DEFINITION of Cook The Books
Cook the books is an idiom describing fraudulent activities performed by corporations to falsify their financial statements. Typically, cooking the books involves augmenting financial data to yield previously nonexistent earnings. Examples of techniques used to cook the books involve accelerating revenues, delaying expenses, manipulating pension plans and implementing synthetic leases.
Cooking The Books
BREAKING DOWN Cook The Books
During the first years of the new millennium, Fortune 500 companies such as Enron and WorldCom were found to have cooked the books to improve their financial figures. The resulting scandals gave investors and regulators a rude awakening concerning the reality that companies were capable of hiding the truth between lines of financial data. To rally investor confidence, the Sarbanes-Oxley Act of 2002 was created. The act of Congress created policies to protect investors against future incidents of corporate fraud. Even with Sarbanes-Oxley in place, there are still numerous ways companies cook the books.
Credit Sales and Inflated Revenue
A company might use credit sales to cook the books. Sales made on credit are booked as sales even if the company allows the customer to postpone payments for six months. In addition to in-house financing, companies can extend credit terms on current financing programs. So, a 20% jump in sales could be due to a new financing program with easier terms than a substantive increase in customer traffic. These sales trickle down through the income statement to net income.
Channel stuffing is a method some manufacturers use to cook the books. Manufacturers engaged in channel stuffing ship unordered products to distributors at the end of the quarter. These transactions are recorded as sales, even though the company fully expects the distributors to send back the products, especially those that did not sell. To avoid confusion, manufacturers should book products sent to distributors as inventory until the distributors record sales. Otherwise, the amount of sales reported is inflated.
Some companies might manipulate expenses to cook the books. One of the most common issues is with nonrecurring expenses. Nonrecurring expenses are meant to be one-time charges classified as extraordinary events, which artificially increase net income. These items are excluded from net income. The issue is that some companies have the same nonrecurring event happen every year, which means it is not extraordinary.
Another way that companies can manipulate earnings is with stock buybacks. Stock buybacks are logical for companies with excess cash, especially if the stock is trading at a low earnings multiple; however, some companies buy stock to disguise a decline in earnings per share. It is not unusual for a company to use debt to pay for stock buybacks, which in turn decreases the number of shares outstanding and increases earnings per share even if there's a decline in net income.