Five Ways Firms Distort Earnings

Posted By: Advisor Analyzer Team

Rules are made for a reason. They ensure everyone is on a level playing field. It is a way to keep some from obtaining an unfair advantage over others. Of course while noble in theory, one thing’s for certain: rules are often broken, and the playing field is lumpier than my aunt’s homemade mashed potatoes.

 

With such inequalities comes a market filled with skeptical investors. We’ve all heard lawsuits against companies for false reporting or clients suing their broker for misrepresentation of investments. The driving reason behind such deceptive behavior is to record higher earnings and enjoy greater stock price appreciation. While most investors are aware of the existence, few are able to name some common tactics used by companies to gain investor confidence. Below are five commonly utilized methods to distort earnings.

Premature Revenue Recognition

Firms are not allowed to recognize cash flows as revenues until there is assurance of payment, and all obligations have been fulfilled. So cash may be received, but the firm cannot record those payments as sales, until they have satisfied their end of the deal. Any payments received prior to delivery of goods or services are recorded on the balance sheet as a cash and prepaid goods. The prepaid goods are a liability of the company and are converted to revenues once they have rendered the agreed services.

 

When there is premature recognition or recognition of questionable revenues, the firm is claiming receipt of sales for services that have not yet occurred. Suppose a car manufacturer obtained a contractual agreement to provide vehicles to a local government agency. However, due to a major employee strike, the company is unable to deliver the vehicles as promised. Subsequently, the government agency decides to use a competing manufacturer for their automotive needs. Obviously, the sale never really took place and should not be included in the company’s income statement. However, there are firms that prematurely recognize sales that may or may not be fulfilled in the future.

One Time Transactions to Generate Gains

Investors of a car manufacturer are not interested in the company’s ability to invest in real estate or stocks. Why? It has little to do with their continuing business operations. If investors wanted to find an investment firm that generated returns based on their investment analysis or real estate valuation abilities, they would invest with such companies. They invest in an automobile manufacturer for the company’s ability to manufacture and distribute cars.

 

Suppose the car manufacturer sold a production plant at a substantial gain, due to real estate appreciation. Obviously, the sale of appreciated real estate has little to do with their continuing operations. Rather, it is a special one-time transaction that does not directly reflect the firm’s ability to sell cars. Firms may manipulate the proceeds and gains from the sale of a plant to give the impression such cash inflows may recur as future revenues.

Shifting Expenses to Different Periods

Expenses are often recognized at the same time as revenues. When a sale is made, the costs associated with manufacturing and delivering the product is also recognized. However, some firms may recognize revenues when the sale was made, but delay recognizing the costs associated with the revenues to a later date. The motive behind the strategy is fairly obvious, to give the impression of higher profits in the current period.

 

However, instead of delayed expense recognition, some firms may shift the associated costs to earlier periods. Although there seems little to be gained from recognizing expenses earlier on, there is always a silver lining to any cloudy day. Suppose a firm has a very bad year ahead, but the subsequent periods have potentially profitable income streams. The firm may engage in what’s known as “Big Bath” behavior, by getting all the bad news and costs out of the way so they can experience better margins in the future.

Deferring current revenues to Future Periods

Similar to shifting expenses, firms may practice delayed revenue recognition if they’ve experienced a phenomenal current quarter. Basically, the goal is to save some of the good earnings for a rainy day in the future.

 

A driving force behind recognizing revenues in later periods is the desire to portray consistent cash flows. Analysts and investors often prefer a predictable stream of revenues. It often provides for more stable stock price movements and less volatility. Firms that have inconsistent earnings and sales may be considered less attractive or even risky. By delaying revenues, firms have created a buffer for future periods of poor performance.

Recording Fictitious Revenues

While some firms tell little white lies, others may engage in a blizzard of misrepresentation. They may record revenues that never occurred from the get go. A firm may take out a loan to engage in a prospective business investment, a fairly normal occurrence. However, suppose the firm did not recognize the loan as such, but instead as revenues from the sale of goods and services. Obviously this is blatant misrepresentation of the source of funds. The cash flows should not be categorized as income and an adjustment to liabilities is required to portray the fact that the funds are an obligation of the company.

Conclusion

While there are many more deceptive practices that may be potentially used by companies, here are some of the more common tactics. While there are no guarantees investors will be able to recognize when such events take place, it is always better to be aware of the different ways firms may misrepresent their gross margins. Put bluntly, investors should always take earnings releases with a grain of salt, and rarely accept figures at face value.