Accounting Shenanigans

Posted by PITHOCRATES - August 13th, 2012

Economics 101

Two Important Accounting Principles are the Realization Principle and the Matching Principle

Accounting isn’t exciting.  It’s dull.  And tedious.  Anyone who struggled to get a trial balance to balance knows this well.  But accounting is a necessary tedious.  Someone has to put those numbers into the proper accounts.  Correctly.  Down to the penny.  Because only then can you prepare financial statements that are useful to business owners.  As well as investors.

When we post these numbers correctly we can produce the income statement.  Or as some call it the profit and loss statement.  Or P&L.   Which tells you whether you made a profit or a loss for an accounting period.  And some of the most important accounts on the income statement are income accounts (or revenue accounts).  The money they get when they sell their goods or services.  And expense accounts.  But not all expense accounts.  They’re all important but some are particularly important.  The expenses used to specifically generate that revenue (the cost of sales).  Production labor.  Production material.  The labor and material that make the things a business sells.  These expenses are variable.  They go up and down with sales.  As opposed to fixed overhead.  Which remains the same regardless of sales.

We have to define the accounting period carefully.  It can be annually.  Quarterly.  Even monthly.  The smaller the period the more useful information for business owners.  Investors study a company’s quarterly statements.  As well as annual statements.  The shorter the accounting period, though, the more careful the posting to the accounts is.  Because of two accounting principles.  The Realization Principle.  And the Matching Principle.   Which places revenue into the accounting period it occurs.  And then matches the expenses to the revenue it created into the same accounting period.  So when you subtract expenses from revenue in that accounting period you get the gross profit for that accounting period.  Given a measure of how business was during that accounting period.  If business was good there is revenue remaining after subtracting all variable expenses and all fixed expenses.  If sales are down there may be a gross profit.  But there may not be enough left over to pay the fixed overhead costs.  Resulting in a business loss.  For that accounting period.

The Smaller the Accounting Period the Greater the Math required to apportion Revenues and Expenses

When businesses ‘cook’ their books they are making business results look differently from what they actually are.  Perhaps the most common way to ‘cook’ the books is to violate the Realization Principle and Matching Principle.  Such as moving revenue or expenses to other accounting periods instead of where they belong.  If a business needs better business results for investors they may realize revenue early.  Or push expenses out to a subsequent accounting period.  Thereby increasing profitability for the one period better than it actually is.  As revenue will be greater and expenses will be smaller.

As an example consider a now common summer business model.  Selling ice-cold water at traffic intersections.  You need some cases of bottled water.  Ice.  And a cooler.  If you buy all the water in July but sell some of it in August you have to split the expense of the water between these two months.  If you don’t your expenses will exceed your revenue in July because it includes water purchased for both July and August.  You would subtract two months of water expense from one month of water sales.  Making July business show an operating loss.  While August would subtract no water expense from August sales making August more profitable than it actually was.  However, if you combine the two months together there will be no misrepresentation of the accounting data.  As you would subtract two months of water expenses from two months of water revenue.

This is why larger accounting periods are easier to post.  As they get smaller you have to do a lot of math to apportion these revenues and expenses into the proper accounting periods.  And sometimes mistakes happen.  Honest mistakes.  A business could have felt they had a good month but their income statement shows a loss.  Or the month could be far better than you feel it should be.  If you look hard enough you can often find a timing error.  Revenues or expenses appearing in the wrong period.  Such as recording a down payment as revenue.  It’s not.  A down payment is a liability.  Because it is a prepayment for you something owe someone at a later date.  And it’s at that later date when you can realize that down payment as revenue.

As you Pull Revenue Up and Push Expenses Out each Subsequent Accounting Period Starts with a Larger Operating Loss

But some businesses cook their books.  And once they start it becomes more difficult with every accounting period.  Which is why most companies that do cook their books fail.  And they fail big.  Here’s why.  If you realize revenue early in this period instead of next period (where it belongs) the following accounting period will underreport revenue.  Worse, the expenses to produce that revenue are still in that period.  When you subtract the properly reported expenses from the underreported revenue it will result in an operating loss.  Unless they cook the books in the following period, too.  By pulling revenue into that period from another period.  Or pushing out expenses to a later period.

The problem is when you keep doing this it makes the following accounting period more difficult to ‘fix’.  For as you pull revenue up and push expenses out each subsequent accounting period starts with a larger operating loss.  And if a business is having problems (which they typically do when they start cooking their books) actual revenue for that period will be depressed as well.  So as they go through subsequent accounting periods beginning operating deficits grow larger in the face of falling revenues.  To keep the scam going they have to take it up a notch.  Taking things ‘off balance sheet’ (basically ignoring some bad financial information).  Creating a shell company to dump bad financial data on.  And other accounting shenanigans.  The bigger the scam, though, the harder the fall.  And there is always a fall.  Think Enron.  And WorldCom.

But it’s just not businesses that cook their books.  Government does, too.  Especially when they want to pass unpopular and costly programs.  They will send the financial data for a program to the Congressional Budget Office to score.  To determine the cost over a 10 year period.  But to make the program less expensive and more palatable to the taxpayers they will cook that data.  Their bill may include new taxes over the ten year period.  But benefits may kick in a few years after the new taxes start.  So you may have 10 years of taxes paying for only 8 years of benefits.  But everyone thinks it’s 10 years of benefits.  Making the program appear less costly than it actually is.  Of course when they get caught in their accounting shenanigans nothing happens.  They just say, “Oops.  We goofed.  Shucks.  Looks like we’ll have to raise taxes.”  Not quite the same thing that happens in the private sector.  Just ask those who were running Enron.  And WorldCom.

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