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Limitations of Financial Statements
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Accounting measurement follows some key assumptions like consistency, accrual, prudence, going concern, and historical cost which we have dealt with in our first chapter. These assumptions give rise to ambiguities and uncertainties in financial statements which manifest themselves in the form of measurement errors in financial statements. Though substantial progress is being made in narrowing the range of acceptable accounting practices, in improving the quality and credibility of financial statements and in reducing the ambiguities and errors, yet it is imperative for every user of these statements to "go behind the numbers" and unearth any such imperfections in the statements. In order to identify these imperfections, one needs to have detailed information about them.
Howard Schilit gave the name 'Financial Shenanigans' to these imperfections in financial statements and commented that they can arise from a number of causes ranging from benign tricks to outright frauds. He described financial shenanigans as actions that intentionally distort a company's reported financial performance and financial condition. In his book he identified thirty techniques that can be used to trick investors and other stakeholders.
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Box 1: The Seven Financial Shenanigans Howard Schilit Proposed
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Shenanigan No.1: Recording Revenue too soon or of Questionable Quality
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Recording revenue when future services remain to be provided.
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Recording revenue before shipment or before the customer's unconditional acceptance.
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Recording revenue even though the customer is not obliged to pay.
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Selling to an affiliated party.
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Giving the customer something of value as a quid pro quo.
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Grossing up revenue.
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Shenanigan No.2: Recording Bogus Revenue
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Recording sales that lack economic substance.
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Recording cash received in lending transactions as revenue.
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Recording investment income as revenue.
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Recording as revenue supplier rebates tied to future required purchases.
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Releasing revenue that was improperly held back before a merger.
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Shenanigan No.3: Boosting Income with One-time gains
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Boosting profits by selling undervalued assets.
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Including investment income or gains as part of revenue.
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Reporting investment income or gains as a reduction in operating expenses.
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Creating income by reclassification of balance sheet accounts.
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Shenanigan No.4: Shifting Current Expenses to a Later or Earlier Period
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Capitalizing normal operating costs, particularly if recently changed from expensing.
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Changing accounting policies and shifting current expenses to an earlier period.
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Amortizing costs too slowly.
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Failing to write down or write off impaired assets.
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Reducing asset reserves.
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Shenanigan No.5: Failing to Record or Improperly Reducing Liabilities
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Failing to record expenses and related liabilities when future obligations remain.
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Reducing liabilities by changing accounting assumptions.
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Releasing questionable reserves into income.
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Creating sham rebates.
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Recording revenue when cash is received, even though future obligations remain.
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Shenanigan No.6: Shifting Current Revenue to a Later Period
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Shenanigan No.7: Shifting Future Expenses to
the Current Period as a Special Charge
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Improperly inflating amount included in a special charge.
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Improperly writing off in-process R&D costs from an acquisition.
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Accelerating discretionary expenses into current period.
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To have a better understanding of the limitations that govern our financial statement analysis, let us dwell into a few of these financial shenanigans. The financial shenanigans can be summarized under the following heads and presented as follows:
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Measurement error caused by GAAP accounting rules.
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Measurement errors caused by imperfect application of accounting estimates.
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Measurement error caused by management's intentional manipulation of the financial statements.
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