In general, accounting gimmicks [also known as aggressive accounting or creative accounting or shenanigans accounting] are actions that intentionally distort a company’s reported financial statement. They range from benign [changes in accounting estimates] to egregious [fraudulent recognitions of bogus revenue]. They occur at companies of all sizes, from small—unknown firms to the most prominent global ones. This post provides a general overview of accounting gimmicks. And answer the following questions: What specific techniques are used? What are the basic strategies underlying the accounting gimmicks? Should investors be more concerned about certain gimmicks? Why do accounting gimmicks exist and where are they most likely to occur? A big story of accounting gimmicks [real life case study] will close this post.
Note: this is purposed to enrich reader’s knowledge and gives basic understanding to detect, uncover and sidestep: Revenue tricks, expense traps and liabilities scams [the accounting gimmicks].
What Specific Techniques Are Used?
The CFRA has identified thirty techniques [grouped into seven categories] that companies use to trick investors and other stakeholders. They are:
Gimmic#1. Recording Revenue Too Soon or of Questionable Quality
There are six tricks commonly used under this category. They are:
- Recording revenue when future services remain to be provided.
- Recording revenue before shipment or before the customer’s unconditional acceptance.
- Recording revenue even though the customer is not obligated to pay.
- Selling to an affiliated party.
- Giving the customer something of value as a quid pro quo.
- Grossing up revenue.
Gimmic#2. Recording Bogus Revenue
There are five techniques commonly used under this category. They are:
- Recording sales that lack economic substance
- Recording cash received in lending transactions as revenue
- Recording investment income as revenue
- Recording as revenue supplier rebates tied to future required purchases
- Releasing revenue that was improperly held back before a merger
Gimmick#3. Boosting Income with One-Time Gains
There are four techniques commonly used under this category. They are:
- Boosting profits by selling undervalued assets
- Including investment income or gains as part of revenue
- Reporting investment income or gains as a reduction in operating expenses
- Creating income by reclassification of balance sheets accounts
Gimmick#4. Shifting Current Expenses to a Later or Earlier Period
There are five techniques commonly used under this category. They are:
- Capitalizing normal operating costs, particularly if recently changed from expensing
- Changing accounting policies and shifting current expenses to an earlier period
- Amortizing costs too slowly
- Failing to write down or write off impaired assets
- Reducing asset reserves
Gimmick#5. Failing to Record or Improperly Reducing Liabilities
There are five gimmicks commonly used under this category. They are:
- Failing to record expenses and related liabilities when future obligations remain
- Reducing liabilities by changing accounting assumptions
- Releasing questionable reserves into income
- Creating sham rebates
- Recording revenue when cash is received, even though future obligations remain
Gimmick#6. Shifting Current Revenue to a Later Period
There are two tactics commonly used under this category. They are:
- Creating reserves and releasing them into income in later period
- Improperly holding back revenue just before an acquisition closes
Gimmick#7. Shifting Future Expenses to the current Period as a special Charge
There are three tactics commonly used under this category. They are:
- Improperly inflating amount included in a special charge
- Improperly writing off in-process R&D costs from an acquisition
- Accelerating discretionary expenses into current period
What Are The Basic Strategies Underlying The Accounting Gimmicks?
The following are two basic strategies underlying all accounting tricks:
- To inflate current-period earnings by inflating current-period revenue and gains or by deflating current-period expenses.
- To deflate current-period earning [and, consequently, inflate future period’s result] by deflating current-period revenue or by inflating current-period expenses.
The first strategy, inflating profits, is intuitive and needs no further clarification. In contrast, the strategy of intentionally making the company look worse than it really is may be confusing. The larger objective of this strategy is to shift earnings to later period when they will really be needed—in other words, to inflate tomorrow’s profits.
How Do The Gimmicks Relate To One Another?
Although all accounting gimmicks fit into seven finite categories, there are important connections and intersections among certain of these categories.
Gimmick#1 and #5 can be thought of as close cousins. A company that receives an advance payment from a customer for future services and improperly recording revenue immediately has employed both gimmick#1 [recording revenue too soon] and gimmick#5 [failing to record or improperly reducing liabilities].
Gimmick#2 is related to #6. A Company that improperly holds back recording all of today’s revenue [tactic#6] will invariably record that revenue in later period [tactic#2].
There is also an important connection between gimmick#5 and gimmick#7. Consider the following example: A company takes a big restructuring charge [gimmick#7, shifting future expenses to the current period as a special charge] and in the next quarter release the reserves with the charge credited [gimmick#5, failing to record or improperly reducing liabilities].
Should Investors Be More Concerned about Certain Accounting Gimmicks?
Certain accounting gimmicks can be fairly benign, whereas others maybe more harmful for investors. In general, gimmicks that inflate revenue should be considered more serious than those that effect expenses. If a company’s revenue growth appears solid and its accounting is proper, the company’s prospects typically remain strong.
The Continuum – From Benign to Outright Fraud – Not all accounting gimmicks are illegal acts or violations of generally accepted accounting principles [GAAP]. They include a broad array of activities that intentionally misreport the financial performance or financial conditions of a company.
Not Great News for Investors – Not surprisingly, the share price invariably performs poorly after a company begins using accounting [financially] gimmicks . Moreover, when companies use particularly egregious gimmicks, the stock price decline will generally be steeper and more permanent. There are two obvious reasons for this:
- Generally, companies that use such accounting chicanery are attempting to cover some major operational deterioration in the business. The truth concerning the operating problem will soon become known by investors.
- Such chicanery leads investors to lose faith in management’s integrity, causing the stock to remain out of favor for a long time.
Why Do Accounting Gimmick Exist and Where Are They Most Likely to Occur?
While most people agree that gimmicks can distort financial statements, there are many theories about the reasons why these gimmicks exist. Based on research held by CFRA, there are three general reasons for accounting gimmicks: (1) It pays to do it, (2) It’s easy to do, and (3) It’s unlikely that you’ll get caught. Let’s go a bit detail into the each reason.
Reason#1: It Pays to Do it
Some managers will resort to accounting gimmicks if they are personally enriched by doing so. Thus, when bonuses encourage managers to post higher sales and profits and no questions are asked how those gains were achieved, an incentive for using gimmicks can be created. Unfortunately, misguided incentive plans are not uncommon today in corporations. In explaining why companies use accounting [financial] gimmick to manage earnings, Baruch College’s Professor Abraham Briloff remarked, “Because it’s their report card”. Executives like their bonuses and other perquisites that are tied to reported earnings.
What To Do: Be Alert for Misguided Management Incentives
Like most of us, managers are affected in their behavior by rewards and punishment. Since many companies offer bonuses and stock options based on financial statement measures, executives and managers are motivated to report more favorable financial results. Similarly, if underperforming divisions in companies are threatened with layoffs or lower compensation for their managers, those managers will often search for ways to report stronger results. Because of this pressure to report higher sales and higher profits, managers may be creative in their interpretation of GAAP.
A compensation structure that heavily emphasizes the bottom line creates an environment that sometimes encourages accounting chicanery. Professor Paul Healy of MIT undertook a study to show empirically that management benefited by choosing accounting procedures that procedures that produced higher earnings. Healy found a connection between bonus schemes and the accounting choices that executives made. Specifically, he found that executives whose bonuses were already at the maximum level tended to choose accounting options that minimized reported profits, whereas those who had no ceiling chose profit-boosting options. Thus, if no additional bonus is paid once profits reach a certain level, it is not in the executive’s interest to have reported profits exceed that amount. In such a case, the manager would be better of deferring any profits above the maximum bonus level to some future period when they might be needed to sustain the manager’s own income.
Reason#2: It’s Easy To Do It
Managers select accounting methods [e.g., for inventory valuation or amortization of intangible assets] from a variety of acceptable choices. Thus, depending on the methods selected and the numerous estimates that must be made, a company’s reported profit can vary considerably and yet still be in compliance with GAAP.
Honest managers’ grapple with the many choices and judgments required with the goal of finding accounting policies that portray the company’s financial performance fairly. Unscrupulous managers, unfortunately, use the flexibility in GAAP to distort the financial reports.
Indeed, it is surprisingly easy for managers to use accounting gimmicks to manipulate financial statement. This true for various reasons, including the following:
- There is substantial flexibility in interpreting GAAP
- GAAP can be applied in ways that boost a company’s reported profits
- Changes in GAAP by FASB often occur long after a deficiency in financial reporting becomes evident
Unlike tax legislation and the related U.S. Treasury Department regulations, financial accounting standards are fairly broad, and consequently management has considerable flexibility in interpreting them. Thus decisions on whether to capitalize a cost or categorize it as an expense, or on selecting amortization periods for fixed asset depend on management judgment.
Furthermore, management can structure transactions or decide when and how to implement new accounting rules to maximize its reporting goals. For example, the use of stock compensation plans [which produce change in income] as a substitute for other forms of compensation has become increasingly popular at many corporations. Similarly, companies can structure lease agreements to keep the debt off their books [e.g., using an operating lease approach].
Question Overly Liberal Accounting Rules
Because management has substantial control over the numbers that are reported, consider whether the accounting policies selected are overly aggressive. Consider various accounting policies of a company, such as inventory method, amortization period and revenue recognition policy. Further, consider any changes in accounting policies and the reasons cited for them.
Beyond the realm of ethics, judgment plays an especially important role in the banking and insurance industries. Bankers use judgment in determining whether and when to write off loans that may not be repaid. If they are slow to recognize problem loans and fail to write them off, the bank will continue accruing interest income, and profits on the bank’s financial statements.
What To Do: Watch For Poor Internal Controls
In addition to taking advantage of the flexibility of GAAP, management may have little difficulty distorting financial reports if the company has weak internal controls. Such controls relate to the organizational structure and to corporate procedures for safeguarding assets against losses and ensuring the reliability of financial records for external reporting purposes. Strong controls [i.e., checks and balances] tend to reduce the temptation for management to engage in gimmicks. If safeguards and controls are lacking, however, unethical employees may engage in gimmicks with impunity. While independent auditors scrutinize the adequacy of these controls, it may be difficult for readers of financial statements to ascertain whether the control contains weaknesses.
Reason#3: It is Unlikely That You Will Get Caught
Just as some people cheat on their tax returns because they think they won’t get caught by IRS, companies may use accounting gimmicks because they believe that they won’t get caught by the auditors or regulators. Unfortunately, for the reasons outlines below, they are usually right. And even when they are caught, the penalty is often too little, and too late.
Note: Quarterly Financial Statements Are Unaudited
Investors and bankers who rely on quarterly financial statements and press release on financial performance may believe that those reports have blessing of an independent CPA. Unfortunately, that is not usually true. Only the annual financial statements of publicly held companies must be audited; quarterly statements need not be. Moreover, most companies are privately held and are rarely audited by an outside CPA. When companies use accounting tricks on unaudited financial statements, there is little risk that they will be caught. As a result, investors must be especially careful when reading quarterly financial statements.
What Types Of Companies Are Most Likely To Use Accounting Gimmicks?
While it is relatively easy for managers to use accounting gimmicks and there is only a moderate chance of their getting caught, most companies DO NOT intentionally distort their financial reports. Unfortunately, since you never know in advance which companies DO publish misleading information, it is prudent to be a bit suspicious of all companies and search for early warning signs of problems. Such signs often include:
- A weak control environment [i.e., lack of independent members on the board of directors or lack of competent/independent external auditors].
- Management facing extreme competitive pressure
- Management known or suspected of having questionable character
Be particularly alert for these factors in the following types of companies:
- Fast-growth companies whose real growth is beginning to slow
- Basket case companies that are struggling to survive
- Newly public companies and private companies
The growth of all fast-growth companies will eventually slow considerably. At that point, managers may tempt to use accounting gimmicks. Investors and lenders should be alert for accounting gimmicks in all such companies. At the other extreme, managers of very weak companies might be tempt to use accounting tricks to deceive the outside world into thinking that their company’s problems are minor. Investors and lenders should be particularly alert when a company may not be in compliance with bank lending covenants on such financial measures as minimum net worth and working capital. Many newly public companies whose shares are first issued through an initial public offering [IPO], have never been audited before and may lack of strong internal controls. Accounting gimmicks maybe prevalent. Finally, private companies, particularly those that are closely held and have not been audited, are more likely to use gimmicks.
Case Study: AOL An interesting Story
Back in 1994, AOL was far different from the media giant AOL Time Wraner of today. In fact, there were real doubts that AOL would survive against its larger and more formidable competitors of that era; CompuServe and Prodigy.
AOL needed sizeable capital infusions from investors, but it had one glaring problem; It was spending considerably more than it was receiving from subscribers. That fact would have been clear to investors has AOL used more conventional accounting.
Specially, in 1994 AOL decided to exclude current marketing costs in calculating its profit—an unusual and aggressive policy. Instead of immediately expensing this cost, AOL shifted them to the balance sheet [as an asset] and charges them off in the future periods. By the following years, profits were becoming more elusive and AOL’s accounting became even more aggressive. The company began amortizing marketing costs over eighteen months, rather than twelve. The shine started coming off AOL in 1996, and the share price sagged. With rapid growth of the number of subscribers, AOL’s infrastructure proved to be inadequate to meet customer’s needs. The result, not surprisingly, was massive subscriber defections. In fact, during the March 1996 quarter, net additions to AOL’s subscriber base were virtually zero. The company again started tinkering with its accounting for marketing costs, pushing out the amortization period from eighteen to twenty-four months.
Warning Sign & Lessons from AOL:
CFRA issued three separate warnings [June 1994, October 1995, and June 1996], focusing on AOL aggressive and unusual accounting for marketing cost. Instead of charging those cost against income immediately, AOL pushed then to future periods, thereby inflating current-period income. Finally, in 1996, AOL changed to the more conservative approach of expensing such costs. In so doing, it also wrote off the previously deferred cost as a “special charge”. As a result, future-period operating income received a boost from the exclusion of the already written off amortization costs.