The balance sheet, income statement, and cash flow statement are foundational to the financial reporting of any company. Public companies are considered to be held to a higher standard because of their mandate to follow generally accepted accounting principles (GAAP). But, that hasn’t stopped companies from cooking their books to post much better than actual results in many categories. Enron, WorldCom, and Lehman Brothers are some of the most commonly known cases of fraud. And they aren't the only ones.

Creative accounting can come in many different forms. It can also occur in many different ways. Keep in mind that certain loopholes exist that may help a company legally spin its financial reporting in a positive light. Spotting creative accounting practices on the balance sheet can be broken down into three categories for analysis: assets, liabilities, and equity. Here we’ll explore some of the ways each of the three categories of the balance sheet can be manipulated.

Why Boost the Balance Sheet?

The balance sheet is closely tied to the income statement, which is often where issues with asset revenue and/or liability expenses can help to create inflated revenues or understated expenses that result💙 in a higher bottom line and retained earnings tied back to the balance sheet.

Companies that manipulate their balance sheets often want to increase their net income earnings power to create the appearance of a stronger financial condition or stronger management performance. After all, financially sound companies can more easily obtain 澳洲幸运5官方开奖结果体彩网:lines of credit at 澳洲幸运5官方开奖结果体彩网:low interest rates, as well as more easily issue 澳洲幸运5官方开奖结果体彩网:debt financing or issue bonds on better terms. Coღmpanies may also be looking to overstate their overall asset position to potential creditors.

Overvaluing Assets

Assets top out balance sheet construction. Like liabilities, assets are divided into two categories: current assets, which are those that will be sold within 12 months, and long-term assets, which will be owned and used for more than one year. Items commonly found in the asset category include: cash and equivalents, accounts receivable, inventory, and intellectual intangibles.

Provision for Doubtful Accounts

澳洲幸运5官方开奖结果体彩网:Accounts receivable (AR) have a direct link to revenues on the income statement. Companies that use accrual accounting can book revenue in accounts receivable as soon♈ as a sale is made. Thus, the processing of accounts receivable can be one high-risk area for premature or fabricated revenues.

AR may be overstated because of inappropriate planning for doubtful accounts. Prudent companies typically take proactive measures for AR defaults. By not doing so, this can inflate earnings. It is up to each company to analyze and estimate the percentage of accounts receivables that regularly go uncollected. If there is no 澳洲幸运5官方开奖结果体彩网:allowance for doubtful accounts, AR will receive a temporary boo🔜st in the short term.

Investors may detect when the reserves for doubtful accounts are inadequate. AR will not be fully turned into cash, which can show up in 澳洲幸运5官方开奖结果体彩网:liquidity ratios like the quick ratio. Write-downs will also need to be made to revenues. If accounts receivable 💞make up a substantial portion of assets and inadequate default procedures are in place this can be a problem. Without doubtful account planning, revenue growth will be overstated in the short term but potentially retracted over the longer term.

Revenue Acceleration

In the asset category, companies can also overstate revenues through acceleration. This could come from booking multiple years of revenue at once. Companies may also 澳洲幸运5官方开奖结果体彩网:manipulate revenues by comprehensively booking a recurrin﷽g revenue stream upfront rather than spreading it out as it is expected to be received. Revenue acceleration is nꦬot necessarily illegal but it is not usually a best practice.

Inventory Manipulation

澳洲幸运5官方开奖结果体彩网:Inventory represents the value of goods manufactured but not yet sold. It is usually valued at wholesale and sold with a markup. When inventory is sold, the wholesale value is transferred over to the income statement as the 澳洲幸运5官方开奖结果体彩网:cost of goods sold (COGS), and the total value is recognized as revenue. Overstating any inventory values could lead to🎃 an overstated COG💫S, which can reduce the revenue earned per unit.

Some companies may look to overstate inventory to inflate their balance sheet assets for the potential use of collateral if they need 澳洲幸运5官方开奖结果体彩网:debt financing. It 🍸is typically a best practice to buy inventory at the lowest possible cost to reaꦅp the greatest profit from a sale.

Laribee Wire Manufacturing manipulated inventory by recording phantom inventory and carrying other inventory at bloated values. This helped the company borrow $130 million from six banks by using the inventory as 澳洲幸运5官方开奖结果体彩网:collateral. Meanwhile, the company reported $3 million in net income for the period, when it lost $6.5 million.

Investors can detect overvalued inventory by looking for telling trends like large spikes in inventory values. The gross profit ratio can also be helpful if it is seen to fall unexpect꧒edly or to be far below industry expectations. This means net revenues may be falling or extremely low because of excessive inventory expensing. Other red flags may include:

• Higher inventory levels than sales
• Higher inventory levels than total assets
• A decrease in 澳洲幸运5官方开奖结果体彩网:inventory turnover
  
• An increase in the cost of sales as a percentage of sales

Any unusual variations in these figures can be indicative of potential 澳洲幸运5官方开奖结果体彩网:inventory accounting fraud.

Subsidiaries and Joint Ventures

When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the 澳洲幸运5官方开奖结果体彩网:equity method depending on their ability to control the subsidiary. T🐼hese investments are booked as assets, which can leave the door open for companies to potentially use subsidiaries, ownership investments, and joint ventures for fraud—oftentimes, off-balance sheet items are not transparent.

Under the equity method, the investment is recorded at cost and is subsequently adjusted to reflect the share of net profit or loss and 澳洲幸运5官方开奖结果体彩网:dividends received. Gains on these investments inflate assets and also lead to higher net income which carries over to the retained earnings portion of shareholders’ equity. While these investments are reported on the balance sheet and income statement, the methodologies can be comple🍌x and may create opportunities for fraudulent reporting.

Investors should be cautious—and perhaps take a look at the 澳洲幸运5官方开奖结果体彩网:auditor's reliability—when companies u𒆙tilize the equity method for accounting in situations where they appear to control the subsidiary. For example, a U.S.-based company operating in China through various subsidiaries in which it appears t🧸o exert control could create an environment ripe for manipulation.

Undervaluing Liabilities

Undervaluing liabilities is a second way to manipulate financial statement reporting from the balance sheet. Any understatement of a company’s expenses can be beneficial in boosting 澳洲幸运5官方开奖结果体彩网:bottom-line profits.

Contingent Liabilities

澳洲幸运5官方开奖结果体彩网:Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee, or the date payable. For example, warranty obligations or anticipated litigation losses may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating them or downplaying their materiality🧸.

Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income and 澳洲幸运5官方开奖结果体彩网:shareholders' equity.

Investors can watch for these liabilities by understanding the business and carefully reading a company's 澳洲幸运5官方开奖结果体彩网:footnotes, which contain information about these obligations. For instance, pending lawsuits are contingent liabilities. That's because there is no guarantee about the outcome. This should be disclosed when 澳洲幸运5官方开奖结果体彩网:earnings reports and financial statements are released.

Other Expenses

Some 澳洲幸运5官方开奖结果体彩网:other ways companies may manipulate expenses can include: delaying them inappropriately, adjusting expenses around the time of an acquisition or merger, or potentially overstating contingent liabilities to adju𒉰st them in the future as an increase to assets. Moreover, subsidiary entities as mentioned above, can alsဣo be a haven for off-balance sheet reporting of some expenses that are not transparently realized.

Pension Obligations

Pension obligations are generally a result of the present value of future payments paid to employees. They are ripe for manipulation by public companies since the liabilitie🃏s occur in the future and company-generated estimates need to be used to account for them. Companies can make aggressive estimates to improve both short-term earnings as well as to create the illusion of a stronger financial position.

One way to potentially manipulate this is through the 澳洲幸运5官方开奖结果体彩网:discount rate used. Increasin❀g the discount rate can significantly reduce the pension obligation. Companies may overstate the expected return o🍸n plan assets. Overstating expected returns creates more assets from which to pay pension liabilities, effectively reducing the overall obligation.

Since pension obligations can be ongoing for a company, accountants could potentially make various adjustments over the full length of the obligations to favorably manipulate 澳洲幸运5官方开奖结果体彩网:net income in the short term or at some time iཧn the future.

Shareholders’ Equity

澳洲幸运5官方开奖结果体彩网:Shareholders’ equity consists of the value of stocks, any additional paid-in capital, and retained earnings, which are carried over from net income on 💖the balance sheet. If a company overstates assets or understates liabilities it will result in an overstated net income, which carries over to the balance sh♒eet as retained earnings and therefore inflates shareholders’ equity.

Shareholders’ equity is used in several key ratios that may be assessed by financial stakeholders when evaluating a company 🐭as well as for maintaining current financing arrangements such as credit lines.

Some of these ratios may include debt to equity, total assets to equity, and total liabilities to equity. It is also used to calculate 澳洲幸运5官方开奖结果体彩网:return on equity (ROE), which is central to evaluating the overall balance sheet performance of a company as well as the performance of✨ management. ROE is the result of net income over shareholders’ equity.

The Bottom Line

Public companies are a great way for everyday retail investors to invest their money because of 澳洲幸运5官方开奖结🍌果体彩网:Securities Exchange Commission (SEC) regulations. If an investor feels they may have spotted creative accounting that involves fraudulent reporting, a review of publicly available audit statements and related financial disc🌼losures can be the first place to look. Methods may be hidden, which can lea𝓡d to shareholder investigations and potential lawsuits if solid evidence is found for unlawful manipulations.

Reading the financial statements, understanding a company’s business, and integrating appropriate knowledge for spotting questionable pra𓆏ctices can be important steps f💖or all investors to take before making substantial investments. Staying away from questionable investments or taking proactive steps to move out of investments when creative accounting measures have been spotted can also be prudent steps to take.