12.5. Putting a Spin on the Numbers (But Not Cooking the Books)

This section discusses two accounting tricks that involve manipulating, or "massaging," the accounting numbers. I don't endorse either technique, but you should be aware of both. In some situations, the financial statement numbers don't come out exactly the way the business wants. With the connivance of top management, accountants can use certain tricks of the trade — some would say sleight of hand, or shenanigans — to move the numbers closer to what the business prefers. One trick improves the appearance of the short-term solvency of the business and the cash balance reported in the balance sheet at the end of the year. The other device shifts some profit from one year to the next to report a smoother trend of net income from year to year.

I don't mean to suggest that all businesses engage in these accounting machinations — but many do. The extent of use of these unholy schemes is hard to pin down because no business would openly admit to using them. The evidence is fairly convincing, however, that many businesses massage their numbers to some degree. I'm sure you've heard the term loopholes applied to income tax. Well, some loopholes exist in financial statement accounting as well.

12.5.1. Window dressing for fluffing up the cash balance

Suppose you manage a business and your controller has just submitted for your review the preliminary, or first draft, of the year-end balance sheet. (Chapter 5 explains the balance sheet, and Figure 5-2 shows a complete balance sheet for a business.) Figure 12-1 shows the current assets and current liabilities sections of the balance sheet draft.

Wait a minute: a zero cash balance? How can that be? Maybe your business has been having some cash flow problems and you've intended to increase your short-term borrowing and speed up collection of accounts receivable to help the cash balance. Folks generally don't like to see a zero cash balance — it makes them kind of nervous, to put it mildly, no matter how you try to cushion it. So what do you do to avoid setting off alarm bells?

Figure 12.1. Current assets and current liabilities of a business, before window dressing.

Your controller is probably aware of a technique called window dressing, a very simple method for making the cash balance look better. Suppose your fiscal year-end is October 31. Your controller takes the cash collections from customers paying their accounts receivable that are actually received on November 1, 2, and 3, and records them as if these cash collections had been received on October 31. After all, the argument can be made that the customers' checks were in the mail — that money is yours, as far as the customers are concerned.

Window dressing reduces the amount in accounts receivable and increases the amount in cash by the same amount — it has absolutely no effect on your profit figure for the period. It just makes your cash balance look a touch better. Window dressing can also be used to improve other accounts' balances, which I don't go into here. All of these techniques involve holding the books open — to record certain events that take place after the end of the fiscal year (the ending balance sheet date) to make things look better than they actually were at the close of business on the last day of the year.

Sounds like everybody wins, doesn't it? You look like you've done a better job as manager, and your lenders and investors don't panic. Right? Wrong! Window dressing is deceptive to your creditors and investors, who have every right to expect that the end of your fiscal year as stated on your financial reports is truly the end of your fiscal year. I should mention, however, that when I was in auditing I encountered situations in which a major lender of the business was fully aware that it had engaged in window dressing. The lender did not object because it wanted the business to fluff the pillows to make its balance sheet look better. The loan officer wanted to make the loan to the business look better. Essentially, the lender was complicit in the accounting manipulation.

Window dressing could be a dangerous game to play. Window dressing could be the first step on a slippery slope. A little window dressing today, and tomorrow, who knows — maybe giving the numbers a nudge now will lead to more serious accounting deceptions, such as profit smoothing techniques (discussed next), or even out-and-out accounting fraud. Moreover, when a business commits some accounting hanky-panky, should the chief executive of the business brief its directors on the accounting manipulation? Things get messy, to say the least!

12.5.2. Sanding the rough edges off profit

You should not be surprised when I tell you that business managers are under tremendous pressure to make profit every year and to keep profit on the up escalator year after year. Managers strive to make their numbers and to hit the milestone markers set for the business. Reporting a loss for the year, or even a dip below the profit trend line, is a red flag that investors view with alarm. Everyone likes to see a steady upward trend line for profit; no one likes to see a profit curve that looks like a roller coaster. Most investors want a smooth journey and don't like putting on their investment life preservers.

Managers can do certain things to deflate or inflate profit (net income) recorded in the year, which are referred to as profit smoothing techniques. Other names for these techniques are income smoothing and earnings management. Profit smoothing is like a white lie told for the good of the business and perhaps for the good of managers as well. Managers know that there is always some noise in the accounting system. Profit smoothing muffles the noise.

12.5.2.1. The pressure on public companies

Managers of publicly owned corporations whose stock shares are actively traded are under intense pressure to keep profits steadily rising. Security analysts who follow a particular company make profit forecasts for the business, and their buy-hold-sell recommendations are based largely on these earnings forecasts. If a business fails to meet its own profit forecast or falls short of stock analysts' forecasts, the market price of its stock shares usually takes a hit. Stock option and bonus incentive compensation plans are also strong motivations for achieving the profit goals set for the business.

The evidence is fairly strong that publicly owned businesses engage in some degree of profit smoothing. Frankly, it's much harder to know whether private businesses do so. Private businesses don't face the public scrutiny and expectations that public corporations do. On the other hand, key managers in a private business may have bonus arrangements that depend on recorded profit. In any case, business investors and managers should know about profit smoothing and how it's done.

12.5.2.2. Compensatory effects

Most profit smoothing involves pushing some amount of revenue and/or expenses into years other than those in which they would normally be recorded. For example, if the president of a business wants to report more profit for the year, he or she can instruct the chief accountant to accelerate the recording of some sales revenue that normally wouldn't be recorded until next year, or to delay the recording of some expenses until next year that normally would be recorded this year.

Chapter 7 explains that managers choose among alternative accounting methods for several important expenses (and for revenue as well). After making these key choices, the managers should let the accountants do their jobs and let the chips fall where they may. If bottom-line profit for the year turns out to be a little short of the forecast or target for the period, so be it. This hands-off approach to profit accounting is the ideal way. However, managers often use a hands-on approach — they intercede (one could say interfere) and override the normal accounting for sales revenue or expenses.

Both managers who do profit smoothing and investors who rely on financial statements in which profit smoothing has been done must understand one thing: These techniques have robbing-Peter-to-pay-Paul effects. Accountants refer to these as compensatory effects. The effects next year offset and cancel out the effects this year. Less expense this year is counterbalanced by more expense next year. Sales revenue recorded this year means less sales revenue recorded next year. Of course, the compensatory effects work the other way as well: If a business depresses its current year's recorded profit, its profit next year benefits. In short, a certain amount of profit can be brought forward into the current year or delayed until the following year.

12.5.2.3. Two profit histories

Figure 12-2 shows, side by side, the annual profit histories of two different businesses over six years. Steady Flow, Inc. shows a nice smooth upward trend of profit. Bumpy Ride, Inc., in contrast, shows a zigzag ride over the six years. Both businesses earned the same total profit for the six years — in this case, $1,050,449. Their total six-year profit performance is the same, down to the last dollar. Which company would you be more willing to risk your money in? I suspect that you'd prefer Steady Flow, Inc. because of the nice and steady upward slope of its profit history.

I have a secret to share with you: Figure 12-2 is not really for two different companies — actually, the two different profit figures for each year are for the same company. The year-by-year profits shown for Steady Flow, Inc. are the company's smoothed profit amounts for each year, and the annual profits for Bumpy Ride, Inc. are the actual profits of the same business — the annual profits that were recorded before smoothing techniques were applied.

For the first year in the series, 2004, no profit smoothing occurred. The two profit numbers are the same; there was no need for smoothing. For each of the next five years, the two profit numbers differ. The difference between actual profit and smoothed profit for the year is the amount that revenue and/or expenses had to be manipulated for the year. For example, in 2005 actual profit would have been a little too high, so the company accelerated the recording of some expenses that should not have been recorded until the following year (2006); it booked those expenses in 2005. In contrast, in 2008, actual profit was running below the target net income for the year, so the business put off recording some expenses until 2009 to make 2008's profit look better. Does all this make you a little uncomfortable? It should.

Figure 12.2. Comparison of smoothed and actual profit histories.

A business can go only so far in smoothing profit. If a business has a particularly bad year, all the profit-smoothing tricks in the world won't close the gap. And if managers are used to profit smoothing, they may be tempted in this situation to resort to accounting fraud, or cooking the books.

12.5.2.4. Management discretion in the timing of revenue and expenses

Several smoothing techniques are available for filling the potholes and straightening the curves on the profit highway. Most profit-smoothing techniques require one essential ingredient: management discretion in deciding when to record expenses or when to record sales.

When I was in public accounting, one of our clients was a contractor that used the completed contract method for recording its sales revenue. Not until the job was totally complete did the company book the sales revenue and deduct all costs to determine the gross margin from the job (in other words, from the contract). In most cases, the company had to return a few weeks after a job was finished for final touch-up work or to satisfy customer complaints. In the past, the company waited for this final visit before calling a job complete. But the year I was on the audit, the company was falling short of its profit goals. So the president decided to move up the point at which a job was called complete. The company decided not to wait for the final visit, which rarely involved more than a few minor expenses. Thus more jobs were completed during the year, more sales revenue and higher gross margin were recorded in the year, and the company met its profit goals.

A common technique for profit smoothing is to delay normal maintenance and repairs, which is referred to as deferred maintenance. Many routine and recurring maintenance costs required for autos, trucks, machines, equipment, and buildings can be put off, or deferred, until later. These costs are not recorded to expense until the actual maintenance is done, so putting off the work means recording the expense is delayed.

Here are a few other techniques used:

• A business that spends a fair amount of money for employee training and development may delay these programs until next year so the expense this year is lower.

• A company can cut back on its current year's outlays for market research and product development.

• A business can ease up on its rules regarding when slow-paying customers are written off to expense as bad debts (uncollectible accounts receivable). The business can, therefore, put off recording some of its bad debts expense until next year.

• A fixed asset out of active use may have very little or no future value to a business. But instead of writing off the undepreciated cost of the impaired asset as a loss this year, the business may delay the write-off until next year.

Keep in mind that most of these costs will be incurred next year, so the effect is to rob Peter (make next year absorb the cost) to pay Paul (let this year escape the cost).

Clearly, managers have a fair amount of discretion over the timing of some expenses, so certain expenses can be accelerated into this year or deferred to next year in order to make for a smoother year-to-year profit trend. But a business does not divulge in its external financial report the extent to which it has engaged in profit smoothing. Nor does the independent auditor comment on the use of profit-smoothing techniques by the business — unless the auditor thinks that the company has gone too far in massaging the numbers and that its financial statements are downright misleading.