There are several legal ways to brush up the income statement and balance sheets. Companies in crisis may also resort to illegal manipulation. The following article discusses a few of the most common ways to manipulate operating profits.
1. Asset sales profits
The most common legal way to improve weak operating profits is to sell operative assets and book the profits to other operating income. This will lead to a corresponding improvement of operating profits and generally also to a significant increase of liquid cash assets.
During times of strong profitability, assets being phased out may be sold at a loss and the losses are booked to other operating expenses. Both of these operations can be easily detected from the income statement.
2. Owner salaries
From a tax perspective, it is often not economical for company owners to draw large salaries. In many countries progressive taxation causes the income tax percentage to exceed the capital income tax percentage quite quickly. Owner salaries set significantly under market values increase operating profits and the possibilities to pay out dividends. The effects on operating profits are emphasized further when performing valuation based on simple multipliers.
Sudden large increases in owner salaries also act as a signal for further investigation. Earlier shareholder loans may have been converted to salaries. It may also be an indication that cash is being taken out before the company goes bankrupt.
3. Loose interpretation of the accrual method
The income statement uses the accrual method which means that profits are booked after the product or service is sold, delivered and billed. The income statement does not take into consideration when the actual payment occurs.
The bookkeeping of crisis companies may include sales invoices where the invoice or the product has not yet been delivered. An extreme example of this was an IT company that signed ten year representation deals with several distributors. Subsequently the company booked the minimum sales commitments related to the deals for all ten years as turnover for the current year. In reality no sales had taken place yet. Since no expenses were booked either, the whole amount was shown as an increase in turnover.
The cash flow analysis is an effective tool to uncover cases where unpaid income is included in the income statement. Cumulative operating margin can be calculated based on the income statement or the cash flow analysis. These values may not be exactly the same due to the terms of payment, but they should converge over time. An increasing gap between the values indicates that there is an increasing amount of sales bookings without corresponding payments.