Laws & Regulations

cook book

What is “cooking a book”?

Cook the books is a slang term for using accounting techniques to make a company’s financial performance look better than it actually is. Typically, bookkeeping involves manipulating financial data to inflate a company’s revenue and reduce its expenses in order to boost its earnings or profits.

key takeaways

  • Cook the books is a slang term for using accounting techniques to make a company’s financial performance look better than it actually is.
  • Typically, bookkeeping involves manipulating financial data to inflate a company’s revenue, cut expenses, and increase profits.
  • Companies can use credit sales to inflate their earnings, while others buy back stock to cover up their earnings-per-share (EPS) declines.

Learn about cookbooks

There are a number of strategies companies can use to manipulate their financial records to improve their financial performance. Some companies do not record all expenses incurred in a period until the next period. For example, by recording a portion of the first-quarter expense in the second quarter, the company’s first-quarter earnings or profits will look more favorable.

Many companies that sell products extend terms to customers, which allow them to pay the company at a later date. These sales are recorded as Accounts Receivable (AR) because they represent products sold and shipped but not yet paid by the customer. The period can be 30, 60, 90 days or longer. Companies can fake their AR by claiming they made a sale and recording receivables on their balance sheets. If a bogus receivable is due within 90 days, the company can create another bogus receivable after 90 days to show that current assets remain stable. Only when a company defaults on its accounts receivable does it indicate a problem. Unfortunately, banks often lend based in part on the value of a company’s receivables and can fall victim to lending false receivables. During a detailed audit, the bank auditor will match the accounts receivable invoice with the amount deposited by the customer into the company’s bank account, which will show any uncollected amounts.

In the first few years of the new millennium, several Fortune 500 companies, such as Enron and WorldCom, were caught using sophisticated accounting techniques to inflate their profitability. In other words, they cooked the book. Once these massive frauds came to light, the scandals that followed taught investors and regulators a hard lesson about how smart some companies have become in hiding the truth between their financial statements.

While the Sarbanes-Oxley Act of 2002 curbed many questionable accounting practices, companies prone to hype still have plenty of ways to do so.

Prohibition of cooking books

To help restore investor confidence, Congress passed the Sarbanes-Oxley Act of 2002. Among other things, it requires the company’s senior officers to certify in writing that their company’s financial statements comply with SEC disclosure requirements and fairly reflect in all material respects the financial position of the operating issuer.The U.S. Securities and Exchange Commission (SEC) helps maintain fair and orderly financial markets, including various financial reporting requirements for public companies.

Executives who knowingly sign false financial statements could face criminal penalties, including jail time. But even if Sarbanes-Oxley goes into effect, if companies are determined to do so, there are still many ways to cook books, as the examples below show.

example of cookbook

Check out these accounting creativity in action.

Credit sales and inflated earnings

Companies can use credit sales to inflate their earnings. That’s because purchases made on credit by customers can be counted as sales even if the company allows customers to defer payments for six months. In addition to providing internal financing, companies can extend the credit terms of current financing programs. Therefore, the 20% increase in sales may simply be due to the more relaxed terms of the new financing program, rather than an actual increase in customer purchases. Those sales are ultimately reported as net income or profit long before the company actually sees revenue — if it will.

channel fill

Manufacturers engaged in “channel filling” ship unordered products to distributors at the end of the quarter. These transactions are recorded as sales, even though the company fully expects the distributor to return the product. The correct procedure is for the manufacturer to reserve the products sent to the distributor as inventory until the distributor records their sales.

Incorrectly described fees

Many companies have “non-recurring charges,” or one-time charges, which are considered extraordinary events and unlikely to recur. Companies can legally classify these expenses in their financial statements. However, some companies use this practice to report their recurring expenses as “non-recurring,” which makes their bottom line and future prospects look better than they actually are.

share repurchase

Share buybacks may be the logical move for companies with excess cash, especially if their shares trade at low valuations. A repurchase is when a company uses its cash to buy some of the company’s outstanding shares. Buybacks reduce the overall share count and generally lead to higher share prices. However, some companies buy back stock for a different reason: To cover up declining earnings per share (EPS), they often borrow money to do so. By reducing the number of shares outstanding, they can increase earnings per share even as a company’s net income declines.

  • For example, if a company has 1,000,000 shares outstanding and records net income or profit of $150,000, the company’s earnings per share will be 0.15 cents ($150,000/$1,000,000).
  • However, if the company buys back 200,000 shares and records the same profit in the next quarter, earnings per share will increase to 0.19 cents ($150,000/$800,000).

As company executives forecast their earnings per share for each of the upcoming quarters, beating that forecast helps build a positive image for the company and causes the stock price to rise. Share buybacks have been a controversial topic for years as a way to boost earnings per share. Unfortunately, some companies abuse this metric by buying back stock to show that EPS has grown and beat their quarterly EPS forecasts, despite earning little additional profit.

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