MANIPULATION OF ACCOUNTS THROUGH RATIO ANALYSIS

Manipulation of Accounts Through Ratio Analysis

Manipulation of Accounts Through Ratio Analysis

INTRODUCTION

Financial statement manipulation is an ongoing problem in corporate America. Although the Securities and Exchange Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between the independent auditor and the corporate client continues to provide the perfect environment for such activity. Due to these factors, investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in order to mitigate the adverse implications of these problems.Factors That Contribute to Financial Statement Manipulation

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company's financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because the Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude in the accounting provisions that are available to be used by corporate management. For better or worse, these GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. In the U.S., the Big Four accounting firms and a host of smaller regional accounting firms dominate the corporate auditing environment. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business. How Financial Statements Are Manipulated

There are two general approaches to manipulating financial statements. The first approach is to inflate current period earnings on the income statement by artificially inflating revenue and gains, or by deflating current period expenses. This approach makes the financial condition of the company look better than it actually is in order to meet established expectations.The second approach to financial statement manipulation requires the exact opposite tactic, which is to deflate current period earnings on the income statement by deflating revenue or by inflating current period expenses. The reason behind this approach may not be as obvious as in the previous example because it may seem counterintuitive to make the financial condition ...