How Cooking the Books Works

While this category of expenses was meant for things that would only occur once in order to keep it from affecting regular operating expenses, it has been abused in the world of "managed earnings." By over-budgeting for a "non-recurring" expense, companies have been known to then move the excess money over as earnings.

In-Process R&D Charge-Offs

In-Process R&D Charge-Offs

Another way companies have increased their earnings per share is through in-process R&D (Research & Development) charge-offs. Here's how it works. A large company buys a small company that has new technology in development. The technology is not yet ready for commercialization, so the large company writes off the related costs. Later on, the technology is further developed and ready for market, but with a much lower R&D expense.

Now the GAAP requires companies to charge off that expense. This charge will reduce earnings and must be disclosed in the financial statements.

Operating expenses are the everyday costs of running a business. Capital expenses are business expenses for long-term assets, such as equipment. They are not tax deductible as business expenses, but may be used for depreciation or amortization -- in other words, the expense is somewhat delayed by being stretched over several years.

Pension Plan Manipulation

Many companies have defined benefit pension plans for their employees. These are plans that pay out a specific, defined amount at retirement. Companies are required to maintain enough money in their retirement account to pay benefits to everyone in the event that the company goes out of business.

It makes sense for companies to invest that money so it will grow. Rather than investing in something safe like bonds, some companies invest in the stock market. Accounting rules allow any "extra" money that the fund earns to be claimed as company profit. Companies can "estimate" how much it believes the money will grow each year rather than going by actual numbers. They use their estimate to figure how much money they should plan to put into the fund and how much they can consider profit.

The potential for companies to inflate their earnings by underestimating the contributions required to fully fund their retirement funds is high. Even assuming a percentage point or less can mean a difference of hundreds of millions of dollars on a company's balance sheet. Many company pension plans have been underfunded because the companies assumed that the stock market will perform as it did in the late nineties, which is nowhere near the rate of returns right now.

These methods for earnings management are just the tip of the iceberg when it comes to ways to manipulate a company's earnings. There's a fine line between legitimate earnings management and "cooking the books." Let's take a look at some real-life cases and learn how they did it.