Revenue Recognition is by far the most common manipulation of a firm’s financial performance. Since companies in different industries acquire revenue from different methods, revenue recognition can easily become a “gray” area when it comes to interpretation. For example, at Enron, the Mark to Market accounting for revenue allowed Enron to recognize the revenue for the complete amount of a contract even if the contract was over multiple years. This approach which was approved by Enron’s external auditor, Arthur Andersen, allowed Enron to manipulate its revenues on a quarterly basis to ensure they corresponded with Enron’s forecast. Revenue recognition was also the manipulation issue discussed with the Krispy Kreme scenario at the beginning of the chapter.
One-Time Charges are allowed when a financial event occurs one time only. Since this event is not expected to occur again, it is treated as a one-time charge. Firms that want to manipulate their financial statements can continue to categorize an event as a one time charge when, in actuality it will likely occur again in the future. It was alleged that when Tyco would buy companies, they would have the acquiring company to take “one time” charges to reduce cash flow before they were merged with Tyco. These charges were not one time in nature but Tyco incorporated these charges in place so that when they became part of Tyco, the new division would quickly report higher earnings and cash flow after the deal was completed to make management look good.
Raiding the Reserves or Cookie Jar Accounting occurs when the firm manipulates cash reserves in order to increase or decrease the reported revenue for the time period. In 2004, Fannie Mae was accused of using “cookie jar” accounting to manage their revenues. It was alleged that current expenses were deferred on the financial statements so that profitability would be higher resulting in the executives receiving bonuses due to Fannie Mae meeting its profitability targets.
Lease Accounting deals with the specific criteria in which leases are recorded on the firm’s balance sheet. Currently, leases are classified as capital or operating leases. If a lease is classified as capital, the asset value must be reported as an asset and the required payments must be classified as a liability. For operating leases, no asset or liability values need to be recorded and only the expense amount of the lease payments are reported every year. As a result, firms can effectively leave off millions of dollars in debt if they should be classified as a capital lease but are recorded as an operating lease.
Off-Balance Sheet Item; Off-Balance Sheet financing creates separate legal entities from the parent company. Former Enron CFO Andy Fastow used off-balance sheet transaction to eliminate a massive amount of debt from Enron’s balance sheet. Enron’s debt was transferred to partnership companies established by Fastow. The net result was that Enron was “able” to report much higher financial performance than was actually the case.
Earnings Management is similar in scope to the cookie jar reserves. Earnings management is the ability of the managers of the firm to manipulate the account balances in various items on the firm’s financial statements. Through this management process, managers can control what the final balances will be in these accounts and then can report these “accurate” numbers to their investors. Earnings management is usually used to ensure that the firm meets the forecasted results for the quarter or for some other time period. How common is earnings management? It appears to be much more common than people realize. A study by Myers, Myers and Skinner titled “Earnings Momentum and Earnings Management” reported that almost 600 companies in their study reported increases in earnings for 20 consecutive quarters over the past four decades, although the professors concluded that not all of the companies may have committed fraud and that there could be legitimate reasons for their amazing growth record. They also assumed that a number of firms in the study did consciously manipulate their quarterly number to ensure the steady growth pattern over time.
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