Companies can manipulate their profitability in a number of ways, depending on their approach, whether conservative or aggressive.
Some of the most common methods include:
- Accelerating revenues: This can be done through channel stuffing (selling more products to distributors than they can actually sell to customers) or fraudulent revenues (recording sales that have not actually occurred). Warning signs of this type of manipulation include growth in receivables that is higher than the growth in revenue, an increase in returns from customers, and compensation that is tied to the company’s financial results.
- Classifying operating expenses as non-operating: This can be done by holding on to expenses and paying them in subsequent quarters, or by capitalizing expenses that should be expensed. This can boost the company’s top-line numbers, such as gross and operating margins.
- Reporting profits in the income statement and realizing losses in other comprehensive income: This can be done by using accounting methods that allow the company to defer losses to future periods. For example, the company may use the lower of cost or market method to value its inventory, which allows it to recognize losses on inventory when the market value of the inventory declines. However, the company can then reverse these losses in future periods if the market value of the inventory increases.
- Changing accounting assumptions: This can be done by increasing the life of assets to reduce depreciation or by adopting a straight-line method of depreciation instead of an accelerated method. This can reduce the company’s expenses and boost its profits.
- Inflating or deflating reserves, allowances, or provisions: This can be done to manipulate the company’s earnings. For example, the company may overstate its reserves for bad debts or understate its reserves for warranty liabilities. This can reduce the company’s expenses and boost its profits.
- Capitalizing in the balance sheet instead of expensing: This can be done for items such as research and development costs or advertising costs. Capitalizing these costs allows the company to spread them over multiple periods instead of expensing them all at once. This can reduce the company’s expenses and boost its profits in the current period.
- Overstating goodwill, understating tangible assets, or understating liabilities by using special purpose vehicles (SPVs): This can be done to manipulate the company’s financial ratios and make it appear more profitable than it really is.
Financial Reporting Irregularities to Manipulate Profitability: Case Studies
- IL&FS Financial Services (IFIN)
IFIN engaged in a variety of accounting irregularities to manipulate its profitability, including:
- Booking fictitious sales: IFIN recorded sales that had not actually occurred. This inflated the company’s revenue and profits.
- Valuing assets at inflated prices: IFIN overvalued its assets, which increased the company’s net worth.
- Using financial instruments to hide debt: IFIN used financial instruments, such as special purpose entities (SPEs), to hide its debt from its financial statements. This made the company appear less indebted and more financially sound.
- Deferring expenses to future periods: IFIN capitalized expenses or accounted for them over an extended period of time, which reduced the company’s current expenses and boosted its profits
- GMR Infrastructure
GMR Infrastructure’s auditors identified two key audit matters related to the company’s profitability:
- Revenue recognition and provision for upfront losses from EPC contracts: GMR Infrastructure’s revenue recognition and provision for upfront losses from EPC contracts are complex and involve significant judgments and assumptions. These judgments and assumptions are inherently subjective and dependent on future events. This makes it difficult to audit the company’s revenue recognition and provision for upfront losses from EPC contracts with certainty.
- Investments in energy subsidiaries: GMR Infrastructure’s investments in its energy subsidiaries, GMR Energy Limited (GEL), GMR Vemagiri Power Generation Limited (GVPGL), and GMR Rajahmundry Energy Limited (GREL), are incurring significant losses due to the unavailability of adequate supply of natural gas. As a result, the carrying value of GMR Infrastructure’s investments in these entities is significantly dependent on the achievement of future profitability. This means that GMR Infrastructure’s investments in its energy subsidiaries could be worth significantly less than their carrying value if the subsidiaries do not become profitable in the future.
- Satyam Computers
Satyam Computers inflated its quarterly profits to meet analyst expectations by:
- Creating fake bank statements: Mr. Raju, the founder and CEO of Satyam Computers, used his personal computer to create fake bank statements to inflate the balance sheet with cash that did not exist.
- Creating fake customer identities and fake invoices: The global head of internal audit at Satyam Computers created fake customer identities and fake invoices to inflate revenue.
- Selling shares at high prices: The increased share price drove the company to sell as many shares as possible while maintaining just enough to remain a part of the company. This allowed Mr. Raju to profit from selling his shares at high prices.
- Withdrawing salaries for employees that did not exist: Mr. Raju withdrew $3 million every month in salaries for employees that did not exist.
- Adani Green Energy
Adani Green Energy’s auditors identified hedge accounting for currency derivatives and the adequacy of the related disclosures as a key audit matter because of the degree of subjectivity/management judgment required to determine hedges effectiveness and requires management to maintain hedge documentation. These transactions may have a significant financial effect.
- This means that Adani Green Energy’s hedge accounting for currency derivatives is complex and involves significant judgments and assumptions.
- These judgments and assumptions are inherently subjective and dependent on future events. This makes it difficult to audit the company’s hedge accounting for currency derivatives with certainty.
Enron engaged in a variety of accounting irregularities to manipulate its profitability, including:
- Recognizing revenue on assets that had not yet generated any revenue: Enron would build assets, such as power plants, and immediately claim the projected profit on its books, even though the asset had not yet generated any revenue. This inflated the company’s revenue and profits.
- Transferring assets to off-the-books corporations: If the revenue from the asset was less than projected, Enron would transfer the asset to an off-the-books corporation, known as a special purpose entity (SPE). This allowed Enron to write off the loss without hurting its bottom line.
- Entering into complex trading contracts with SPEs: Enron would enter into complex trading contracts with its SPEs, which would then generate fake profits for Enron. This inflated the company’s revenue and profits.
The cases illustrate a variety of ways that companies can manipulate their profitability. These accounting irregularities can have a devastating impact on a company’s shareholders, creditors, employees, and the economy as a whole. It is important for investors to be aware of these different ways that companies can manipulate their financial statements and to be able to identify the warning signs.