3 Ways companies cook the books using accounting tricks

This post was inspired by Investopedia’s 8 ways companies cook the books and is a fun analysis on how public companies take advantage of loopholes in accounting to trick shareholders. Everyone in accounting has heard of the infamous story of Enron and the disaster that it caused. ColdFusion has made a video about this and its worth the watch if you have the time. Our Xero accounting trainers also talk about this in our accounting courses and this is a fun way to test your understanding of bookkeeping and accounting.

Accelerating revenue and booking payments ahead of time

Accelerated revenue refers to booking payments as current sales when they should be booked in the future. The income statement shows financial activity for goods & services delivered in the current financial period and the cashflow statement shows financial activity for payments made in the current financial period. To show higher revenue, many companies like to reflect earnings for goods that will be delivered in the future (e.g. in one year) ahead of time.

For example, say that I run a shoe company. I collect preorders of $1M. The preordered shoes will only be manufactured and delivered to customers next year in 2023 The income statement of 2022 should not reflect the $1M in revenue but the cashflow statement of 2022 should reflect a $1M increase in cash holdings.

Accountants that accelerate revenue will note the $1M as revenue in 2022 although it should be reflected in revenue in 2023 since that’s when the shoes will be delivered to customers.

Retail companies using channel stuffing to accelerate revenue to show untrue higher sales

The above example is the most common way to accelerate revenue. But many companies have also used a more deceiving and unethical accounting method called “channel stuffing”. This is usually done in retail industries that deal with physical products.

Continuing from our shoe example above, say that you have lots of distributers and shops that sell your shoes. The distributor orders 100 shoes because that’s what they think that they can sell. But because you want to increase your sales artificially to inflate your income statement, you tell your distributor that you’ll send over 1,000 shoes. But if the distributor can’t sell the 900 additional shoes within 3 years, you’ll accept a refund and take the shoes back and offer them credit or a full refund.

Let’s assume that each shoe costs $10. Without any accounting tricks, your revenue would be $10 x 100 shoes = $1,000. But with channel stuffing, your revenue is now $10 x 1,000 shoes = $10,000. But you didn’t just increase sales tenfold. Instead, you know that there’s a very high probability that the distributor will refund the other 900 shoes since they won’t be able to sell them. You just want to record a higher figure of $10,000 in your income statement to show an artificially high sales figure.

This is an intentional effort to deceive investors through misleading sales figures on the income statement. Because of such accounting tricks, the 2002 Sarbanes-Oxley Act was introduced to prevent public companies from committing such accounting fraud.

Delaying expenses by categorising expenses as an asset and writing them off in coming years

Delaying expenses refer to intentionally wrongly categorising expenses in order to reduce the figures on the income statement. The best example of this done by a public company is AOL. AOL paid a $3.5M penalty after it was found guilty of accounting manipulations of certain advertising costs.

AOL sent computer disks to potential customers in order to increase awareness of CDs. AOL viewed this as an advertising campaign. However, instead of categorising the sent computer disks as an expense, they categorised them as assets instead. They planned to write off the CDs over a period of years, which would have prevented this expense from showing up in the income statement in the fiscal year that the CDs were sent out to potential customers.

AOL should have noted the sent CDs in the fiscal year that they were sent to customers. For example, if 1,000 CDs were sent to customers between March and May of 1995, that expense should show up in AOL’s 1995 income statement. Instead, it was hidden and put in the balance sheet and AOL planned to write off that “asset” over the coming few years.

Simply put, AOL treated an advertising campaign as a fixed asset instead of the operating expense it was. They treat sending CDs to potential customers as a machine in a factory that they could write off over the coming years.

The biggest reason that AOL did this was because they wanted to report a profit in their 1995 and 1996 quarterly financial statements. In fact, AOL reports profits for six (of the eight quarters) instead of the losses that they would have reported otherwise. This mislead how the company was doing and AOL did this to keep its share price high and maintain the mirage of a positive quarter to investors.

Prepaying for post-merger expenses before the merger

In mergers & acquisitions, a lot of going-to-be-acquired companies often prepay all their expenses that they’ll incur after the merger. This may seem odd but makes sense once you understand the accounting side of things.

Say that the shoe company prepays $10,000 for their IT expenses like web hosting for their next fiscal year. They end up decreasing their expenses for the next fiscal year which will mean a higher earnings and EPS (Earnings Per Share) in the next fiscal financial statement.

Therefore the company that acquires the shoe company will be able to show a “higher EPS” and “higher earnings” after taking over the company. This may be true, but is very misleading since any company that prepays for expenses in one year will naturally have higher profits in the next year because expenses will be lower (since they were prepaid for).