By Jeremy Horn, CFA

“You only find out who is swimming naked when the tide goes out.” -Warren Buffett

Not everyone in this world is honest and, unfortunately, the world of financial reporting is no exception.

The income statement of a public company does not reflect cash transactions, i.e. reported revenue doesn’t equal cash received and reported expenses aren’t the same as cash spent. There are a number of ways financials can be massaged.

Here are 3 examples:

1. Accelerating the recognition of future revenue

Essentially a company could record revenue for services that haven’t been completed or for the sale of goods that haven’t shipped. A classic case study is Enron.

2. Capitalizing operating expenses

When a company purchases equipment, or some other long-lived asset, the full cost isn’t recorded as an expense on the books all at once. It’s reported as an asset on the balance sheet and expensed through depreciation over time. A possible manipulation would be to record some ordinary expenses as capitalized assets; effectively deferring those expenses to future periods.

3. Bad debt expense

Any company that extends credit, whether it’s a bank or a manufacturer with receivables, expects to experience defaults. For this reason, a reserve is established on the balance sheet to account for future credit losses. When the reserve is increased a corresponding bad debt expense is recorded on the income statement. If a company unjustifiably lowers the reserve for bad debts, it also unjustifiably reduces bad debt expense for the period.

Accounting manipulations aren’t limited to extreme examples like Enron.

They can occur on a much smaller scale to hit quarterly earnings targets or other misguided reasons. But even on a small scale they can harm investors. So it’s important to be diligent about finding discrepancies.

To aid in the discover of such malfeasance:

1. Gain a solid understanding of accounting principles.

2. Have a diligent eye for unusual numbers. Look at financials over several periods. If something in one quarter doesn’t jive with trends in other periods, a deeper examination is warranted.

3. Become best friends with the statement of cash flows. Cash flow is much harder to manipulate, absent outright fraud, because cash has to be reconciled. Any meaningful manipulations of cash are likely to be discovered by the company’s outside audit firm.