Do numbers lie?

Corporate management has significant latitude in choosing what numbers to report and when. But business pressures can cloud their judgment. This article examines how using accounting gimmicks and manipulating financial statements might satisfy investors but can cross into fraudulent territory.

John Smith, CEO of ABC Doughnuts, had a problem: Revenue was down for the first time in company history. And he attributed this to two main reasons.

First, he'd launched an aggressive growth strategy to expand ABC Doughnuts from its traditional storefronts into grocery aisles and gas stations nationwide. Unfortunately, these moves came at a horrible time. The country had just entered a low-calorie diet fad, and doughnut sales were declining.

Smith also had a personal stake in hitting his earnings numbers — the board of directors had offered him a lucrative bonus tied to the price of the firm's stock value. An off quarter would no doubt reduce the stock price and consequently his bonus. Smith was counting on this bonus to pay for his daughter's wedding and, perhaps, a nice Caribbean vacation for the family.

There were only a few more weeks left in the quarter and Smith needed to motivate his troops, so he called a meeting of the C-suite and the department heads. He listened to the head of marketing drone on about promotion ideas and the head of sales talk about re-doubling their efforts and selling the "sizzle and not the steak."

The CFO, on the other hand, offered unique suggestions. He proposed they massage their accounting to reduce expenses and increase net profits. And in five easy ways, he said, the company could increase its net profits to meet Wall Street's projections without having to sell more product:

1. Extend the expected lives of some depreciable assets it had just purchased.
2. Decrease the estimate of how many customers wouldn't pay their bills.
3. Change its inventory value method from last-in, first-out (LIFO) to first-in, first-out (FIFO) (because of the declining flour cost).
4. Increase the cost of equipment sold to franchises and then refund this additional charge in the form of credits for future purchases.
5. Hold cash longer by stretching out payments to suppliers from 26 days to 38 days.

Smith was sold. ABC Doughnuts could appear to be more profitable than it actually was just by re-working its accounting. He asked the CFO if all these changes to the books were legal. The CFO looked down at the table and said "sure."

Unfortunately, the chief compliance officer wasn't in this meeting so he couldn't tell the CEO 1) which one of the five suggestions wasn't legal, and 2) that although the other four were legal, he had strong reasons not to use these accounting tricks. (The illegal suggestion was the fourth because it directly circumvents the very purpose of accounting. The SEC doesn't allow artificially inflating sales because it can mislead investors about how profitable a company actually has been during that accounting period.)