What Is 'Cook the Books'?
Cook the books is a slang term for using accounting tricks to make a company's financial results look better than they really are. Typically, cooking the books involves manipulating financial data to inflate a company's revenue and deflate its expenses in order to pump up its earnings or profit.
Key Takeaways
- Cook the books is a slang term for using accounting tricks to make a company's financial results look better than they really are.
- Typically, cooking the books involves manipulating financial data to inflate a company's revenue, deflate expenses, and pump up profit.
- Companies can use credit sales to exaggerate their revenue while others buy back stock to disguise a decline in their earnings per share (EPS).
Understanding Cook the Books
Companies can manipulate their financial records to improve their financial results using a multitude of tactics. Some companies don't record all of their expenses that incurred in a period until the next period. By recording a portion of Q1's expenses in Q2, for example, a company's Q1 earnings or profit will look more favorable.
Many companies who sell their product, extend terms to their customers, which allows them to pay the company at a later date. These sales are recorded as accounts receivables (AR) since they represent product that's been sold and shipped, but the customers have yet to pay. The terms can be 30, 60, 90 days, or more. Companies can falsify their AR by claiming that they made a sale and record the accounts receivable on the balance sheet. If the fake receivable is due in 90 days, the company can create another fake receivable 90 days from now to show that current assets remain stable. Only when a company falls behind collecting its receivables will it show that there's a problem. Unfortunately, banks often lend, in part, based on the value of a company's accounts receivables and can fall victim to lending off false receivables. During a detailed audit, the bank auditors would match the AR invoices to customer payments into the company's bank accounts, which would show any amounts not being collected.
During the first years of the new millennium, several large Fortune 500 companies, such as Enron and WorldCom, were found to have used sophisticated accounting tricks to overstate their profitability. In other words, they cooked the books. Once these massive frauds came to light, the ensuing scandals gave investors and regulators a stark lesson in how clever some companies had become at hiding the truth between the lines of their financial statements.
Even though the Sarbanes-Oxley Act of 2002 reined in many dubious accounting practices, companies that are inclined to cook their books still have plenty of ways to do so.
Regulations Against Cooking the Books
To help restore investor confidence, Congress passed the Sarbanes-Oxley Act of 2002. Among other things, it required that the senior officers of corporations certify in writing that their company's financial statements comply with SEC disclosure requirements and fairly present in all material aspects the operations and financial condition of the issuer. The U.S. Securities and Exchange Commission (SEC) helps to maintain a fair and orderly financial market, which includes various financial reporting requirements for publicly-traded companies.
Executives who knowingly sign off on false financial statements may face criminal penalties, including prison sentences. But even with Sarbanes-Oxley in effect, there are still numerous ways that companies can cook the books if they're determined to do so, as the following examples illustrate.
Examples of Cooking the Books
Check out these manifestations of accounting creativity.
Credit Sales and Inflated Revenue
Companies can use credit sales to exaggerate their revenue. That's because the purchases customers make on credit can be booked as sales even if the company allows the customer to postpone payments for six months. In addition to offering in-house financing, companies can extend credit terms on current financing programs. So, a 20% jump in sales could simply be due to a new financing program with easier terms rather than a real increase in customer purchases. These sales end up being reported as net income or profit, long before the company has actually seen that income—if it ever will.
Channel Stuffing
Manufacturers engaged in "channel stuffing" ship unordered products to their distributors at the end of the quarter. These transactions are recorded as sales, even though the company fully expects the distributors to send the products back. The proper procedure is for manufacturers to book products sent to distributors as inventory until the distributors record their sales.
Mischaracterized Expenses
Many companies have "nonrecurring expenses," one-time costs that are considered extraordinary events and unlikely to happen again. Companies can legitimately classify those expenses as such on their financial statements. However, some companies take advantage of this practice to report expenses that they routinely incur as "nonrecurring," which makes their bottom line and future prospects look better than they are in reality.
Stock Buybacks
Stock buybacks can be a logical move for companies with excess cash, especially if their stock is trading at a low valuation. A buyback is when a company uses its cash to purchase a portion of the company's outstanding equity shares. Buybacks reduce the overall share count and typically lead to a higher stock price. However, some companies buy back stock for a different reason: to disguise a decline in earnings per share (EPS), and they often borrow money to do so. By decreasing the number of shares outstanding, they can increase earnings per share even if the company's net income has declined.
- For example, if a company had 1,000,000 outstanding equity shares and recorded net income or profit of $150,000, the company's EPS would be .15 cents per share ($150,000 / 1,000,000).
- However, if the company bought back 200,000 shares and recorded the same profit in the next quarter, the EPS would increase to .19 cents per share ($150,000 / 800,000).
Since company executives forecast their earnings per share for each upcoming quarter, beating that forecast can help create a positive image for the company and lead to a jump in the stock price. Share buybacks as a method to boost EPS have been a controversial topic for many years. Unfortunately, some companies abuse the metric by repurchasing shares to show that EPS has grown and exceeded their quarterly EPS forecast despite earning little-to-no additional profit.
