I've always had a sweet tooth, so in this Cookbook, let's bake some cookies! Actually, I'll use two recent cases and one classic older recipe to illustrate the fraudulent financial reporting scheme known as "cookie jar" reserves. This fraud involves unnecessarily setting up liabilities by either accruing excess expenses or deferring revenue that should be recognized.
And once we've baked the cookies, let's eat them! An important characteristic of cookie-jar reserves is their impact on multiple years of financial statements. When a company establishes cookie-jar reserves, it falsely underreports net income for a period. In later years, when management dips into the reserves, it falsely inflates net income (or reduces a net loss).
Companies sometimes employ cookie-jar reserves during periods of strong financial performance as cushions for the inevitable future periods when performance will decline.
The legitimacy of reserves like these is covered under the accounting rules for contingent liabilities: the U.S. Generally Accepted Accounting Principles at ASC (the Financial Auditing Standards Board's Accounting Standards Codification) 450 and the International Financial Reporting Standards at IAS 37. Generally, a liability should be recorded in the financial statements only if all three of the following conditions are present:
- The underlying causal event occurred prior to the balance sheet date.
- It's probable that a loss has been incurred (i.e. more likely than not, an outflow of resources will be required).
- A reasonable basis for estimating the loss reliably exists.
The absence of any one of the three precludes recognition of a liability. And fraudsters can manipulate any of the three. However, the second criterion is the most subjective, which makes it the most likely candidate for fraud. Companies shouldn't record obligations that are merely possible or potential — not probable.
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