I recently blasted out a 30+ tweet thread about various tax maxims:

Roger Ledbetter | RE & SMB CPA @rledbetterCPA A 🧵 of tax maxims: 10:51 AM • Nov 29, 2024 8 Retweets 91 Likes Read 9 replies

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The one I feel most strongly about is that the balance sheet is where the dead bodies are buried. More fraud has been committed on the balance sheet than the income statement 😱 - it's the only way to move the needle without moving cash.

Today, I'll walk through a few examples of how a balance sheet can be used to perpetrate financial and tax fraud.

But first ☝️, some background on basic financial statements.

Remember that there are three "basic financial statements:": the income statement, the balance sheet, and the state of cash flows.

The income statement is a summary of income and expenses in the year 📝 - think Page 1 of your 1040 (wages as income and then deductions on Schedule A).

The balance sheet is a "snapshot" of how much you have at a specific date 📸 - think your bank account balance at December 31.

The statement of cash flows, which no one knows how to use, provides useful categories for where the business sourced cash from to survive (operations, debt, equity) and where the business spent cash (operations, CAPEX, dividends). 🪣🪣🪣

As an auditor, the golden rule was the "hammer the balance sheet" 🔨 and the rest of the financial statements are just grouping issues. By that, we would dig into every number on the balance sheet and test it for accuracy, etc.

That means we're looking at cash, how much are in receivables, how much inventory is there and how is it valued, how much fixed assets existed, how much did the company owe in payables and debt, etc.

If you can get your beginning and ending balance sheet right, your income statement is a flush 🧻 and you just need to get those classifications right.

And we hammer the balance sheet because that's where the real games get played:

Accounts Receivable

Let's start with a basic example - accounts receivable.

You sell a widget 🪀 for $100 and let your customer pay you in 30 days. Between the time the customer takes the widget and pays you, they owe you $100. And accrual accounting will say that the revenue (income) should be recorded and the anticipation of cash being paid is in accounts receivable.

The games that get played here are:

• Moving sales between months 🚙 / years to get a desired result. For example, if you need to hit an earnings goal for your stock you may pre-book revenue that hasn't sold yet.
• Not writing off or allowing for bad debt (uncollectible receivables). 💸 In this case, if accounts receivable have amounts that the customer will never pay you, you should hit the income statement for an expense. But again, if you want to hit earnings you'll ignore that growing amount for now.
• Making up sales. 🥸 I've seen significant invoices for "goodwill" sold to related parties that were booked as revenue. It's a terrifying reality that companies will lie, cheat, and steal to keep a loan in compliance or make shareholders happy.

Accounts Payable

Similar concept to receivables. Payables are how much your company owes another company for goods or a services you used. 🫴 And if the service was performed, that accounts payable represents an expense that has been recorded on the income statement.

And just like receivables, the games played here are:

• Shifting expenses between months. 👉 If you want to inflate income, you push these to expenses and payables to future months. But if you want to decrease income (say for taxes) you pull these into earlier months.
• Under-recording the amount to be booked. 😲 Sometimes customers won't invoice you timely, but you know the amount that they will be charging so you need to make an estimate. You can play games on the estimate by low-balling (or increasing) the amount of costs.

Related Parties

Millions of dollars in fraud have been perpetrated with related parties 👬 - shifting income between entities with only a tax or financial statement purpose.

This looks like creating invoices between commonly controlled entities to make one look better (or worse) that aren't really supported by any underlying reality.

A major example is how Enron re-wrote the related party accounting rules after their fraud. 🥷 They created this minority owned Variable Interest Entities (VIEs) that they offloaded a metric ton of debt into to make Enron's balance sheet look great.

After their collapse, we got a new set of consolidation rules for these VIEs. It was a clever way for off-balance sheet financing that was technically legal but ethically corrupt.

Deferred Taxes

Speaking of Enron, they also recorded millions of dollars of earnings by inflating deferred tax assets. They reported real earnings per share, some quarters, based almost totally from income tax effects. 🤦‍♂️

For a C-Corp, when they pay tax on income earlier than they record it for accounting purposes (GAAP), they get to record a deferred tax asset. The offsetting entry for the deferred tax asset is income tax INCOME (not expense). So Enron, and many other companies, play games with how to manufacture these non-cash income tax pick-ups. 🏗️

A good auditor will also hammer these assets and liabilities to really understand if they are legitimate and if not, they will need what's called a "valuation allowance" to offset any income statement impact.

There are hundreds of other ways to manipulate income and expense with the balance sheet, but these layout the basic concepts and most common ways.

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