Financial statement manipulation refers to the practice of using creative accounting tricks to make a company’s financial statements reflect what the company wants its performance to look like rather than its actual performance.
Despite numerous steps taken by legislatures and regulatory bodies – such as the Securities and Exchange Commission (SEC) – to curb manipulation of financial statements, especially by publicly traded companies, the practice is still widespread.
Financial statement manipulation is the practice of altering a company’s financial records to present a false picture of its financial condition.
The manipulation invariably consists of either inflating revenues or deflating expenses or liabilities.
Accounting standards and best practices are administered by the Generally Accepted Accounting Principles (GAAP) in the United States and by the International Financial Reporting Standards (IFRS) in the European Union.
Why Do Companies Manipulate Their Financial Statements?
The higher-paid executives who run major corporations can be tempted to “cook the books” on their financials for several potential reasons, such as:
1. Feeling intense pressure to show a positive picture
Often, it’s not the case that they are inherently evil people who delight in deceiving the public. It’s more often the case that they simply give in to the enormous pressure they’re under, being paid outrageous sums of money and expected to direct their company to ever-increasing growth and profitability, amid an increasingly competitive business landscape.
2. Tapering investors’ expectations
There are several situations that may make it tempting for a CEO to manipulate a company’s financials a bit. It might be something as relatively innocent as not wanting investors to develop unrealistic expectations. Let’s say the company just flat out got lucky on a number of fronts, and it ended up achieving, by far, its best year ever.
But then the CEO starts thinking, “If we print these numbers, as is, then our investors are going to expect to see over-the-top results all the time. If we just show an average year, then when they see those numbers, they’re going to think something’s wrong and start jumping ship.” So, he makes the CFO change the date on a couple of major sales so that revenue gets pushed forward to the next fiscal year, making the current fiscal year look just a little less promising.
In the example above, the guilty party isn’t even manipulating the numbers to try to make the company look better – instead, he’s making it look worse. And his motives aren’t terribly nefarious – he’s not actively scheming to rip someone off.
3. Triggering executive bonuses
A very common motivation for manipulating financial statements is to meet sales/revenue goals that trigger a big bonus for upper-level management. The structure of such incentive bonuses has often been criticized as being, in effect, an incentive for an executive to “cheat.”
Perhaps, major corporations might consider doing away with bonuses paid out that way. Instead, they might offer performance bonuses based on a non-financial metric. For example, the CEO and CFO could be paid bonuses if customer service satisfaction rises five percentage points.
1. The lack of standardized accounting standards
Along with the structure of management incentives, there are other factors in play that appear to contribute to an environment where fraud is almost commonplace. One of the factors is the lack of standardized accounting standards.
It was thought that the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) would’ve long since set aside their differences and come to an agreement on a single set of universally recognized accounting practices.
Unfortunately, as of 2020, it looks less and less likely that such a universal set of practices and standards will ever be carved out. The lack of consensus on exactly how corporate accounting should be completed makes it easier for dishonest people to get away with being dishonest.
2. Conflicts of interest relationship between companies and accounting firms
The Enron scandal clearly pointed out another contributing factor to financial statement manipulation – the often too close, filled with potential conflicts of interest relationship between companies and the accounting firms that audit them.
How Financial Statements Are Manipulated
Manipulation of financial statements always involves doing one of two things – either manipulating records to inflate apparent revenue or manipulating them to reduce apparent expenses or liabilities.
More specifically, here are some of the accounting tricks used to provide a false picture of a company’s actual financial condition:
Recording revenue prior to supplying goods or services
Reporting income from investments or capital obtained by taking out a loan as business revenue
Capitalizing ordinary business expenses, thus shifting them from the income statement to the balance sheet
Inaccurately reporting liabilities – or altogether neglecting to report them at all
A surprisingly simple method of manipulating financial statements is that of inflating assets with false inventory count values. For example, a company may do an ordinary inventory count, but then add 100 items to each count – so, 500 desktop computers become 600 desktop computers, or 150 computer monitors become 250 monitors, etc.
If the average inventory item value is $350, and there are 10 categories of items, then, using such a creative inventory addition technique, the company can quickly increase the value of its total assets by $350,000.
How to Protect Yourself From Financial Statement Manipulation
Individual investors need to do all they can to avoid being the victim of financial fraud, including fraudulently altered financial statements. The best way to do it is simply to obtain a strong financial education. Fortunately, there are plenty of resources available to help you educate yourself. CFI offers a FREE course on “How to Read Financial Statements.”
Knowing how to read and understand the three main financial statements – the income statement, the balance sheet, and the cash flow statement – will enable you to more easily spot when some of the numbers don’t quite seem to add up.
Understanding the actual components of the income statement, for example, will also help you to better assess the validity of the projections the CEO makes during the “guidance” and Q&A portions of a company’s earnings call.
Thank you for reading CFI’s guide to Financial Statement Manipulation. To keep advancing your career, the additional resources below will be useful: