Accounting practices in the United States have improved over the years, due in large part to major reforms enacted after the 1990s Enron and WorldCom scandals, and again following the 2007-2008 financial crisis. Even so, there are still plenty of ways that companies can manipulate their financial results (Kuepper, 2010). This paper reviews two articles on the subject.
Balanced Scorecard
The Balanced Scorecard, or BSC, is a managerial tool first put forth by Kaplan and Norton in their landmark 1992 article (Kaplan and Norton, 1992). The BSC was well-received and has been widely followed, adopted by thousands of public and private enterprises around the globe. It has been the subject of a great amount of literature over the years. The BSC was originally compared to “the dials and indicators in an airplane cockpit” (which is not so different from today’s popular dashboard concept). Just as pilots need detailed information about fuel, air speed, altitude, and other indicators, managing a complex organization in today’s world requires that managers be able to view performance in several areas simultaneously for a snapshot of the current and predicted environment (Kaplan and Norton, 1992, p.72). The BSC emphasizes four important perspectives: customer, internal, innovation and learning, and financial perspectives. At the same time, BSC avoids information overload by excluding all but the most important data, forcing managers to focus on the most critical areas (Kaplan and Norton, 1992, p.72-73).
The BSC concept has grown and evolved over time, and is now also seen as encompassing the communication and implementation of business strategy. In other words, BSC today is much more than just a performance measurement tool; it can now be used as an interactive management system for a company’s strategy execution (Kaplan, 2010, p.2). The “new” BSC takes a company’s strategic plan and changes it from a passive document into active "marching orders.” It not only provides a framework for performance measurements, but also enables executives to truly execute their strategies (Balanced Scorecard, 2016).
Preventing Manipulation of Financial Statements
For all its attributes, whether BSC is an effective tool for preventing manipulation of financial statements is another question. The BSC is used almost exclusively for internal purposes (excluding here governmental entities, of course), and is largely based on proprietary information (Balanced Scorecard, 2016). A BSC would not be included in financial statements filed with regulators or otherwise distributed to third parties. The BSC could be certainly be used internally to detect distortions in financial reports. Numbers manipulated to improve reported performance in one area would often cause an opposite and negative result in another area of the BSC. It is not clear, though, how any outsiders (regulators, analysts, investors, etc.) could effectively use BSC to review a company’s financial statements.
Fuzzy Numbers
“Fuzzy Numbers” discusses several “legal” accounting practices whose common thread is their easy adaptability for overstating a company’s financial performance (and the article was written before the financial crisis of 2007-2008, which was triggered in large part by variations of the very kind of manipulations warned of) (Henry, 2004). Any given company might be tempted to manipulate its financial statements for any number of specific reasons, of course, or just to generally create the appearance of a stronger financial condition. Needless to say, financially stronger companies can among other things obtain credit on better terms, including bond or debt financing (Kuepper, 2010). Henry gives several examples of these questionable accounting practices, with some of the most troublesome being related to the manipulation of cash flow.
Manipulating Cash Flow
“Fuzzy Numbers” points out some of the various ways in which operating cash flow can be “improved” on a cash flow statement. Because cash flow is seen by many analysts and investors as one of the best indicators of financial health, those numbers are now “a prime target for massaging (Henry, 2004). Some companies, for example, like Boeing, Ford, and Harley-Davidson would count sales proceeds (from their airplanes, cars, and motorcycles) as cash from operations - even where the buyers were financed by those companies' wholly owned finance subsidiaries. This “increases” cash from operations on the cash flow statement, though it really just amounts to turning trade receivables into cash, with the stroke of a pen. Boeing itself would have to report hundreds of millions of dollars in negative cash flow, but for this very questionable accounting technique. According to Henry, however, all three companies would insist that their reporting was in full compliance with GAAP (Henry, 2004).
Selling receivables at a discount is another such practice. The cash is booked immediately, giving a temporary lift, but the company has obviously experienced a true loss rather than a gain. And yet one of the simplest ways for a company to improve its cash flow is to sell receivables (usually from their most creditworthy customers) at a discount, and then represent the move as good management and a boost to liquidity (Henry, 2004).
Another practice companies can use is applying excess cash to buy securities (when business is good) and then re-selling them at a later date (when business is slower). In 2003, Comcast reported over $85 million in additional operating cash flow from the sale of securities. Though this move was apparently legal, it distorted cash flow from operations very significantly. The gains clearly had nothing to do with the success of Comcast’s normal business operations (and the company admitted that in earlier years such resale proceeds would have been booked as cash from investments). Comcast later dropped this practice entirely to comply with a 2002 FASB standard (Henry, 2004).
Freeing up working capital by cutting inventories, or pressuring customers for payment, or delaying payment to suppliers is another questionable practice. This short-term fix may also look good on a financial statement, but it tends to harm growth, and often leads to adjustments in later periods, obviously depressing cash flow on some later date. Relationships with customers and suppliers can also be strained, further jeopardizing long-term growth. While senior executives may claim that these moves make the company more profitable, the opposite may actually be true (Henry, 2004).
Needless to say, putting too much emphasis on short-term cash flows can have negative consequences. Companies may become less inclined to make worthwhile investments that could add to growth and promote long-term returns on capital. Valuable projects can be by-passed, and in the open market, stocks may deceptively tend to move up when better cash flow is reported, “a measure that looks better when companies scrimp on capital investments”. Companies’ desire to show better cash flow may be one reason overall corporate investment is declining (Henry, 2004).
The Fixes
Since Fuzzy Numbers was written, the Sarbanes-Oxley Act has come into full implementation, and there have been numerous other legal and regulatory changes, including the Dodd-Frank Act, and updated FASB standards (Accounting Standards, 2016). Many of these reforms came after the financial crisis of 2007-2008. For example, in 2014 the FASB (Financial Accounting Standards Board) released new financial accounting standards for recognizing revenue entitled “Revenue from Contracts with Customers,” to provide a new and consistent global approach to revenue recognition on financial statements (Barnes, 2015).
In Fuzzy Numbers, though, Henry presciently proposed several fixes to the problems he wrote about in 2004. His principal recommendations were (as to Cash Flow statements) requiring operational cash to be reported separately from investment cash, requiring cash flow and income to be reported for the same periods, and requiring cumulative results for the previous four quarters to also be shown. Henry believed that analysts and investors needed the ability to make reliable comparisons, saying:
An obvious and simple step would be for companies to present their statements of cash flows for the same periods as their earnings statements. Even better would be to show the cumulative earnings and cash flows for the previous four quarters as well. Now most companies simply compare the latest quarter's earnings with those for the same quarter a year before, but present a year-to-date statement of cash flows without a comparison.
Auditors
Even with years of experience and many new reforms, there is yet another layer to the problem. According to one study, the outside professional auditors hired by companies to conduct final review of financial statements are often themselves unreliable. Some audit firms seem to be “spinning opinions out of thin air” (Bloxham, 2015). One of four audits is so affected, according to a 2015 report by the Public Company Accounting Oversight Board (PCAOB). According to the report, an audit firm’s sign-off is not reliable more than 25% of the time “because the auditors never performed the work necessary” to justify their signature (Bloxham, 2015). And in general audit quality seems to be getting worse in any case. 43 percent of all audits inspected by the PCAOB in 2013 had deficiencies, compared to 16 percent in 2009 (Bloxham, 2015).
Conclusion
This paper focuses on manipulation of cash flow, but as Henry noted, and as many have pointed put since then, there are other dangers. Henry also examined earnings manipulation (through overestimating revenues, underestimating bad debt, manipulating inventory and forecasting unusual gains and losses) (Henry, 2004). Others have warned against companies’ “storing” earnings for future periods, overvaluing assets, manipulating transactions with subsidiaries and affiliates, undervaluing pension and other liabilities and failing to record contingent liabilities (Kuepper, 2010).
New laws and regulations since 2004 have gone a long way towards addressing the concerns raised in “Fuzzy Numbers.” With better and more consistent data in financial statements, investors and analysts will be able to reward (or punish) companies based on the quality of their accounting. Stocks might be “discounted” in the market if the underlying financial data was not deemed reliable, and vice versa. Auditors (the good ones, at least) would be on an increased state of alert, knowing that investors and analysts are looking over their shoulders more closely than ever. Some companies will always have an incentive and many opportunities to hype their results, but investors need a clear picture of a corporation's finances.
References
Accounting Standards Updates (2016). Financial Accounting Standards Board. Retrieved from http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1218220137102
Balanced Scorecard Basics. Balanced Scorecard Institute (2016). Retrieved from http://balancedscorecard.org/Resources/About-the-Balanced-Scorecard
Barnes, V. (2015, Jun. 8). IRS Requests Comments On Effect Of New Financial Accounting Revenue Recognition Standards On Taxpayers’ Methods Of Accounting. Bloomberg BNA. Retrieved from http://www.bna.com/irs-requests-comments-b17179927468/
Bloxham, E. (2015, Oct. 19). Here’s why you can’t trust a company’s financials. Fortune. Retrieved from http://fortune.com/2015/10/19/auditors-financial-reports/
Henry, D. (2004, Oct. 4). Fuzzy Numbers. Bloomberg Business. Retrieved from http://www.bloomberg.com/bw/stories/2004-10-03/fuzzy-numbers
Kaplan, R. (2010). Conceptual Foundations of the Balanced Scorecard. Harvard Business Review. Working Paper 10-074.
Kaplan, R. and Norton, D. (1992, Feb.) The Balanced Scorecard - Measures That Drive Performance. Harvard Business Review 70(1), pp.71–79.
Kuepper, J. (2010, Mar. 25). Spotting Creative Accounting On The Balance Sheet. Forbes. Retrieved from http://www.forbes.com/2010/03/25/balance-sheet-tricks-personal-finance-accounting.html
