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.
Reasons Behind Financial Statement Manipulation
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, they have 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 a relatively easy thing to do. The Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude and interpretation in accounting provisions and methods. For better or worse, these GAAP standards afford a significant amount of flexibility, making it feasible for corporate management to paint a particular 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, often quite significantly, 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 the client happy – and keep its business.
How Financial Statements Are Manipulated
How Financial Statements Are Manipulated
There are two general approaches to manipulating financial statements. The first is to exaggerate 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 requires the exact opposite tactic, which is to minimize current period earnings on the income statement by deflating revenue or by inflating current period expenses. It may seem counterintuitive to make the financial condition of a company look worse than it actually is, but there are many reasons to do so: to dissuade potential acquirers; getting all of the bad news "out of the way" so that the company will look stronger going forward; dumping the grim numbers into a 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.
Specific Ways to Manipulate Financial Statements
When it comes to manipulation, there are a host of accounting techniques that are at a company's disposal. Financial Shenanigans (2002) by Howard Schilit outlines seven primary ways in which corporate management manipulates the financial statements of a company.
- 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
- 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
While most of these techniques pertain to the manipulation of the income statement, there are also many techniques available to manipulate the balance sheet, as well as the statement of cash flows. Moreover, even the semantics of the management discussion and analysis section of the financials can be manipulated by softening the action language used by corporate executives from "will" to "might," "probably" to "possibly," and "therefore" to "maybe." Taken collectively, investors should understand these issues and nuances and remain on guard when assessing a company's financial condition.
Financial Manipulation via Corporate Merger or Acquisition
Another form of financial manipulation may happen during the merger or acquisition process. One classic approach occurs when management tries to whip up support for a merger or acquisition based primarily on the improvement in the estimated earnings per share of the combined companies. Let's look at the table below in order to understand how this type of manipulation takes place.
|Proposed Corporate Acquisition||Acquiring Company||Target Company||Combined Financials|
|Common Stock Price||$100.00||$40.00||-|
|Book Value of Equity||$10,000,000||$2,000,000||$12,000,000|
|Earnings Per Share||$5.00||$4.00||$5.83|
Based on the data in the table above, the proposed acquisition of the target company appears to make good financial sense because the earnings per share of the acquiring company will be materially increased from $5 per share to $5.83 per share. Following the acquisition, the acquiring company will experience an increase of $200,000 in company earnings due to the addition of the income from the target company. Moreover, given the high market value of the acquiring company's common stock, and the low book value of the target company, the acquiring company will only have to issue an additional 20,000 shares in order to make the $2 million acquisition. Taken collectively, the significant increase in company earnings and the modest increase of 20,000 common shares outstanding will lead to a more attractive earning per share amount.
Unfortunately, a financial decision based primarily on this type of analysis is inappropriate and misleading, because the future financial impact of such an acquisition may be positive, immaterial or even negative. The earnings per share of the acquiring company will increase by a material amount for only two reasons, and neither reason has any long-term implications.
Guarding Against Financial Statement Manipulation
There are a host of factors that may affect the quality and accuracy of the data at an investor's disposal. As a result, investors must have a working knowledge of financial statement analysis, including a strong command of the use of internal liquidity solvency analysis ratios, external liquidity marketability analysis ratios, growth, and corporate profitability ratios, financial risk ratios and business risk ratios. Investors should also have a strong understanding of how to use market multiple analysis, including the use of price/earnings ratios, price/book value ratios, price/sales ratios and price/cash flow ratios in order to gauge the reasonableness of the financial data.
Unfortunately, very few retail investors have the necessary time, skills and resources to engage in such activities and analysis. If so, it might be easier for them to stick to investing in low-cost, diversified, actively managed mutual funds. These funds have investment management teams with the knowledge, background, and experience to thoroughly analyze a company's financial picture before making an investment decision.
The Bottom Line
There are many cases of financial manipulation that date back over the centuries, and modern-day examples such as Enron, Worldcom, Tyco International, Adelphia, Global Crossing, Cendant, Freddie Mac, and AIG should remind investors of the potential landmines that they may encounter. The known prevalence and magnitude of the material issues associated with the compilation of corporate financial statements should remind investors to use extreme caution in their use and interpretation.
Investors should also keep in mind that the independent auditors responsible for providing the audited financial data may very well have a material conflict of interest that is distorting the true financial picture of the company. Some of the corporate malfeasance cases mentioned above occurred with the compliance of the firms' accountants, like the now-defunct firm Arthur Anderson. So even auditors' sign-off statements should be taken with a grain of salt.