company used fraudulent accounting, Wall Street would be empty and we'd all be investing in government bonds. (Unfortunately, not everyone on Wall Street weighs their decisions based on what is right and wrong. Learn more about the moral dilemmas of investing by reading Ethical Issues For Financial Advisors.)
What can you do to protect your investments from Enron-style disasters? You need to learn the basic warning signs of earnings manipulation. While the details are usually hidden - even from the accountants - learning these money-manipulation methods will keep you alert to companies who may be cooking the books:
1. Accelerating Revenues
One way to accelerate revenue is booking lump-sum payment as current sales when services will be provided over a number of years. For example, a software service provider receives upfront payment for a four-year service contract but records the full payment as sales of only the period that the payment is received. The correct, more accurate, way is to amortize the revenue over the life of the service contract.
A second revenue-acceleration tactic is called "channel stuffing." Here, a manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales; however, the distributor has the right to return any unsold merchandise. Because the goods can be returned and are not guaranteed as a sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.
2. Delaying Expenses
AOL got in trouble for this in the early 1990s when it capitalized the costs of making and distributing its CDs. AOL viewed this marketing campaign as a long-term investment and capitalized the expense. This transferred the costs from the income statement to the balance sheet where it was going to be expensed over a period of years. The more conservative (and appropriate) treatment is to expense the cost in the period the CDs were shipped. (The balance sheet is an important tool for gaining insight into a company's operations. To learn how to analyze a company's financial position, check out Reading The Balance Sheet.)
3. Accelerating Expenses Preceding an Acquisition
This may sound a little counterintuitive, but before a merger is completed, the company that is being acquired will pay, possibly prepay, as many expenses as possible. Then, after the merger, the EPS growth rate of the combined entity will be easily boosted when compared to past quarters. Furthermore, the company will have already booked the expense in the previous period.
4. "Non-Recurring" Expenses
By accounting for extraordinary events, these one-time charges were meant to help us better analyze ongoing operating results. It seems, however, that some companies take one of these each year. Then a few quarters later, they "discover" they reserved too much and are able to put something back into income (see next tactic).
5. Other Income or Expense
This category can house a multitude of sins. Here companies book any "excess" reserves from prior charges (non-recurring or otherwise). This is also the place where companies can hide other expenses by netting them against other newfound income. Sources of other income include selling equipment or investments.
6. Pension Plans
If a company has a defined benefit plan, it can use some special techniques to smooth earnings. During a bull market, the company can improve earnings by reducing its pension expense. If the investments in the plan grow faster than the company's assumptions, the company could record this gain as revenue. During the late 1990s, this was done by a number of large firms, some of them blue chips.
7. Off-Balance-Sheet Items
A company can create separate legal entities that can house liabilities or incur expenses that the parent company does not want to have on its financial statements. Because the subsidiaries are separate legal entities that are not wholly owned by the parent, they do not have to be recorded on the parent's financial statements and are thus hidden from investors.
8. Synthetic Leases
A synthetic lease can be used to keep the cost of new building from appearing on a company's balance sheet. The lease is a long-term (five to ten year) agreement under which a company will pay a fixed lease expense to be in a new headquarters. At the end of the lease, the company is obligated to buy the building, but because of the nature of the lease, this liability is not included on the balance sheet. (Who said accountants were boring and uncreative?) At the time the lease was made, the company may have been in fine financial shape and the economy may have been booming; however, the ability of the company to meet this huge obligation is hard to determine until shortly before maturity (one to two years).
The Bottom Line
If you tune into the items hidden in a company's financial statements, you may be able to spot some of the warning signs that point to earnings manipulation. This doesn't mean that the company is definitely cooking the books, but if a company makes you suspicious, that's a sure sign that you should dig deeper before making an investment.
Despite a succession of reform legislation, corporate misdeeds still go on. Learn how to analyze a company's management to predict if there may be an intent to cook the books. Read Putting Management Under The Microscope