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”