Financial statements can be manipulated in three main ways: moving earnings between periods, avoiding taxes, or hiding debts. For example, telecom companies inflated short-term profits by selling fiber network access rights to each other for 10 years, recording the full amount as revenue up front. Enron hid debts through off-balance sheet special purpose entities. Signs of potential manipulation include frequent write-offs to manage future earnings, serial acquisitions using stock that inflate earnings, slower asset depreciation than peers, and earnings growing faster than cash flows. In response, the Sarbanes-Oxley Act of 2002 increased legal accountability for executives and auditors regarding financial disclosure accuracy.

1. Financial Bamboozling: How to Spot It
Accounting frauds by Enron, world com, Xerox, Merck, Arthur
Andersen, Tyco and many others, have shown that analysts can no
longer blindly assume that a firm's published financial statements are the
best representation of its financial position, clearly many companies
were “pushing the envelope" if not outright lying in an effort to make
their companies look better.
An earlier fortune article point out that there are only three basic ways to
manipulate financial statements: moving earnings from the future to the
present. Avoiding taxes, or hiding debts.
For example: suppose one telecom firm (think world come or global
crossing) sold the right to use parts of its fiber –optics network for ten
years to another telecom for $100 million. The seller would immediately
record revenues of $100 million. The buyer however could spread the
expense over ten years and report an expense of only $10 million this
year. The buyer would simultaneously sell similar rights to the original
seller for $100 million. This way, no cash changes hands; both
companies report an extra $100 million in revenue. But each reports a
cost of only $10 million expense each year for the remaining nine years.
But they have each boosted short-term profits and thus this year’s
executive bonuses. To boost earning next year, all they have to do is
play the same game, but on a bigger scale.

2. For hiding debts, it’s hard to beat Enron’s special purpose entities. These
(SPEs) owed hundred millions of dollars and it’s turned out that Enron
was responsible for these debts, even though it never showed up on
Enron’s financial statements.
Now the question arise how can you spot bamboozling? Here are some
tips,
1) When companies have lots of write-offs or charges for
restructuring, it could be that they are planning on managing
earnings in the future. In other words, they sandbag this year to pad
next year’s earnings.
2) Beware of serial acquirers. Especially if they use their own stock to
buy other companies. This can increase reported earnings. But it
often erodes value since the acquirer usually pays a large premium
for the target.
3) Watch out for companies that depreciate their assets much slower
than others in the industry (this is shown in the financial statements
footnotes). This causes current earning to look larger than their
competitors , even though they aren’t actually performing any
better,
4) Perhaps the best evidence of bamboozling is if earning are
consistently growing faster than cash flows which is almost always
indicates a financial scam.

3. Sarbanes-Oxley Act -2002
In response to the series of accounting and management scandal
and other abuses, congress passed the Sarban-oxley Act of 2002
.The act creates a more rigorous legal environment for the board,
the management committee, internal and external auditors. And the
CRO (chief risk officer).
One of its provisions requires both the CEO and the CFO to sign a
statement certifying that the “Financial Statements and disclosures
fairly represent, in all material respect, the operations and financial
condition” of the company. This will make it easier to haul off in
handcuffs a CEO or CFO who has been misleading investors.
Whether this will prevent future bamboozling remain to be seen.