This chapter examines one of the most common goals of unscrupulous managers—overstating profits relative to the underlying reality. The chapter addresses cases that range from aggressive reporting (premature revenue recognition) to outright fraud (reporting nonexistent revenues). The chapter presents real cases of companies that have been accused, but not necessarily ascertained guilty, of manipulating their reported results and provides techniques and warning signs to detect this type of activity.

In this chapter, we explore techniques used by companies to overstate earnings and present some warning signs (so-called “red flags”) that may alert you to potential problems. In some cases, companies will play games that do not overstate bottom-line earnings (net income) but overstate revenues or some subtotal of earnings such as gross margin or operating margin. These techniques will also be addressed in this chapter.

What motivates a company to overstate earnings? As noted in Chapter 1, both investors and creditors are interested in the level of profits of a company. The higher the earnings or profit, the more can be returned to investors and creditors or invested for the future. If management want to make themselves look better to creditors or investors they may be motivated to play accounting games to make earnings appear better than they actually are, especially if managers’ compensation is linked to earnings or share price.

There are four ...

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