Accounting manipulation is meant to make a company appear more profitable or financially stronger than it actually is. The sobering reality is that while this might provide a short-term boost to stock prices or help secure financing, it always negatively impacts future earnings or financial strength.
Accounting manipulation therefore is often an exercise in futility. While company accountants can make things look rosy today, it will inevitably come back to haunt them, and their boards.
This article looks at some of the methods companies use to create a facade of financial health, and ultimately how these efforts are unsustainable, inevitably leading to a deterioration in earnings or impaired solvency. Let's dive in:
Delaying essential expenses
Companies delay operating expenses to create an illusion of profitability in the current reporting period that cannot be maintained because the company will need to incur these expenses in future financial periods.
Moreover, the more a company delays essential opex, such as maintenance, the greater the risk of a disruption to future business activity or a decline in product quality. Both will affect future profits.
Improperly capitalizing expenses
When a company capitalizes an expense, it records the expense as an asset and must depreciate or amortize the cost of the asset over future years. This is appropriate for long-lived assets that will give service over time, but not appropriate for operating expenses and SG&A expenses.
These should be recognized in the income statement in the period when they occur.
The more aggressively a company capitalizes operating expenses, thus delaying expense recognition, the more amortization costs will be in future years. Profit margins must necessarily fall in future years. Companies that aggressively delay expense recognition create a ticking expense time bomb that eventually comes back to haunt them.
Hiding expenses or debt
This is certainly an effective way to boost current earnings or create an appearance of balance sheet strength. However, this approach means that a company is less cash generative or less solvent than it appears.
Debt must still be serviced and hidden expenses will still incur a cost which must be hidden in some fake asset on the balance sheet (i.e., an asset that will not generate future income). The inevitable consequence is that profitability ratios such as return on equity will decline over time.
A most common response to such a problem is to borrow even more funds to plug the gaps, but this only serves to weaken solvency and threaten bankruptcy when difficult economic conditions arrive.
Winter is always coming.
Using accruals aggressively
Recall that accruals are accounting entries used to recognize revenues and expenses that have been earned or incurred but not yet received or paid in cash. Their susceptibility to manipulation makes them a focal point for potential earnings management.
Companies might inflate current earnings by aggressively accruing revenue (e.g., recording sales before they meet all revenue recognition criteria) or deferring expenses (e.g., delaying the write-off of bad debts). This creates a temporary illusion of profitability that cannot be sustained.
Consider a hotel which recognizes the revenue of all of its bookings for the year in the current quarter. If the hotel is fully booked, this means there will be no revenue in the remaining quarters of the year. This is an extreme example but perfectly illustrates the danger of accruals.
Accruals, like all forms of premature revenue recognition, necessarily rob from future sales and hence future earnings. Also important, manipulating accruals doesn't create actual cash. If a company accelerates revenue recognition, it might lead to higher reported earnings but not necessarily higher cash inflows.
If accrued earnings are not realized, as frequently occurs, the company will eventually need to restate earnings. Conversely, delaying expenses might free up cash in the short term but will eventually require payment, reducing future cash flows.
Conclusion
Manipulating accounting figures creates a misleading picture of a company's financial health that can be beneficial for certain corporate goals in the short term.
As this article shows though, this is unsustainable and will eventually lead to a deterioration in earnings or impaired solvency in the long-term - the very things that the company was striving to avoid in the first place by massaging its accounts.
You can only paper over the cracks for so long before the walls cave in.
%20-%20Wirecard.png)
