Spotting Creative Accounting on the Balance Sheet

The balance sheet, income statement, and cash flow statement are foundational to the financial reporting of any company. Public companies are considered to be held to a higher standard because of their mandate to follow Generally Accepted Accounting Principles (GAAP) but that hasn’t stopped several companies throughout history from cooking their books to post much better than actual results in many categories. Enron, WorldCom, and Lehman Brothers are some of the top-known cases of fraud but there are others.

Overall, creative accounting can come in many different forms. It can also occur in many different ways. Keep in mind that certain loopholes do exist that may help a company positively spin financial reporting in their favor legally. On the balance sheet, spotting creative accounting practices can be broken down into three categories for analysis: assets, liabilities, and equity. The balance sheet is closely tied to the income statement which is often where issues with asset revenue and/or liability expenses can help to create inflated revenues or understated expenses that result in a higher bottom line net income and furthermore a higher level of retained earnings tied back to the balance sheet. Here we’ll explore some of the ways each of the three categories of the balance sheet can be manipulated. However, keep in mind that any scenario involving the illegal overstatement of assets, understatement of liabilities, or overall under- or overstatement of shareholders’ equity can reap short term benefits but when spotted will have negative consequences. (See also: Reading the Balance Sheet.)

Key Takeaways

• On the balance sheet, spotting creative accounting practices can be broken down into three categories for analysis: assets, liabilities, and equity.
• Overstating assets and/or understating liabilities leads to increased net income on the income statement.
• Fraudulently increasing net income can create the illusion of better performance, both by the company and management.
• Inflating assets and understating liabilities on the balance sheet can also improve key performance ratios that creditors may be interested in when assessing or following lines of credit.
• Overall, a company’s balance sheet ratios are an important factor in performance assessment by all types of stakeholders and creatively improving them through balance sheet manipulation can have many advantages.

Why Boost the Balance Sheet?

Companies that manipulate their balance sheet are often seeking to increase their net income earnings power in order to create the appearance of a stronger financial condition or stronger management performance. After all, financially sound companies can more easily obtain lines of credit at low interest rates, as well as more easily issue debt financing or issue bonds on better terms. Companies may also be looking to overstate their overall asset position to potential creditors.

Overvaluing Assets

Assets top out balance sheet construction. Like liabilities, assets are divided into current (12 months or less) and long-term (more than 12 months). Items commonly found in the asset category include: cash and equivalents, accounts receivable, inventory, and intellectual intangibles.

Provision for Doubtful Accounts

Accounts receivable have a direct link to revenues on the income statement. Companies that use accrual accounting can book revenue in accounts receivable as soon as a sale is made. Thus, the processing of accounts receivable can be one high risk area for premature or fabricated revenues.

One reason accounts receivables may be overstated can be inappropriate planning for doubtful accounts. Prudent companies typically take proactive measures for account receivable defaults. By not doing so, this can inflate earnings. It is up to each company to analyze and estimate the percentage of accounts receivables that goes uncollected on a regular basis. If there is no allowance for doubtful accounts, accounts receivable will receive a temporary boost in the short term. Investors can possibly detect when the reserves for doubtful accounts are inadequate. Accounts receivable will not be fully turned into cash, which can show up in liquidity ratios like the quick ratio. Write-downs will also need to be made to revenues. If accounts receivable makes up a substantial portion of assets and inadequate default procedures are in place this can be a problem. Without doubtful account planning, revenue growth will be overstated in the short term but potentially retracted over the longer term.

Revenue Acceleration

In the asset category, companies can also overstate revenues through acceleration. This could come from booking multiple years of revenue at once. Companies may also manipulate revenues by comprehensively booking a recurring revenue stream upfront rather than spreading it out as it is expected to be received. Revenue acceleration is not necessarily illegal but it is not usually a best practice.

Inventory Manipulation

Inventory represents the value of goods that were manufactured but not yet sold. Inventory is usually valued at wholesale but sold with a markup. When inventory is sold, the wholesale value is transferred over to the income statement as cost of goods sold and the total value is recognized as revenue. As a result, overstating any inventory values could lead to an overstated cost of goods sold, which can reduce the revenue earned per unit. Some companies may look to overstate inventory to inflate their balance sheet assets for the potential use of collateral if they are in need of debt financing. Typically, it is a best practice to buy inventory at the lowest possible cost in order to reap the greatest profit from a sale.

One example of manipulated inventory includes Laribee Wire Manufacturing Co., which recorded phantom inventory and carried other inventory at bloated values. This helped the company borrow some $130 million from six banks by using the inventory as collateral. Meanwhile, the company reported $3 million in net income for the period, when it really lost $6.5 million.

Investors can detect overvalued inventory by looking for telling trends like large spikes in inventory values. The gross profit ratio can also be helpful if it is seen to fall unexpectedly or to be far below industry expectations. This means net revenues may be falling or extremely low because of excessive inventory expensing. Other red flags can include inventory increasing faster than sales, decreases in inventory turnover, inventory rising faster than total assets, and rising cost of sales as a percentage of sales. Any unusual variations in these figures can be indicative of potential inventory accounting fraud.

Subsidiaries and Joint Ventures

When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the equity method depending on their ability to control the subsidiary. Regardless, these investments are booked as assets. This can leave the door open for companies to potentially use subsidiaries, ownership investments, and joint venture structuring for concealment or fraudulent purposes—oftentimes, off-balance sheet items are not transparent.

Under the equity method, the investment is recorded at cost and is subsequently adjusted to reflect the share of net profit or loss and dividends received. Gains on these investments inflate assets and also lead to higher net income which carries over to the retained earnings portion of shareholders’ equity. While these investments are reported on the balance sheet and income statement, the methodologies can be complex and may create opportunities for fraudulent reporting.

Investors should be cautious—and perhaps take a look at the auditor’s reliability—when companies utilize the equity method for accounting in situations where they appear to control the subsidiary. For example, a U.S.-based company operating in China through various subsidiaries in which it appears to exert control could create an environment ripe for manipulation.

Note

Inflating assets can lead to higher revenues or higher inventory values that can make a company’s asset position stronger than it actually is.

Undervaluing Liabilities

Undervaluing liabilities is a second way to manipulate financial statement reporting from the balance sheet. Any understatement of a company’s expenses can be beneficial in boosting bottom line profits.

Contingent Liabilities

Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee, or the date payable. For example, warranty obligations or anticipated litigation losses may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating them or downplaying their materiality.

Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income and shareholders’ equity. Investors can watch for these liabilities by understanding the business and carefully reading a company’s footnotes, which contain information about these obligations. Lenders, for example, regularly account for uncollected debts incurred through defaults and often discuss this area when earnings reports are released.

Other Expenses

Some other ways companies may manipulate expenses can include: delaying them inappropriately, adjusting expenses around the time of an acquisition or merger, or potentially overstating contingent liabilities for the purpose of adjusting them in the future as an increase to assets. Moreover, in the realm of expenses, subsidiary entities as mentioned above, can also be a haven for off-balance sheet reporting of some expenses that are not transparently realized.

Note

Ownership in non-transparent entities can raise red flags for off-balance sheet items that may be disguised within subsidiaries rather than fully integrated in a company’s bottom line results.

Pension Obligations

Pension obligations are ripe for manipulation by public companies, since the liabilities occur in the future and company-generated estimates need to be used to account for them. Companies can make aggressive estimates in order to improve both short-term earnings as well as to create the illusion of a stronger financial position. There are two key assumptions that companies may adjust.

In general, pension obligations are a result of the present value of future payments paid to employees. One way to potentially manipulate this is through the discount rate used. Increasing the discount rate can significantly reduce the pension obligation. Companies may also overstate the expected return on plan assets. Overstating expected return creates more assets from which to pay pension liabilities, effectively reducing the overall obligation. Since pension obligations can be ongoing for a company, accountants could potentially make various adjustments over the full length of the obligations in order to favorably manipulate net income in the short term or at some time in the future. (See also: Analyzing Pension Risk)

Shareholders’ Equity

Shareholders’ equity consists of the value of stocks, any additional paid-in capital, and retained earnings—which are carried over from net income on the balance sheet. If a company overstates assets or understates liabilities it will result in an overstated net income, which carries over to the balance sheet as retained earnings and therefore inflates shareholders’ equity. Shareholders’ equity is used in several key ratios that may be assessed by financial stakeholders when evaluating a company as well as for maintaining current financing arrangements such as credit lines. Some of these ratios may include debt to equity, total assets to equity, and total liabilities to equity. Comprehensively, shareholders’ equity is also used in the calculation of return on equity (ROE), which is central to evaluating the overall balance sheet performance of a company as well as the performance of management. ROE is the result of net income over shareholders’ equity.

The Bottom Line

Companies can manipulate their balance sheets in many different ways, ranging from inventory accounting to contingent liabilities. Oftentimes, the goal is to increase net income, which comes with integration of actions that also show on the income statement. Sometimes, companies may seek to inflate their assets or understate their liabilities to present a stronger financial position for stakeholders who are assessing their willingness to provide new capital through either debt or equity financing. Any dramatic spikes in a company’s assets or dramatic decreases in a company’s expenses can be reason for alarm and further investigation. Public companies are required to adhere to GAAP accounting but oftentimes use non-GAAP measures, which should also be investigated and understood by investors.

Public companies can be a better universe for the sourcing of investments for everyday retail investors because of the regulations that have been instituted by the Securities Exchange Commission. If an investor feels they may have spotted creative accounting that involves fraudulent reporting, a review of publicly available audit statements and related financial disclosures can be the first place to look. Sometimes though, methods may be hidden, which can lead to shareholder investigations and potentially lawsuits if solid evidence is found for unlawful manipulations. Reading the financial statements, understanding a company’s business, and integrating an appropriate knowledge for spotting questionable practices can be important steps for all investors to take before making substantial investments. Staying away from questionable investments or taking proactive steps to move out of investments when creative accounting measures have been spotted can also be prudent steps to take.

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