Financial statements are a link between a company and its stakeholders. Through this link, companies can present a picture of their operations. Usually, they show this picture through four primary financial statements. These include the balance sheet, income statement, cash flow statements and statement of changes in equity. Companies can use these statements to communicate quantitative information with their stakeholders.
Financial statements can provide information about a company’s operations. Each of these statements presents a different aspect of those operations. On top of that, they cover a specific period or show a picture at a time. Either way, they are crucial in reporting how the company fares and has performed. Stakeholders can use this information to decide about their relationships with the company.
Stakeholders can make informed decisions if the financial statements present a true and fair view. However, some companies may manipulate those statements to show a favourable view of their operations. Usually, they do so to attract investors or financers. In the past, companies have used manipulations to achieve a better position. Nonetheless, there is substantial evidence used to manipulate financial statements.
Why do companies manipulate financial statements?
The decision to manipulate financial statements lies with a company’s management. Usually, they may have several reasons to do so. In most cases, they use manipulative techniques to dress the financial statements to present a favourable position. By doing so, they can satisfy their stakeholders and distort their views. Sometimes, they may also avoid implications or consequences related to an adverse financial picture by doing so.
One of the most primary causes of financial manipulation relates to financial performance. The income statement shows the profits or losses made by a company for a specific period. Usually, this performance dictates how stakeholders react to the company’s operations. If this performance is adverse, stakeholders are likely to take actions against the management. Therefore, it may avoid it by manipulating the financial statements.
Companies may also manipulate financial statements to show an advantageous financial position. Although it is more complex than financial performance, it is still achievable. Companies can use window dressing techniques to present a favourable assets position. On the other hand, they can also decrease their liabilities to manipulate the financial statements. By doing so, they can attract more investors in the future.
Accounting standards also play a significant role in allowing companies to manipulate financial statements. Although these standards exist to prevent any manipulation attempts, they may come with vague requirements. These requirements can lead to different interpretations, which companies can exploit to present a favourable view. However, accounting standards go against the use of such manipulative techniques.
Lastly, companies also manipulate financial statements because they have the opportunity to do so. Usually, it is unlikely that investors may detect such instances. They rely on independent auditors to provide their opinion on the financial statements presenting a true and fair view. However, even auditors may not detect any manipulation attempts to the financial statements. Therefore, companies can manipulate their financial statements without hassle.
What are the ways of manipulating financial statements?
Manipulating financial statements may fall under felony in many jurisdictions. Due to the implications associated with this behaviour, companies can suffer significant losses. On top of that, the management employees in the process can face imprisonment and fines. However, these disadvantages of manipulating financial statements haven’t stopped such instances in the past.
Many ways exist to manipulate financial statements. These may relate to exploiting loopholes in standards or regulations. On top of that, they may also involve using window dressing or creative accounting techniques. Each financial statement may have a different approach toward manipulation. However, there are many ways to detect them.
Nonetheless, the nine popular ways for manipulating financial statements include the following.
Recognizing revenues in a different period
Accounting standards are clear in the treatment of how companies must record revenues. On top of that, they also state how to differentiate between the income from different periods. Nonetheless, that does not prevent companies from recording them in another period. By doing so, companies can increase their revenues for a specific period to show better performance. This exploit impacts the income statement directly.
Recording fictitious revenues
Accounting standards require companies to record revenues when they occur. These standards clarify the criteria for the occurrence of those revenues. However, companies can still record fictitious revenues backed by fake supporting documents. On top of that, companies may also funnel other incomes into the revenues account. The principal accounting treatment will remain the same. Nonetheless, the presentation will differ significantly.
Recognizing expenses in a different period
Like revenues, companies can also change the accounting period for an expense. This method results in a similar impact as the former cases. By doing so, companies can increase their profits for a specific period or decrease their expenses. There are several techniques that companies can use within this approach. For example, they can ignore impairment or recognize depreciation slowly.
Manipulating profits directly through ad-hoc income
Companies usually concentrate on increasing their profits to show better financial performance. While the above methods can achieve it, companies can also impact them directly. Sometimes, companies may sell assets to realize a gain. By doing so, they can record them in the financial statements to increase their profits. Similarly, they can also categorize income from other sources as profits.
Related party transactions
In the modern world, most companies do not operate on their own. Usually, they have some other companies that help in their operations. Some of these companies may also be independent. Nonetheless, companies can use transactions with those parties to manipulate their financial statements. By doing so, they can increase or decrease their finances favourably in any way they way.
Inventory recognition and valuation relate to accounting standards. Accounting standards assign various methods to evaluate a stock. However, each approach can result in a different valuation of inventory or goods. Companies can use it to their advantage to overvalue inventory. By doing so, they can show a better asset position on the balance sheet. Similarly, it can increase its profits through closing stock.
Changing accounting estimates
Accounting estimates are another area where the accounting standards are vague. Usually, companies can use their judgement to assess these estimates. However, it can create a variance between the methods used by companies. Companies can also change these estimates to reach a favourable position. For example, companies can manipulate depreciation and amortization. Both of these involve using accounting estimates.
When obtaining finance, companies must ensure they have low leverage. If financial liabilities are lower, companies can obtain finance easily. Companies with higher obligations face challenges to get loans. However, companies can understate liabilities through several creative accounting methods. For example, they can use off-balance sheet accounting to manipulate those figures. This way, they can obtain finance without a hassle.
Capitalizing expenses or writing-off assets
Companies must differentiate between capital and revenue expenditure. By doing so, they can separate assets from expenses. However, the accounting standards with recognizing these expenditures relies on judgement. Companies can use it to justify capitalizing expenses or writing-off assets. This way, they can create a favourable position in the financial statements. It is one of the other ways companies can manipulate those statements.
Financial statements are a crucial part of the communication between companies and their stakeholders. However, they are prone to manipulation, which has occurred in the past. There are several ways for influencing financial statements. These ways may relate to fraudulent activity or exploding vague accounting standard requirements. Some of the most popular methods of manipulating financial statements are available above.