Financial Shenanigans, Fourth Edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports 4th Edition
by Howard Schilit (Author), Jeremy Perler (Author), Yoni Engelhart (Author)
Leo: detail techniques & ways to find frauds in financial & accounting reports from companies, should keep by hand to refer anytimes.
Take out: keep skepticism, and always ask Why for the change? Why NOW? Like a detective mind.
— Some quotes & good usages —-
Be Alert for Companies That Lack Checks and Balances Among Management
Watch for Senior Executives Who Push for Winning at All Costs
Be Skeptical of Boastful or Promotional Management
Boards Lacking Competence or Independence
Techniques to Record Revenue Too Soon
- Recording revenue before completing material obligations under the contract
- Recording revenue far in excess of work completed on the contract
- Recording revenue before the buyer’s final acceptance of the product
- Recording revenue when the buyer’s payment remains uncertain or unnecessary
Key Lessons for Investors Two important lessons can be gleaned from the MicroStrategy story:
(1) Funds flowing back and forth between a customer and seller should raise suspicions about the legitimacy of both transactions,and
(2) the suspicious timing of press releases announcing new sales (just after a period ended) should raise questions about whether revenue might have been recognized too early.
Be Wary of Companies That Extend Their Quarter-End Date
Changing Accounting Policies to Keep the Streak Alive
Changing Estimates and Assumptions When Using POC (Percentage of Completion) Accounting
Be Alert for Up-Front Recognition of a Long-Term License Contract
Watch for Shipping Product to an Intermediary, Rather Than the Actual Customer
Be Wary of Sellers Deliberately Shipping Incorrect or Incomplete Products
Be Alert to Sellers Shipping Product Before the Agreed-upon Shipping Date
Be Mindful of Sellers Recording Revenue Before the Lapse of the Right of Return
Watch for Companies That Change Their Assessment of Customers’ Ability to Pay
Watch for Companies That Offer Extended or Flexible Payment Terms
Techniques to Record Bogus Revenue
- Recording revenue from transactions that lack economic substance
- Recording revenue from transactions that lack a reasonable arm’s length process
- Recording revenue on receipts from non-revenue-producing transactions
- Recording revenue from appropriate transactions, but at inflated amounts
Be extremely cautious when a company reports barter or “nonmonetary” sales, especially when the buyer is a related party.
Be Wary of Related-Party Customers and Joint Venture Partners
Watch for Transactions with Parent Companies
Be Alert for Suspicious Revenue from Transactions with Joint Venture Partners
Turning the Sale of a Business into a Recurring Revenue Stream
Be sure to always review both parties’ disclosures on the sale of businesses to best grasp the true economics of the transactions.
Watch for Changes in Accounting Policies That Accelerate Recognition of Income
Watch for Companies That Constantly Record “Restructuring Charges”
Watch for Companies That Shift Losses to Discontinued Operations
Watch for Companies That Include Investment Income as Revenue
Techniques to Shift Current Expenses to a Later Period
- Excessively capitalizing normal operating expenses
- Amortizing costs too slowly
- Failing to write down assets with impaired value
- Failing to record expenses for uncollectible receivables and devalued investments
WARNING SIGNS OF IMPROPERLY CAPITALIZING NORMAL OPERATING EXPENSES
- Unwarranted improvement in profit margins and a large jump in certain assets
- A big unexpected decline in free cash flow, with an equally sizable increase in cash flow from operations
- Unexpected increases in capital expenditures that belie the company’s original guidance and market conditions
Watch for Improper Capitalization of Marketing and Solicitation Costs
Watch for Earnings Boosts After Adopting New Accounting Rules
Regardless of the legitimacy of an accounting change, investors should strive to understand the impact that this change had on earnings growth.
Simply put: any growth related to the change will not recur. To be maintained, the growth must be replaced with improved operational performance.
A new or unusual asset account (particularly one that is increasing rapidly) may signal improper capitalization.
When all reserve accruals are moving in the wrong direction (i.e.,declining), head for the hills!
Watch for a Decline in Allowance for Doubtful Accounts
Watch for a Decline in Loan Loss Reserves
Loan loss reserves decline relative to bad (nonaccrual or nonperforming) loans.
Be Extra Cautious When Companies Lend Money to Their Own Customers
Employing Other Techniques to Hide Expenses or Losses
- Failing to record an expense at the appropriate amount from a current transaction
- Recording inappropriately low expenses by using aggressive accounting assumptions
- Reducing expenses by releasing reserves from previous charges
Always view cash receipts from vendors with suspicion. Cash normally flows out to vendors, not in from vendors, so unusual cash inflows from vendors may signal an accounting shenanigan.
Be Alert for Changes in Self-Insurance Assumptions
Companies can take great liberties in setting up large restructuring (or other) reserves and later inflate profits when closing out these unnecessary expense accounts.
- Creating reserves and releasing them into income in a later period
- Smoothing income by improperly accounting for derivatives
- Creating reserves in conjunction with an acquisition and releasing them into income in a later period
- Recording current-period sales in a later period
Creating Deferred (or Unearned) Revenue
The ultimate gain was not earnings creation but earnings smoothing. Both types of shenanigans clearly violate accounting rules and misrepresent the economic reality to investors.
Investors should be cautious when a company reports large gains from hedging activities,
Investors should also be wary of “hedges” that move in the same direction as the underlying asset or liability, as this may signal that management is using derivatives to speculate, not to hedge
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
the write-off of fixed assets, goodwill, and purchased technology. Naturally, writing off these assets would reduce future-period depreciation and amortization expense and increase net income
Watch for Dramatic Improvement in the Numbers Right After the Restructuring Period
Creating a Larger-Than-Needed Restructuring Reserve and Inflating Future Earnings by Releasing the Reserve
When management is planning to lay off employees, it instead takes an inappropriately large restructuring charge (e.g., it plans to lay off 100 people but takes a charge for 200). By announcing a 200-person layoff when 100 would be sufficient, management doubles the restructuring expense and liability.
Watch for Companies That Create Reserves at the Time of an Acquisition
High net income along with low CFFO often signals the presence of some Earnings Manipulation Shenanigans.
Although net income and CFFO represent different measures of a company’s performance, investors should generally expect them to move in the same direction. That is, if a company reports growing net income, it would be worth raising questions if cash flow from operations is shrinking.
It is well worth your time to look for changes in disclosure each quarter, particularly in the most important sections of the filings. Most research platforms and word processing software have “word compare” or “blackline” functionality. Reviewing both filings side by side is not as
cumbersome as it sounds. Whenever companies disclose that a mysterious new arrangement is a driver of CFFO (or of any important metric, for that matter), investors should seek to understand the mechanics of the arrangement.
Sometimes companies get confused and include cash received as part of cash flow from operations even though credit risks remain and the proper categorization should be in the Financing section.
Rapidly increasing “soft” asset accounts (e.g., “prepaid expenses,” “other assets”) may be a sign of aggressive capitalization.
Free cash flow measures the cash generated by a company, including the impact of cash paid to maintain or expand its asset base (i.e., purchases of capital equipment). Free cash flow typically would be calculated as follows: Cash flow from operations minus capital expenditures
While many investors are pleased when management says that it is “aggressively managing working capital,” you should take this as a warning sign that recent CFFO growth may not be sustainable
Many consider same-store sales to be the most important metric in analyzing a retailer or restaurant. We agree that if it is reported in a logical and consistent manner, SSS is extremely
valuable for investors.
However, because same-store sales (and the other metrics discussed in Part Four) fall outside of GAAP coverage, no universally accepted definition exists, and calculations may vary from company to company.
“Cash Earnings” and EBITDA Are Not Cash Flow Metrics
Paying out enormous dividends while generating negative free cash flows was simply not a sustainable strategy—and should have been a strong warning sign.
For the purposes of identifying aggressive revenue recognition practices, we suggest that
investors use the ending (not the average) receivables balance when calculating DSO.
Days’ sales outstanding is generally calculated as follows: Ending receivables/revenue × number of days in the period (for quarterly periods, 91.25 days is a normal approximation)
When management changes how it computes operational metrics it is often
attempting to hide some deterioration from investors.
Normally, investors would be reluctant to purchase new bonds and equity from a poorly performing company that was strapped with heavy debt obligations and had no cash.
The centerpiece of Parmalat’s fraud seems to have been the company’s use of offshore entities to hide fictitious or impaired assets, fabricate the reduction of debt, and create fake income.
As an investor, you should cringe when you see a company having a public disagreement with its auditor, particularly on a shady transaction of significant magnitude.
There are many reasons that acquisitions fail to live up to the hype. In our
experience, three of them seem particularly resonant:
- Widespread overconfidence in the magic of “synergies”
- Reckless transactions motivated by intense fear or greed
- Deals driven by artificial accounting and reporting benefits rather than business logic
fees to a middleman. the cut for investment bankers typically would be 1 to 2
In real economic terms, FPAM paid $197 million and received $55 million rebate over two years, resulting in a net acquisition cost of $142 million and zero revenue on this deal.
- Inheriting operating inflows in a normal business acquisition
- Acquiring contracts or customers rather than developing them internally
- Boosting CFFO by creatively structuring the sale of a business
Unfortunately, heavy reliance on CFFO for acquisitive companies is ill
advised because of a deep, dark secret that companies want to hide from
Cash spent to purchase inventory and other costs related to the sale occurred before the acquisition, and when you close on the deal, you obviously must pay the seller for inventory, receivables, and so on, but those outflows are reflected in the Investing section. the deal closes, you collect all that delicious cash from customers and show it as inflows in the Operating section. By liquidating and not replenishing these assets (i.e.., keeping the acquired business’s inventories at a lower level), you can show an unsustainable benefit to cash flow. Brilliant! In an
acquisition context, cash outflows never hit the Operating section, yet all the inflows do
When buying another business, companies inherit a new stream of cash flows without having to incur a CFFO outflow. Moreover, by liquidating the working capital of the acquired business, a company can provide itself with an unsustainable CFFO boost. These accounting nuances are why companies that grow through acquisitions often appear to have stronger CFFO than companies that grow organically.
“Free cash flow after acquisitions” is a useful measure of cash flow when analyzing serial acquirers. This metric can easily be calculated from the Statement of Cash Flows: CFFO minus capital expenditures minus cash paid for acquisitions.
When a company is in the process of correcting past accounting errors, smart investors will stay away until they have the chance to analyze the company’s true performance. There is a good chance that the corrected numbers and underlying business performance will be worse than
News of an internal accounting investigation, particularly one focused on revenue recognition, should never be taken lightly.
Thoughtful investors, however, should never overlook a culture of unethical business or
financial reporting practices.
As you know by now, we are no big fans of an M&A-driven approach because so much can (and often does) go wrong. But when the seller has been a longtime owner (and ideally, the founder), we can breathe a sigh of relief knowing that the business probably was built carefully, with a
solid foundation, and often with a goal of being built to last.
Things get more complicated when the seller has a very short-term horizon, like a leveraged buyout firm. The goals of such firms are to benefit themselves and their limited partners by flipping the acquisition and maximizing their gain.
They often do so by:
(1) putting little equity into the investment, using mainly debt;
(2) paying themselves special dividends, even if it means loading more debt on the Balance Sheet of a portfolio company;
(3) making further acquisitions adding yet more debt;
(4) cutting “discretionary” costs, such as R&D, which may help short-term earnings but make long-term success more uncertain. executives at Valeant cared little about maintaining culture and values fostered at newly acquired companies; that should be a flashing red flag for investors.
Investors who can remain objective and skeptical, while the herds echo and amplify each
other’s excitement, have a better chance of profiting from the more blatant disconnects from reality.
APPLYING THE FORENSIC MINDSET
- Skepticism is a competitive advantage.
- Pay close attention to changes—always ask “why?” and “why now?”
- Look past “accounting problems” to see if business problems are being covered up.
- Pay attention to corporate culture and watch for breeding grounds of bad behavior.
- Never blindly adopt the company’s profitability framework.
- Incentives matter: pay close attention to how executives are compensated.
- Even in financial disclosures: location, location, location.
- Like in golf, every shot counts.
- Patterns of behavior provide a reliable signal.
- Be humble and curious, and never stop learning.
non-GAAP metrics as its “EBITDA,” “underlying business profit,” “adjusted earnings,” or many
other variants. In some cases, these alternative metrics provide a valuable supplement to the GAAP-based figures; however, in many cases they leave out important aspects of the business’s cost structure. Even if certain metrics become industry standards, investors must consider how well they actually reflect the full economics of the business.
What has been will be again, what has been done, will be done again; there is nothing new under the sun. (Ecclesiastes 1:9)