Earnings manipulation is easy with the right–or should I say wrong–accounting tricks such as cookie jar reserves. In this article, we explore how businesses inflate profits and sometimes decrease the same, depending on what the company desires. Financial statement fraud is common, so let’s see how these schemes work.
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.
What does it mean to inflate earnings? Inflating earnings means a company uses fraudulent schemes to make their earnings look better than they really are.
Companies can magically create earnings by:
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.
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.
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.
Though much less likely, some businesses intentionally decrease their earnings with fraudulent accounting. Why would they do so? Maybe the business has an exceptionally good year, and it would like to save some of those earnings for future periods. For instance, management bonuses might be tied to profit levels. If those thresholds have already been met, it’s possible that the company will defer some current year earnings in order to ensure bonuses in the following year.
Deferring earnings is often called a cookie jar reserve. For example, if a company’s allowance for uncollectibles accounts is acceptable within a range (say 1% to 2% of receivables), it might use the higher percent in the current year. The higher reserve decreases current year earnings (the allowance is credited and bad debt expense is debited, increasing expenses and decreasing net income). Then in the following year, the company might use 1% to increase earnings (even though 1.75% might be more appropriate). This is called smoothing.
Honest companies record their numbers based on what is correct, not upon desired results. But not all companies are honest.
See my full article regarding how to audit receivables and revenues.
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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[…] When earnings are manipulated, the company’s long-term prospects may suffer. An artificially inflated earnings report may prevent a company from making necessary investments in its business or from making enough money […]