Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
Aggressive and Conservative Accounting Series
For previous articles in the series, click on the links below.
- Aggressive and Conservative Accounting Policies
- How to Detect Aggressive Revenue Recognition Policy
- FIFO LIFO Inventory Valuation Methods
- Straight Line and Accelerated Depreciation Methods
- Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
- How Companies Misuse Capitalizing of Expenses
Definition of Cookie Jar Reserve
Cookie jar reserve is defined as
“allowances or reserves created or increased in a particular year in order to boost future years’ earnings”
How a Cookie Jar can Rot more than a Tooth
In order to meet the expectations of Wall Street, a cookie jar is extremely tempting for a company to manipulate. You saw it in full action during the bust of 2009 when companies started taking one time restructuring charges and “big bath” losses.
The benefit of taking such a special charge, even if it is only a one time occurrence, is that future operating income will be inflated because the future costs have already been written off.
Such large losses creates a liability on the balance sheet which becomes a reserve which is then used to reduce expense and increase income in future periods.
How a Cookie Jar Works
Since a liability typically has credit balances, it is a tool to inflate future profits. How it works is simple.
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The company creates a fake liability with adequate credit balances and then whenever extra profit is needed, an accounting entry will be made to move the credit from the liability line to the expense line. This obviously has end results of increasing profits by reducing expenses.
A simple example would be where the company announces a restructuring charge where 1,000 employees are expected to be let go. This will create both a restructuring expense and an increase in severance liability.
But what happens if the company really only layoff half the intended staff?
The restructuring expense is reduced by half and the severance liability is also cut by half. Therefore since only half the intended amount is taken as a liability and expense, the remaining half will be added back to the future period, resulting in an increase of earnings.
Aggressive Form of Reserves and Allowances
Most companies will have a number of horrible customers who do not pay on time. To account for this, companies must write down accounts receivables each period by recording an estimated amount for likely bad debts.
This amount is recorded as a “bad debts expense” on the income statement and at the same time, the accounts receivables amount is also reduced on the balance sheet with an “allowance for doubtful accounts” which offsets gross receivables.
Under normal business conditions, the doubtful accounts will grow at a rate similar to the gross accounts receivables. If however, you notice a steep decline in the doubtful accounts compared to an increase in receivables, it is a sign that the company has failed to record enough bad debt expenses resulting in an overstatement of earnings.
On the contrary, the ideal situation isn’t having a high doubtful accounts. Having a high estimate of doubtful accounts, leans closer to earnings manipulation than aggressive accounting as the company is purposely planning to reduce earnings so that it can store it for a time when earnings may not meet expectations and requires an added boost.
Walking a Fine Line
All of these accounting practices walk on a fine line. Companies can play around with these policies so easily within GAAP rules without investors ever knowing. The only way to detect such practices is to read the footnotes of the annual reports and to always read it with an investigative eye. It is too easy to get suckered into a report and fall into the flow.
The legal and accounting jargon makes some of the reading extremely difficult to decipher, but that’s the lengths companies will go to in order to hide aggressive accounting policies.