Financial Statement Manipulation

What Is Financial Statement Manipulation?

The manipulation of financial statements is one of the most widespread and corrupt practices among publicly traded companies. Despite numerous attempts by the SEC to mitigate this practice, it remains an ongoing problem in corporate America. 

Financial statement manipulation is when a publicly-traded company alters information on its financial records to reflect an inaccurate portrayal of the company's financial condition. 

Companies often do this to show what they want their performance to look like rather than their actual performance. 

This falsification of financials can be done through numerous accounting tricks. However, it usually involves inflating revenues or deflating expenses or liabilities.

Companies manipulate their reports for a variety of reasons. It usually happens because managers feel extreme pressure to perform well and want an increase in compensation, and it is relatively easy to pull off. 

It is easy to pull off because the Generally Accepted Accounting Principles (GAAP) provide grey areas for such activity. Most independent auditors have a conflict of interest with the corporate client.

The GAAP standards have significant leeway for this type of activity because most accounting provisions and methods are up for interpretation by the financial accounting standards board (FASB). 

These standards are also very flexible, which allows corporate management to manipulate their accounts to paint their own picture of how they want their financials to appear. 

Because of these reasons, investors must be aware that financial statement manipulation is possible and should watch out for any warning signs before investing in a company. 

The U.S. government has tried to take action to prevent financial fraud in the past. They passed the Sarbanes-Oxley act in 2002 as a direct result of financial fraud schemes committed by Enron, WorldCom, and Tyco. 

Sarbanes-Oxley supplemented the existing Securities and Exchange Act of 1934, which made it stronger. Despite this, manipulation fraud remains a prevalent issue.

Why Do Companies Manipulate Their Financial Statements?

Company managers' compensation is usually tied directly to the company's financial performance. You can probably see why they would be tempted to "cook the books."

However, there is a list of reasons why companies might be motivated to manipulate their financials.

1. Pressure to perform well 

Managing a publicly-traded company is one of the most challenging jobs. There is enormous pressure to lead the company to have consistent growth year after year. Sometimes, executives give in to this pressure and slightly alter their financials out of fear of failing. 

Executives are not always bad people with evil intent. More often, they manipulate statements due to increased pressure rather than selfish reasons. 

2. Boost personal compensation

Executive bonuses are often tied directly to the financial performance of the company. Sometimes, an executive does have selfish intentions when manipulating financial accounts. 

These bonuses are often triggered by meeting a certain revenue goal, which results in a large payout for upper management. The corporate structure of such incentive bonuses is often criticized for being the underlying cause of executives cheating their way to larger salaries.

3. It is easy to do 

The financial accounting standards board (FASB) is the board that sets the standards for the accounting principles that we use today. The issue is that these standards are hardly standardized at all.

The generally accepted accounting principles (GAAP) standards provide significant interpretation and flexibility, making it easy for corporate management to paint their own picture of the company's financial position without ever violating the norms.

It is also improbable for an auditor to detect financial manipulation within a company because independent auditors often have a conflict of interest with the companies they audit. In addition, these auditors are often compensated by the companies they audit. 

This system motivates auditors to ignore any accounting "mistakes" they see to keep the company's financial condition looking strong and their compensation high. The better the company does, the more it will be willing to pay its auditor. 

4. Tapering investor's expectations 

Sometimes a CEO might find it strategic to change the company's financial results slightly to avoid raising investor expectations.

For example, if a company had the best year it has ever had by far, then investors would start to expect those numbers. If all of a sudden the company starts posting more average numbers the following year, investors would think the company is going downhill. 

The CEO might be tempted to change some of the dates of sales to later dates to reflect revenue increase in the following year instead of the first year. While this manipulation does not have an evil intent to rip someone off, it is still manipulation of the financial accounts. 

How common is financial statement manipulation?

Financial statement fraud is the costliest type of fraud, with a median cost of $2 million per scheme. It occurs least often out of fraud schemes, making up only 10% of all fraud schemes. 

Fraud in the financial statements occurs mostly due to the lack of auditor regulation. Independent auditors are usually compensated by the companies they audit, so there is a conflict of interest.

Since independent auditors have no real motivation to catch companies for committing financial manipulation, investors are often left to their own devices when it comes to detecting fraud in the financials. 

Investors have to be extra cautious when investing if they want to avoid being burned by fraudulent accounting in a company's financials. There are a variety of things to look out for that are signs of potential accounting fraud. 

Exaggerating Facts

One warning to look out for is when a company exaggerates the facts. 

When a company is going to take a loss, they often write off everything they possibly can. This can lead to manipulation because sometimes companies write off unsold inventory as a loss when it has the potential to be sold in the future for a profit. 

Smoke and Mirrors

Another thing to look out for is smoke and mirrors. 

There are several subjective figures in financial reports that accountants can tweak to elevate the good numbers and omit the bad ones.

A company can choose to leave out certain costs that are unrelated to the core operations of the business but then include the revenue from this unrelated business venture. If you don't look closely at the financials beyond the main figures, you will easily miss it.

Use of Accomplices

Another thing to look out for to spot financial accounting fraud is the use of accomplices.

Some common accomplices are special purpose entities (SPE) and sister companies. Both of these accomplices can be used to hide debt. 

For example, Enron used SPEs to hide massive amounts of debt from its balance sheet. Sister companies can also be used to hide debt in the form of a new business. 

All these things to look out for, such as: smoke and mirrors and accomplices, are all manipulative tricks used to deceive investors, but they can all be spotted if you just read the financial filings carefully. 

Every company that uses tricks like this must report it somewhere, whether in the footnotes or another obscure part of the filing. Regardless, as long as you read every word of the financial statement carefully, you will not be easily deceived by financial manipulation.

How Financial Statements Are Manipulated

Financial filings are usually altered in two ways: inflating revenue or reducing liabilities. This manipulation makes the company look better than it actually is.

Inflating revenue makes a company look much more profitable than it truly is, and reducing liabilities makes a company look like they have much less debt than they actually do. Therefore, it is essential to look out for these deceiving tricks by reading the footnotes in financial statements.

Financial filings can also be altered by deflating revenue or increasing liabilities. This seems counterintuitive because it is making the company look worse than it really is, but there are certain situations where a company would be compelled to do so. 

These situations are when a company wants to taper investor expectations or avoid getting acquired by another company. 

A company would want to taper investor expectations if they achieved unattainable earnings in one quarter and did not want investors to expect this to be the new norm.

A company might also want to make itself look worse to avoid being acquired by another company. There are various accounting tricks used to achieve these financial alterations.

Some of the accounting tricks used to manipulate the numbers on a financial statement are: 

• Recording revenue before supplying goods or services: recording revenue before completing all services, shipping products, or for products that are not required to be purchased

• Reporting false revenue: recording revenue for sales that didn't happen or reporting income from investments or capital obtained by taking out a loan as a business revenue

• Shifting ordinary business expenses from the income statement to the balance sheet

• Altering the time of expenses: shifting current expenses to an earlier or later period by amortizing costs too slowly or changing accounting standards

• Inaccurately reporting or omitting liabilities.

• Pushing back current revenue to a later period: holding back revenue or saving revenue for future times of poor performance

• Shifting future expenses to the current period as a special charge: accelerating expenses into the current period or changing accounting standards to allow manipulation through depreciation and amortization

Most of these techniques involve manipulating figures on the income statement, but there are many techniques to manipulate the balance sheet and cash flow statement as well.

Even sections such as the management discussion and analysis section can be manipulated by using soft language such as "possibly" and "maybe." Investors should understand these issues and remain alert to any potential fraud when assessing a company's financials. 

How to protect yourself from financial statement manipulation

Individual investors need to be extremely careful when reading financial filings so that they can avoid being victims of financial fraud, specifically financial statement manipulation. 

The best way to protect yourself from falling victim to this fraud is to obtain a strong financial education.

Knowing how to read and understand the three primary financial statements, the income statement, balance sheet, and cash flow statement will be the best way to protect yourself. 

The more you practice reading these statements, the better you will become at spotting potential fraud when some numbers aren't adding up. 

For example, if you understand the income statement well, you will be better at assessing the validity of the CEO's claims during the earnings call. This will help you become an all-around better investor and keep you better protected from accounting manipulation. 

Investors should also be familiar with market multiple analysis and know how to use price/earnings ratios, price/book value ratios, price/sales ratios, and other tools to gauge the reasonableness of the financial statements information. 

These tools are highly important for protecting yourself because they will allow you to understand financial statements and know when a company is trying to deceive you.

Unfortunately, very few retail investors have the patience, skills, or time it takes to learn all of these tools for market analysis. 

Suppose you are a regular investor who wants to stay protected from financial manipulation, but you don't have the time to learn all of the tools and techniques for analysis. In that case, you might want to consider investing in low-cost, diversified mutual funds or index funds. 

These funds will properly diversify your money and protect you from falling victim to investing in a company that is not as financially stable as it says it is. 

On the business side, hiring an external auditor can help eliminate, if not reduce, fraud. It can also help eliminate honest mistakes in financial filings and improve the detection and prevention of accounting fraud. 

Legality associated with financial statement manipulation

Manipulating financial accounts is illegal and is a type of accounting fraud. Overstating revenue, failing to record expenses, and misstating assets and liabilities are all ways to commit accounting fraud.

Accounting fraud is a very wide range of crimes that do not always cover the act of manipulating financial statements.

The U.S. government has responded to financial fraud with various preventative measures. Sarbanes-Oxley is one of those measures. Sarbanes-Oxley is an act passed by U.S. Congress to help protect investors from fraudulent financial reporting. 

It was passed as a result of the Enron, Worldcom, and Tyco scandals that all involved the manipulation of financial filings.

Financial statement frauds were too common of an occurrence, so the Sarbanes-Oxley act was passed to help deter companies from this behavior.

The rules implemented by the act amended or supplemented existing laws in the securities exchange act of 1934. The new law set out reforms and additions in these four areas:

• Corporate responsibility
• Increased criminal punishment 
• Accounting regulation 
• New protections 

Despite the passage of Sarbanes-Oxley and the newly added rules to the securities exchange act, accounting fraud continues to happen today. 

The bottom line is that investors must be careful whenever reading financial filings and looking for potential investments. There are many modern-day cases of financial accounting fraud, between the most famous we have:

• Enron
• WorldCom
• Tyco

These cases should remind investors of the potential dangers they might encounter. Accordingly, all investors should use extreme caution in their use and interpretation of financial statements because there is a known prevalence of issues associated with these statements. 

Investors should also not rely on auditors to catch companies committing fraud because the auditors often have conflicts of interest with the companies that compensate them. 

The only tool investors can reliably count on to protect them from financial statement manipulation is their own financial knowledge. Knowing how to read and understand the balance sheet, income statement, and cash flow statements is the best way to protect yourself.

Edited by Colt DiGiovanni | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Fraud Triangle
• Net Book Value
• PP&E (Property, Plant, and Equipment)
• Research and Development (R&D)
• Three Financial Statements