Showing posts with label cooking the books. Show all posts
Showing posts with label cooking the books. Show all posts

Thursday 13 May 2010

Cooking the Books: Investors, be warned.

This discussion should make you better able to see the clues of fraud and remind you to be vigilant.

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: The Auditor's Job

Just as some people cheat on their tax returns, thinking they will not be caught, some companies "cook the books" hoping auditors and regulators will not catch them either.

Like "borrowing" $20 from the till until payday, and then not being able to repay the "loan," small illegalities can snowball into major fraud.

Remember, an auditor's job is only to review systematically the company's accounting and control procedures and then sample its business transaction to see whether appropriate policies and procedures are being followed in practice. But it is quite possible for a dedicated and corrupt management to mask transactions and deceive these auditors.


Related:

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.


Related:

Cooking the Books: Puffing up the Income Statement

Puffing up the Income Statement most often involves some form of bogus sales revenue that results in increased profit.

One of the simplest methods of cooking the books is padding the revenue; that is, recording sales before all the conditions required to complete a sale have occurred.  The purpose of this action is to inflate sales and associated profits.  A particularly creative technique is self-dealings such as increasing revenue by selling something to yourself.

Revenue is appropriately recorded ONLY after all these conditions are met:

  1. An order has been received.
  2. The actual product has been shipped.
  3. There is little risk the customer will not accept the product.
  4. No significant additional actions are required by the company.
  5. Title has transferred and the purchaser recognizes his responsibility to pay.
The other common route to illegal reporting of increased profit is to lower expenses or to fiddle with costs.  A simple method to accomplish this deception involves shifting expenses from one period into another with the objective of reporting increased profits in the earlier period and hoping for the best in the later period.

Cooking the Books: This is very different from "Creative Accounting."

The vast majority of audited financial statements are prepared fairly.  They are assembled in accordance with GAAP and evidence sound fiscal controls and integrity of management.  However, sometimes this is not the case and financial fraud is committed:  illegal payments made, assets misused, losses concealed, expenses under-reported, revenue over-recorded and so forth.

Cooking the books is very different from "creative accounting."

It is creative to use accounting rules to best present your company in a favourable financial light.  It is legal and accepted.

"Cooking the books" means intentionally hiding or distorting the real financial performance and/or financial condition of a company.  Cooking the books is done for a deceptive purpose and is meant to defraud.


Related:

Cooking the Books: Why do managers cook the books?

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.

"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.

Cooking is most often accomplished by moving items that should be on the Income Statement onto the Balance Sheet and sometimes vice versa.

A variety of specific techniques can be used to raise or lower income, raise or lower revenue, raise or lower assets and liabilities, and thereby reach whatever felonious objective the businessperson desires.  A simple method is outright lying by making fictitious transactions or ignoring required ones.


Related:

Cooking the Books: Techniques to Sweeten the Balance Sheet

C. Improperly increased or shifted period income.
D. Improperly increased assets and equity.


C.  Improperly increased or shifted period income

C1.  Current expenses shifted into later period
  • C1a.  Improperly capitalized costs as inventory.
  • C1b.  Assets depreciated or amortized too slowly.
  • C1c.  Worthless asset not written off immediately.
C2.  Shift revenue and income into later periods with reserves.


D.  Improperly increased assets and equity.

D1.  Increased equity through one-time gains
  • D1a.  Report gains on exchange of similar assets
  • D1b.  Report gains by selling undervalued assets
  • D1c.  Retire debt.
D2.  Report revenue rather than liability on receipt of cash.



"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.

Related:

Cooking the Books: Techniques to Puff Up the Income Statement

A.  Improperly increased revenue
B.  Improperly lowered cost or expenses.

A.  Improperly increased revenue

A1.  Sales recorded before completed and final

  • A1a.  Goods shipped before sale final
  • A1b.  Revenue recorded while future services still due

A2.  Bogus revenue recorded

  • A2a.  Supplier refunds recorded as revenue
  • A2b.  Revenue recorded from self-dealing
  • A2c.  Revenue recorded from asset exchanges.

B.  Improperly lowered costs or expenses

B1.  Current expenses shifted into later periods
  • B1a.  Period expenses capitalised onto Balance Sheet
  • B1b.  Assets depreciated too slowly.
  • B1c.  Probable liabilities not accrued.
B2.  Operating losses masked in discontinued operations


"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.