One of the biggest problems in the world of corporate finance (in fact, in the world of finance generally) is the manipulation of financial statements – management carrying out deliberate acts to achieve a desired outcome, occasionally for their own benefit.
Companies have been known to mislead, quite deliberately, their stakeholders (those people with an interest in the company’s activities, including potential investors, employees, shareholders, Her Majesty’s Revenue and Customs (HMRC) and so on).
Here’s an example of how financial statements can come to be manipulated. Consider the concept of maximising shareholder wealth. Shareholders clearly want a return on their investment and this return comes in the form of a dividend. If the company makes a big profit in one year, the dividend paid to shareholders may also be fairly large.
If the company isn’t so fortunate in the next year, however, and doesn’t make as much profit, management can get worried that shareholders are going to start asking some awkward questions, such as ‘why isn’t my dividend as high this year? What’s happened to the profits?’
So, if the company has an amazingly fantastic year and profits are high, the management may think ‘if we’ve done this well, shareholders are going to expect even better next year, and so we’ll bring the profit down a bit’. They can do so in many ways and in some cases their actions may even go unnoticed by the auditors. In the next year, if profits aren’t so high, management can essentially ‘reverse’ what they did in the previous year to get the profits back up to expected levels.
All this manipulation ‒ known in the UK as creative accounting ‒ is bad and in many cases carries serious penalties (directors found guilty can be sent to prison). Why? Well, it results in the financial statements being wrong for a start. Wrong financial statements lead to wrong corporate finance decisions, as well as potential investors and existing shareholders making wrong investment decisions. Creative accounting also serves to mislead organisations, such as HMRC, banks and pension funds, who pumped money into the company.
Luckily such scandals are quite rare, but they can’t be ignored. Manipulating financial statements to achieve a set outcome has catastrophic risks, for the directors and for everyone involved. Such acts have been known to result in companies going bust, which then turns into a loss of jobs, people’s lives being turned upside down and an impact on the overall economy.