Financial and managerial accounting standards provide guidance to companies as to how to estimate balance sheet and income statement items. The income statement reflects how expenses are subtracted from revenues to arrive at net earnings. The balance sheet presents asset and liability balances, changes of which reflect cash inflows and outflows. While companies must follow industry guidelines exist, company management still has some discretion as to how aggressive or conservative their accounting will be. This is often situational.
There are many ways to manage revenue recognition, often stemming from complex, shifting operating environments. For example, if a company has a history of somewhat predictable sales to a customer, in certain situations the accounting can be exploited by billing for sales not yet made, assuming that they will be made up in the future. Deferring too much or not enough revenue is a common way to manipulate earnings. For example, sales returns may be deferred in order to meet revenue targets.
Banks maintain an account for uncollectable loans that remain relatively stable over time and across the industry. In some cases of high-profile bank collapses, management refused to acknowledge the deteriorating nature of its loan portfolio, which would require increasing the provision, which is offset in double-entry accounting with an increase in bad debt expense. When this occurs, reported earnings don't reflect the higher bad debt expense, nor do loans receivable reflect the losses on the balance sheet.
Changing Accounting Principles
Various methodologies are available to account for similar projects using different accounting methods, which can result in differences in the timing and amount of revenues and expenses throughout the duration of the project. If a project, such as a construction project, appears to be over budget under one accounting convention, the company may switch to the more-aggressive accounting method to obscure economic realities. Auditors often take note of such activities; therefore, a company that switches auditors often raises red flags.
Enron was a very high-profile case of corporate fraud in which fraudulent related-party transactions played a large part in causing. The company set up related-party entities and shifted the company's debt obligations to related parties. The company also recognized fraudulent revenues by recording sales to related parties for services that never occurred. Likewise, a company can effectuate a sale-leaseback transaction in which it sells an asset to generate a one-time spike in earnings, while deferring the expenses associated with leasing back use of the asset.
Often, when management foresees a poor fiscal period approaching to be followed by additional poor results, the company will take early write-downs of assets and recognize assets early in order to create the impression that the declining financial performance is only temporary. This reflects highly aggressive accounting that fails when actual cash flows do not match up with the revenues and expenses for accounting purposes. Companies that consistently report positive earnings but negative operating cash flows are a red flag for these tactics.
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