What is cookie jar accounting?

2. Example of cookie jar accounting

Let's take a look at an imaginary company called Great Bakery Equipment, Inc. This is a public company. Financial analysts expect that the company's net income will grow 10% each year for the next three years.

During Year 1, Great Bakery Equipment, Inc. gets a lot of new clients, and their earnings double compared to the prior year showing 15% increase. The earnings went up from $200,000 to $230,000 between the two years ($30,000 increase).

During Year 2, the number of new customers decreases, but the company is still able to maintain its high growth and earnings by expanding the product line to the existing and new customers. The earnings grow 15% again to become $265,000 ($35,000 increase).

At the end of Year 2, nonetheless, the company's management prepares a forecast for Year 3 and realizes that the company will be short of analysts' earnings growth expectation by 3% (i.e. the earnings growth is expected to be only 7%; hence, the earnings are expected to be $284,000). In order to remediate this, the company decides to use cookie jar accounting: it artificially increases its warranty reserves by applying unrealistic assumptions at the end of Year 2. The increased warranty reserves result in an additional expense of $4,000 and reduce earnings for Year 2 to $261,000 (i.e. 13% increase from Year 1).

During Year 3, the company has earnings of $284,000, or 7% increase compared to the prior year, before cookie jar accounting. To meet the expectations, management decides to adjust the warranty reserves assumptions and reverses the $4,000 additional warranty expense recognized in Year 2. This reversal creates an additional income of $4,000 for Year 3 and gets the earnings right on target with the analysts' expectations of the 10% growth.

Note: This is a simplified example where the impact of income taxes, etc. was not considered.

See a table below where all numbers from the example are listed:

 

Year 0

Year 1

Year 2

Year 3

Before cookie jar accounting:

       

Earnings

200,000

230,000

265,000

284,000

Earnings growth (%)

 

15%

15%

7%

         

After cookie jar accounting:

       

Earnings

200,000

230,000

265,000

284,000

Warranty reserve impact

   

(4,000)

4,000

Earnings after warranty reserve impact

200,000

230,000

261,000

288,000

Earnings growth (%)

 

15%

13%

10%

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