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8 Ways Companies Cook the Books

Every company manipulates its numbers to a certain extent to make sure budgets balance, executives score bonuses, and investors continue to offer up funding. Such creative accounting is nothing new. However, factors such as greed, desperation, immorality, and bad judgment can cause some executives to cross the line into outright corporate fraud.

Enron, Adelphia, and WorldCom are extreme examples of companies who cooked the books claiming billions in assets that just didn’t exist. They are exceptions to the rule. Regulations such as the 2002 Sarbanes-Oxley Act, a federal law that enacted comprehensive reform of business financial practices aimed at publicly held corporations, their internal financial controls, and their financial reporting audit procedures, has reigned wayward companies to a large extent.

However, investors should still know how to recognize the basic warning signs of falsified statements. While the details are typically hidden, even from accountants, there are red flags in financial statements that can point to the use of manipulating methods.

1. Accelerating Revenues

A second revenue-acceleration tactic is called “channel stuffing.” Here, a manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales. But the distributor has the right to return any unsold merchandise. Because the goods can be returned and are not guaranteed as a sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.

2. Delaying Expenses

3. Accelerating Pre-Merger Expenses

4. Non-Recurring Expenses

By accounting for extraordinary events, non-recurring expenses are one-time charges designed to help investors better analyze ongoing operating results. Some companies, however, take advantage of these each year. Then, a few quarters later, they “discover” they reserved too much and put an amount back into income (see next tactic).

5. Other Income or Expense

6. Pension Plans

7. Off-Balance-Sheet Items

8. Synthetic Leases

A synthetic lease can be used to keep the cost of a new building, for example, from appearing on a company’s balance sheet. Effectively, a synthetic lease allows a company to rent an asset to itself. It works like this: a special purpose entity established by a parent company purchases an asset then leases it back to the parent company. As a result, the asset of the special purpose entity is shown on the balance sheet, which treats the lease as a capital lease and charges depreciation expense against its earnings. However, the asset does not appear on the balance sheet of the parent company. Instead, the parent company treats the lease as an operating lease and receives a tax deduction for the payments on the income statement. Nor is it revealed that, at the end of the lease, the parent company is obligated to buy the building—a huge liability that appears nowhere on the balance sheet.

The Bottom Line

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About Amy Harvey

Amy R. Harvey writes forStartUps Sections In AmericaRichest.

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