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Understanding Financial Statements
In 2001–2002, Goldman Sachs aided the government of Greece after its admission to the Eurozone to better its deficit numbers by conducting large currency swaps. These transactions, totaling more than 2.3 billion Euros, were technically loans but concealed as currency swaps in order to circumvent Maastricht Treaty rules on member nations deficit limits and allowed Greece to “hide” an effective 1 billion euro loan. After Goldman Sachs had engineered the financial instrument and sold it to the Greeks—simply shifting the liabilities in the future and defrauding investors and the European Union, the investment bank’s president Gary Cohn pitched Athens another deal. After Greece refused the second deal, the firm sold its Greek swaps to the Greek national bank and made sure its Short and Long positions towards Greece were in balance—so that a potential Greek default would not affect Goldman Sachs. The term as generally understood refers to systematic misrepresentation of the true income and assets of corporations or other organizations.
By the mid-1800s the term cooking the books had come into use to mean manipulating financial records in order to deceive. The name Sarbanes-Oxley comes from the two major sponsors of the act who were Sen. Paul Sarbanes and Representative Michael Oxley. The act also known as SOX deals with the reform of auditing and accounting controls and procedures, the oversight duties of corporate officers and directors that deals with the regulation of conflicts of interests and the disclosure of special compensation such as bonuses. The act also deals with conflicts of interest by stock analysts and it deals with regulations on filing more complete disclosures of financial information for things that might directly and indirectly affect the financial results of a company.
However there are exceptions and sometimes fraud and deceptive practices are committed. Examples of the types of fraud misused assets, illegal payments made by a business, the concealment of financial losses, under reporting of expenses, over recording revenue, etc. This article is designed to show you methods cooking the books, not to facilitate you in preparing fraudulent financial reports but rather to help you be able to spot signs of fraud in a business and its financial reports.
The term arises from an alternate meaning of the verb to cook which is no longer in much use in the English language. It could be roughly translated as to deceive or to mislead, or to serve false information. The term creative accounting may be used as a synonym for cooking the books.
While companies may use non-GAAP reporting metrics where GAAP figures do not fully portray their financial condition, they must report non-GAAP metrics accurately. A company might manipulate non-GAAP measures to reflect stronger growth or higher earnings. Since 2013, there has been a dramatic increase in publicly traded companies reporting non-GAAP numbers in their financial statements. In addition to improperly capitalizing expenses, a company may use other expense recognition schemes to inappropriately overstate net income.
Within most parts of the European Union and the United States, this practice is perfectly legal and often executed in plain sight or with explicit approval of tax regulators. We examine the penalties imposed on the 585 firms targeted by SEC enforcement actions for financial misrepresentation from 1978—2002, which we track through November 15, 2005. The penalties imposed on firms through the legal system average only $23.5 million per firm. Our point estimate of the reputational penalty—which we define as the expected loss in the present value of future cash flows due to lower sales and higher contracting and financing costs—is over 7.5 times the sum of all penalties imposed through the legal and regulatory system.
For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation. In firms that survive the enforcement process, lost reputation is even greater at $3.83. In the cross section, the reputation loss is positively related to measures of the firm’s reliance on implicit contracts. This evidence belies a widespread belief that financial misrepresentation is disciplined lightly.
Manufacturers engaged in “channel stuffing” ship unordered products to their distributors at the end of the quarter. These transactions are recorded as sales, even though the company fully expects the distributors to send the products back. The proper procedure is for manufacturers to book products sent to distributors as inventory until the distributors record their sales. Even though the Sarbanes-Oxley Act of 2002 reined in many dubious accounting practices, companies that are inclined to cook their books still have plenty of ways to do so. Julius’ business experience is dynamic and includes leading the finance and operations management teams of companies in multiple industries which include real estate, logistics, financial services, and non profit organizations.
To the contrary, reputation losses impose substantial penalties for cooking the books. Other methods of cooking the books involve the simple but illegal act of changing profits/losses statements by bold-faced lying about true figures, claiming they are better or worse than they are. The term white-collar crime is a term used to refer to crimes that are nonviolent in nature and usually financially motivated and therefore committed many times by business professionals and government actors. The damages for violating this can be very costly as this provision has a $500,000 fine and also levies a penalty of up to five years in prison. Furthermore some of the other provisions in this title make it a crime to interfere with any official proceedings of the Securities and Exchange Commission or to tamper with any records that are used as part of an investigation.
This section requires that publicly traded companies specifically discuss transactions that were previously not addressed. What this means is that companies are now required to discuss things such as off-balance-sheet financing and any other relationships or transactions that could have a material influence in the financial position of the company. Also in order to aid transparency any officers, directors, stockholders of a company that owned 10% or more of the company are now required to make transactions like bonuses and stock grants public information. As previously stated the Sarbanes-Oxley act of 2002 was created in response to the financial fraud epidemic that was prevalent throughout the late 20th century and into the 21st century.