To jack up profit, an accountant must CREDIT (CR) the accounts in Profit and Loss accounts. The beauty of accounting is that inevitably he has no choice but DEBIT (DR) the accounts in Balance Sheet.
Dr Balance Sheet
(Increase assets like stocks, trade debtors, etc. or reduce liabilities like trade creditors, provisions, etc.)
Cr Profit and Loss accounts
(Increase revenue or reduce costs)
The above double entry is the mother of all profit manipulation. There are rare exceptions and we will address them later.
Backed by the above core double entry, these are the common masks of profit manipulation:
- Reduce cost of sales by increase the value of closing stock
- Refuse to provide for uncollectible bad and doubtful debts
- Reverse previously provided provisions for bad and doubtful debts without true sign of debts recovery
- Delaying in charging out expenses
- No accrual was made for known and quantifiable expenses
- Fake cash (less common, more difficult to perform and subject to higher risk of being prosecuted as criminal.)
- Etc.
The way to detect profit manipulation or to ensure the authenticity of profit is first to look at the movement of Balance Sheet! In the case of jacking up profit, beside the increase in retained profit, Balance Sheet will also reflect a significant increase in assets or reduction in liabilities.
Part 1: Reading financial statements
Part 2: The principle of profit manipulation
Part 3: Detecting profit manipulation - Overview
- Step 1 - Net profit and depreciation
- Step 2 - Net cash or debt movements
- Step 3 - Stocks add trade debtors less trade creditors
- Step 4 - Capital expenditure, goodwill, tax and dividends
- Step 5 - Other debtors and creditors
- Concluding Steps
