Preparing and maintaining precise and reliable financial statements is the essence of fair financial reporting. However, as practice shows, many companies are looking for ways to present their financial standing in a better light rather it actually is. The purpose for such unethical behavior could be an intention to increase a company's market capitalization, ease off the debt load or simply avoid paying dividends or fulfill contract obligations to its partners.
Things To Watch
The most common way to present things in a better light is to increase earnings and hide costs. A simple way to boost earnings in income statements is to recognize revenues earlier than they actually occur. Fraudulent asset valuations happen when companies utilize off-balance sheet financing or create hidden reserves to show minimal income. These are the unethical accounting practices to watch for on financial statements.
The only way a company can recognize and report earnings on a financial statement is when most of the job is complete, the costs are known and its clients are ready to pay their bills. Unethical accounting introduces fraudulent timing differences, such as recognizing revenues at the time of contract signing before producing or shipping the product. As a result, earnings may never happen due to unreliable clients that do not pay or unexpected increases in production costs. There are two primary methods of revenue recognition: the sales method and percentage of completion. The first method defines revenue at the moment of sale -- the moment when goods or services are transferred to the buyer in exchange for cash. The second method defines revenue as a percentage of the work completed -- this method is common for large-scale manufacturers, such as aircraft makers or construction companies.
Off-balance Sheet Financing
Some managers have been known to apply particular accounting methods to show little debt on the balance sheet. Off-balance sheet financing allows companies to hide expenses by putting them into joint ventures, research projects or purchasing equipment through operating leases rather than reporting the full ownership. In order to examine the reliability of debt structure, users of financial statements should also consider the influence of top managers over accounting policies.
Creating hidden reserves is another unethical accounting method to decrease taxable income. By creating fraudulent asset valuations, a company shows less resources on the balance sheet but overstates its liabilities, such as listing buildings or land for a price below market value. By releasing hidden reserves, a company can show higher income and improve its numbers on financial statements. Therefore, savvy investors should carefully study the footnotes where companies have to state the release of hidden reserves.