Cook the Books

Cook the books is a slang term for using accounting tricks to make a company's financial results look better than they really are. Typically, cooking the books involves manipulating financial data to inflate the company's earnings and deflate its expenses in order to pump up its bottom line.

During the first years of the new millennium, several large Fortune 500 companies, such as Enron and WorldCom, were found to have used sophisticated accounting tricks to overstate their profitability. In other words, they had cooked the books. Once these massive frauds came to light, the ensuing scandals gave investors and regulators a stark lesson in how clever some companies had become at hiding the truth between the lines of their financial statements.

To help restore investor confidence, Congress passed the Sarbanes-Oxley Act of 2002. Among other things, it required that the senior officers of corporations certify in writing that their company's financial statements "comply with SEC disclosure requirements and fairly present in all material aspects the operations and financial condition of the issuer." Executives who knowingly signed off on false financial statements faced criminal penalties, including prison sentences. But even with Sarbanes-Oxley in effect, there are still numerous ways that companies can cook the books if they're determined to do so, as the following examples illustrate.

Check out these manifestations of accounting creativity.

Credit sales and inflated revenue

Companies can use credit sales to exaggerate their revenue. That's because the purchases customers make on credit can be booked as sales even if the company allows the customer to postpone payments for six months. In addition to offering in-house financing, companies can extend credit terms on current financing programs. So, a 20% jump in sales could simply be due to a new financing program with easier terms rather than a real increase in customer purchases. These sales end up being reported as net income, long before the company has actually seen that income—if it ever will.

Channel stuffing

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.

Mischaracterized expenses

Many companies have "nonrecurring expenses," one-time costs that are considered extraordinary events and unlikely to happen again. The companies can legitimately classify those expenses as such on their financial statements. Some companies take advantage of this practice to report expenses that they routinely incur as "nonrecurring," which makes their bottom line and future prospects look better than they are in reality.

Stock buybacks

Stock buybacks can be a logical move for companies with excess cash, especially if their stock is trading at a low earnings multiple. However, some companies buy back stock for a different reason: to disguise a decline in earnings per share, and they often borrow money to do so. By decreasing the number of shares outstanding, they can increase earnings per share even if the company's net income has declined.