Every company maneuvers the numbers to a certain extent to make sure budgets balance and executives score bonuses. This sort of creative accounting 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 cross the line into outright corporate fraud.
TUTORIAL: Fundamental Analysis
Enron, Aldelphia, and WorldCom are extreme examples of companies who cooked the books, claiming billions in assets that just didn't exist. They are exceptions to the rule (if every company used fraudulent accounting, Wall Street would be empty and we'd all be investing in government bonds). Even so, investors need to learn the basic warning signs of falsified statements. While the details are usually hidden, even from the accountants, recognizing these money-manipulation methods when you read a balance sheet will keep you alert to companies who may be creating their own numbers:
1. Accelerating Revenues
One way to accelerate revenue is booking lump-sum payment as current sales when services actually will be provided over a number of years. For example, say a software service provider receives an upfront payment for a four-year service contract but records the full payment as sales for the period that the payment was 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. But 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 was first distributing its installation CDs. AOL viewed this marketing campaign as a long-term investment and capitalized the costs —that is, it transferred them 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.
3. Accelerating Pre-Merger Expenses
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 earnings per share (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.
Cooking The Books
4. "Non-Recurring" Expenses
By accounting for extraordinary events, these one-time charges were meant to help investors better analyze ongoing operating results. It seems, however, that some companies take some 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 hide 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 play some games with it. The company can improve earnings by reducing the plan's expenses. If the investments in the plan then grow faster than the company's assumptions, the company could record these gains as revenue. During the late 1990s, a number of large firms, some of them blue chips, employed such techniques.
7. Off-Balance-Sheet Items
A company can create separate subsidiaries that can house liabilities or incur expenses that the parent company does not want to be made transparent. If these subsidiaries are set up as separate legal entities that are not wholly owned by the parent, they do not have to be recorded on the parent's financial statement 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. Basically, it allows a company to rent an asset to itself. It works like this: A special purpose entity established by a parent company purchases an asset then leases it back to the parent company. As a result, the asset is shown on the balance sheet of the special purpose entity, which treats the lease as a capital lease and charges depreciation expense against its earnings. However, the asset does not show up on the balance sheet of the parent company. Instead, the parent company treats the lease as an operating lease—and gets a tax deduction for the payments on the income statement. Nor is it revealed that, at the end of the lease, the parent company is obligated to buy the building—a huge liability that appears nowhere on the balance sheet.
The Bottom Line
Despite a succession of reform legislation, corporate misdeeds still go on. 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.