Question

how do investors, creditors and the profit margin play into the need for accounting rules and regulations such as GAAP and FASB?

Answer 1

Financial statement manipulation is an ongoing problem in corporate America. Although the Securities and Exchange Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between the independent auditor and the corporate client continues to provide the perfect environment for such activity. Due to these factors, investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in order to mitigate the adverse implications of these problems.

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.

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