Question

The most common scheme type used in financial statement fraud involves manipulation of revenue figures. Schemes to manipulate revenue figures typically involve posting sales before they are made or prior to payment. Examples include recording product shipments to company-owned facilities as sales, re-invoicing past due accounts to improve the age of receivables, Pre-billing for future sales and duplicate billings.

How easy or hard is it to manipulate the revenue figures? Why? Anyone?

Answer 1

Reasons Behind Financial Statement Manipulation

There are three primary reasons why management manipulates financial statements. First, in many cases, the compensation of corporate executives is directly tied to the financial performance of the company. As a result, they have a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is a relatively easy thing to do. The Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude and interpretation in accounting provisions and methods. For better or worse, these GAAP standards afford a significant amount of flexibility, making it feasible for corporate management to paint a particular picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. In the U.S., the Big Four accounting firms and a host of smaller regional accounting firms dominate the corporate auditing environment. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated, often quite significantly, by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep the client happy – and keep its business.

How Financial Statements Are Manipulated

There are two general approaches to manipulating financial statements. The first is to exaggerate current period earnings on the income statement by artificially inflating revenue and gains, or by deflating current period expenses. This approach makes the financial condition of the company look better than it actually is in order to meet established expectations.

The second approach requires the exact opposite tactic, which is to minimize current period earnings on the income statement by deflating revenue or by inflating current period expenses. It may seem counterintuitive to make the financial condition of a company look worse than it actually is, but there are many reasons to do so: to dissuade potential acquirers; getting all of the bad news "out of the way" so that the company will look stronger going forward; dumping the grim numbers into a period when the poor performance can be attributed to the current macroeconomic environment; or to postpone good financial information to a future period when it is more likely to be recognized.

Specific Ways to Manipulate Financial Statements

When it comes to manipulation, there are a host of accounting techniques that are at a company's disposal. Financial Shenanigans (2002) by Howard Schilit outlines seven primary ways in which corporate management manipulates the financial statements of a company.

1. Recording Revenue Prematurely or of Questionable Quality
   1. Recording revenue prior to completing all services
   2. Recording revenue prior to product shipment
   3. Recording revenue for products that are not required to be purchased
2. Recording Fictitious Revenue
   1. Recording revenue for sales that did not take place
   2. Recording investment income as revenue
   3. Recording proceeds received through a loan as revenue
3. Increasing Income with One-Time Gains
   1. Increasing profits by selling assets and recording the proceeds as revenue
   2. Increasing profits by classifying investment income or gains as revenue
4. Shifting Current Expenses to an Earlier or Later Period
   1. Amortizing costs too slowly
   2. Changing accounting standards to foster manipulation
   3. Capitalizing normal operating costs in order to reduce expenses by moving them from the income statement to the balance sheet
   4. Failing to write down or write off impaired assets
5. Failing to Record or Improperly Reducing Liabilities
   1. Failing to record expenses and liabilities when future services remain
   2. Changing accounting assumptions to foster manipulation
6. Shifting Current Revenue to a Later Period
   1. Creating a rainy day reserve as a revenue source to bolster future performance
   2. Holding back revenue
7. Shifting Future Expenses to the Current Period as a Special Charge
   1. Accelerating expenses into the current period
   2. Changing accounting standards to foster manipulation, particularly through provisions for depreciation, amortization, and depletion

While most of these techniques pertain to the manipulation of the income statement, there are also many techniques available to manipulate the balance sheet, as well as the statement of cash flows. Moreover, even the semantics of the management discussion and analysis section of the financials can be manipulated by softening the action language used by corporate executives from "will" to "might," "probably" to "possibly," and "therefore" to "maybe." Taken collectively, investors should understand these issues and nuances and remain on guard when assessing a company's financial condition

There are many cases of financial manipulation that date back over the centuries, and modern-day examples such as Enron, Worldcom, Tyco International, Adelphia, Global Crossing, Cendant, Freddie Mac, and AIG should remind investors of the potential landmines that they may encounter. The known prevalence and magnitude of the material issues associated with the compilation of corporate financial statements should remind investors to use extreme caution in their use and interpretation.

Investors should also keep in mind that the independent auditors responsible for providing the audited financial data may very well have a material conflict of interest that is distorting the true financial picture of the company. Some of the corporate malfeasance cases mentioned above occurred with the compliance of the firms' accountants, like the now-defunct firm Arthur Anderson. So even auditors' sign-off statements should be taken with a grain of salt.