Managers most often cook the books for personal financial gain - to justify a bonus, to keep stock prices high and options valuable or to hide a business's poor performance. Companies most likely to cook their books have weak internal controls and have a management of questionable character facing extreme pressure to perform.
All fast-growing companies must eventually slow down. Managers may be tempted to use accounting gimmicks to give the appearances of continued growth. Managers at weak companies may want to mask how bad things really are. Managers may want that last bonus before bailing out. Maybe there are unpleasant loan covenants that would be triggered but can be avoided by cooking the books. A company can just be sloppy and have poor internal controls.
One key to watch for is management changing from a conservative accounting policy to a less-conservative one, for example, changing from LIFO to FIFO methods of inventory valuation or from expensing to capitalizing certain marketing expenses, easing of revenue recognition rules, lengthening amortization or depreciation periods.
Changes like these should be a red flag. There may be valid reasons for these accounting policy changes, but not many. Be warned.
Related:
- Cooking the Books: Why do managers cook the books?
- Cooking the Books: This is very different from "Creative Accounting"
- Cooking the Books: Puffing up the Income Statement
- Cooking the Books: Techniques to Puff Up the Income Statement
- Cooking the Books: Sweetening the Balance Sheet
- Cooking the Books: Techniques to Sweeten the Balance Sheet
- Cooking the Books: The Auditor's Job
- Cooking the Books: Investors, be warned.
