Thursday, 13 May 2010

Cooking the Books: Sweetening the Balance Sheet

Most often both the Balance Sheet and the Income Statement are involved in cooking the books.  A convenient cooking is exchanging assets with the purpose of inflating the Balance Sheet and showing a profit on the Income Statement as well!

For example, a company owns an old warehouse, valued on the company books at $500,000, its original cost minus years of accumulated depreciation.  In fact, the present value of the warehouse if sold would be 10 times its book value, or $5 million.  The company sells the warehouse, books a $4.5 million profit and then buys a similar warehouse next door for $5 million.

Nothing has really changed.  The company still has a warehouse, but the new one is valued on the books at its purchase price of $5 million instead of the lower depreciated cost of the original warehouse.  The company has booked a $4.5 million gain, yet it has less cash on hand than it had before this sell-buy transaction.

Why would a company exchange one asset for a very similar one ... especially if it cost them cash and an unnecessary tax payment?  The only "real" effect of this transaction is the sale of an undervalued asset and booking of a one-time gain.  If the company reports this gain as part of "operating income,": the books have been cooked - income has been deceptively inflated.  If the company purports that this one-time capital gain is reoccurring operating income, it has misrepresented the earning capacity of the enterprise.


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