If you overstate sales or understate expenses, you’ll pay more income tax than necessary. To understand why, you must be familiar with how an income statement works. In some cases, financial misstatements are due to errors or incomplete information. However, when executives deliberately manage earnings to meet a desired goal, their actions may be considered unethical or even fraudulent.
The Income Statement
Most corporations issue quarterly earnings reports and annual financial reports. The income statement shows the results of activities for the reporting period. The statement begins with sales revenues, followed by the direct costs associated with generating those revenues. For a merchandising or manufacturing company, this is the cost of goods sold. A service company lists the cost of services delivered. Other costs, expenses, revenues and gains follow, first from operations and then from other sources, such as the sale of a division. The last expense is interest -- you subtract this to figure taxable income. You arrive at net income when you subtract the tax on your taxable income. If you overstate net income, you inflate retained earnings and owner’s equity, because you add net income to retained earnings at the end of the period.
You can overstate sales in a number of ways. One way is failing to record selling expenses, such as allowances, discounts, commissions and returns. All of these costs reduce net sales, so omitting some of them will increase taxable income. Some companies are too aggressive at recognizing revenue. For example, if a customer provides an advance on future services, you should carry this as a liability in the unearned revenue account, not as sales revenue. You should not recognize revenue based on anticipated sales or unshipped goods. At the more fraudulent extreme, managers can manufacture phantom sales to boost income, perhaps to qualify for a bank loan or to give a boost to stock prices.
If your company sells inventory, you have many opportunities to understate the cost of goods sold. Generally accepted accounting principles require you to mark down inventory when its market price falls below its cost. Failure to take markdowns for distressed or missing inventory understates COGS and overstates the value of inventory. You can also create phantom inventory, which will reduce COGS. A company can postpone discretionary expenses, such as executive bonuses or profit-sharing contributions, until a later period. Another ploy is to capitalize costs that you should expense entirely in the current year. When you capitalize a cost, you carry it as an asset on the balance and amortize it over a number of years, thereby postponing expenses.You also can understate depreciation expenses and fail to write off obsolete equipment.
If you are considering the acquisition of another company, you must be alert to overstated earnings. You can detect financial misstatements in several ways. Look for revenues that are overstated because of one-time events that are included in normal income, such as the sale of a real estate parcel. Be wary of a sudden increase in non-current assets and a drop in expenses, however, because it might indicate incorrect capitalization of expenses. Another way to detect hidden expenses is a sudden rise in prepaid expenses, which are current assets. For example, a company should not treat insurance expenses due in the current period as prepaid expenses.
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