Top 10 Ways Companies Cook the Books

Published on August 20, 2020

With the recent economic slowdown, companies are under increased pressure to show stability, or even growth, and paint a rosy picture for investors. That pressure will undoubtedly cause some companies to engage in accounting fraud to distort their financial results, thereby misleading investors. As with most accounting scandals, companies are usually unable to sustain the deception, and the house of cards eventually collapses.

The following are 10 of the primary accounting schemes that we regularly see in our practice representing whistleblowers at the Securities and Exchange Commission. Under the SEC whistleblower program, individuals are eligible to receive monetary awards for bringing such frauds to light. In certain circumstances, compliance personnel, including auditors, accountants, officers and directors, may be eligible for awards under the program. Since 2012, the SEC has awarded more than $500 million to whistleblowers, which includes three awards to compliance officers. 

1. Improper timing of revenue recognition

The most common way that companies cook the books is through improper revenue recognition schemes. According to a study by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), more than 60 percent of SEC enforcement actions against companies for financial statement fraud relate to improper revenue recognition.

Revenue should only be recognized once it has been both earned and realized. Improper timing of revenue recognition occurs when a company inappropriately shifts revenue from one period to another. Most commonly, companies inappropriately accelerate revenue recognition in order to meet their earnings targets. Conversely, companies may also inappropriately delay recognizing revenue if they have already met their revenue guidance for the period. This accounting scheme can be difficult to detect, especially when companies have multiple elements or bundled contracts.

2.  Fictitious revenue

Another common revenue recognition scheme is recognizing fictitious revenue. For example, a company may falsely inflate its earnings by recognizing revenue related to fake contracts or other nonexistent sales. Most recently, an internal investigation at Luckin Coffee, a company with a $3 billion market capitalization at the time, revealed that it had recognized $300 million in fictitious revenue in 2019. News of the fraud caused the company’s stock price to plummet overnight.

3.  Channel stuffing

Channel stuffing is an improper revenue recognition practice in which a company fraudulently inflates its sales by sending excessive amounts of products to its distributors ahead of demand. This practice typically occurs near the end of reporting periods when a company needs to increase its revenues to meet financial projections and market expectations. A company will oversell inventory to distributors in amounts that far exceed the public’s demand for the products and prematurely recognize revenue on future sales.

4.  Third-party transactions

Companies may also inappropriately recognize revenue through improper or fraudulent third-party transactions. The transactions that are most susceptible to fraud include bill and hold sales, consignment sales, side letter agreements and other contingency sales.

5.  Fraudulent management estimates

A company’s management may improperly adjust and inaccurately report accounting estimates to favorably impact financial statements. For example, management may use inappropriate methodologies to determine and report write-offs or other key metrics, resulting in inaccurate accounting and misstatement of income.

6.  Improper capitalization of expenses

Companies should classify the costs of expenditures as assets or expenses in their financial statements. Improper capitalization of expenses occurs when a company capitalizes current costs that do not benefit future periods. By doing so, a company will understate its expenses in the period and overstate net income. The most well-known example of this scheme involved WorldCom, in which the company overstated its net income by more than $9 billion by, among other accounting tricks, improperly capitalizing operating expenses.

7.  Other improper expense recognition schemes

In addition to improperly capitalizing expenses, a company may use other expense recognition schemes to inappropriately overstate net income. For example, a company may falsely inflate its net income in a period by improperly eliminating or deferring current period expenses; by allocating more costs to inventory than cost of goods sold; by creating excess reserves by initially over-accruing a liability in one period (also known as “cookie-jar” reserves) and then reducing the excess reserves in later periods; by understating reserves for bad debt and loan losses; or by failing to record asset impairments.

8.  Misleading forecasts or projections

A company may issue misleading forecasts to avoid disclosing a known, increased risk of missing key financial goals or metrics that investors rely on to evaluate financial statements. Even when a company becomes aware of an increased risk of missing the projections, public statements may reaffirm the original projections, in violation of securities laws. The Securities Act of 1933 prohibits untrue statements or omissions in the offer or sale of securities.

9. Misleading non-GAAP reporting

While companies may use non-GAAP reporting metrics where GAAP figures do not fully portray their financial condition, they must report non-GAAP metrics accurately. A company might manipulate non-GAAP measures to reflect stronger growth or higher earnings. Since 2013, there has been a dramatic increase in publicly traded companies reporting non-GAAP numbers in their financial statements.

10.  Inadequate internal controls over financial reporting

The Exchange Act requires all companies reporting to the SEC to devise and maintain a system of internal controls over financial reporting, which must provide reasonable assurance that transactions are properly recorded and financial statements are prepared in accordance with GAAP. A wide range of accounting scandals violate this requirement.

(Source:  AccountingToday – Daily Briefing – August 19, 2020)