This is the fourth in a series of eight articles examining different forms of accounting manipulation. Previous articles included pieces on channel stuffing and improper revenue recognition.
Companies wishing to misrepresent their short-term financial performance frequently delay expense recognition. Improper expense recognition is one of the most common forms of accounting manipulation.
Under the matching principle, businesses should record expenses in the same period as the revenues they generate. For example, if a company sells a product in December, the wage cost associated with making the product should be recognized as an expense in December even if it doesn't pay its employees for the work until January. By failing to recognize this wage expense, the company can boost its reported earnings for the December quarter.
The best way to learn about improper accounting practices is to see real-life examples. With this in mind, we provide four famous examples of improper expense recognition.
The first example is Tesco, which simply delayed the recording of expenses. This short-term ploy is frequently employed by companies attempting to smooth their earnings. Sometimes companies seek to delay expense recognition for longer time periods than exemplified by Tesco.
This typically involves two types of manipulation:
- Improper capitalization of expenses: This occurs when a company fails to recognize a cost that should be recorded in the income statement, instead recording it as an asset on the balance sheet. It represents an incorrect classification that artificially inflates a company's earnings in the short term, as it defers the recognition of expenses.
- Inappropriate depreciation or amortization of long-term assets: This occurs when a company depreciates an asset too slowly, thus failing to match the depletion of an asset with the revenue it produces.
WorldCom is the most famous example of improper expense capitalization, Waste Management is a notorious example of manipulation of depreciation expense, and AOL is a famous example of inappropriate amortization.
Where relevant, we complement these examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In some of the cases below, the TRE certainly picked up risky signals well before the problems bubbled to the surface.
After the manipulation was revealed, WorldCom and Waste Management collapsed, AOL was acquired and Tesco suffered a significant share-price decline. These examples illustrate the danger of manipulation. Manipulation robs future earnings and allows management to hide problems that should be addressed, creating even greater difficulties at some future point. Those seeking a greater understanding of improper expense recognition will find these companies an excellent place to start.
Tesco
Tesco, a British multinational grocery retailer, faced an accounting scandal in 2014 related to aggressive expense recognition practices.
The company was accused of delaying the recognition of costs, such as promotional expenses, pushing them into future periods to make their current earnings look better.
In addition, Tesco was accused of prematurely booking income from suppliers, known as "commercial income," which included rebates and discounts. They allegedly recognized this income before it was earned or realized, boosting their reported profits.
The accounting scandal led to a significant overstatement of Tesco's profits. The company was forced to restate its earnings by hundreds of millions of pounds. The share price plummeted, and the company faced lawsuits from investors who claimed they had been misled by the company's accounting practices.
The UK's Serious Fraud Office (SFO) launched an investigation into Tesco's accounting practices, and fined the company £129 million to settle the charges.
The key takeaway is that manipulating the timing of income and expense recognition to inflate profits is a serious accounting violation that can have severe consequences for companies and their stakeholders.
In 2014, the Transparently Risk Engine gave Tesco’s accounts a C rating, putting it in the bottom third of global consumer staples companies for accounting quality. The system’s top concerns for that year included income quality and it recommended investigating Tesco’s sources of income.
WorldCom
WorldCom is a well-known example of a company that improperly capitalized expenses. WorldCom was a telecommunications giant at the forefront of the internet boom in the late 1990s and early 2000s.
WorldCom's most egregious practice involved capitalizing "line costs," which were fees paid to other telecom companies for using their networks. These costs were a significant operating expense for WorldCom. Instead of expensing these costs immediately, as required by accounting standards, WorldCom classified them as capital expenditures, treating them as assets on their balance sheet.
This improper capitalization significantly understated WorldCom's expenses and inflated its profits, creating a false impression of financial health. The company eventually admitted to improperly capitalizing $11 billion in expenses.
As we have documented in a separate article, the company also engaged in aggressive asset valuation practices, mostly in relation to its acquisition of MCI Communications in 1998.
WorldCom's expense recognition manipulations, combined with the improper valuation of MCI, represented a massive accounting fraud and ultimately led to collapse in 2002. The scandal led to the largest bankruptcy filing in U.S. history at the time. Several executives, including CEO Bernard Ebbers, faced criminal charges. Ebbers was convicted of securities fraud and sentenced to 25 years in prison.
WorldCom emerged from bankruptcy as a rebranded MCI entity in 2004, which was acquired by Verizon Communications two years later. WorldCom’s network assets are now part of a Verizon division that serves corporate and government customers.
Waste Management
Waste Management is a well-known example of a company that manipulated expenses by using artificially low depreciation rates. Waste Management was the largest waste disposal and management company in the world during the 1990s.
The company significantly extended the estimated useful lives of its garbage trucks and landfills. By stretching out the depreciation period over a more extended time, they reduced their annual depreciation expense, boosting profits.
In addition, the company also capitalized a significant portion of their environmental remediation costs, treating them as an investment rather than expensing them immediately in the income statement. These costs were associated with cleaning up contaminated landfills. This manipulation further understated expenses and inflated assets and earnings.
Waste Management's actions were eventually exposed as a massive accounting fraud. The company had to restate earnings by $1.7 billion, one of the largest restatements in U.S. history at the time. The SEC investigated Waste Management in 1997 and found that the company had engaged in a systematic scheme to inflate its earnings and mislead investors. Waste Management paid $132 million in fines and penalties. Several former executives of Waste Management faced criminal charges related to the accounting fraud.
While companies have some flexibility in determining the useful lives of assets and capitalizing certain costs, manipulating these judgments to inflate earnings is illegal and unethical.
The Transparently Risk Engine gave Waste Management’s 1997 accounts a risk score of 64%, putting it in the worst 13% of companies globally for accounting quality. The system’s top concerns for that year included suspect growth signals, credit and income quality.
AOL
AOL (formerly America Online) was an early internet service provider during the dot-com boom in the late 1990s.
AOL spent heavily on marketing, particularly on free-trial compact discs which it distributed widely. Instead of expensing these marketing costs immediately, as required by accounting standards for expenses that don't provide future benefits, AOL capitalized a significant portion of them. The company then amortized these capitalized marketing costs over extended periods, sometimes as long as 24 months, arguing that the benefits of these marketing campaigns would last for several years.
This practice significantly understated AOL's marketing expenses and inflated its reported profits during a period of rapid growth in internet users. It allowed AOL to show more favorable subscriber growth metrics, as the cost of acquiring those subscribers was spread out over a longer timeframe.
The SEC started investigating AOL's accounting practices in 2002, eventually finding that the company had improperly capitalized over $1 billion in marketing expenses. AOL agreed to pay a $300 million fine and restate its earnings. The accounting scandal eroded investor confidence in the company. AOL's aggressive accounting practices, along with similar practices at other internet companies, contributed to the inflated valuations and the subsequent burst of the dot-com bubble.
The AOL case demonstrates that even seemingly routine expenses like marketing costs can be manipulated to present a misleadingly positive financial picture. It highlights the importance of carefully scrutinizing a company's accounting policies and ensuring that expenses are recognized in accordance with accounting standards.
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