Do numbers lie?

Corporate management has significant latitude in choosing what numbers to report and when. But business pressures can cloud their judgment. This article examines how using accounting gimmicks and manipulating financial statements might satisfy investors but can cross into fraudulent territory.

John Smith, CEO of ABC Doughnuts, had a problem: Revenue was down for the first time in company history. And he attributed this to two main reasons.

First, he'd launched an aggressive growth strategy to expand ABC Doughnuts from its traditional storefronts into grocery aisles and gas stations nationwide. Unfortunately, these moves came at a horrible time. The country had just entered a low-calorie diet fad, and doughnut sales were declining.

Smith also had a personal stake in hitting his earnings numbers — the board of directors had offered him a lucrative bonus tied to the price of the firm's stock value. An off quarter would no doubt reduce the stock price and consequently his bonus. Smith was counting on this bonus to pay for his daughter's wedding and, perhaps, a nice Caribbean vacation for the family.

There were only a few more weeks left in the quarter and Smith needed to motivate his troops, so he called a meeting of the C-suite and the department heads. He listened to the head of marketing drone on about promotion ideas and the head of sales talk about re-doubling their efforts and selling the "sizzle and not the steak."

The CFO, on the other hand, offered unique suggestions. He proposed they massage their accounting to reduce expenses and increase net profits. And in five easy ways, he said, the company could increase its net profits to meet Wall Street's projections without having to sell more product:

1. Extend the expected lives of some depreciable assets it had just purchased.
2. Decrease the estimate of how many customers wouldn't pay their bills.
3. Change its inventory value method from last-in, first-out (LIFO) to first-in, first-out (FIFO) (because of the declining flour cost).
4. Increase the cost of equipment sold to franchises and then refund this additional charge in the form of credits for future purchases.
5. Hold cash longer by stretching out payments to suppliers from 26 days to 38 days.

Smith was sold. ABC Doughnuts could appear to be more profitable than it actually was just by re-working its accounting. He asked the CFO if all these changes to the books were legal. The CFO looked down at the table and said "sure."

Unfortunately, the chief compliance officer wasn't in this meeting so he couldn't tell the CEO 1) which one of the five suggestions wasn't legal, and 2) that although the other four were legal, he had strong reasons not to use these accounting tricks. (The illegal suggestion was the fourth because it directly circumvents the very purpose of accounting. The SEC doesn't allow artificially inflating sales because it can mislead investors about how profitable a company actually has been during that accounting period.)

Abuse of power

This case is fictional, but it's indicative of how fraud can easily happen. There's a certain reassurance that numbers are suggestive of factual certainty — this isn't always the case. Management has significant latitude in choosing what numbers to report and when, and their choices might create situations in which they convey one business transaction in two very different — yet legal — ways. However, playing too fast and loose with these choices can easily lead to illegal manipulations.

Companies use these same tricks to mask poor performance, bribery payments, fraud and theft. Finding these tricks — or at least realizing when a company is trying too hard to make the numbers fit — might lead to the discovery of a larger underlying fraud. As former Enron CFO Andrew Fastow said of the now infamous corporate fraud and corruption at the company:

It's a little difficult to say when the fraud started because it's better described as the aggregation of all of these deals, which were each maybe technically correct but also misleading. We created something that was monstrously misleading, but any one of those deals alone wasn't necessarily considered fraudulent. The aggregation of the impact of the deals, however, was fraudulent, so I'm not sure at which point we crossed the line, where it became too big and too misleading.

The GAAP framework

Financial statements in the U.S. are prepared according to Generally Accepted Accounting Principles (GAAP). GAAP allows — and in many cases requires — management to make assumptions and estimates in their accounting. It's intentionally flexible to allow accountants the leeway necessary to record a myriad of transactions across the business.

Consider this metaphor. GAAP is a road with a speed limit of 65 mph. A company can use certain techniques to alter their speed by, say, 10 mph and still stay within the "reasonable" limit. The company that chooses to go 55 mph is using a conservative accounting style; the company that chooses to go 65 is using an aggressive accounting style. Both of these styles are legal. However, CFEs — the highway patrol — need to recognize this permissible range so they can spot aggressive drivers pushing their speeds to 80 mph.

The aggressive style is sometimes colloquially referred to as "managing earnings," "making the numbers fit," or "touching up the books." Whatever the euphemism, it's taking advantage of the flexibility in accounting rules, and recognizing revenue and expenses at the most opportune time. This flexibility can have a huge effect on the three main financial statements: income statement, balance sheet and statement of cash flows.

To illustrate, my MBA accounting professor had her students prepare an adjusted income statement and balance sheet using both aggressive and conservative styles. The most aggressive accounting estimates led to a net income more than four times higher than the net income from conservative estimates. (See Do Earnings Lie — A Case Demonstrating Legally Permissable Manipulation of Corporate Net Income, by James Bannister and Susan Machuga, University of Hartford.)

Why exaggerate? The pressure of modern business

It's no secret that corporate executives are under significant pressure. In an age of instant gratification, it's harder than ever to slowly and steadily develop their business models. Investors are looking for sustained growth quarter after quarter. Accordingly, companies have learned to use creative accounting to smooth out normal fluctuations in the business cycle and appease investors who prefer to see stability. Moreover, even an honest person can find it difficult to follow the spirit and the letter of GAAP when they know their competitors are pushing the limit. For all these reasons, it's tempting for public companies to exaggerate the positive and hide the negative.

According to a survey of 169 CFOs, approximately 20 percent of public companies and 30 percent of private companies manage earnings to misrepresent their actual business performances. (See Earnings Quality: Evidence from the Field, by Dichev, Graham, Harvey, Rajgopal.) According to those surveyed, the most common reasons companies do this are:

1. To influence stock price.
2. Because of outside pressure to hit earnings benchmarks.
3. Because of inside pressure to hit earnings benchmarks.
4. To influence executive compensation.
5. Because senior managers fear adverse career consequences if they report poor performance.
6. To avoid violations of debt covenants (agreements between a lender/creditor stating limits for certain financial ratios that the company may not breach).
7. Because there's pressure to smooth earnings.
8. Because they believe such misrepresentation will likely go undetected.

The discretionary areas

Below are a few of the common accounting decisions in which management must make assumptions, a summary of how they treat each decision under an aggressive and conservative approach, and examples of how fraudsters can exploit this leeway.

Decision point 1: When do we recognize revenue?

Significance

Before revenue is recognized, companies must meet these criteria: persuasive evidence that an arrangement exists, delivery must have occurred or services rendered, the seller's price must be fixed or determinable, and payment collection should be reasonably assured. (See SEC Staff Accounting Bulletin No. 101.)

Early revenue recognition is the most common way to cook the books. A company can simply record revenue before it delivers the product or service or when the customer can still terminate the sale. More sophisticated scams include selling to an affiliate but nothing of real value exchanges hands, mischaracterizing refunds as new revenue, channel stuffing or bill-and-hold schemes.

Aggressive

Recognize revenue at time of sale even though some risk remains over collectability and delivery.

Conservative

Recognize revenue after the sale transpires leaving less risk of the deal falling through.

Real-world example gone too far

Computer Associates (now CA Technologies) sells computers, software and long-term licenses for product updates. CA would immediately record the present value of the entire sum of the licenses despite the fact that the actual cash wouldn't be earned for several years. This gimmick resulted in $3.3 billion of premature revenue.

CA also kept its books open after a quarter ended to squeeze in more revenue and make earnings expectations. In FY 2000, these extended quarters resulted in approximately 36 percent higher revenue. A Securities and Exchange Commission (SEC) official summed up the scheme by stating, "Like a team that plays on after the final whistle has blown, Computer Associates kept scoring until it had all the points it needed to make every quarter look like a win." (See the SEC release, Company Agrees to Settlement with SEC and Justice Department Including $225 Million in Restitution and Corporate Governance Reforms.)

To make matters worse, CA's executives obstructed justice by making false and misleading statements in proffer sessions and to their outside counsel. This fraud resulted in a $225 million fine and eight criminal indictments.

Decision point 2: How do we match our inventory with what we've sold?

Significance

The biggest deduction from sales revenue is cost of goods sold (COGS). COGS simply means, "How much did it cost to acquire or make what we just sold?" Under GAAP, two of the most common COGS choices are FIFO and LIFO. When inflation is high or the cost of materials has fluctuated, the difference in using FIFO or LIFO can have a big impact on gross profits. The choice of inventory valuation also affects assets on the balance sheet. It's a double win for the fraudster if he can create false revenue while reducing expenses like COGS that cut into these profits.

Aggressive

There's a certain reassurance that numbers are suggestive of factual certainty — this isn't always the case.

The company chooses to value inventory using the LIFO method to show the highest cost of goods sold.

Real-world example gone too far

A computer parts supply company defrauded Best Buy out of nearly $33 million and evaded more than $3 million in taxes by tinkering with its COGS. On one income statement it lowered its COGS to fool Best Buy into thinking that it was a more successful company than it actually was. This tricked Best Buy into using the computer parts supply company as a certified provider. At the same time, it raised its COGS on statements that it gave to its accountant to lower its profits and reduce its tax burden. The company accomplished this trickery by switching between LIFO and FIFO when it best suited its fraudulent need and by simply lying about the cost of the component materials it had used in its product. (See the FBI release, Illinois Couple, Company Insider Sentenced for Defrauding Best Buy.)

Decision point 3: How many sales are actually final?

Significance

In any sale, the customer might return the purchased good, and the company must apply a refund. GAAP requires a company to estimate how many of its sales will be returned and how many of its sales on credit won't be paid in full.

Aggressive

Assume customers won't return or pay a low percentage of sales.

Conservative

Assume customers won't return or pay a higher percentage of sales.

Real-world example gone too far

Keeping revenue higher in the current quarter by not recording a return until the next quarter would be a simple means of committing fraud. In a more devious fraud, Vitesse Semiconductor conveniently reduced its estimated sales returns, inventory obsolescence expenses (inventory that's outdated, damaged, etc.) and bad debt expenses from $49.9 million in 2002 to $2.2 million in 2003. (See "Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Report, 3rd Edition," by Howard Schilit and Jeremy Porter, 2010, McGraw-Hill.) This new estimation increased Vitesse's 2003 operating income by $50 million.

Decision point 4: How long will our physical assets last based on our estimates?

Significance

This question determines how quickly you'll depreciate your assets and directly impacts a company's bottom line. 

Aggressive

Management chooses longer useful lives to lower the amount of depreciation expense and maximize profits in the short run.

Conservative

Management chooses shorter estimated useful lives that are still within the reasonable range to increase the amount of depreciation expense, which results in lower profits and lower taxes.

Real-world example gone too far

Between 1992 and 1997, Waste Management's revenues weren't growing fast enough to meet predetermined targets. To make up for this shortfall, management drastically reduced depreciation expenses by extending the useful lives and increasing the salvage values of their garbage trucks.

In 1997, a new CEO ordered a review of Waste Management's accounting policies and the company had to admit the company inflated its pre-tax earnings by approximately $1.7 billion. This revelation caused Waste Management stock to plummet and shareholders lost $6 billion in market value. (See the SEC release, Waste Management Founder, Five Other Former Top Officers Sued for Massive Fraud.)

Decision point 5: Should we capitalize expenses?

Significance

Generally, a company is able to capitalize the cost of acquiring a resource only if the resource provides the company with a tangible benefit for more than one operating cycle. Such resources are known as capital assets. However, management has discretion in deciding how to categorize certain expenditures. Advertising and marketing expenditures are two common areas in which expenditures are categorized.

Sometimes, they can be expensed as they are incurred, or they can be capitalized. If they're expensed right away, they reduce profits (and taxes). If they're capitalized, the value of that asset is placed on the balance sheet and amortized over time thus reducing the immediate effect of the expenditure. In effect, the cost is spread out over time.

Additionally, these companies will show more assets on the balance sheet and will appear to be more lucrative. (However, future profits will reduce incrementally.)

Aggressive

Capitalize as many expenses as you can.

Conservative

Expense your expenditures as you go.

Real-world example gone too far

WorldCom exploited this maneuver when it chose to capitalize hundreds of millions of dollars of costs incurred to lease lines on the networks of other telecommunication providers. WorldCom initially classified them properly as operating expenses; however when the technology bubble burst in 2000 the company saw an opportunity to make up lost revenue. By capitalizing its expenditures, WorldCom moved significant expenses off its income statement and onto its balance sheet where it treated them as an asset. When this trickery was discovered, WorldCom was forced to restate their earnings with a swing of more than $70 billion. (See "Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition," by Howard Schilit and Jeremy Porter, 2010, McGraw-Hill.)

Pushing the speed limit

Companies have legitimate business reasons for varying their speeds. However, management can pervert these acceptable techniques and take their companies outside the legal limit. Like many other crimes, fraudsters begin by lightly cheating until they find themselves sliding down slippery slopes. Each manipulation or violation takes them away from what's permissible and increases the magnitude of subsequent violations. I call this going from simmering the books to outright cooking them.

Numbers might not lie, but people certainly do. Unfortunately, the next big corporate fraud is likely already underway. Will you be the one who finds the true intent behind the numbers and stops the underlying fraud?

Tom Baugher, J.D., CFE, is a supervisory special agent with the FBI Tampa, Florida, division. The views expressed in this article don't necessarily reflect the views of his employer. His email address is: Thomas.Baugher@ic.fbi.gov.