One of the basic principles of accounting is called the matching principle. It simply means that expenses must be recorded in the same period that the related revenues were earned.
This is usually fairly simple and straightforward. But the matching principle has a very, very dark side (you read that correctly) that results in real mischief disguised as “creative” accounting.
A Simple Example
Let’s go through a simple example, and then I will share with you the darker side of the matching principle.
Let’s say that in your business you have an insurance contract for professional liability insurance that runs from Jan-Dec 2019.
The cost of the insurance is $3,600 per year.
If you paid for the insurance in Jan 2019, you would not expense the entire $3,600 in January.
Why? Because the benefit of the insurance extends for the whole year. So, you would expense $300 each month for 12 months.
The clear aspect of this kind of deferral is that you have a time-based contract in place.
With the reporting of revenue the correct accounting practice is to record the revenue in the period it is earned, regardless of when cash is received.
There can be some interesting seeming exceptions to this rule. For example, in the real estate industry it is common practice to only record a sale when the deal is closed, and title has transferred.
What a minute you might be thinking, hasn’t the money been earned the minute a solid deal is agreed to?
Well in other industries that may be the case, however, in real estate with all the conditions that must be removed before title is transferred this means that many deals are not realized. It would be grossly unfair to record revenue (and pay tax) on all those collapsed deals that would need to be reversed later!
Let’s now look at the “dark side” of the application of the matching principle….
The Dark Side of the Matching Principle
The largest fraud and bankruptcy in the USA was the collapse of World.com.
So, how did they try to pull this off?
First, let us look at the motivation and the pull to do these things based on the “system” or environment in the capital markets which stresses short-term quarterly results.
I believe the pressure to perform once a company goes public and is playing in that arena is immense.
The pressure to perform means making sure pre-stated revenue targets must be met or analysts criticize the company, resulting in depressed stock prices.
One of the key measurable targets that analysts look at closely is called EBITDA. EBITDA stands for “earnings before interest, taxes, depreciation and amortization”.
A simpler working definition could simply be pre-tax operating profit.
And, profit, dear reader, as you know is simply the difference between the total revenues and total expenses of that period.
How Did the World.Com Fraud Happen?
Another great question to ask is – how could a company with external auditors and internal auditors, and a whole building full of CPAs and professional bookkeepers pull off the world’s largest fraud.
Did they cook the books? Did they hide expenses? Did they not record expenses?
When most people think of fraud they think of stolen money.
They never think of the creative use of accounting principles – like the matching principle.
Here is how the pressure cooker starts and what comes out the back end:
- The company is experiencing rapid growth followed by a decline in market share or just tough market conditions;
- The pressure to perform by the analysts and shareholders intensifies;
- The Board of Directors, plus the CEO, CFO, and top management Team want to report a good Income Statement with high profit
- So, they start shifting expenses from the Income Statement to the Balance Sheet
In fact, I believe that the CEO and Founder of World.Com, Bernard Ebbers (who happened to be Canadian) never, ever thought he was pulling off a fraud. If you don’t believe me take a look at the videos and testimony around the time of the trial. (I am not saying what he did wasn’t criminal, I am just saying that he did not believe he was doing anything wrong).
Bernie Ebbers did not believe he was doing anything wrong because he didn’t “steal” money in the traditional sense of funnelling money to a private bank account.
What World.com did was simply move expenses from the Income Statement to the Balance Sheet.
How Did They Justify Such a Maneuver?
They got away with it – even with a large public accounting firm auditing the books – because they created an argument for the costs being moved to the Balance Sheet based on “future value”.
In other words, they rationalized their fraud by using the solid matching principle.
The justification for deferring expenses is always that there is some future value in those costs that can be matched to future revenue.
No one defers costs without some rationale.
The trouble with deferring costs – other than in very strict circumstances – is that they often have no real value.
If you cannot measure the future value as in the insurance example above, then accountants (when they get creative) try to rationalize some arbitrary means of determining a future value.
And, here is the problem – when accounting gets subjective – based on estimates and guesses about future value, the business is on a slippery slope.
Look at Your Balance Sheet
Rather than put all your attention on the Income Statement take a hard look at your Balance Sheet.
Look at each asset and ask yourself – does this have a current or future value? Would someone pay you for that “asset”? Can those assets be converted to cash? Is the deferral based on a contract that expires, or is it a loose, made up estimate of value?
Look at Your Cash-Flow
When you defer costs to the Balance Sheet (usually labour is the one area people pick to defer), this will make your operating profit look better, however, has your cash-flow changed?
Nope. It is the same. You still spent the money.
And, eventually you will have to write those costs off, so they will hit your Income Statement eventually.
It is a short-term deception that may seem innocent enough in small doses, but when done on a massive scale by a public company it is called fraud, even when your external auditors rubber-stamp it.
And even if Bernie Ebbers did not see it as fraud, sadly, he is in jail serving a 25-year sentence for allowing it to happen at World.Com.
Thanks for reading…