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
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
Just to explain, we look for unexpected increase in ratio of receivables to sales (DSO)
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.
Understate payables or accrued expenses such as accrued benefits, accrued warranties etc. Look for unexplained decrease in ratio of payables to corresponding expenses
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 revenues (premature recognition)|
|Deflate expenses (delayed recognition)|
We shall discuss more about manipulations in coming articles
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