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The year 2002 saw the end of an era of skyrocketing stock prices and booming businesses. Things that had seemed to be too good to be true were just that. Companies that we previously thought of as unstoppable didn't have the earnings they told us they did.
Instead, they had been "cooking the books" to create the appearance of earnings that really didn't exist. A company is guilty of cooking the books when it knowingly includes incorrect information on its financial statements -- manipulating expenses and earnings to improve their earnings per share of stock (EPS).
In this article, we'll look at the tricks that some companies used to beef up their financial documents as well as why they do it. We'll also examine some of the fallen giants like Enron and WorldCom to see what happened and where they are now.
Why Cook the Books?
Managing earnings (or "cooking the books"), is simply a way of making things look better than they actually are to keep stockholders happy, entice new investors, meet budgets, and most importantly, earn executive bonuses. Executive bonuses are tied to specific levels of earnings, making it extremely tempting to do just about anything to meet -- or appear to meet -- the goal. But not all book cooking is motivated by greed. By making revenues appear larger than they actually are, a struggling company could stay afloat with investors' money until it can turn a true profit.
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Here's an example. Imagine you're a kid with a lemonade stand and you want to build a roof over it so that you and your customers aren't in the hot sun. You don't have the money because business hasn't been that good. Your brother has the money, but he won't lend it to you unless he knows that he'll make something in the deal. You're sure that having a covered lemonade stand will make all the difference for your business because your customers will enjoy sipping their drinks in the cool shade. So you decide to creatively boost your current sales figures and offer your brother a chance to invest in your business. He gives you the money to build your roof in exchange for 25 percent of your profits. For reasons unknown to you, the covered stand doesn't really sell any more lemonade than the uncovered stand did. Now your brother is mad, because the profit he thought he was going to make was based on phony sales figures. At this rate, it'll take four summers to break even and much more to actually make a profit.
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Up to No Good... |
Investors are attracted by rising stock prices of public companies, which make the company's financial statements extremely important documents. Wall Street analysts depend on the documents and input from the companies themselves for their recommendations. The public company depends on the infusion of cash from investors to fund company growth. Stockholders expect the price per share to go up once they buy stock. When the price goes down, they lose money. (See How the Stock Market Works for more on stock prices and earnings per share.)
