What Is Aggressive Accounting?
Aggressive accounting refers to accounting practices that are designed to overstate a company's financial performance. Aggressive accounting is akin to creative accounting, which means a company could delay or cover up the recognition of a loss.
Companies engaged in aggressive accounting practices might also hide expenses and inflate earnings. Aggressive accounting is in contrast to conservative accounting, which is more likely to understate performance and, thus, the firm's value.
- Aggressive accounting refers to accounting practices that are designed to overstate a company's financial performance.
- Aggressive accounting can be done by delaying or covering up losses or artificially inflating its value by overstating earnings.
- Companies can inflate revenue by reporting gross revenue and maintain deferred expenses on the balance sheet instead of reporting them on the income statement.
Understanding Aggressive Accounting
Aggressive accounting may follow the letter of the law while deviating from the spirit of accounting rules. The goal behind aggressive accounting is to project a more favorable view of the financial performance of a company than what's actually occurring. Most accountants don't employ aggressive accounting techniques since it's considered unethical and, in some cases, illegal.
Aggressive Accounting Techniques
Aggressive accounting can range from overstating income to understating costs, but below are a few examples of aggressive accounting strategies.
Companies can overstate revenue by reporting gross revenue, even if there are expenses that reduce it. Also, companies can record revenue before a sale has been finalized in order to capture it earlier. For example, a company can record revenue for a sale in the current fiscal year versus the next to bolster this year's earnings—despite the revenue being realized next year.
A portion of a company's overhead such as staff is typically allocated to inventory because there are indirect costs associated with finished goods as well as work-in-process items. The allocation increases the value of inventory and, as a result, reduces the value of cost of goods sold (COGS). COGS are the costs directly tied to production, such as the direct labor and materials used in producing goods. If companies overstate the amount of overhead applied to inventory, it inflates the value of the company's current assets.
A deferred expense is a cost that a company hasn't consumed yet. As a result, the item is recorded as an asset until it has been consumed, which is typically less than one year. Once the item has been consumed, it's recorded as an expense on the income statement. For example, rent would be consumed during the month and first recorded as an asset. Once the rent payment is made at the end of the month, it would be recorded as an expense.
Companies can manipulate their profits using deferred expenses by keeping them on the balance sheet instead of bringing them over to the income statement as an expense. The result would be an inflated net income or profit since expenses would be lower than in reality.
Examples of Aggressive Accounting
During the late 1990s, some companies engaged in the fraudulent falsification of financial statements or cooking the books. Accounting scandals at Enron, Worldcom, and other firms led to the Sarbanes-Oxley Act. The Act improved disclosures and increased the penalties for executives who knowingly sign-off on inappropriate financial statements. The Sarbanes-Oxley Act also requires companies to improve their internal controls and audit committees. Below are some of the most infamous aggressive accounting scandals.
Aggressive accounting methods include inflating net income by recording expenses as capital purchases, as Worldcom did in 2001 and 2002, or understating depreciation expenses. Typically, the expenses are recorded when they paid for while capital purchases are allowed to be spread out over time in small increments to allow revenue to be generated from them. Worldcom spread out their operating expenses over time in smaller portions, treating them as capital expenses, which inflated the company's profits.
Other techniques involve inflating the recorded value of assets and the premature recognition of revenues. Krispy Kreme booked revenue from doughnut equipment it sold to franchisees, long before they had to pay for it. By selling to the franchisee, the parent company earned revenue from the sales of the high-profit machines.
Creative off-balance sheet-accounting can also be used to hide capital expenditures and corporate debt. In 2002, Krispy Kreme donuts appeared to be increasing sales without any increase in capital. As it turned out, it had used synthetic leases to move $35 million it spent on a new manufacturing and distribution center off its balance sheet. This was legal, but it was also a deception.
Because the new assets were reported as an expense on the income statement, rather than a liability on the balance sheet, Krispy Kreme appeared to have a better return on capital employed than was really the case.
In order to inflate revenue, energy companies like Enron reported the value of energy contracts as gross revenue, instead of the commission they received as traders. Using this trick, the top five energy trading firms in the U.S. increased their total revenue sevenfold between 1995 and 2000. Enron also used off-balance-sheet corporations called special purpose entities to hide underperforming assets and book phantom profits.