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Understanding Financial Statements: The Meaning of Cooking the Books
 
 

Understanding Financial Statements: The Meaning of Cooking the Books

Cooking the Books Overview:

In this article we deal with issues of accounting and financial statement fraud, the recent background of systemic fraud, and some of the methods used to commit fraud. In this article we will also discuss the Sarbanes-Oxley Act of 2002 in greater detail. In accounting the term cooking the books is generally meant to describe the intentional distortion or the hiding of the accurate financial performance or actual per financial condition of a business. Cooking the books implies falsification a financial documents. Generally the majority of audited financial statements are prepared accurately and fairly. This is because they are usually assembled according to the GAAP as well as sound fiscal controlling, and the checks and balances system for the integrity of the management team in most businesses. However there are exceptions and sometimes fraud and deceptive practices are committed. Examples of the types of fraud misused assets, illegal payments made by a business, the concealment of financial losses, under reporting of expenses, over recording revenue, etc.

This article is designed to show you methods cooking the books, not to facilitate you in preparing fraudulent financial reports but rather to help you be able to spot signs of fraud in a business and its financial reports. Usually when the manager of a business or someone involved in the accounting process for business is cooking the books it is most often for personal financial gain. The companies that are statistically the most likely to have fraudulent reporting on their books tend to have poor internal controls with very little checks and balances, and usually have a management team of questionable integrity. Most often cooking the books is accomplished by moving items that should either be on the balance sheet the income statement or vice versa. There are varieties of individual techniques that can be employed in order to lower income or raise income, raise revenue or lower revenue, and similarly either raises assets in liabilities or lower assets than liabilities. Cooking the books it's a felonious practice and can have serious legal implications and ramifications that have sent many members of Fortune 500 companies to prison.

Objectives

• You should be familiar with the strategies or "recipes" used in cooking the books.

• You should be able to identify and interpret fraudulent transactions in the Balance Sheet.

• You should be able to identify and interpret fraudulent reporting in the Income Statement.

The Sarbanes-Oxely Act of 2002:

As previously stated the Sarbanes-Oxley act of 2002 was created in response to the financial fraud epidemic that was prevalent throughout the late 20th century and into the 21st century. This is not to say that fraud is not a problem today, financial fraud is still a very serious issue that plagues corporate. However the United States Securities and Exchange Commission along with the FASB and other accounting regulatory bodies have passed new legislation to actively combat various forms of financial fraud. A specific example of why the Sarbanes-Oxley act was created can be illustrated by the Enron Corporation scandal. In December 2001 the energy giant known as Enron filed for corporate bankruptcy. Enron was a publicly traded energy corporation that was based out of Houston, Texas and dealt with commodities and services revolving around energy trading and the energy industry as a whole. Between 1994 and 2001 Enron had overstated its earnings by almost $600 million. Roughly a month later Enron filed for bankruptcy and became the largest bankruptcy case in United States history. Investors lost billions of dollars and Enron employees who had taken bonuses and invested in the company lost their entire savings. As a result of this on July 30, 2002 President Bush officially signed into law was called the Public Accounting Reform and Investor Protection Act of 2002.

The name Sarbanes-Oxley comes from the two major sponsors of the act who were Sen. Paul Sarbanes and Representative Michael Oxley. The act also known as SOX deals with the reform of auditing and accounting controls and procedures, the oversight duties of corporate officers and directors that deals with the regulation of conflicts of interests and the disclosure of special compensation such as bonuses. The act also deals with conflicts of interest by stock analysts and it deals with regulations on filing more complete disclosures of financial information for things that might directly and indirectly affect the financial results of a company. The act also deals with the criminalization of fraudulent reporting of financial documents and requires chief executive officers to certify the financial results of the company personally and to sign tax documents dealing with federal income tax. This means that the Sarbanes-Oxley act principally governs the activity of publicly traded companies in order to protect anyone with an interest in the financial activities of those companies. The Sarbanes-Oxley act has 11 titles or subcategories as it is more commonly referred to which are all divided into subsections. The 11 titles that make up the Sarbanes-Oxley act are listed below.

Title I: The Development of a Public Accounting Oversight Board-

This title is intended to create an independent public accounting oversight board that is a derivative of the United States Securities and Exchange Commission. The public accounting oversight board is also more commonly referred to as the PAOB. The PAOB is a self-funded board that operates off of the fees that they charge and has the responsibility of oversight for companies that audit publicly traded companies, as well as dealing with registering and inspecting those companies to make sure that they are following proper regulations.

Title II: Independence of an Auditor-

The second title or category of the Sarbanes-Oxley act legislates how auditing firms are supposed to behave. One of the most important provisions of this category are set to heavily restrict auditing firms from performing compensated activities of accounting for their clients that are considered to generally be outside of the narrow auditing boundaries. An example of an outside activity would include any internal accounting or bookkeeping jobs any designing of financial information systems or other jobs designing internal accounting structures for business.

The theory behind this is that if the auditing firm or to set up controls are accounting systems for the business that they are auditing then they would likely have a biased and their auditing process which would favor the client and therefore make it statistically more likely and easier to have in accurate and fraudulent auditing practices. Another provision of this category requires that the auditing partners must be rotated after five years of dealing with an individual client, which tries to mitigate long-term relationships that can lead to oversights. Another action of this title is that it prohibits the auditing of a business where the financial officers of that business had previously been employed by the auditing firm. The theory behind this also follows the same logical progressions and tries to mitigate the likelihood of past personal and professional relationships having any bias the fact and the auditing process or procedures of a company.

Title III: The Responsibilities of a Corporation-

This is the category that outlines the specific responsibilities public companies have relating to their financial statement reporting and accounting practices and internal policies. One of the requirements states that publicly traded companies must establish an audit committee that is made up of independent board members that have absolutely no financial ties to the business with the exception of being paid for their duties as a board member. To further strengthen the system of controls another provision states that both the chief financial officer as well as the Chief Executive Officer must certify that their financial statements are materially correct and correspond correctly with the audit reports, and it additionally prohibits any officers of the company or board members of the company from attempting to have any positive or negative influence over the financial statement audits and auditing process.

Interested in learning more? Why not take an online class in Understanding Financial Statements?

The system tries to completely remove any of the officers for the company from the auditing process altogether so that there's not any bias brought into the auditing of the company. Additionally if it's found that the financial statements for a company have to be revised because of the actions of the CEO or the CFO then they may be barred from continuing employment with the company for violating SEC requirements as well as forfeiting the right to any bonuses or incentives that they may have gained because of their actions. This is specifically designed to counteract what is known as insider trading which is trading stock or the sale of securities with insider information in order to manipulate the stock market for financial gain.

Title IV: Enhanced Financial Disclosures-

This section requires that publicly traded companies specifically discuss transactions that were previously not addressed. What this means is that companies are now required to discuss things such as off-balance-sheet financing and any other relationships or transactions that could have a material influence in the financial position of the company. Transactions like off-balance-sheet financing is in part what caused the failure of Enron and it deals with unconsolidated subsidiaries and used to allow for the parent company to hide any losses in the subsidiary company therefore making the financial position of the parent company to be overstated. Also in order to aid transparency any officers, directors, stockholders of a company that owned 10% or more of the company are now required to make transactions like bonuses and stock grants public information.

Additionally this section bans publicly traded companies from making financial loans to any of the company's executives. This type of situation is similar to what was discovered as one of the problems during the WorldCom scandal in 2002. Finally this section requires that the codes of ethics for a company must be public information and that every annual report which the company will release must contain a special section covering their internal accounting controls procedures and policies which must be maintained and reassessed every year. This section is more commonly known as section 404 and contains special testing methods to determine the accuracy and validity of the data listed in the financial reports.

Title V: Conflicts of Interest for Analysts-

The fifth title or category deals with the behavior of stock analysts (also referred to as securities analysts) and how they report their analytical opinions to the clients. The theory behind this section is to cut down on insider trading where a stock analyst may have information regarding the sale or purchase of assets that could either positively or negatively impact the business and therefore could be used by either the analyst or one of their clientele to manipulate the stock market for positive financial gain with information that is not available to the public. To combat this, Title V requires that national securities exchanges as well as associations of registered securities develop and implement a framework of rules for governing the conflicts of interests that analysts may run into.

Title VI: Commission Resources and Commission Authority-

This category is made up of four subsections that outline the framework and defined the practices that are designed to restore public confidence and investor confidence in securities analyst. Additionally this category also outlines the Securities and Exchange Commission's authoritative scope to ban securities professionals from practicing as a financial advisor or as a stockbroker.

Title VII: Commission Studies and Reports-

Title VII is made up of five subsections that task the Securities and Exchange Commission as well as the Comptroller Gen. with performing studies and reporting the findings of those studies to the public. These studies are designed to test and report on the effects of the role of credit rating agencies and accounting firms regarding how they affect the securities markets, enforcement actions for securities violations, and whether or not lending agencies such as investment banks assisted in helping to conceal or enable any fraudulent behavior.

Title VIII: Accountability for Corporate and Criminal Fraud-

This category was developed coincide with legal regulations and makes the destruction of financial documents and the creation of fraudulent documents that would aid in the deception of any federal investigations a felony crime. This category also mandates that anyone was an auditor for publicly traded companies must keep all of their paperwork related to the audits of that company for five years and it simultaneously alters the statute of limitations on securities fraud claims and gives more legal protection to anyone that is considered a "whistleblower". Term whistleblower refers to anybody who helps disclose any fraudulent information regarding the transactions and reports for publicly traded companies. Previously being a whistleblower was in a way de-incentivized because it lacked many of the legal protections that it now has from tortious and criminal litigation.

Title IX: Penalty Enhancements for Committing "White Collar" Crime-

Title IX is designed to combat what is known as "white collar" crime. The term white-collar crime is a term used to refer to crimes that are nonviolent in nature and usually financially motivated and therefore committed many times by business professionals and government actors. This category is one of the better known provisions of the Sarbanes-Oxley act and it requires that the CEO and CFO must certify that financial reports for a company that are given to the Securities and Exchange Commission are within legal and regulatory compliance and include all material information regarding the financial position of the company. The damages for violating this can be very costly as this provision has a $500,000 fine and also levies a penalty of up to five years in prison. Furthermore some of the other provisions in this title make it a crime to interfere with any official proceedings of the Securities and Exchange Commission or to tamper with any records that are used as part of an investigation. Title IX also gives the Securities and Exchange Commission the right to seek a court ordered injunctive freeze of any payments to officers, directors, and employees of a business during an SEC investigation.

Title X: Tax Returns for a Corporate Entity-

Title X sets out to further issue a control mechanism on the chief executive officer of a company. Under this title the section known as "Section 1001" requires the CEO for publicly traded company to sign the company tax return. Thought process behind this is to act as another mechanism of control that will have further legal ramifications for the CEO for making any fraudulent changes that would result in inaccurate information for tax reporting purposes and an inaccurate tax return.

Title XI: Accountability for Corporate Fraud-

Title XI has been given a special name by Congress which is known as the "Corporate Fraud Accountability Act of 2002" which sets out to amend part of the United States judicial code in order to make altering records or interfering with official investigations a crime that carries a penalty of either a monetary fine or imprisonment for no longer than 20 years. This section also gives the SEC the right to band any person that has previously been convicted of securities fraud from serving as an officer or director of a publicly traded company.

Cooking the Books- Balance Sheet:

As previously stated the income statement and the balance sheet are the financial statements that are most often involved in cooking the books. What is known as convenient cooking means the exchanging of assets with the sole purpose to inflate the balance sheet and show a profit on the income statement simultaneously. An example of this would be if the company owns an old commercial building that has been valued on the books at $200,000, which is its original cost minus the years of accumulated depreciation. The fact is that a piece of property like that likely has a present value 10 times greater than what would be reported therefore if the company were to sell the warehouse it can report a $1.5 million profit and then turn around and by another piece of property for $2 million. In reality almost nothing has actually changed because the company still has a warehouse but the key is the new one is valued on the books at the purchase price of $2 million as opposed to the original lower depreciated cost of the old warehouse. Doing this allows the company to put a $1.5 million gain on its books however it has less cash on hand Bennett had before the buy-sell transaction took place.

Maybe ask yourself why the company would exchange an asset for a similar asset that it already owned, this is especially sure if it costs them cash in the business had to incur an extra tax payment. The fact of the matter is the only true effect but this transaction had is the sale of an undervalued asset and the booking of what is considered a one time being. So therefore the company reports again as part of their operating income then the books and income has been falsely and underhandedly inflated.

There is a theoretical system in place to try and mitigate and potentially stop the fraudulent cooking of the books. This is where financial auditors come in the play. Financial auditors have the job but systematically reviewing of businesses accounting and control procedures and additionally testing various business transactions see if the company is following the appropriate procedures and policies in its practice. However, the system is not foolproof there are still a few corrupt and intelligent members of management teams that will do everything in their power the mask of deceptive practices and for the auditors. This can be seen historically and many fast-growing companies that will eventually slow down. Once a slowdown of the company has begun and they are not generating the amount of revenue or are not as profitable as they once were then the temptation to cook the books is introduced because the management team wants the perception of value for the company. A key thing to watch for is it the management team changes from a conservative counting practice to a less conservative one. For example if a company was doing poorly and the managers wanted to cook the books and switched from the LIFO system to the FIFO system of inventory valuation or from expensing to capitalizing certain types of marketing expenses as well as the easy of revenue recognition rules and trying to extend or wine than the amount of time used for amortization and depreciation.

Methods for Inflating the Balance Sheet Through Increased or Shifted Income:


Methods for Inflating the Balance Sheet Through Increased Assets and Equity:


Cooking the Books- Income Statement:

One of the quickest and easiest ways of cooking the books would be to pad or inflate the revenue for a business. More specifically the recording of sales before all of the conditions required to complete a sale have actually occurred in reality. This technique has the purpose of inflating sales and the associated profits. Another uniquely deceptive and admittedly creative technique is something called self dealings. Self dealings can be exemplified through actions such is trying to increase revenue by the business selling itself something.

Revenue Should Be Recorded ONLY After These Conditions Are Met:

1.) An order has been received

2.) The actual product has been shoved by the business

3.) There is very little risk that the customer will not accept the product

4.) There are no significant additional actions which are required by the company

5.) Title has transferred in which the purchaser then recognizes his responsibility to pay

Methods for Inflating the Income Statement Through Improper Revenues:


Methods for Inflating the Income Statement Through Improperly Lowered Expenses:


KEY POINTS REVIEW

  • The Sarbanes-Oxley act of 2002 was created in response to the financial fraud epidemic that was prevalent throughout the late 20th century and into the 21st century.
  • The Sarbanes-Oxley act principally governs the activity of publicly traded companies in order to protect anyone with an interest in the financial activities of those companies.
  • The income statement can be improperly inflated by lowering costs or expenses through depreciating assets too slowly.
  • The income statement can be improperly inflated by raising revenues through recording sales before they are final and complete.
  • The balance sheet can improperly inflated by increasing assets or equity through the reporting of gains on the exchange of similar assets.

 
 
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