Welcome back to Follow the Money. In the first article, we looked at how hidden transactions can shift the entire direction of a case. This month, we’re turning to something that tends to be quieter, harder to spot, and often more damaging in the long run: companies inflating what they own and downplaying what they owe.
These issues arise regularly in shareholder disputes, post-acquisition cases, and partnership breakups. On the surface, the financials may look polished. But once you start testing the numbers, you see where the story falls apart. That’s where forensic accounting becomes less about crunching numbers and more about understanding what someone was trying to achieve—and how far they were willing to go to get there.
Why Inflate Assets or Hide Liabilities?
Most of the time, the motivation is simple: to look better than you really are.
- Higher asset values mean stronger leverage positions, better ratios, and more attractive sale or investment prices.
- Lower liabilities reduce the perception of risk and make earnings appear healthier.
When litigation enters the picture, these distortions can change the economic landscape of a dispute. A couple examples that show up often:
- A seller in an M&A transaction quietly boosts inventory figures to support a higher purchase price.
- Executives stretching accounting policies and recognition of assets and liabilities to satisfy loan covenants or bonus thresholds.
We’ve all seen what happens when this behavior scales. WorldCom capitalized billions of expenses. Enron shifted debt and investment risk into entities no one was meant to scrutinize. While most cases aren’t that dramatic, the underlying tactic is familiar—polished numbers masking fragile foundations.
Red Flags and Techniques Used to Manipulate Statements
In practice, certain patterns show up again and again. Some of the most common include:
- Inflated Asset Values
- Inventory that hasn’t been written down despite being overvalued, obsolete, or unsellable.
- Fixed assets are staying on the books far past their useful lives.
- Receivables are reported as current even when collection is doubtful.
A simple indicator: sudden appreciation or revaluation adjustments inconsistent with history.
2. Improper Capitalization
When expenses that should be recorded in the income statement are instead booked as assets, earnings immediately look better. Repairs, routine maintenance, and certain development costs are frequent targets.
3. Hidden or Understated Liabilities
- Contingent liabilities are not recognized on the balance sheet.
- Related-party loans or guarantees are buried in footnotes—or not disclosed at all.
- Reserves are manipulated to keep earnings smooth and predictable.
Pressure from lenders, investors, and internal performance metrics often influences poor management’s decisions.
4. Numbers That Don’t Match Behavior
This includes:
- Declining asset turnover despite reported growth.
- Healthy profits paired with stagnant or negative cash flow.
- Growth of Accounts Receivable and Inventory Accounts paired with stagnant sales
- Frequent shifts in accounting policies or large manual journal entries at month-end or year-end.
When the story being told by the numbers doesn’t align with economic reality, it’s worth taking a closer look.
How Forensic Accountants Uncover the Truth
Our work isn’t about catching someone with a single “gotcha” moment. It’s a layered approach—building a full picture from many angles:
1. Source Document Testing
Invoices, contracts, appraisals, and inventory counts—what’s on paper often contradicts what’s recorded in the system. In one matter I handled, a physical inventory walkthrough immediately revealed discrepancies that the books had masked for years.
2. Analytical Testing
Ratio analysis, trend reviews, and comparisons to industry benchmarks highlight where numbers diverge from what’s typical or expected.
3. Data Analytics
Transaction-level records often show timing issues or unusual behavior. Deleted entries, edited fields, or clusters of adjustments around financial close dates can be especially telling.
4. Lifestyle or Net Worth Comparisons
Sometimes, the simplest test is comparing reported income to public or observable spending patterns. When someone shows a lifestyle their reported income can’t support, it’s usually not because they found coupons or received discounts.
5. Third-Party Confirmation
Banks, vendors, customers, appraisers—independent sources help confirm or contradict what the company has represented.
Visual tools—charts, schedules, and flow diagrams—help clarify patterns that otherwise get lost in spreadsheets.
How This Matters in Litigation
Uncovering asset inflation or hidden liabilities doesn’t just adjust the math—it changes the interpretation of events:
- Fraud or breach becomes clearer.
- Valuations shift, potentially significantly.
- Earn-outs, indemnification, or clawback provisions can swing drastically.
- Scenarios may become criminal.
Early forensic involvement prevents parties from anchoring themselves to numbers that shouldn’t have been trusted in the first place.
Key Takeaways for Litigators and Business Owners
- Establish strong internal controls and maintain them consistently.
- Don’t rely solely on management’s representations—verify.
- In disputes, bring a forensic accountant in early rather than waiting for discovery to reveal surprises.
Financial statements are supposed to reflect the truth. But when someone chooses to manipulate them, the inconsistencies eventually surface. The challenge is knowing where to look—and asking the right questions at the right time.
AUTHOR BIO:
Charles “CJ” Pulcine, CPA, CFF is a Manager in Smolin’s Forensic and Valuation Services practice, specializing in forensic accounting, fraud investigations, and litigation support. He is a licensed Certified Public Accountant in New Jersey and holds the Certified in Financial Forensics (CFF) credential.
With more than seven years of experience in forensic accounting, financial audits, and fraud investigation, CJ works with businesses and legal counsel on financial fraud investigations, commercial litigation support, matrimonial litigation, business valuation analyses, and shareholder disputes. His work focuses on uncovering hidden transactions, tracing assets, and analyzing financial misconduct.
As a member of Smolin’s forensic team, CJ supports attorneys throughout the litigation lifecycle, including asset tracing, damages analysis, and preparation of financial evidence for mediation, depositions, and trial. He practices out of Smolin’s Red Bank, New Jersey office.
