Accrual accounting aligns expenses with the periods in which they are incurred and thus provides a much clearer picture of the financial condition of an enterprise than the cash accounting method which more typically would be used by smaller businesses.  However, it also creates opportunities for manipulation to either understate or overstate performance. In a large enterprise, this practice can be particularly hard to detect, but it is critical to understand the areas where such manipulation might occur and how to spot potential red flags.

One example of this type of manipulation is the accrual of health care benefits. In many companies, these costs are based on estimates of future claims, which makes them ripe for over-accrual. By inflating the amount of health care expense during a period of strong performance, executives can create a reserve that can be released in future periods, artificially boosting earnings when performance would otherwise be unsatisfactory. This “rainy day fund” approach, though unethical and often against company policies, can be difficult to detect unless someone pays attention to this and reviews the back-up to the accrual journal entries.

Health care benefits are just one area where accruals can be misused. Other areas include:

· Warranty Reserves: Companies may overstate the anticipated costs of future warranty claims in periods of strong performance and then release the excess in weaker periods to smooth earnings.

· Legal Reserves: Executives might over-accrue for potential legal liabilities, especially in cases where settlements are highly uncertain, and then release these amounts when convenient.

· Environmental Liabilities: Environmental cleanup or compliance costs can be difficult to estimate, creating opportunities to inflate these expenses and adjust them later to manage earnings.

· Deferred Revenue: In some cases, companies may overstate the costs of fulfilling contracts and later recognize the excess deferred revenue without the corresponding expense.

Hopefully, executives engaging in these practices will get caught matter how much care is taken to avoid detection during audits or internal reviews. One of the primary ways they can get caught is through inconsistencies with internal accounting procedures. If an audit reveals that accruals are not based on reasonable and documented estimates—especially if they violate company accounting policies—this can raise red flags. Auditors are also trained to look for patterns where accruals are consistently overstated during strong quarters and released during weak quarters, a hallmark of earnings management.

Another risk comes from the lack of appropriate journal entry backup, particularly when releasing accruals. Proper documentation is required to support the rationale for accruals and their eventual reversal. If there is no clear justification or if the timing seems opportunistic (e.g., releasing an accrual just before a reporting period), it can indicate manipulation. Without solid backup, these entries fortunately become harder to defend under scrutiny.

For anyone involved in due diligence on a potential acquisition, it’s essential to take a close look at the company’s accruals and reserves. Understanding the methodology used to estimate these items, reviewing their consistency over time, and cross-referencing them with internal policies can help identify whether these accruals are being used inappropriately as a tool for managing earnings to a more desirable result.

Under-accruing is equally as deceptive as over-accruing. It involves deliberately understating reserves for current liabilities in areas like health care benefits, warranty reserves, or legal liabilities, among others. The goal is to inflate current-period profitability by reducing the expenses recognized on the income statement. This effectively borrows against future profitability, with the hope that a strong upcoming period will provide enough cushion to catch up on the understated reserves.  The risk for the dishonest executives here is that if the anticipated strong future reporting period doesn’t materialize, the company will be forced to either take a larger hit to profitability when the true liabilities come due or continue manipulating its financials, compounding the problem.

For companies engaging in this behavior, the lack of adequate reserves in future periods could also raise questions about the company’s financial health and create additional pressure on future earnings. In the context of an acquisition, discovering under-accrued liabilities during due diligence can signal a deeper problem with the company’s financial management and the integrity of its senior management.

Both over- and under-accruing are forms of earnings manipulation that create misleading financial statements. Whether a company is smoothing earnings by over-accruing or inflating profitability by under-accruing, the end result is the same—an inaccurate picture of the company’s financial health and performance.