Recently, while delivering a seminar at the University of Toronto, I was asked how a WorldCom or Enron could ever possibly happen. After all, I had just discussed GAAP (Generally Accepted Accounting Principles) and the fact that they govern the preparation of financial statements. How then, the participants wondered, could management concoct a financial story that had strayed so recklessly from GAAP? My answer surprised them: accounting is an art, not a science. True, accountants are required to abide by the eleven principles of GAAP when preparing financial statements. However, they serve as merely guidelines, not rules. Furthermore, the interpretation of GAAP is somewhat subjective and their application varies from company to company. Some companies bend the principles to meet their changing needs while other companies adhere to them with an almost religious zeal. So how can GAAP be used to transform numbers into something they aren't? Fasten your seatbelt and get ready for a wild ride!

This is the classic sleight-of-hand where Revenue magically appears out of thin air. Here is how it works. According to GAAP, revenue shown in an Income Statement should reflect the value of products and services that have already been delivered to the customer. However, a CEO who is under tremendous pressure to meet earnings expectations (Earnings Per Share estimates) might be tempted to book revenue in the Income Statement before it has actually been earned. And in some extreme cases, the GAAP principle of Revenue Recognition gets stretched beyond our sensibilities. Take the Sunbeam Corporation as a case in point. The CEO brought in to turn the organization around, Al "Chainsaw" Dunlap, decided to book revenue in the Income Statement for the sale of gas barbecue grills that were neither invoiced nor shipped. He simply "reallocated" anticipated revenue from future periods to the current period. And also conveniently forgot to reflect the associated cost of those gas barbecue grills. Voila! With all that phantom revenue and no related costs hitting the Income Statement, the bottom-line heated up. When these accounting "irregularities" came to light, Al was eventually turfed by the board, but not without a nasty fight.

- Accounting Trick #2 -

The Matching Principle of GAAP specifies that revenue should be matched with the expenses incurred to generate the revenue. In other words, if I generate one dollar of revenue in December, the seventy-five cents I spent to generate that one dollar of revenue should be shown in the Income Statement as an expense in December. This results in a profit of twenty-five cents. However, what if I throw the costs associated with generating revenue onto the Balance Sheet as a capital item (to be depreciated over a number of years), instead of showing it as an expense? With less expense in the Income Statement relative to the revenue I've generated, the bottom-line looks positively marvelous. And this is precisely what WorldCom did. Instead of showing the cost of externally purchased band-width as an expense in the Income Statement, the CFO elected to capitalize it on the Balance Sheet. This means a little less than four billion dollars of expenses would have been written-off over a number of years instead of hitting the bottom-line immediately, if his game hadn't been uncovered.

Sometimes we have to recognize expenses in the Income Statement today that we will pay for at a future date. And in some cases the actual amount of an expense is not known with certainty. Therefore, an estimate of the amount has to be accrued, or reflected, in the Income Statement. This is called a provision. For example, let's say that Commissions paid to sales reps have historically amounted to 5% of revenue. Therefore, if monthly revenue was $10 million dollars, the Commission payout would be $500,000 (5% of $10 million dollars). Now let's assume we decide to be ultra-conservative and record a Commission provision equal to 7% of revenue. In this case, the Commission provision would be $700,000 (7% of $10 million dollars). The Income Statement would effectively absorb $200,000 ($700,000 minus $500,000) of Commission expense in excess of what we would need for the payout at year end. And here is where it gets interesting. If recording a provision is pain to the bottom-line, then reversing a provision must be pure pleasure. We can decide to reverse all of the $200,000, only a portion of it, or none of it at all. While individual provisions might not have a significant impact on the bottom-line, a bunch of provisions collectively could turn an operating loss into an accounting profit. Here's what you probably don't want to hear: virtually every company, to a varying degree, uses provisions to manage the bottom-line. And it's all acceptable within the guidelines of GAAP!