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Financial Statements Manipulation: Part-1

Most of us are aware of “financial statements”. It presents state of affairs of a company. Broadly, they can be classified to-Income Statement, Balance Sheet, Cash flow statement.

We shall try to understand it as we discuss further. Please note, the legality/ethical part of manipulating statements is something which is subjective and debatable. In first part of article, we will talk about


Definition of 'Income Statement'

A financial statement that measures a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year. Also known as the "profit and loss statement" or "statement of revenue and expense

Source: - Investopedia

Why income statements are manipulated?

For any company, most important parameter is “Bottom line” or “Profit”. Is the company earning enough to sustains its operations/ pay dividends to shareholders/ enough reserves to fund capital needs Company’s management may tend to overstate Net Income/profit to

  • Satisfy Investors
  • Maintain Brand/reputation risk
  • Maintain certain legal covenants

Sometimes, management tends to understate Net Income/profit to negotiate wage increase with staff/unions and obtain temporary relief from Creditors

Revenues-Expenses= Net Income/Profit

Above equation is simplest way to express profit. Clearly, we can increase profit either by increasing/overstating revenues or understating expenses

  1. Recognize Income earlier
    1. This can be done by recognizing revenues before work is done on a contract, booking revenues to fictitious customers. This generally leads to :-
      • Increase receivables/accrued revenues/prepayments/assets
      • Understate deferred revenues/liabilities/payables

Just to explain, we look for unexpected increase in ratio of receivables to sales (DSO)

Receivables Actuals Manipulation  Result
 Revenues 100 10 110
Receivables 20 10 30
Receivables/Revenues 20.0%   27.3%

Inflate prepayments or deferred expenses such as inventory, prepayments and PP&E (property plant & equipment). To detect inflated inventory, look for unexplained increase in ratio of inventories to COGS. To check for inflated prepayments, look for an unexplained increase in the ratio of prepayments to corresponding expenses.

Prepayments Reality Manipulation  Result
Expenses 100 10 110
Prepayments 20 10 30
Payables/Expenses 20.0%   27.3%

Understate payables or accrued expenses such as accrued benefits, accrued warranties etc. Look for unexplained decrease in ratio of payables to corresponding expenses

Payables Reality Manipulation  Result
Expenses 100 10 110
Payables 20 (10) 10
Payables/Expenses 20.0%   9.1%

Overall effects: Recognizing income earlier has following effects, helpful to detect manipulation:-

   Overstate Assets             Deflate liabilities         
Cash   Deflate advances or deferred revenues
Inflate receivables or accrued revenues   Deflate payables or accrued expenses
Inflate prepayments or deferred expenses  
    Inflate equity
    Inflate revenues (premature recognition)
    Deflate expenses (delayed recognition)

We shall discuss more about manipulations in coming articles


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