Why do companies manipulate their financial reports?

Financial reports are to companies what an annual report of health is to a person. Investors, lenders, and prospective key customers go through a company’s financial reports before they associate with them. Employees of a company are incentivised based on how much profits a company makes. It is therefore quite natural that companies have a high incentive to manipulate their financial reports since the stakes are so high.

Investors and analysts who advice investors on which stocks to pick look at some key factors in a financial report:

  • Net debt
  • Ratio of operating cash flow to operating profit
  • Taxes – particularly in the case of companies with operations in different countries and how they handle transfer pricing
  • Reserves – considering the past few years have been recession hit, how will the company protect itself
  • Line of credit from banks and other financial institutions - will they be available?
  • Projections of growth and profits
  • Valuation of current assets
  • Depreciation
  • Inventory

Unfortunately, companies tweak each of these factors to make financial reports look better. They can present unrealistic projections without actually fulfilling them. To present lower current bad debt expenses, bad debt reserves are reduced.

The method of valuing current assets is changed to inflate holdings. Use depreciation methods to show lowered depreciation and therefore boost earnings. Show inventory as being higher than it is or reduce the obsolete inventory amount. Manipulate figures for earnings from operations outside home base. All of this ‘dressing up’ of financial reports is to hoodwink investors.

Some cases of manipulation of financial reports are so brazen, they can only be called fiction. Enron was one such instance.

The SEC in its press release about charging Jeffrey K. Skilling, Enron Corp.'s former President, Chief Executive Officer and Chief Operating Officer, with violating, and aiding and abetting violations of, the antifraud, lying to auditors, periodic reporting, books and records, and internal controls provisions of the federal securities laws. It also charged Richard A. Causey, Enron's former Chief Accounting Officer and others with charges of manipulating accounts.

The Amended Complaint alleges that Skilling and others improperly used reserves within Enron's wholesale energy trading business, Enron Wholesale, to manufacture and manipulate reported earnings; manipulated Enron's "business segment reporting" to conceal losses at Enron's retail energy business, Enron Energy Services ("EES"); manufactured earnings by fraudulently promoting Enron's broadband unit, Enron Broadband Services ("EBS"); and improperly used special purpose entities ("SPEs") and the LJM partnerships to manipulate Enron's financial results. In addition, the Amended Complaint alleges that Skilling made false and misleading statements concerning Enron's financial results and the performance of its businesses, and that these misrepresentations were also contained in Enron's public filings with the Commission. The Amended Complaint further alleges that Skilling sold Enron stock while in possession of material, non-public information that generated unlawful proceeds of approximately $63 million

Some of the key charges against Enron were:

  1. Improper use of reserves: Skillings and co. was charged with dipping into reserves to cover up losses from energy trading and other businesses that they owned. They used reserve funds kept to buffer against dips to hype earnings per share, which did not match the performance for that quarter.
  2. Enron wholesale was made to absorb EES huge losses. This was done by in the guise of reorganising the business during which a part of EES was absorbed into ENRON.
  3. Manufactured earning: On the back of the fake hike of the earnings per share, Skillet aggressively spoke about Enron’s broadband business and its proprietary technology none of which was true. He therefore willfully misled investors.
  4. Special purpose vehicles and fake partnerships”: Skilling and his team entered into partnerships with a company headed by Enron’s CFO. This was done to avoid public reporting of diminishing value of their energy portfolio. It also allowed Enron hedge investments without due diligence.
  5. Skillet indulged in insider trading. On the one hand he was knowledgeable about the poor performance of several of Enron’s assets and he inflated prices of the shares on the other hand. He then sold vast amounts of Enron’s stocks earning approximately $63 million from them.

When the end finally came, investors lost heavily and employees lost their jobs in thousands thanks to the inability to face plain facts and the greed of easy money by the top management at Enron. Despite this Enron is not the only example of a large corporation willfully manipulating their financial records.

Financial reports it must be understood at best work like mirrors and should be used as such to lay bare facts as seen. This can help cut losses quickly and reduce damage. Companies who dress up the warts and try to cover the moles end up nurturing cancers that end up killing the whole business and the stake-holders with it.