Cooking the books is the act of falsifying financial information about a company. This can be done to avoid paying taxes or to keep investors happy and stock prices rising, or alternately companies may cook the books in order to draw new investors or to obtain loans. The term arises from an alternate meaning of the verb to cook which is no longer in much use in the English language. It could be roughly translated as to deceive or to mislead, or to serve false information. The term creative accounting may be used as a synonym for cooking the books.
There are two directions under which a company might practice this illegal activity. One is to show losses that don’t really exist in order to take advantage of tax breaks. The practice deliberately shows less profit or direct losses that are not an accurate representation of the true state of the company’s financial affairs. This is done to either qualify for tax breaks or to evade a larger share of taxes.
More commonly, though, companies don’t want to post losses. They want to show high revenues and profits so that investors remain committed to their company. When such is the case, they may practice cooking the books by purposefully altering financial accounts to show the company is performing much better than it really is. There are a number of ways in which companies can practice cooking the books to keep investor confidence high.
Up until 2002, there were certain methods allowed that would help companies practice cooking the books without doing anything illegal. One method was the use of off-balance sheet accounting. Companies could use money in certain ways that would not have to be noted on financial statements. In some cases debts could be off-balance or not listed on financial statements by creating what are called special purpose entities (SPEs), actually new companies formed by the parent company.
SPEs allowed parent companies to not record some of the debt they owed as a company, since that debt belonged to the “new company.” In this way, debt contracted for the SPE could be off-balance, and not noted on the parent company’s financial records. Alternately, the parent company could funnel a part of its debt to the SPE to make its profits to debt ratio appear larger than it actually was. This was previously legal, but is now prohibited with the 2002 passage of the US Sarbanes-Oxley Act, which calls for greater transparency in financial reporting.
Other methods of cooking the books involve the simple but illegal act of changing profits/losses statements by bold-faced lying about true figures, claiming they are better or worse than they are. Other incidences include counting money intended for retirement pay as part of assets to offset large debts, counting inventory that has already been sold but not sent as part of assets, or recording extra expenses (and actually making them) to raise customer confidence, even when the company can ill afford these extra expenses.
Many of these “creative accounting” methods are now illegal since 2002, and some have been illegal for much longer. They are all practiced methods of deceit, intended to create a financial portrait of a company that is false. Yet, there are many large companies that have made cooking the books part of their financial practice. They do get caught in many cases, and if the practice is longstanding, they can’t simply claim clerical errors. Though it might be tempting to try creative accounting, in the end it is usually illegal, punishable by law, and unfair to those who might invest in a company or to the government because it expects and depends upon companies to pay their fair share in taxes based on a company’s profits.