Earnings manipulation is easy with the right–or should I say wrong–accounting tricks. In this article, we explore how businesses inflate profits with fraudulent accounting practices.
One Wall Street Journal article said a California company used “a dozen or more accounting tricks” including “one particularly bold one: booking bogus sales to fake companies for products that didn’t exist.” These machinations inflated earnings, making the company look more profitable than it really was.
Today I show you how fraudsters use financial statement fraud to magically transform a company’s appearance. Then you will better know how to prevent these earnings manipulations.
Financial Statement Fraud
Companies can magically create earnings by:
- Accruing fictitious income at year-end with journal entries
- Recognizing sales for products that have not been shipped
- Inflating sales to related parties
- Recognizing revenue in the present year that occurs in the next year (leaving the books open too long)
- Recognizing shipments to a re-seller that is not financially viable (knowing the products will be returned)
- Accruing projected sales that have not occurred
- Intentionally understating receivable allowances
Think about it: A company can significantly increase its net income with just one journal entry at the end of the year. How easy is that?
You may be thinking, “But no one has stolen anything.” Yes, true, but the purpose of manipulating earnings is to increase the company’s stock price. Once the price goes up, the company executives sell their stock and make their profits. Then the company can, in the subsequent period, reverse the prior period’s inflated entries.
Earnings Manipulation Control Weakness
Such chicanery usually flows from unethical owners, board members, or management. The “tone at the top” is not favorable. These types of accounting tricks usually don’t happen in a vacuum. Normally the top brass demands “higher profits,” often not dictating the particulars. (These demands are typically made in closed-door meetings with no recorders or written notes.) Then years later, once the fraud is detected, those same leaders will plead ignorance saying their lieutenants worked alone.
This why the control environment, an entity-level control, is so important. Codes of conduct and conflict of interest statements do matter. Moreover, communicating appropriate ethical requirements is critical to an organization’s integrity.
Lower the Risk of Earnings Manipulation
The fix is transparency. This sounds simple, but transparency will usually remove the temptation to inflate earnings. If you work for a company (or a boss) that is determined to “win at any cost,” and repeatedly hides things (“don’t tell anyone about what we’re doing”), it is time to look for another job. When people hide what they are doing, they know it’s wrong–otherwise, why they wouldn’t hide it?
A robust internal audit department can enhance transparency. The board should hire the internal auditors. Then these auditors should report directly to the board (not management). The company’s internal auditors should know that the board has their back. If not, then you’ll continue to have opaque reporting processes. Why? The internal auditors’ fear of reprisal from management (or the board itself).
And what if the leaders of an organization won’t allow transparency? If possible, remove them. Unethical leadership will destroy a business.
Also, use retrospective reviews of the receivable allowance account. By comparing current period allowances with the prior period, you might detect the intentional lowering of receivable allowance accounts. Why would a company do this? Lower allowances result in higher profits. It’s another form of financial statement fraud.
See my full article regarding how to audit receivables and revenues.