Almost every day, it seems, companies are outed for fiddling their numbers to show profit being higher than it really is. How do they do it?
There’s no one answer. It can involve deliberately false accounting, breaking the rules or making an unreasonable judgement – and they can all be intertwined. The first two are difficult if internal controls are good; the last may not be.
While financial statements show actual results (e.g. for the last month or year) many numbers in them rely on judgement about the future. For example, will that debt be paid, will the inventory all be sold at a profit, how long will that asset last, are goodwill and brand names valued reasonably? And so on.
These judgements often materially affect profit so it’s important to assess whether they are reasonable or too optimistic – a judgement in itself.
If poor judgements have been made in the past, whether deliberately or poorly, profit may be unreasonably high compared with cash flow. Unless deliberately falsified, cash flow can’t be fiddled; profit can. Cash flow being consistently lower than profit may indicate unreasonable profit numbers.
However, sooner or later, unreasonable numbers are found out. Rumours may start circulating; the auditors may raise concerns; some managers may feel uncomfortable.
Deliberate falsification can result in criminal prosecution so even if you’re a manager whose bonus could benefit in the short term by fiddling the numbers, my advice is to ensure you’re happy with judgements made and that the profit stacks up with the cash flow. Ensuring good internal controls is a good idea too.