When I was younger, I thought, “Oh, that’s just being conservative.” And in my misguided naivete, I also didn’t have a problem with smoothing out earnings (positive) hiccups which could be used for a rainy day.
But it’s also reckless rationalization. Especially when we examine the intent of over-expensing leading to holding down earnings on purpose.
Now that I’m older and wiser, call me a reformed cookie jar monster.
What a Minute, Explain Cookie Jar Accounting
I vividly recall my grandmother stashing away spare coins and dollars for a rainy day during my youth. The odd thing? She didn’t need to. She just did. She endured the depression.
Similarly, a savvy business owner required to report earnings to a bank, board, or other outsiders may see some turbulence or rough waters a year or so down the road.
If earnings are good now, there will be the temptation to over-accrue expenses on the P&L which decreases earnings today. When the turbulence hits, those deferred profits (in the form of accrued expenses) will be pulled back into the P&L to strengthen or enhance earnings.
The CEO and/or business owner has accomplished his/her purpose–smoothing out earnings. And we call that cookie jar accounting.
You’re Kidding Me – Who Practices Cookie Jar Accounting Anyway?
You’re right. It doesn’t happen often.
The most famous case I can recall is the one where the SEC ruled against Microsoft after the turn of the new century.
Most public companies that cheat typically fudge on over-estimating revenues. Not Microsoft. They built balance sheet reserves so that earnings could be smoothed out over time. The case was settled in 2002.
As I hinted earlier, small to mid-sized businesses will do this if they have a strong understanding of financial statements and the right motivation.
Their reasoning may be sound without wanting to mislead. If that’s truly the case, the CEO and/or owner should make it very clear to their external readers that they are being ultra conservative on certain expenses.
To ‘cookie jar’ or ‘not to cookie’ jar. That’s what I show in the video below which may shed more light on how earnings can be manipulated, even in a good year.
Internal Financial Analysts Hate Cookie Jar Accounting
Think about it. The business analysts are monitoring expenses line item by line item using Tableau.
There’s a huge spike in warranty expenses with an offset to the warranty reserve on the balance sheet. There’s no rhyme or reason for the cost. Out-of-pocket warranty costs have been negligent for years.
In short, cookie jar reporting screws up the integrity of the underlying numbers in the financials. And what happens when the accrual is accreted to the P&L when earnings are down. Again, the analysis process is tainted because the underlying numbers lack integrity.
Cookie Jar Reporting – Just Say No
First, cookie jar reporting is not GAAP even though such a practice may meet the conservatism principle.
More importantly, such an expense is not going to fly with IRS. If your company has claimed that (excess) expense for tax purposes, good luck in withstanding a clean audit should that happen.
Recommendations for Bankers and Other Third Party Financial Statement Readers
Are the prior-period earnings looking maybe a little too perfect rising at a consistent rate over time?
Pay careful attention to 1) the accruals over time and then 2) take note of the operating cash flows looking for large disparities between earnings and free cash flow.
Most cookie jars are going to be found in existing accounts:
- Bad Debt Reserve
- Reserve for Slow Moving and Obsolete Inventory
- Warranty Reserve
Even the accrued PTO liability might be a place to store (legitimate) excess earnings the CEO or owner wants to store away for a rainy day.
If you believe there are excess charges to certain reserves on the balance sheet, just ask the owner, “Do you have cookie jars, and why?”
I’m Not Casting Stones
I’m not here to judge. I just want to share my perspective. If you have cookie jars, be transparent and share this with your readers.
Make sure your tax CPA knows as they’ll probably not reflect these excess charges to the P&L on the tax return.
Finally, go back and read that Microsoft case mentioned earlier. It’s a great case study on staying away from this practice.