Management wants to paint the rosiest possible picture of a company’s financial performance, but aggressive earnings management, or ‘spin,’ can mislead investors and lenders. Here are some ways U.S. Generally Accepted Accounting Principles (GAAP) can be manipulated to obscure the truth.
Creative accounting vs. cooking the books
Earnings management usually starts out small, but it can become increasingly aggressive and eventually cross the line into fraud if it goes unchecked. An external audit may help detect the red flags of earnings management, including:
Premature revenue recognition. Some companies recognize revenue early to make the income statement temporarily appear more attractive. This ploy is common when a company is applying for bank financing or up for sale.
Miscellaneous ‘cookie jar’ reserves. Management can create a hidden reserve of funds during good times. Then the reserves can be tapped into to nourish earnings in lean times.
‘Big bath’ restructuring changes. Some companies overstate the costs associated with restructuring. This enables them to clean up their balance sheets and create reserves for a rainy day.
Immediate acquisition write-offs. Acquired companies may classify a portion of the purchase price as “in process research and development,” which they immediately write off. This reduces the amortization of the purchase price to future earnings.
Overreliance on earnings before interest, taxes, depreciation, and amortization (EBITDA). EBITDA and other non-GAAP metrics have become popular ways to evaluate a company’s performance, but they are not usually audited, and they may be calculated differently from company to company.
EBITDA is generally intended to resemble cash flow. This metric can obscure problems for start-up companies with major debt. Although their EBITDAs give these start-ups appeal, their debt service may mean they will not be profitable for many years.
Too good to be true?
Pay attention when reviewing financial statements and corporate press releases — the opportunity and pressure to spin earnings is everywhere. Contact us for more information on how to identify when a business may have engaged in ‘creative’ accounting practices to improve their financial picture.