Financial Shenanigans — A Summary
The collapse of crypto exchange FTX, WireCard’s fraudulent M&A scheme, Nikola’s fake hydro trucks, Theranos’ never-existing blood test machine, Enron, Lehman Brothers, and the list goes on…
This article represents a summary of the book Financial Shenanigans — How to Detect Accounting Gimmicks and Fraud by Schilit and Perler.
Areas of focus: 1) how companies touch up financial statements to hide their deteriorating financial health from investors, and 2) what questions need to be asked in order to find those warning signs.
I can’t afford the operation, but would you accept a small payment to touch up the x-rays? Warren Buffet
Financial shenanigans are actions taken by management that mislead investors about a company’s financial performance or economic health.
The following manipulation schemes are discussed:
- Earnings manipulation
- Cash flow manipulation
- Key metrics manipulation
- Acquisition accounting manipulation
Earnings Manipulation Shenanigan No. 1: Recording Revenue Too Soon
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
1. Recording revenue before completing material obligations under the contract
Warning Signs in Odd Press Releases
- When money flows in both directions, from seller (MSTR) to customer (NCR) and then from customer to seller, we call it a “boomerang” transaction.
- Funds flowing back and forth between a customer and seller should raise suspicions about the legitimacy of both transactions.
- 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.
Calendar Games
Be Wary of Companies That Extend Their Quarter-End Date to close their books only after reaching the desired sales and profits.
Changing Accounting Policies to Keep the Streak Alive
The company whimsically changed its decision rules on when recognition begins and where large-quantity rebates get categorized on the Income Statement.
A company began to recognize some revenue earlier in the sales process — at the point of shipment, rather than delivery.
It started to treat incentives or “rebates” to customers as an operating expense rather than a reduction of sales.
2. Recording Revenue Far in Excess of Work Completed on the Contract
Changing Revenue Recognition Policy to Record Revenue Sooner (and Greater Amounts)
Watch for a Change in Revenue Recognition Policy to Hide Collapsing Business, especially changing revenue recognition approach to percentage-of-completion (POC).
POC revenue recognition allows companies to report revenue even before a project has been completed. It was introduced so that firms working on long-term construction-type contracts could report business activity each period even if a product was not delivered to the customer.
Be Alert for Up-Front Recognition of a Long-Term License Contract, this is: the company would recognize the present value of all licensing revenue for the entire contract immediately.
Investors should use a measure called “days’ sales outstanding” (DSO) to evaluate how quickly customers are paying their bills relative to how quickly revenue is recorded. A higher DSO could indicate more aggressive revenue recognition in addition to simply poor cash management.
3. Recording Revenue Before the Buyer’s Final Acceptance of the Product
Recording revenue (1) before shipment of product to the buyer, (2) after shipment but to someone other than the buyer, and (3) after shipment but while the buyer still could void the sale.
Seller Records Revenue Before Shipment
- Watch for Bill-and-Hold Transactions Initiated by the Seller
Seller Records Revenue upon Shipment to Someone Other Than the Customer
- Watch for Shipping Product to an Intermediary, Rather Than the Actual Customer
- Be Wary of Consignment Arrangements. Think of the consignee as an outside sales agent who is given the task of finding a buyer.
- Who Is the Actual Customer — the Distributor or the End User? “Stuff the channel,” meaning co shipped much more product to the distributors than they could sell to their customers.
Seller Records Revenue, but Buyer Can Still Reject the Sale
- 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
4. Recording Revenue When the Buyer’s Payment Remains Uncertain or Unnecessary
Buyer Lacks the Ability or the Necessary Approval to Pay
- Watch for Companies That Change Their Assessment of Customers’ Ability to Pay
Seller Induces Sale by Allowing an Exceptionally Long Time to Pay
- Watch for Seller-Provided Financing
- Watch for Companies That Offer Extended or Flexible Payment Terms
- Sound the Alarm When New Extended Payment Terms Are Disclosed and DSO Jumps
Earnings Manipulation Strategy 2: Recording Bogus Revenue
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
Warning Sings
- Watch for Barter Transactions with Related Parties
- 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
- Question Revenue Recorded When Cash Is Received in Lending Transactions
- Watch for Companies Grossing Up Revenue to Appear to Be Much Larger
Earnings Manipulation Strategy 3: Boosting Income Using One-Time or Unsustainable Activities
Techniques to Boost Income Using One-Time or Unsustainable Activities
- Boosting income using one-time events
- Boosting income through misleading classifications
Warning Signs
- Turning the Sale of a Business into a Recurring Revenue Stream
- Beware of Commingling the Sale of a Business with the Sale of Product
- 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
- Be Suspicious of Inflated Operating Income Related to Subsidiaries
Earnings Manipulation Strategy 4: Shifting Current Expenses to a Later Period
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
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
- Be Wary of Unusual Asset Accounts on the Balance Sheet
- Capitalizing Software Development Costs
- Watch for an Increase in Software Capitalization
- Watch for Growing Advances or Prepayments
- Be Alert for Boosts to Income by Stretching Out the Amortization Period
- Be Particularly Wary of Big Income Boosts from Stretching Out Depreciable Lives
- Be Alert for Slow Amortization of Inventory Costs
- Failure to Write Off Impaired Plant Assets
- Failure to Write Off Obsolete Inventory
- Watch for an Unexpected Inventory Buildup
- Watch for a Decline in Bad Debts Expense
- Watch for a Decline in Allowance for Doubtful Accounts
- Watch for a Decline in Loan Loss Reserves
- Be Extra Cautious When Companies Lend Money to Their Own Customers
- Watch for Tricks to Make Losses from Impaired Assets Disappear
Earnings Manipulation Strategy 5: Employing Other Techniques to Hide Expenses or Losses
Employing Other Techniques to Hide Expenses or Losses 1. Failing to record an expense at the appropriate amount from a current transaction 2. Recording inappropriately low expenses by using aggressive accounting assumptions 3. Reducing expenses by releasing reserves from previous charges
Earnings Manipulation Strategy 6: Shifting Current Income to a Later Period
Techniques to Shift Current Income to a Later Period
- 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
Earnings Manipulation Strategy 7: Shifting Future Expenses to the Current Period
Techniques to Shift 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
Cash Flow Shenanigans
Cash Flow Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section
Techniques to Shift Financing Cash Inflows to the Operating Section
- Recording bogus cash flow from operations (CFFO) from a normal bank borrowing
- Boosting CFFO by selling receivables before the collection date
- Inflating CFFO by faking the sale of receivables
Be Wary Around Pro Forma CFFO Metrics
Watch for Sudden Swings on the Statement of Cash Flows
Read the Quarterly Filings to Know What to Anticipate
Watch Carefully for Disclosure Changes in the Risk Factors
Cash Flow Shenanigan No. 2: Moving Operating Cash Outflows to Other Sections
Techniques to Move Cash Outflows to Other Sections
- Inflating CFFO with boomerang transactions
- Improperly capitalizing normal operating costs
- Recording the purchase of inventory as an investing outflow
- Shifting operating cash outflows off the Statement of Cash Flows
Consider Differences in Accounting Policies When Comparing Competitors
Question Any Investing Outflow That Sounds like a Normal Cost of Operations
Look for “Supplemental Cash Flow Information”
Cash Flow Shenanigan No. 3: Boosting Operating Cash Flow Using Unsustainable Activities
Techniques to Boost Operating Cash Flow Using Unsustainable Activities
- Boosting CFFO by paying vendors more slowly
- Boosting CFFO by collecting from customers more quickly
- Boosting CFFO by purchasing less inventory
- Boosting CFFO with one-time benefits
Watch for Large and Suspicious Increases in Payables
Look for Large Positive Swings on the Statement of Cash Flows
Be Alert When Companies Use Accounts Payable “Financing”
Watch for Swings in Other Payables Accounts
In 10-Q and 10-K filings, turn to the Management Discussion and Analysis (MD&A) — in a section often called “Liquidity and Capital Resources.” This section is a must-read for every company you analyze.
KEY METRIC SHENANIGANS
Remember to ask these two important questions:
1. What are the best metrics of that specific company’s performance, and does management highlight, ignore, distort, or even make up its own version of these metrics? 2. What are the best metrics that would reveal a specific company’s deteriorating economic health, and does management highlight, ignore, distort, or even make up its own version of these metrics?
Key Metric Shenanigan No. 1: Showcasing Misleading Metrics That Overstate Performance
Techniques to Showcase Misleading Metrics That Overstate Performance
- Highlighting a misleading metric as a surrogate for revenue
- Highlighting a misleading metric as a surrogate for earnings
- Highlighting a misleading metric as a surrogate for cash flow
Compare Same-Store Sales to the Change in Revenue per Store
Watch for Changes in the Definition of Same-Store Sales
Pay Close Attention to Which Parts of the Business Reported Growth Reflects
Pretending That Recurring Charges Are One-Time in Nature
Key Metric Shenanigan No. 2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration
Techniques to Distort Balance Sheet Metrics to Avoid Showing Deterioration
- Distorting accounts receivable metrics to hide revenue problems
- Distorting inventory metrics to hide profitability problems
- Distorting financial asset metrics to hide impairment problems
- Distorting debt metrics to hide liquidity problems
Watch for Increases in Receivables Other Than Accounts Receivable
Watch Out for Varying Company DSO Calculations
Watch for Changes in a Company’s DSO Calculation
Watch for Inventory That Moves to Another Part of the Balance Sheet
Be Cautious About New Company-Created Metrics
ACQUISITION ACCOUNTING SHENANIGANS
Main reasons that acquisitions fail:
- 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
Acquisition Accounting Shenanigan No. 1: Artificially Boosting Revenue and Earnings
Acquisition Accounting Techniques to Artificially Boost Revenue and Earnings
- Inflating profits through tricks at a target company before a deal closes
- Inflating profits by hiding losses at deal closing
- Creating dubious new revenue streams after closing
- Inflating profits by releasing suspicious reserves either before or just after closing
Certain costs that typically should be reflected as expenses on the Income Statement are instead found on the Balance Sheet in goodwill or intangibles.
Watch for a Slowdown in Revenue at the Target Prior to the Acquisition Close
Watch for Unusual Sources of Revenue at the Time of an Acquisition
Watch for Either a Buyer or Seller Creating an Unrelated Nonrecurring Revenue Stream
Question the Management of the Acquirer When Changing Accounting Practices of a Target Inflate Profits
Watch for Big Gains from Reductions of Contingent Consideration Liability
Acquisition Accounting Shenanigan No. 2: Inflating Reported Cash Flow
Acquisition Accounting Techniques to Artificially Boost Cash Flow from Operations
- 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
Treat CFFO Differently for Acquisitive Companies
Review the Balance Sheets of Acquired Companies
Watch for New Categories on the Statement of Cash Flows
Acquisition Accounting Shenanigan No. 3: Manipulating Key Metrics
Raise Your Antennae When Key Metrics Include Acquired Revenue Streams
Look for Strange Definitions of Organic or Pro Forma Sales Growth
Be Skeptical When GAAP Earnings Materially Lag “Adjusted Earnings”
Example Companies
Hertz, Toshiba, Valeant Pharmaceuticals, Microstrategy, Sunbeam, Keurig Green, Ulvac, Krispy Kreme Doughnuts, Symbol Technologies, Informix, Kendall Square Research Corporation, Openwave, Fitbit, AIG, Symbol Technologies, Syntax-Brillian, Hanergy Solar, Iconix, Delphi Corporation, Stop & Shop and Giant, Enron, AOL, IBM, AT&T, SoftBank, Boston Chicken, WorldCom, Lucent, Ultimate Software Group, Vitesse Semiconductor, New Century Financial, Signet Jewelers, Deere & Company, Rent-A-Center Inc., Navistar International Corp., Marvell, Dell, Microsoft, Freddie Mac, GE, Washington Mutual Inc., NVIDIA, Toys ‘R’ Us, Scott Paper Company, 3com, Xerox, Cardinal Health, Peregrine, Computer Associates, Zoomlion, Global Crossing, Netflix, Cephalon, Nuance Communications, Biovail, T-Mobile, Tesla Motors, Silicon Graphics, Home Depot, Coach Inc., Thomson Reuters, Sirius Satellite Radio, ACI Worldwide, Sabre Corporation, Linn Energy, UTStarcom, Merck & Co., Parmalat Finanziaria, UAL, Sears, Salix
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.
Questions to Ask
- Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds?
- Do outside members of the board play a meaningful role in 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 improperly taken circuitous steps to avoid regulatory scrutiny?
Watch for Senior Executives Who Push for Winning at All Costs
- Be careful when management shows a necessity of always “making the numbers”.
Be Skeptical of Boastful or Promotional Management
- Be careful when management publicly boasts about its long consecutive streak of meeting or exceeding Wall Street’s expectations.
Boards Lacking Competence or Independence
Sitting as an outside director on a corporate board brings prestige, perks, and a nice paycheck, with cash and noncash compensation often exceeding $200,000 per year.
Investors must evaluate board members on two levels:
- Do they belong on the board, and are they qualified for the committees on which they sit (e.g., audit or compensation)?
- Are they appropriately performing their duties to protect investors?
Red flags include
- Failure to Challenge Management on Related-Party Transactions
- Failure to Challenge Management on Inappropriate Compensation Plans
- Auditors Lacking Objectivity and the Appearance of Independence
- Incompetent Auditors Can Serve as Shills for Management
- Too Long and Close a Relationship Prevents a Fresh Look at the Picture
- Management Schemes to Avoid Regulatory Scrutiny
- Lack of Regulatory Scrutiny Before Going Public, aka SPACs
SEC 10-K and 10-Q Examples
Keurig Green 10-K Footnotes
10-K 2007 — Revenue from wholesale and consumer direct sales is recognized upon product delivery. In addition, the Company’s customers can earn certain incentives, which are netted against sales in the consolidated income statements. [Italics/bold added for emphasis]
10-K 2008 — Revenue from wholesale and consumer direct sales is recognized upon product delivery, and in some cases upon product shipment. In addition, the Company’s customers can earn certain incentives, which are netted against sales or recorded in operating and selling expenses in the consolidated income statements. [Italics/bold added for emphasis]
First Solar 10-K Footnotes
10-K 2014 —Company updated its estimates for total project costs to recognize an additional $40 million of sales (following a boost of $8.5 million in 2013). Since no additional costs were associated with this windfall revenue, gross profit and operating income increased by an equal amount.
Sunbeam 10-K Footnotes
Sunbeam recognized $29 million in revenue earlier by using bill-and-hold transactions.
Openwave Systems 10-Q Footnotes
10-Q 2005 — Openwave initially waited until the receipt of cash before recognizing any revenue from “deadbeat” customers that it feared might not pay. Under a new policy, Openwave could recognize revenue immediately, simply by concluding that the customer no longer was a deadbeat. The immediately recognized inflow provided a once-off boost to revenue.
Phrase examples:
- The Company revised its policy regarding the determination factor for deferrals of revenue recognition for arrangements deemed not probable for collection.
- Prior to the quarter […], the Company continued to defer revenue recognition on arrangements originally deemed not probable for collection until the receipt of cash from that arrangement. As of the quarter ended December 31, 2005, the Company revised its policy such that revenue on arrangements previously deemed not probable for collection, which are subsequently deemed probable for collection, is recognized in the period of the change in the assessment of collectability […]
Syntax-Brillian (SynBri) Footnotes
10-K 2005–2007 — Footnote disclosing unusually large vendor credits and significant related-party transactions. Between 2006 and 2007, SynBri reported a gross profit of $142 million, which included credits from its primary supplier totaling $214 million for which it never received cash; they were just bookkeeping entries. As a result, Syntax-Brillian showed decent profitability, but it showed severely negative cash flow from operations.