Cooking the Books

How can a financial statement reflect transactions in less than an accurate manner? Investors depend on the independent audit to ensure that a company's financial statements are accurate. But this audit involves much more than just checking to make sure no one is embezzling and that the company has adequate financial controls. Auditing firms look more deeply into the workings of the company to ensure that income, costs, and expenses are posted at the correct time. They also strive to ensure that, in every respect, financial statements present an accurate reflection of what occurred during the year, the valuation of assets and liabilities, and the handling of transactions so that investors can know with a high degree of certainty that the fundamentals are dependable.

Even with the safeguards in place, it is possible to "cook the books." This means that financial statements are altered in some way. Management is under considerable pressure from its board of directors in some cases. From management's point of view, the most desirable yearly result has to do with the marketability of stock, meaning that market price has to be maintained over time. The most obvious reflection of this is profits at a higher level than last year and a consistent net margin. Investors expect this, and so management is pressured to produce desired results. Those desired results do not always come to pass from the results of operations.

As a consequence, a chief financial officer (CFO) or CEO may be tempted to make adjustments in the books so that a desired result will be possible, including higher sales, consistent net margin, or higher net profits than the year before. The pressure is only made worse when analysts in brokerage firms or with research services make predictions based on detailed studies of the company's past financial statements. Those predictions determine whether or not the stock remains in favor. A "buy" recommendation by a brokerage firm may be changed if the company's results don't come out as predicted—even if the final result is still satisfactory based on long-term trends and internal forecasts. So in some respects, outside analysts have a lot to do with the stock's marketability, which also leads to pressure on financial executives to meet those outsiders' expectations.

Historically, audits by the SEC have uncovered some more serious examples of book cooking. A distinction has to be made between interpretation within the rules, and out-and-out cooking of the books. As reported in the June 25, 1984, issue of Fortune, "Managers don't have to cook the books to manipulate earnings; they often have all the power they need in the leeway built into accounting rules."

KEY POINT

Financial decisions involve many judgment calls. The financial statement does not represent an absolute "right" or "true" answer, only an interpretation of what occurred during the year.

Certain types of corporations, notably in the financial industry— banks and insurance companies, for example—have considerable leeway in the methods they choose for establishing reserves. While reserves are required by statute, the leeway is to be found in translating from statutory to generally accepted accounting principles (GAAP), a process that takes up considerable time and effort during audits, both on the part of management and the auditing firm. The less reserve a financial services company compiles during the year, the higher the current profits.

The reserve illustration is only one example of how profits can be manipulated, and it is not necessarily dishonest. A reserve requirement may have numerous interpretations, and management might argue that they have the right to place the most favorable interpretation on financial estimates, as long as those estimates fall within the broad guidelines range. Another example may be the deferral of writing off loans that, in fact, will never be collected. When a bank or savings institution underestimates its bad loans, it reduces its bad debt expense (thus, raising profits). The institution also may continue to accrue interest income on those loans, compounding the misleading reportage.

One especially troubling practice is that of attempting to engineer earnings so that profits are reporting consistently, creating the impression of stability. This practice is referred to as banking earnings. In the real world, earnings often occur irregularly and without any dependable consistency. However, management prefers steady growth over the years, so the temptation to bank earnings may lead to some fancy accounting.

Here's how it works. A portion of this year's earnings are deferred until a future period, with some type of justification. Accounting rules require that transactions are to be booked into the correct period. Thus, income should be recognized, or booked, in the year it is earned, even if it is not received until the following year. Costs and expenses are to be recognized in the year incurred, even if not paid until the following year. This practice accurately reflects the true status of business as of the end of the period, assuming that all income, costs, and expenses are truly recognized in their earned or accrued period. This system is referred to as accrual basis accounting. Figure 3.1 summarizes the way it works.

FIGURE 3.1 The Accrual System

The problem with this accounting system is that it can be complicated—not in the mechanical or procedural sense, but in the discretionary sense. When is income actually earned? In some instances, arguments can be made to record income immediately or to spread it over time. The motive should be to apply a consistent principle, but in practice the accrual system provides some flexibility to management, often enough flexibility to create the appearance of a very smooth and consistent income level year after year.

KEY POINT

The accrual system is the most accurate because it recognizes transactions in the correct period. It also complicates matters and provides more flexibility in interpretation of the numbers.

Deferral of earnings, or banking, is only one method used by some financial managers. Another involves changing of accounting methods or estimates. For example, a corporation estimates a reserve for bad debts, intended to allow for future accounts receivable that will not be collected. A lot of discretion may be available in the method chosen for establishing the reserve. In this area of accounting—estimating—a lot of discretion is allowed. Thus, in a particularly good year, it will be tempting to establish a larger than necessary reserve estimate. It can be reduced in future periods, when actual results are not as good. This practice creates a different kind of reserve, called the "sugar bowl."

It is not just exceptionally large earnings that are deferred for later use. Perhaps more troubling is the practice of deferring the reporting of large losses. For example, a corporation may know it has to take a write-off on a subsidiary investment that has lost money. It might defer booking the loss for a year or more, however, which artificially creates the impression that the corporation is continuing on a profitable course. When corporations buy assets, those assets are always booked at cost value. So if the asset is worth considerably more several years later, that fact is not usually acknowledged—at least not until the asset is sold and a big profit is realized. This can work in reverse as well. Let's say a company invests in an asset that subsequently loses value. If the corporation keeps the asset on its books at original cost, deferring the sale because it doesn't want to report the loss, that is a form of deferring bad news. When assets are kept longer than it makes sense so that losses are not reported, it can also eventually result in larger losses.