John Brian Fast, CPA

Some think that accounting is an exact science.  It is more like a black art.  Here are some possible manipulations of the numbers that you should be aware of:

Investors like to see a nice smooth earnings trend line, going up, of course.   One way to accomplish this is to “store” earnings in the balance sheet.

The reserve for bad accounts receivable companies can be manipulated to understate or overstate a company’s bad accounts.  If you overstate the true amount of bad accounts, you reduce assets and income and store future income until the accounting period when you reduce the bad debt reserve to the correct amount.

Valuing inventories is a black art.

Inventory offers many opportunities for manipulating earnings.  Inventory represents the value of goods that were manufactured but not yet sold. When these goods are sold, the value is transferred over to the income statement as cost of goods sold.  Overstating inventory value will lead to an understated of cost of goods sold, and therefore an artificially higher net income.  Understating inventories, reduces income.  If you deliberately understate your inventories, you can always hold back the possiblility of recognizing their true value when you need income.  Smart readers of balance sheets look at changes in inventories.  Look for inventory increasing faster than sales, decreases in inventory turnover, inventory rising faster than total assets and falling cost of sales as a percentage of sales.  Any unusual variations in these figures can be indicative of potential inventory accounting fraud.

Construction projects in progress offer additional opportunities for tricks.  If you overestimate the progress of a project it will increase net income.  If you recognize less progress, you reduce the value of the project on the balance sheet and the effect is to reduce income.

The opposite of storing earnings is manufacturing earnings.  Some companies utilize creative accounting to overstate a company’s assets or understate its liabilities.  The effect of both of these tricks is to overstate income.

When you hide liabilities, you overstate income.  Enron maintained separate entities that were “off balance sheet” that they loaded up with debt that was really owed by Enron.  In our post:

http://www.johnbrianfastcpa.com/1565/ernst-and-young-complicit-in-the-lehman-collapse/

Lehman hid significant liabilities.

we documented that Lehman Brothers used “Repo 105” transactions to keep millions of liabilities off their balance sheet and hide their shaky financial position.

Pension obligations are ripe for manipulation by public companies, since the liabilities occur in the future and company-generated estimations need to be used to account for them.  Companies can make aggressive under-estimations of the true liability in order to improve both short-term earnings as well as to create the illusion of a stronger financial position.

Obligations under the new health care law may be manipulated as well.  Some large companies have made recent additions to their projected liabilities under the new law that some experts question.  Are these companiies really just trying to “store” earnings.

It is like the warning on your auto mirrors:  Earnings may be larger (or smaller) than they appear.  Accounting figures are created by human beings and many assumptions and estimates are made to determine the end results.