Management naturally wants to portray the rosiest picture of a company’s financial performance that they can. This overzealous earnings management (aka “spin”) could easily mislead lenders and investors. Look at these practices below, where U.S. Generally Accepted Accounting Principles (GAAP) could potentially be manipulated to obscure the truth.
Creative accounting vs. cooking the books
Earnings management will typically begin small, but it could grow increasingly aggressive, and, if left unchecked, ultimately cross the line into fraud. An external audit might assist in detecting any earnings management red flags, including:
Premature revenue recognition. Some companies choose to acknowledge revenue early to temporarily pump up the income statement. This occurs mainly when a company is available for purchase or when applying for bank financing.
Miscellaneous “cookie jar” reserves. Management could invent a hidden reserve of funds during good times. Later, they could tap into the funds to build up earnings when times are lean.
“Big bath” restructuring changes. At times, businesses will overstate restructuring expenses, thus allowing them to clean up their balance sheets and stockpile cash for a rainy day.
Immediate acquisition write-offs. Companies that have been acquired could categorize part of the purchase price as “in-process research and development,” then promptly write it off. This decreases the amortization of the purchase price to future earnings.
Overreliance on EBITDA. Common ways to assess a company’s performance include EBITDA — earnings before interest, taxes, depreciation and amortization, and other non-GAAP metrics. However, these metrics generally aren’t audited, so the calculations could vary from company to company.
Typically EBITDA is meant to appear like cash flow. But this metric can conceal trouble in start-up companies with major debt. Despite an appealing EBITDA, these start-ups could have debt that keeps them from turning a profit for many years to come.
Too good to be true?
Notice in corporate press releases or when looking over financial statements — the opportunity and demand to spin earnings is everywhere. To better detect when a business has used “creative” accounting practices to embellish their financial performance, please call 949-860-9902 or click here to contact us for help.