3 Ways a Company Can Deflate Its Expenses

When I was younger and more naive, I always thought that accounting is extremely scientific and systematic. I thought that everything in accounting is fixed and all accountants can just follow a fixed set of rules to do their work.

It was only when I started learning about investing and later on, marrying an accountant, did I find out how wrong I was.

In fact, accounting can be full of ambiguity. How a company wants to record its performance is up to the assumptions their accountants are making.

We looked at how a company can inflate its revenue in our previous article. You can read about it here.

In this article, we will look at how a company can deflate its expenses in order to paint itself as a more profitable company than it really is. Here are three ways a company can deflate its expenses (some of these examples are outright fraudulent practices but it does not mean companies would not attempt them).

Classifying Expenses As Capital Expenditure

Typically, operating expenses such as employees’ salaries and material cost are considered expenses while buying equipment and machinery would be considered as capital expenditure. However, some companies might attempt to blur the link between the two by classifying some of its operating expenses as capital expenditure. In this way, although the company has spent the money, it does not need to create it as an expense which would lower down its earnings. Rather, it would record it as capital expenditure and boost its asset size.

Classify Expenses As One-Off

Another interesting way for the company to boost its earnings is by reclassifying some of its usual expenses as one-off expenses. It might use this method to show investors that it would have been profitable if not for the “unusual one-off” expenses.

Deferring Credit Losses

Lastly, a company would need to record a loss if it has determined that some of its customers might not be able to pay back its debt to the company. In such cases, sometimes the company can choose to extend the credit term for the customers. In this way, the company would not have to record the loss and would be able to show a much higher profit for that period. This method is quite often used in many industries, and even with banks, when they extend the credit terms for some of their defaulted loans so that the banks would not have to write-off the loans straight away.

Foolish Summary

There are no fixed rules in accounting. There are many assumptions the company needs to take when recording its performance. Some companies might use this ambiguity to engage in very aggressive accounting and deflate their expenses in hope to show a much higher profit than usual.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.