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Financial statement manipulation is an ongoing problem in corporate America, and investors who buy stocks or bonds should be aware of its signs and implications.

Management manipulates financial statements for three reasons:

  1. The compensation of many corporate executives is tied to the company’s financial performance.
  2. It’s relatively easy to alter numbers.
  3. Conflict of interest with auditing firms, which are paid by the same companies they audit.

Many manipulated financial statements inflate current period earnings with artificial revenues, or they deflate current period expenses. Others deflate current period earnings by decreasing revenue or increasing expenses. The latter approach – making a company look financially worse than it really is – may seem like a bad idea, but it can deter potential acquirers.

Management can use any of several techniques to alter a company’s income statements, balance sheets and cash flows.

Noted author Dr. Howard Schilit found seven primary ways corporate management manipulates financial statements.

  1. Recording revenue prematurely
  2. Recording fictitious revenue
  3. Increasing income with one-time gains
  4. Shifting current expenses to an earlier or later period
  5. Failing to record or improperly reduce liabilities
  6. Shifting current revenue to a later period
  7. Shifting future expenses to the current period as a special change

Financial manipulation frequently occurs during mergers and acquisitions, when management convinces all parties that the earnings per share of the combined companies will improve. Management will often use misleading information to come up with their numbers.

To spot manipulated statements, investors should understand financial statement analysis, and the ratios used to gauge a company’s performance and risk. They should also remember that many auditors have conflicting interests that compel them to distort a firm’s true financial picture.

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