Welcome to a further piece of our ‘Value Essentials’ series. ‘Financial Shenanigans’ is written by Howard M. Schilit, PhD, CPA and Jeremy Perler, CFA, CPA. It presents an empirical journey through many accounting tricks in an entertaining way while teaching its readers what to look for when analyzing balance sheets. This blog post is by no means a summary of all the facts given in the book. It is merely meant to give you an idea and remind you of the key lessons. I would highly recommend reading it as soon as possible, as it is also part of our recommended reading list that you find on our website. After all, there are passages that show the recklessness of managers and the absurdity of huge frauds (that have stayed unnoticed for decades) which makes the reading experience quite joyful.
NOTE: In this post we directly quote the book. If you find this interesting, please consider buying it (e.g. via this link).
The authors first discuss the nature of financial shenanigans. It is important that shenanigans in one of the sections income, cash flow or balance sheet are usually visible in at least one of the others. This is described as “checks and balances”. There is a typical kind of environment in which these accounting tricks can occur, so you can ask yourself these questions:
- Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds?
- Do outside members of the board play a meaningful rolein protecting investors from greedy, misguided, or incompetent management?
- Do the auditors possess the independence, knowledge, and determination to protect investors when management acts inappropriately?
- Has the company taken circuitous steps to avoid regulatory scrutiny?
Since there are many ways for a company to adjust its results, the book states categories to give you an overview: Earnings, Cash Flow and Key Metrics. The following list summarizes all of the crucial warning signs and red flags that can occur:
General Overview
Breeding Ground for Shenanigans
- Absence of checks and balances among senior management
- An extended streak of meeting or beating Wall Street expectations
- A single family dominating management, ownership, or the board of directors
- Presence of related-party transactions
- An inappropriate compensation structure that encourages aggressive financial reporting
- Inappropriate members placed on the board of directors
- Inappropriate business relationships between the company and board members
- An unqualified auditing firm
- An auditor lacking objectivity and the appearance of independence
- Attempts by management to avoid regulatory or legal scrutiny
Earnings Manipulation Shenanigans
Recording Revenue Too Soon
- Recording revenue before completing any obligations under contract
- Recording revenue far in excess of work completed on a contract
- Up-front revenue recognition on long-term contracts
- Use of aggressive assumptions on long-term leases or percentage of completion accounting
- Recording revenue before the buyer’s final acceptance of the product
- Recording revenue when the buyer’s payment remains uncertain or unnecessary
- Cash flow from operations lagging behind net income
- Receivables (especially long-term and unbilled) growing faster than sales
- Accelerating sales by changing the revenue recognition policy
- Using an appropriate accounting method for an unintended purpose
- Inappropriate use of mark-to-market or bill-and-hold accounting
- Changes in revenue recognition assumptions or liberalizing customer collection terms
- Seller offering extremely generous extended payment terms
Recording Bogus Revenue
- Recording revenue from transactions that lack economic substance
- Recording revenue from transactions that lack a reasonable arm’s-length process
- Lack of risk transfer from seller to buyer
- Transactions involving sales to a related party, affiliated party, or joint venture partner
- Boomerang (two-way) transactions to nontraditional buyers
- Recording revenue on receipts from non-revenue-producing transactions
- Recording cash received from a lender, business partner, or vendor as revenue
- Use of an inappropriate or unusual revenue recognition approach
- Inappropriately using the gross rather than the net method of revenue recognition
- Receivables (especially long-term and unbilled) growing much faster than sales
- Revenue growing much faster than accounts receivable
- Unusual increases or decreases in liability reserve accounts
Boosting Income Using One-Time or Unsustainable Activities
- Boosting income using one-time events
- Turning proceeds from the sale of a business into a recurring revenue stream
- Commingling future product sales with buying a business
- Shifting normal operating expenses below the line
- Routinely recording restructuring charges
- Shifting losses to discontinued operations
- Including proceeds received from selling a subsidiary as revenue
- Operating income growing much faster than sales
- Suspicious or frequent use of joint ventures when unwarranted
- Misclassification of income from joint ventures
- Using discretion regarding Balance Sheet classification to boost operating income
Shifting Current Expenses to a Later Period
- Improperly capitalizing normal operating expenses
- Changes in capitalization policy or accelerated capitalization of costs
- New or unusual asset accounts
- Jump in soft assets relative to sales
- Unexpected increase in capital expenditures
- Amortizing or depreciating costs too slowly
- Stretching out depreciable asset life
- Improper amortization of costs associated with loans
- Failing to record expenses for impaired assets
- Jump in inventory relative to cost of goods sold
- Failure by lenders to adequately reserve for credit losses
- Decrease in loan loss reserve relative to bad loans
- Decline in bad debt expense or obsolescence expense
- Decrease in reserves related to bad debts or inventory obsolescence
Employing Other Techniques to Hide Expenses or Losses
- Failing to record an expense from a current transaction
- Unusually large vendor credits or rebates
- Unusual transactions in which vendors send out cash
- Failing to record an expense for a necessary accrual or reversing a past expense
- Unusual declines in reserve for warranty or warranty expense
- Declining accruals, reserves, or “soft liability” accounts
- Unexpected and unwarranted margin expansion
- Unusually “lucky” timing on the issuance of stock options
- Failing to accrue loss reserves
- Failing to highlight off-balance-sheet obligations
- Changing pension, lease, or self-insurance assumptions to reduce expenses
- Outsized pension income
Shifting Current Income to a Later Period
- Creating reserves and releasing them into income in a later period
- Stretching out windfall gains over several years
- Improperly accounting for derivatives in order to smooth income
- Holding back revenue just before an acquisition closes
- Creating acquisition-related reserves and releasing them into income in a later period
- Recording current-period sales in a later period
- Sudden and unexplained declines in deferred revenue
- Changes in revenue recognition policy
- Unexpectedly consistent earnings during a volatile time
- Signs of revenue being held back by the target just before an acquisition closes
Shifting Future Expenses to an Earlier Period
- Improperly writing off assets in the current period to avoid expenses in a future period
- Improperly recording charges to establish reserves used to reduce future expenses
- Large write-offs accompanying the arrival of a new CEO
- Restructuring charges just before an acquisition closes
- Gross margin expansion shortly after an inventory write-off
- Repeated restructuring charges that serve to convert ordinary expenses to a one-time expense
- Unusually smooth earnings during volatile times
Cash Flow Shenanigans
Shifting Financing Cash Inflows to the Operating Section
- Recording bogus CFFO from a normal bank borrowing
- Boosting CFFO by selling receivables before the collection date
- Disclosures about selling receivables with recourse
- Inflating CFFO by faking the sale of receivables
- Changes in the wording of key disclosure items in the financial reports
- Providing less disclosure than in the prior period
- Big margin expansion shortly after an inventory write-off
Shifting Normal Operating Cash Outflows to the Investing Section
- Inflating operating cash flow with boomerang transactions
- Improperly capitalizing normal operating costs
- New or unusual asset accounts
- Jump in soft assets relative to sales
- Unexpected increase in capital expenditures
- Recording purchase of inventory as an investing outflow
- Investing outflows that sound like a normal cost of business
- Purchasing patents, contracts, and development-stage technologies
Inflating Operating Cash Flow Using Acquisitions or Disposals
- Inheriting Operating cash inflows in a normal business acquisition
- Companies that make numerous acquisitions
- Declining free cash flow while CFFO appears to be strong
- Acquiring contracts or customers rather than developing them internally
- Boosting CFFO by creatively structuring the sale of a business
- Categories appearing on the Statement of Cash Flows
- Selling a business, but keeping the related receivables
Boosting Operating Cash Flow Using Unsustainable Activities
- Boosting CFFO by paying vendors more slowly
- Accounts payable increasing faster than cost of goods sold
- Increases in other payables accounts
- Large positive swings on the Statement of Cash Flows
- Evidence of accounts payable financing
- New disclosure about prepayments
- Offering customers incentives to pay invoices early
- Boosting CFFO by purchasing less inventory
- Disclosure about the timing of inventory purchases
- Dramatic improvements in CFFO
- CFFO benefit from one-time items
Key Metrics Shenanigans
Showcasing Misleading Metrics That Overstate Performance
- Changing the definition of a key metric
- Highlighting a misleading metric as a surrogate for revenue
- Unusual definition of organic growth
- Divergence in trend between same-store sales and revenue per store
- Inconsistencies between the earnings release and the 10-Q
- Highlighting a misleading metric as a surrogate for earnings
- Pretending that recurring charges are nonrecurring in nature
- Pretending that one-time gains are recurring in nature
- Highlighting a misleading metric as a surrogate for cash flow
- Headlining a misleading metric on the earnings release
Distorting Balance Sheet Metrics to Avoid Showing Deterioration
- Distorting accounts receivable metrics to hide revenue problems
- Failing to prominently disclose the sale of accounts receivable
- Converting accounts receivable into notes
- Increases in receivables other than accounts receivable
- A huge decline in DSO following several quarters of growing receivables
- Inappropriate or changing methods of calculating DSO
- Distorting inventory metrics to hide profitability problems
- Moving inventory to another part of the Balance Sheet
- Distorting financial asset metrics to hide impairment problems
- Stopping the reporting of certain key metrics
- Distorting debt metrics to hide liquidity problems
All of these bullet points are illustrated with real (and partly unbelievable) case studies which makes reading the book really worth it. I hope you were able to get an insight into the key lessons and potentially some appetite to get a copy.
Note: I hope you have not missed our latest analysis on METKA.
