Creative Accounting

Everything should be in black and white

Creative accounting can be used to manage earnings and to keep debt off the balance sheet. 

Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. 

companies utilize creative accounting to overstate a company's assets or understate its liabilities

Why Boost the Balance Sheet?

Companies that manipulate their balance sheet are often seeking to increase their earnings power in future periods (or the current period) or create the appearance of a strong financial condition. After all, financially-sound companies can more easily obtain lines of credit at low interest rates, as well as more easily issue debt financing or issue bonds on better terms.

Overvaluing Assets

Provision for Doubtful Accounts

Accounts receivables play a key role in detecting premature or fabricated revenues, but they can also be used to inflate earnings on their own by way of the provision for doubtful accounts.

Investors can detect when the reserves for doubtful accounts are inadequate by comparing accounts receivable to net income and revenue. When the balance sheet item is growing at a faster pace than the income statement item, then investors may want to look into whether or not the provision for doubtful accounts is adequate by further investigating.

Inventory Manipulation

One example of manipulated inventory was Laribee Wire Manufacturing Co., which recorded phantom inventory and carried other inventory at bloated values. This helped the company borrow some $130 million from six banks by using the inventory as collateral. Meanwhile, the company reported $3 million in net income for the period, when it really lost $6.5 million.

Investors can detect overvalued inventory by looking for telling trends, such as inventory increasing faster than sales, decreases in inventory turnover, inventory rising faster than total assets and falling cost of sales as a percentage of sales. Any unusual variations in these figures can be indicative of potential inventory accounting fraud.

Subsidiaries and Joint Ventures

When public companies make large investments in a separate business or entity, they can either account for the investment under the consolidation method or the equity method depending on their ability to control the subsidiary.

Undervaluing Liabilities

Pension Obligations

Companies can make themselves appear in a stronger financial position by changing a few assumptions to reduce the pension obligation. Because the pension benefit obligation is the present value of future payments earned by employees, these accounts can be effectively controlled via the discount rate. Increasing the discount rate can significantly reduce the pension obligation depending on the size of the obligation.

An increase in the expected return on plan assets will reduce the pension expense in the income statement and boost net income. (For additional information, take a look at Analyzing Pension Risk.)

Contingent Liabilities

Contingent liabilities are obligations that are dependent on future events to confirm the existence of an obligation, the amount owed, the payee or the date payable. For example, warranty obligations or anticipated litigation loss may be considered contingent liabilities. Companies can creatively account for these liabilities by underestimating their materiality.

Companies that fail to record a contingent liability that is likely to be incurred and subject to reasonable estimation are understating their liabilities and overstating their net income or shareholders' equity. Investors can avoid these problems by carefully reading a company's footnotes, which contain information about these obligations.

5 Tricks Companies Use During Earnings Season

five of the most common shenanigans that management and communications teams use in their companies' releases.

1. The Friday News Release

Communication teams looking to "bury" a bad earnings report (or bad news in general) will sometimes seek to disseminate the release at a time when it suspects the lowest number of people are watching.

to send out the release after the close of the market on a Friday afternoon, preferably heading into a holiday weekend, or on a day when a variety of economic data was due for release and the spotlight wasn't on the company.

 (To learn more, see Trading On News Releases and Can Good News Be A Signal To Sell?)

 Surprising Earnings Results

communications teams, however, may attempt to bury the bad news by using phrases and/or words that mask what's really going on. 

Language like "challenging, "pressured," "slipping" and "stressed" should not be taken lightly and could even be red flags. For example, rather than say in a release that the company's gross margins have been declining and that as a result the company's earnings may get pinched in the future, management may simply say that it "sees a great deal of pricing pressure." Meanwhile, the investor is left to calculate gross margin percentages from the provided income statement - something that few retail investors have time to do.

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