Financial Shenanigans Watch for: executive incentives which encourage managing financial statements poor internal controls quarterly

rly financial statements (they are not audited) companies with weak control environment (board of directors is not independent; auditors not independent) management facing extreme competitive pressure management with questionable character fast growth companies whose real growth is beginning to slow basket case companies struggling to survive newly public companies private companies (especially those which arent audited)

The Seven Shenanigans

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"ecording "evenue #oo $oon shipping goods before the sale is finali%ed recording revenue when important uncertainties exist recording revenues when future services are still due "ecording 'ogus "evenues recording income on the exchange of similar assets recording refunds from suppliers as revenues using bogus estimates on interim financial reports 'oosting )ncome With *ne #ime +ains boosting profits by selling undervalued assets boosting profits by retiring debt failing to segregate unusual and nonrecurring gains or losses from recurring income burying losses under noncontinuing operations $hifting -urrent .xpenses to a /ater 0eriod improperly capitali%ing costs depreciating or amorti%ing costs too slowly failing to write off worthless assets 2ailing to "ecord or 3isclose 4ll /iabilities reporting revenue rather than a liability when cash is received failing to accrue expected or contingent liabilities failing to disclose commitments and contingencies engaging in transactions to keep debt off the books $hifting -urrent )ncome to a /ater 0eriod creating reserves to shift sales revenue to a later period $hifting 2uture .xpenses to the -urrent 0eriod accelerating discretionary expenses into the current period writing off future years depreciation or amorti%ation

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Gathering Financial Data 789 auditors report absence of opinion qualified report reputation of auditor audit committee (independent directors act as intermediary with auditors) footnotes accounting policies : changes (in policies or estimates) review inventory valuation (/)2* vs! 2)2* : specific id)(except technology) revenue recognition (after sale vs! 4t sale with risk remaining) depreciation (accelerated vs! $traight line) amorti%ation of goodwill (shorter vs! /onger) estimate of warranty (high vs! /ow) estimate of bad debts (high vs! /ow) treatment of advertising (expense vs! -apitali%e) loss contingencies (accrue loss vs! 2ootnote only) pending or imminent litigation ()tem (; better than footnote in annual) long term purchase commitments (at what price<) contingencies or commitments industry specific notes segment information (showing unhealthy segment) =3>4 (management discussion and analysis) specific concise disclosures (liquidity; capital expenditures; candor) consistent with footnotes 4nnual "eport presidents letter forthrightness vs! 4lways upbeat 0roxy (for annual meeting) litigation executive compensation turnover of management related party transactions 78? unaudited
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consistency with 789 @89 (special events) auditor changes disagreements over accounting policies (opinion shopping) change in control of the company acquisitions dispositions resignation of directors bankruptcy 0rospectus past performance quality of management and directors

Rule 1: Recording Revenue Too Soon "evenue should be recorded after the earnings process has been completed and an exchange has occurred! earnings process should be substantially complete arms length exchange #hree #ypical $cenarios
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$hipping +oods 'efore a $ale is 2inali%ed goods must be exchanged for cash or reliable promise to pay before revenue recogni%ed watch for early shipping before sale occurs (especially at end of quarter) shipments in advance of delivery dates partial shipments of merchandise; containing only part of a customers order shipments of merchandise for which customers had canceled their orders long term contracts can be an exception (often use percentage of completion); but their could still be problems: uncertainties exist A estimates of future costs interim measures of completion rate can be difficult changes in cost and completion estimates to manipulate earnings political uncertainties can change contract (e!g!; defense orders canceled) new companies with uncertain products or markets "ecording "evenue When )mportant Bncertainties .xist there should be a high probability that goods will be paid for and not returned must determine whether: risks and benefits of ownership have been transferred to the buyer sale of receivables to factor with recourse or without recourse the buyer might return the goods does right of return exist the buyer may not pay for the goods does buyer have financing to pay for goods

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is buyers purchase contingent on his ability to resell product is buyer obligated to pay

"ecording "evenue When 2uture $ervices are $till 3ue should only recogni%e revenue earned to date; remainder of receipts are a liability often the case with franchisers recogni%e revenue while still promising future services Carea development rightsD to have exclusive right to open franchises in area these should not be considered to be current income (defer until franchises open)

Rule 2: Recording Bogus Revenues "evenue should be recorded after the earnings process has been completed and an exchange has occurred! #hree #ypical $cenarios
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"ecording )ncome on the .xchange of $imilar 4ssets no gain should be recorded on the exchange of similar property "ecording "efunds from $uppliers as "evenue retailers often receive refunds from suppliers! #his is not revenue! Bsing 'ogus .stimates on )nterim 2inancial "eports must estimate sales returns; future warranty costs; longevity of plant and equipment with quarterly report; estimate inventory level and cost of goods sold often done by using Cgross profit rateD

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Rule 3: Boosting Income with One Time Gains "evenue should be recorded after the earnings process has been completed and an exchange has occurred! $imilarly; gains should be reported only after an exchange has taken place! 2our -ommon #echniques
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'oosting 0rofits by $elling Bndervalued 4ssets these are nonrecurring gains typical examples include: selling assets acquired in a pooling transaction company that uses /)2* (especially with many inventory pools; which allow management to especially manage cost of goods sold) e!g!; separate inventory into three pools! .ach pool has inventory purchased in each of the last three years (higher prices each year)! Bse all of one pool to get to the lower priced inventory and increase earnings! real estate (or other assets) acquired long ago 'oosting 0rofits by "etiring 3ebt this is especially interesting when new debt is issued at higher rates such gains do not recur 2ailing to $egregate Bnusual and Eonrecurring +ains or /osses 2rom "ecurring )ncome nonoperating gains (e!g!; sale of assets) noncontinuing activities (e!g; discontinued business) some companies try to argue that since they engage in a particular type of transaction frequently; it is revenue from normal operations (e!g!; a hotel chain that sells its old properties) watch for the mingling of operating with nonoperating income i!e!; income from operations; as opposed to revenue from ancillary services (such as interest and rental income) 'urying /osses Bnder Eoncontinuing *perations noncontinuing operations include discontinued operations; extraordinary gains : losses; and the cumulative effect on income from changing accounting principles

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Rule !: Shi"ting #urrent $%&enses to a 'ater (eriod 4n enterprise should capitali%e costs incurred that produce a future benefit and expense those that produce no such benefit! )f the asset is immaterial or the benefit will be received over a short period of time; expense the item! .xpenses should be charged against income in the period in which the benefit is received! 4s an enterprise reali%es the benefit from using an asset; the asset or a part thereof should be written off as an expense of the period! When there is a sudden and substantial impairment in an assets value; the asset should be written off immediately and in its entirety; rather than gradually! #hree -ommon $cenarios
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)mproperly -apitali%ing -osts shifts expense to a later period improper capitali%ation often includes start8up costs; research and development costs; advertising; and administrative costs this is done by creating an asset (a deferred asset) it can also be done by charging some of this expense to inventory (delaying the expense until the merchandise is sold) 3epreciating or 4morti%ing -osts #oo $lowly slow depreciation (longer useful lives) can result in: higher net worth (i!e!; higher asset values) higher profits compare depreciation policies with industry norms be especially careful of companies using long useful lives in industries experiencing rapid technological advancement look at what depreciation would be if done on a replacement basis; rather than a historical basis watch for overly long amorti%ation periods for intangibles and leasehold improvements leasehold improvements such as carpet or theater seats should be amorti%ed over the shorter of: the remaining life of lease the useful life of the improvements watch for slow amorti%ation of inventory costs in certain industries; it is difficult to determine inventory expense (-*+$)
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e!g!; film expense capitali%ed and matched against proGected revenues; life of film revenues and amount of revenues are crucial assumptions be concerned when the depreciation or amorti%ation period increases often times; this is clear manipulation to increase earnings

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2ailing to Write *ff Worthless 4ssets a permanently impaired asset must be abruptly written off as a loss e!g!; accounts receivable become uncollectible or investments become worthless while this hurts current year profits; it helps future years (since income will not be affected by depreciation in future)! #his can help stock price! watch for bad loans and other uncollectibles that have not been written off a bad loan must be written down to net reali%able value must estimate amount of defaults (or bad debts) and record a reserve (or allowance for uncollectibles! banks do this; as well as insurance companies (estimate future claims) these amounts are deducted from profits in the year in which they are estimated; not in the year a claim is paid out or a loan becomes worthless when a loan is written off; the bank removes it from assets and deducts an equal amount from the pool of loss reserves (at this point; it does not affect income statement; it has already passed through statement) each year; reserves are adGusted to maintain them at proper level be wary of worthless investments investments in stocks; bonds; and real estate must be written down if their market value declines and that decline is not temporary! this is particularly important for insurers

Rule ): Failing to Record or Disclose *ll 'ia+ilities 4n enterprise has incurred a liability if it is obligated to make future sacrifices! Hiding liabilities; or keeping them off of the books; is often referred to as Coff balance sheet financing!D 2our 0rimary #echniques
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"eporting "evenue "ather #han a /iability When -ash is "eceived (2uture $ervices $till 3ue) e!g!; franchisers; maga%ines; airlines (frequent flier programs) once cash is received; must ask if their are additional obligations still due have the risks or benefits all passed to the buyer (or do some remain with seller) 2ailing to 4ccrue .xpected or -ontingent /iabilities losses should be accrued for expected payments related to litigation; tax disputes; etc! must accrue if there is a probable loss and it can be reasonably estimated accruing this loss takes from net income immediately (and sets up estimated liability; or reserve) 2ailing to 3isclose -ommitments and -ontingencies future commitments and contingencies should be disclosed e!g!; a long term purchase agreement probe for a trouble company with fixed payments e!g!; leases that cant be extinguished if business deteriorates watch for unrecorded postretirement liability ($24$ Eo! 75) transition costs can be immediately recogni%ed or deferred this is the difference between the obligations to which the company has committed and the fmv of assets that they have set aside to pay this obligation (often nothing) read debt covenants carefully for contingencies provisions often allow lender to call loan if ratios fall below set level .ngaging in #ransactions to 9eep 3ebt *ff the 'ooks
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examine any debt for equity swaps as stock prices rise; a company might give bondholders equity! #his reduces debt and interest expense! )t increases equity! 4lso have gain from the difference between the value of the stock and the face value of the bonds (and no tax on the gain)! be wary of companies using subsidiaries for borrowing now; parents must consolidate balance sheets of all maGority owned subsidiaries watch for defeasance of debt if a company has debt outstanding; it can buy treasury bonds which will have interest sufficient to cover the interest payments on the debt and with maturity value that is sufficient to pay the debt when it comes due! not only is the debt wiped off the books; but the company records a profit equal to the difference between the book value of the bonds and the price of the #reasury bonds!

Rule ,: Shi"ting #urrent Income to a 'ater (eriod -com&anies that have had +etter than e%&ected .ears sometimes shi"t income to a later &eriod/ "evenue should be recorded in the period in which it is earned! *ne 0rimary #echnique:
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-reating "eserves to $hift $ales "evenue to a /ater 0eriod done by deferring sales revenue; record a liability initially and transfer it to revenue the following year often done through reserve account can also be done by post dating shipping documents or failing to process documents within fiscal year (so that products sold at the end of one year are recorded as sales in the next year) the idea is to smooth income desire is to have steady earnings sometimes this is result of incentive plan which only compensates manager for income up to certain level smoothing income usually brings unpleasant surprises later many see nothing wrong with income smoothing! #hey dont reali%e that investors and creditors should be using all available information to make decision! be critical of successful companies with large reserves

Rule 0: Shi"ting Future $%&enses to the #urrent (eriod .xpenses should be charged against income in the period in which the benefit is received! #wo 0rimary #echniques
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4ccelerating 3iscretionary .xpenses )nto the -urrent 0eriod be alert for prepayment of operating expenses often times; you will see companies ordering large amounts of overhead items at the end of the year (e!g!; stamps) and expensing them immediately be concerned when the depreciation or amorti%ation period decreases e!g!; fixed assets; intangibles; leasehold assets Writing *ff 2uture Iears 3epreciation or 4morti%ation big bath accounting having a bad year; so write off everything and get ready for a future without depreciation new management often does this to show improvement in future sometimes; it is admirable to take big bath; if firm is actually taking aggressive action to cut costs

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#ash is 1ing: Stud. the Statement o" #ash Flows 4ccounting profit is result of accrual accounting (and subGect to manipulation)! =ust look at cash flow statement and income statement together! -ash 2low from *perations measures operating performance on a cash basis (net income does it on accrual basis) this ignores sales for which money is due also ignores expenses for which money is owed measures the quality of earnings compare -22* with Eet )ncome if E) is positive; while -22* is negative; (year after year) might be problem similarly; if -22* is continually less than E) this is particularly important comparison for established companies whose sales; receivables; and inventory generally dont fluctuate rapidly less applicable to new; high growth companies which incur substantial costs to fund their growth in receivables and inventory cash flow analysis may help predict bankruptcy may see -22* negative for years while income positive! =ay result from booming accounts receivable! 4dditional =easures of ?uality of .arnings ?uality of )ncome J -22* : *perating )ncome )nterest -overage J -22* before )nterest and #axes : )nterest "eturn on 4ssets J -22* before )nterest and #axes : 4ssets

1ee&ing $ver.thing in Balance: Inventor.2 Sales2 and Receiva+les $igns of =isleading 2inancial $tatements #hat =ay 4ppear on the 'alance $heet
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*verstating assets or showing balances at amounts in excess of their net reali%able values Bnderstating assets A where companies attempt to smooth income by shifting future expenses into the current fiscal year Bnderstating liabilities; either by excluding them entirely from the balance sheet or by recording overly conservative estimates of future obligations *verstating liabilities A using reserves to smooth income by shifting current year revenue to the future =isstating owners equity

Watch the amount of capital! how quickly is it growing or shrinking *verstated assets often indicate future declines in earnings in particular; watch inventory and accounts receivable -ompare growth in inventory to growth in sales they should match -ompare the growth in sales with the growth in accounts receivable these should match (if not; trouble in collecting from customers) otherwise; a company will experience negative cash flow -ompare growth in sales with both inventory and accounts receivable if both inventory and accounts receivable are growing faster than sales; troubles are intensified if inventory is not selling and receivables are not being collected; trouble will follow Warning $igns for Bncollectibility of "eceivables large amount of overdue receivables large increase in receivables with flat sales exaggerated dependence on one or two customers related party receivables slow receivable turnover receivables consisting largely of goods that customers may return Warning $igns of )nadequate $alability of )nventory slow inventory turnover
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large increase when sales are flat faddish inventory collaterali%ed inventory insufficient insurance change of corporate inventory valuation methods increase in number of /)2* pools inclusion of inflation profits in inventory large; unexplained increase in inventory inclusion of improper costs in inventory

Warning $igns of )mproper Kaluation of )nvestments switching between current and noncurrent categories investments recorded in excess of cost risky investments that must be written off Warning $igns of *bsolescence of 2ixed 4ssets old equipment and technology high maintenance and repair expense declining output level inadequate depreciation charge change in depreciation method lengthening depreciation period decline in depreciation expense large write off of assets Warning $igns of *verstatement of )ntangibles slow amorti%ation period lengthening amorti%ation period high ratio of intangibles to total assets and capital large balance in goodwill even though profits are weak Warning $igns 2or /iabilities warranties amorti%ed quickly arbitrary adGustments over8reserve warranties (smoothing income) $igns of =isleading 2inancial $tatements liberal accounting policies unGustified changing of accounting policies deferring expenses (overstating income) income smoothing (understating profits)
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recogni%ing revenue too soon (overstating income) underaccruing expense (overstates income; understates liability) overaccruing expense (understates profits) big bath (future profits are boosted) changing discretionary cost (manipulating profits) low quality controls (risk of fraud) change in auditor (risk)

1& #echniques for 2inding 2raud

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be alert for misguided management incentives watch for poor internal accounting controls question overly liberal accounting rules watch for qualified opinions favor companies with conservative accounting policies be alert for aggressive inventory valuation consider the significance of pending or imminent litigation question long term purchase commitments watch for changes in accounting principles read the letter from the president with a grain of salt focus on management and its estimates be wary when the auditor and:or lawyer resign abruptly watch for early shipping; before sales occurs weigh uncertainties of companies using the percentage of completion method look for improper use of the percentage of completion method check whether the risks and the benefits have transferred to the buyer determine whether the buyer is likely to return the goods check if the buyer has financing to pay determine whether the customer is obligated to pay watch for hasty recognition of franchise revenue question how retailers account for returned goods be alert for revenue recorded on the exchange of property determine whether management estimates are realistic watch for the sale of pooled assets acquired in a business combination be alert for tricks with /)2* pools watch for gains from the sale of undervalued investments; including real estate dont be fooled by profits from retiring debt adGust for the mixing of gains from recurring and nonrecurring activities watch for co8mingling of operating and nonoperating income be alert for companies hiding losses as CnoncontinuingD watch for the capitali%ation of start8up costs consider the propriety of capitali%aing ">3 costs look for companies that capitali%e advertising watch for companies that capitali%e administrative costs question companies that depreciate fixed assets too slowly be alert for lengthy amorti%ation periods be concerned when the depreciation or amorti%ation period increases
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watch for bad loans and other uncollectibles that have not been written off be wary of worthless investments ascertain that cash received has been earned probe for a troubled company with fixed payments watch for unrecorded postretirement liability read debt covenants carefully for contingencies examine any debt for equity swaps be wary of companies using subsidiaries for borrowing watch for defeasance of debt be critical of successful companies with large reserves be alert for prepayment of operating expenses be concerned when the depreciation or amorti%ation period decreases use cash flow analysis to measure quality of earnings compare growth in sales with growth in inventory compare growth in sales with growth in receivables

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(ro"ita+ilit. Ratios +ross 0rofit =argin J +ross 0rofit : $ales margin available to cover expenses and yield a profit *perating =argin J *perating 0rofit : $ales profitability from main operations Eet 0rofit =argin J E) : $ales earnings from each dollar of sales "*4 J E) : 4ssets return on investment of both stockholders and creditholders "*. J E) : .quity return on investment for shareholders .0$ J E) : Eumber of $hares profitability to shareholders on a per share basis

'i3uidit. Ratios -urrent "atio J -urrent 4ssets : -urrent /iabilities extent to which claims by short term creditors are covered by current (short term) assets Working -apital J -urrent 4ssets 8 -urrent /iabilities cushion to meet unforeseen cash requirements ?uick "atio J (-urrent 4ssets 8 )nventory) : -urrent /iabilities extent to which claims of short term creditors are covered without the need for an inventory sell off )nventory to Eet Working -apital J )nventory : (-urrent 4ssets 8 -urrent /iabilities) extent to which companys working capital is tied up in inventory Solvenc. Ratios
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3ebt to 4ssets J #otal 3ebt : #otal 4ssets extent to which a company borrows money to finance its operations 3ebt to .quity J #otal 3ebt : #otal .quity the creditors funds as a percentage of stockholders funds /ong #erm 3ebt to .quity J /ong #erm 3ebt : #otal .quity balance between a companys debt and its equity measures level of risk in meeting principal and:or interest on debt )nterest -overage "atio J *perating )ncome : )nterest .xpense measures the multiple by which operating income exceeds the fixed interest expenses indicates the chance of defaulting on the payment *ctivit. Ratio )nventory #urnover J -ost of $ales : 4verage )nventory number of times a company turns over all its inventory in a year how quickly inventory is selling 4ccounts "eceivable #urnover J $ales : 4verage 4ccounts number of times a company turns over all its receivables during a year how quickly customers are paying bills $ources 4lmanac of 'usiness and 2inancial "atios (0rentice Hall) 4nnual $tatement $tudies ("obert =orris 4ssociates) 3uns "eview (3un > 'radstreet) *ther 'ooks *glove; #hornton! ?uality of .arnings: #he )nvestors +uide to How =uch =oney a -ompany is "eally =aking! Eew Iork: #he 2ree 0ress; F@6! 0otts; =ark! 3irty =oney! Eew Iork: Eational 0ress 'ooks; FF&!
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$taley; 9athryn 2! When $tocks -rash Eicely: #he 2iner 4rt of $hort $elling! Eew Iork: Harper8'usiness; FF ! $ternberg; William; and =atthew -! Harrison! 2eeding 2ren%y! Eew Iork: Henry Holt and -ompany; F@F! Waldman; =ichael! Who "obbed 4merica< Eew Iork: "andom House; F@F!

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