Robust accounting standards help ensure that information on business financial statements is fairly stated. Still, for every accounting rule on the books, there's a way to break it. Managers who want to distort a company's financial position can manipulate asset values, understate liabilities and shift earnings to inappropriate accounting periods.
Assets Are Overstated
Undervalued Allowance Accounts
Managers and owners can manipulate accounting data so asset accounts seem higher than they really are. One way managers do this is by understating the allowance for doubtful accounts. This is a contra-asset account that represents what portion of receivables the company thinks it can't collect. The allowance account reduces the balance of accounts receivable, so if it's artificially low, assets are artificially high.
Forbes notes that investors should understand how the company calculates this allowance account -- it should be noted in the financial statements -- and pay careful attention to the balance. If the account seems low relative to revenues or the accumulated accounts receivable balance, management might be underestimating the allowance account.
Another asset account that can easily be manipulated is the inventory asset account. Generally accepted accounting principles, or GAAP, dictate that inventory should be valued at the lower of original cost or current market value. Thus if inventory has been damaged or spoiled or becomes obsolete in some way, management should write down the inventory value on the balance sheet.
Management doesn't always write down inventory though. If managers fail to revalue inventory, assets will be overstated.
Liabilities Are Understated
Liabilities represent a company's financial obligations, so managers are sometimes tempted to downplay them. Professional accounting association CGA notes that companies sometimes manipulate information about contingent liabilities, such as lawsuits and environmental hazards.
GAAP only requires management to recognize a contingent liability on the balance sheet if the event is probable and the amount can be estimated. By labeling the event as possible, but not probable, the company can leave the dollar amount out of the liabilities section.
Failing to properly classify unearned revenue is another common manipulation of liabilities. If a company has received cash but hasn't performed the work yet, the revenue is unearned and should be recorded as a liability. CGA notes that some companies fail to do this and simply mark the cash as revenue.
Managers who are hoping to meet certain earnings targets or control stock prices will often engage in earnings management, which involves manipulating the timing of when revenues and expenses are recorded. One popular type of earnings management is income smoothing. To make financial results appear more consistent, managers will try to push revenues into a different period or adjust expenses so they match last year's. An alternate approach is the big bath. Using this method, managers recognize lots of expenses in one year so they can "get it over with" and make next year's results look better.
Some types of income smoothing -- like a big sales push before the end of the year -- are legitimate business techniques. Others -- like adjusting allowance accounts, recording revenues in the wrong period or switching inventory valuation methods to affect expenses -- are purposeful efforts to distort business results.