How can earnings be manipulated

One type of significant event that may be used to mask other charge-off is mergers and acquisitions. In most cases, there is some form of restructuring involved creating the need for a large one-time charge along with other merger-related expenses. The event provides the acquirer with the opportunity to establish accruals for restructuring the transaction, possibly attribute more expense than necessary for the transaction. The company may also identify certain expenses that are revalued on the seller's balance sheet, increasing goodwill.

If the conservative valuations prove to be excessive, the company is able to reduce its operating expenses in the near term by reducing its estimate for the liability. The additional goodwill created would be amortized over a long period of time and not have a significant impact on near term results. There are two methods of accounting for mergers and acquisitions. Pooling of interests "pooling" accounting and purchase accounting. Pooling recognizes the transaction as a merger of equals, thus the transaction is recorded as company A plus company B.

Purchase accounting treats the transaction as a purchase. The fair value of the purchased company is assessed and compared to the purchase price. Any excess or premium paid above the fair value of the assets is recognized as goodwill. Goodwill is amortized over a period of time not to exceed forty years. Abraham Brilloff, professor emeritus at Baruch College, in an article in the October 23, issue of Barron's entitled "Pooling and Fooling" brought attention to the use of pooling accounting by Cisco Systems to inflate its operating earnings.

In addition, five of the acquisitions were deemed "too immaterial" to restate prior period financial statements. If a company pays a premium to acquire another firm, the premium, or goodwill, is amortized and reduces earnings going forward. Thus, companies seek transactions that will allow them to use pooling of interests. It has been contended that additional premiums have been paid in instances where pooling of interests will be allowed.

Criticism of pooling accounting has been significant and the FASB has reacted by announcing the elimination of the method. However, the effective date has been delayed as the FASB has received strong opposition from industry.

Under the purchase method of accounting for acquisitions if the price paid by the acquiring firm exceeds the fair value of the company acquired, the difference is recorded as an intangible asset, goodwill. Goodwill is amortized over future periods, thus, the creation of goodwill causes future expenses, therefore reducing reported earnings. If the acquirer conservatively values assets such as private placement or illiquid securities and real estate or liabilities reserves, accrued liabilities , the company may be able to recognize additional earnings in the near future as it estimates become less conservative.

Professor Brilloff has also been a critic of the accounting practices of Conseco, a financial services company. Brilloff contended that Conseco had manipulated its earnings through its acquisition practices. In summary, he argued that Conseco had inflated the loss or claim reserves of the insurance entities it acquired and recognized a corresponding asset of goodwill at the time of acquisition.

It could then reduce the reserves over the near term to inflate earnings while amortizing the goodwill over a significantly longer period of time. The timing of the recognition of revenue is the most likely area to target for management and manipulation.

From an operational standpoint, firms can take aggressive actions to boost revenues and sales in one period through providing incentives to their sales force, utilize overtime to push shipments out the door. They may also take aggressive accounting actions such as selling securities classified held for sales recognize gains in income versus stockholders equity, aggressive in the timing of the recognition of sales or aggressive in the application of broad or unclear accounting guidance.

Unethical leadership will destroy a business. Though much less likely, some businesses intentionally decrease their earnings with fraudulent accounting. Why would they do so? Maybe the business has an exceptionally good year, and it would like to save some of those earnings for future periods. For instance, management bonuses might be tied to profit levels. Deferring earnings is often called a cookie jar reserve.

The higher reserve decreases current year earnings the allowance is credited and bad debt expense is debited, increasing expenses and decreasing net income. This is called smoothing. Honest companies record their numbers based on what is correct, not upon desired results.

But not all companies are honest. See my full article regarding how to audit receivables and revenues. Full Terms and Conditions apply to all Subscriptions. Or, if you are already a subscriber Sign in. Other options. Close drawer menu Financial Times International Edition. Search the FT Search.

World Show more World. How crazy is that? So much for being aligned with shareholder interests. Buy-side analysts and short-sellers tend to be better at detecting these red flags, but too often they get shouted down when trying to raise the alarm. This has led to a bizarre culture where executives manipulate earnings to reward themselves with bigger bonuses, and everyone knows this is happening, but when anyone tries to call them out on it they get accused of being greedy and self-serving.

The activist investors who might be best positioned to curb executive bonuses rarely do anything about them. Pershing Square founder Bill Ackman actively encouraged the aggressive acquisition accounting at Valeant that helped executives nearly triple their compensation in , and he has been a staunch supporter of the executive team at Jarden JAH that uses an exec friendly form of adjusted earnings to help executives boost their own pay at the expense of shareholders. Ideally, this situation will change at some point, and the correct enforcement mechanisms will be in place to prevent earnings manipulation.

It takes a lot of work to reverse all the loopholes that executives exploit to serve their own purposes. This is a BETA experience.

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