The range of possible ways a company can manipulate its financial reports is broad. One of the most troubling among these is the act of putting revenue onto the books before it is actually earned. This inflates net profit and artificially creates the illusion of improved revenue and profits.
Accounting rules are based on the premise that all revenue is supposed to be booked, or “recognized,” in the period it is earned. Likewise, costs and expenses are supposed to be booked in the period incurred. Matching up the transactions with the proper period helps produce an accurate income statement. This is why it becomes necessary to make a series of accrual entries at the end of the fiscal year.
Accounts Receivable, Accounts Payable
For example, a company has earned revenue it has not yet collected. A journal entry is made to book that revenue with an offset to the asset, Accounts Receivable. When the money is received, cash is increased and the receivable is decreased.
The same steps take place with costs and expenses. For example, at the end of the year a company has ordered thousands of dollars worth of supplies, incurred telephone expenses, advertising, travel, utilities, and many other on-going “general and administrative” items. However, these bills are not going to be paid until next month. So an accrual is set up to book the expense now, in the proper accounting year, offset by an increase in the liability, Accounts Payable.
It is very straightforward. By using the Accounts Receivable and Accounts Payable accruals, revenue and expenses are booked into the proper year. As simple as this is, it is also where the problems begin. Booking revenue early is one of the several methods used to inflate earnings and in the recent past, many companies and their auditing firms have had to recalculate earnings when they were caught making entries like this.
How to spot manipulation
Using the accrual system, the company books revenue and offsets it as a “deferred asset.” In future periods, the deferred asset is decreased and so is revenue. A justification can be made as an “estimate” of orders scheduled but not yet entered, or as an accrual to simply recognize revenue the company has not earned, no matter what the rationale. One easy test is to go back to the initial premise. Is the current year’s revenue all matched against direct costs and expenses? Invariably, when a company manipulates its revenue to inflate earnings, no offsetting entry is made to also report related costs. This is where the manipulation is easily spotted.
Among the many methods for creating inaccurate financial statements, early booking of revenue is one of the most troubling. It involves creating revenues that have not been earned rather than the opposite, pushing earnings to the future (a technique called cookie jar accounting, used when a company’s income is higher than expected). If the company that books revenues early does not earn better levels in the future, the artificially inflated revenues eventually have to be absorbed; and that means stock prices go lower, although in a later period.
Manipulation defrauds stockholders and analysts from the honest reports they expect and deserve. To the extent that auditors who are supposed to be independent get involved in helping with this kind of fake accounting, it only makes matters worse. Outsiders rely on the audit and its integrity and, sadly, past experience has shown that even with an outside audit, financial statements have to be viewed with a healthy dose of skeptism.
Michael C. Thomsett is the author of more than 60 books, including Winning with Stocks and Annual Reports 101, and Getting Started in Stock Investing and Trading. He lives in Nashville, Tennessee and writes full time.
Tricks of Financial Reporting: Booking Revenue Early was provided by Minyanville.com.