While most companies act ethically and follow the rules when reporting their financial performance, some take advantage of grey areas in the rules (or worse, ignore the rules altogether) to “make the numbers.”

Management desire to put a positive spin on financial results has been around for as long as corporations and investors themselves. Dishonest companies have long used these tricks to prey on unsuspecting investors, and it is unlikely that will ever change.

The lure of accounting gimmickry is particularly strong at struggling companies that are trying to keep up with their investors’ expectations or their competitors’ performance. And while investors have become savvier to these gimmicks over the years, dishonest companies innovate to find new tricks (and recycle old favorites) to fool shareholders.

What Are Financial Shenanigans?

Financial shenanigans are acts or actions designed to misrepresent the true financial performance of a company. As a result, investors are outwitted into believing that a company’s earnings are stronger, its cash flows are robust, and its Balance Sheet position is more secure than are the case.

Some shenanigans can be detected in the numbers presented by carefully reading a company’s Annual report its Balance Sheet, Statement of Income, and Statement of Cash Flows. Proof of other gimmicks might not be explicitly provided in the numbers and therefore requires examining the narratives contained in footnotes, quarterly earnings releases, and another publicly available management interview.

In the Financial Shenanigans blog, will highlight a few of the tricks that companies manipulate (facts or figures) to give a more acceptable result. There are various ways in which the company can do this and we will look at how these are done in detail.

Types of Financial shenanigans are as follow:-

Earnings refer to a company’s net income or profit for a certain period, such as a fiscal quarter or year. Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month, quarter, or year. Large fluctuations in income and expenses may be a normal part of a company’s operations, but the changes may alarm investors who prefer to see stability and growth. A company’s stock price often rises or falls after an earnings announcement, depending on whether the earnings meet or fall short of analysts’ expectations.

Recording Revenue Too Soon 

Companies can book revenues too soon, push revenues to a later period or book completely bogus earnings to manipulate earnings.

Suppose if the company is seeing some tough times that the business environment going forward is tough they can book revenue early.

On the other hand, if it is doing very well currently, it may want to save for future days and postpone booking revenues later in a dull period. This is to meet the guidance they have given to the analyst during the con-calls.

Companies should record actually when the revenues are earned and not when money is received. For example- In a subscription business, the company received the subscription fees before the customer uses the benefit. If for 3 Months the cost of subscribing any channel is Rs 1800 the company cannot record the full amount at a time as they have received cash now, it should be recorded on pro-rata basis. But some companies will record it as in when they receive the cash to boost the revenue, which is not the right way of recording.

Rising Receivables

Another important metric is to look after receivable days and the trend over time. Increasing receivable days would indicate that the company is extending credit periods to its customer. We should also check receivables as a percentage of sales. The increasing trend in receivable days or if we see a large portion of sales being on credit can be a red flag. On the same side, a proper investigation should be done to understand why this is done by the company.

Some time channel stuffing is also done by a few companies to boost their revenue. Products are sold to dealers and distributors even when they don’t have the requirement, just to move the inventory from their showroom to the dealer’s showroom to inflate the revenue. (Such type of information cannot be found on company’s financial statement, in this case, we can go for scuttlebutts or we can judge in this way if the industry is showing sluggish growth but the company is reporting good top line).

Boosting Income Using One Time Items

One-time items, also known as “extraordinary items”, are often used to boost net income. By definition, one-time items should occur infrequently such as gain/loss from the sale of equipment or damage incurred from a natural disaster.

Corporate management often tells investors to ignore one-time items because they do not reflect the continuous business operations.  They tell investors to focus on normalized income, which is often called “operating income.”

Investors do pay more attention to operating income than the net income number. Therefore, management has the opportunity to inflate operating income by shifting positive benefits from one-time items above the operating income line and shifting normal expenses below the operating line. The former outcome can be achieved by shifting a gain from the sale of an asset above the operating income line as a reduction to operating expenses.

For example in 1999, IBM sold a business to AT&T but instead of disclosing the gain on the sale in the one-time item’s line on the income statement, IBM decided to book the $4.06 billion gain on sale as a contra expense. The effect of IBM’s accounting decision significantly reduced operating expense by $4.06 billion (reducing the $18.8 billion operating expenses to only $14.7 billion!). Investors thought IBM found a magic way to reduce operating expenses and decided to give a higher valuation for the stock only to find out later that those expense reductions didn’t continue into future periods.

Savvy investors reading the financial footnote would have noticed this trick because the company, by law, had to disclose how the sale of a business is accounted for. Companies often bury these unwanted disclosures deep in the footnotes since they know most investors never bother to read 100 pages of financial footnotes. However, it pays off to go through the footnotes of financial statements!

Other means to Boost Revenue

Companies shift their revenue to future period by creating deferred revenue account on the balance sheet this method can also be done by management to boost revenue. Suppose a company makes sales of Rs 1,000 it may choose to record Rs 800 as revenue and defer rest amount to the balance sheet as an asset. In future, it may remove it from asset and can book as revenue on P&L.

Some of the other ways that the company would boost revenues:-

• Recording revenue before shipment or before the customer’s unconditional acceptance.
• Recording revenue even though the customer is not obligated to pay.
• Selling to an affiliated party.
• Giving the customer something of value as a quid pro quo (something for something).
• Grossing up revenue.
• Recording revenue when future services remain to be provided.
• Recording cash received in lending transactions as revenue
• Recording investment income as revenue

As explained above there are lots of little things you can do to increase the revenue side of the equation. There are ways to build false statements to see if receivables are rising, or if they are doing doubtful things to increase revenues and how you might want to investigate such companies before investing by looking forward on this metrics.

In Part 2, we will cover the other metrics of Financial Shenanigans.

Part: 2

Cash Flow Shenanigans

The excessive financial reporting scandals and earnings restatements in recent years have left many investors questioning whether reported earnings can ever be free of management manipulation. Increasingly, investors have expanded their focus to include the Statement of Cash Flows and, more specifically, the section that highlights Cash Flow from Operations (CFFO). Many investors believe that unlike earnings, cash flow is rock solid and difficult to manipulate. Sadly, this is wishful thinking. The Statement of Cash Flows is not immune to accounting gimmicks, and in many ways, manipulating cash flow can be just as easy as manipulating earnings.

Three categories of Cash Flow (CF) Shenanigans that result in misrepresentations of a business’s real cash profitability.

CF Shenanigan No. 1: Shifting financing cash inflows to the Operating section

CF Shenanigan No. 2: Moving cash outflows from the Operating section to other sections

CF Shenanigan No. 3: Boosting operating cash flow using unsustainable activities Shenanigans

Cash Flow from Normal Borrowing

Borrowing is a normal business activity. It should be documented as an inflow under Cash from Financing. However, creative borrowing structures can shift inflow of cash as a Financing Activity to inflow for Cash from Operations. For example, using inventory as collateral on a loan is normal but selling that inventory with the obligation of buying it back at a later time is not so normal.

Another tactic that utilizes borrowing to document cash where it shouldn’t be is the use of complicated special purpose vehicles or subsidiaries. A larger company can create an SPV or Subsidiary and help that individual entity borrow money. The money that entity borrows can be used to “purchase” from the company that helped set it up. Under this structure, the larger (or parent) company gets an inflow of cash reported under Cash from Operations. The SPV or Subsidiary takes the hit to their balance sheet with higher debt that was used to finance an operating expense. This was one of the many tactics Enron used to keep meeting expectations during its fraudulent run.

Spotting Cash Flow from borrowing activities can be difficult. One area to thoroughly analyze is any stray act from normal reporting definitions. If a company has decided to redefine a standard metric or label for reporting purposes, it is worth understanding what might be the motivation behind that action. In addition, when a company discloses its relationship with an SPV or an outside entity, do your research to understand how much that relationship is affecting inflows of Cash from Operations.

Inventory as an Investing Activity

The cost of inventory makes up a large part of Cost of Goods Sold (COGS). Logically, this should be documented as an operating expense and therefore directly impacting the company Operating Cash Flow. However, sometimes a company can make a strong argument for why what some would consider inventory, they consider an investment asset.

Take for example the practical situation Netflix encountered. In its earlier days of operation, Netflix had to make a decision as to how they would treat the purchase of DVDs. Was it a normal operating expense of inventory (think replacement and consistent turnover), or an actual asset.

Typically companies will specify how they are treating decisions of this nature and stick to one method or another. If a company flip-flops, it warrants taking a closer look to understand the real story as to why they are changing the rules well into the game. As an investor, it is important to understand management’s decisions around this and how it affects the numbers you are analyzing.

Other key Metric

Few Quantifiable Ratios can be used to find red flags or accounting checks in the companies before investing.

Conclusion: Despite real-world accounting is more complicated than what you learned in financial shenanigans book, I believe everyone has the necessary tools to detect accounting frauds. The key is to read the footnotes carefully so that you can detect aggressive accounting assumptions, whether it is related to revenue, expenses or one-time items.

Source:

FINANCIAL SHENANIGANS: how to detect accounting gimmicks & fraud in financial reports, Kenny Yang.