7 2010, 2011, 2012 & 2013 AICPA

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1 The 7 Financial Shenanigans: How Companies Cook the Books Leah Donti Ldonti@AdvantageMontrealSeminars.com 2010, 2011, 2012 & 2013 AICPA Outstanding Discussion Leader Award Recipient Welcome! Agenda Games companies play to create deceptive financial reporting What are the 7 financial shenanigans Walk through an example of each one how to detect financial shenanigans 1

2 What are Shenanigans? Shenanigans are actions or omissions designed to hide or distort the real financial performance or financial condition of a company Why do Shenanigans Exist? It pays to do it (greed factor) It may boost performance-related bonuses It may prevent negative outcomes (fear factor) It may help company obtain financing It may dispel negative market perceptions It may help company financing covenants It is easy to do it It is unlikely you will get caught 2

3 What Types of Companies are Most Likely to Use Shenanigans? Companies with a weak control environment - few independent board members - Lack of competent / independent auditor - Inadequate internal audit function Management facing extreme competitive pressure or known or suspected of having questionable character Small fast-growth Newly-public companies Privately held companies Basket-case companies Definition Earnings Manipulation (EM) Purposeful intervention in the external reporting process with the intent of obtaining some private gain (Schipper) When managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (Healy & Wahlen) 3

4 Intent of Management Is all EM unethical? depends on management intent. Management intent unobservable Distinction between aggressive accounting choices including acceptable GAAP based estimates / judgments vs. fraudulent accounting practices intended to deceive others Aggressive Accounting Choices Examples of accounting choices allowed by FASB Changing life of assets affecting depreciation Changing estimate of allowance for doubtful accounts affecting bad debt expense Changing estimate of sales return allowances affecting net revenue Choosing inventory valuation methods thus affecting cost of goods sold Estimating higher restructuring charges than required affecting earnings before interest & taxes 4

5 Earnings Manipulation Schilit s 7 Shenanigans 1. Recording revenue too soon 2. Recording bogus revenue 3. Boosting income with one-time gains 4. Shifting current expenses to a later or earlier period 5. Failing to disclose all liabilities 6. Shifting current income to a later period 7. Shifting future expenses into the current period Shenanigan No. 1: Recording revenue too soon Shipping goods before sale is finalized Recording revenue when important uncertainties exist Recording revenue when future services are still due Examples: Sports Line USA Inc., a sports-related internet site, had 18% of total revenue coming from barter transactions Priceline.com reported entire receipts from customers as revenue, instead of commission 5

6 Shenanigan No. 2: Recording bogus revenue Recording income in exchange for similar assets Recording refunds from suppliers as revenue Using bogus estimates on interim financial reports Example Sunbeam channel stuffing: offered generous discounts to its distributors to sell their products immediately & increase A/R These sales were not confirmed & had the right of return Shenanigan No. 3: Boosting Income with One-time gains Boosting profits by selling undervalued assets Boosting profits by retiring debt Failing to segregate non-recurring activities Examples: IBM used the proceeds from the sale of its optical transceiver business to JDS Uniphase to lower its operating expenses, rather than accounting for it as a one-time gain Verizon included gains from its pension fund investments in its earnings 6

7 Shenanigan No. 4: Shifting Current Expenses to Later Period Improperly capitalizing costs Depreciating or amortizing costs too slowly Failing to write off worthless assets Example: Worldcom claimed over $3 billion operational expenses as capital investment in 2001 Shenanigan No. 5: Failing to disclose all liabilities Reporting revenue when cash is received in advance of providing services Failing to accrue expected or contingent liabilities Failing to disclose all material commitments and contingencies Engaging in transactions to keep debt off books Example: Increasing the discount rate for pension obligations 7

8 Shenanigan No. 6: Shifting Current Income to Later Period Creating reserves and releasing them into income in a later period Holding back revenue without reporting and showing them in future periods ie cookie jar reserves or income smoothing Usually before an acquisition Example: Microsoft s target EPS met for 9 consecutive quarters Shenanigan No. 7: Shifting Future Expenses to Current Period Accelerating discretionary expenses into the current period Writing off future years depreciation and amortization during the current year Example Big Bath approach Take all possible expenses in one bad year so the future performance is likely to be impressive Large estimates of restructuring charges are deducted from revenues to show lower income in one quarter/year and then revised few quarters/years later to show higher income 8

9 Shenanigans at Internet Companies Sales to related parties Vendor financing Barter transactions Extended payment terms Creative use of company s own stock 10 Clues to Detect Shenanigans 1. Dishonest Management 2. Inadequate control environment 3. Changes in auditors, outside legal counsel, or CFO 4. Changing in accounting principles or estimates 5. Large deficit of CFFO relative to net income 6. Substantial disparity between sales and receivable growth 9

10 10 Clues to Detect Shenanigans cont d 7. Substantial disparity between sales and inventory growth 8. Large increase or decrease in gross margins (GP/sales) 9. Recording revenue when risks remain with seller 10. Presence of commitments and contingencies Pressures to Manipulate Earnings Why does management manage earnings? External pressures Analysts forecasts Access to debt markets Competition Contractual agreements & debt covenants Roaring stock market Emerging financial instruments Market disregard for big charges 10

11 Pressures to Manipulate Earnings cont d Pressures within the company Merger attractiveness Management compensation Short term focus Unrealistic budgets and plans Excessive profits followed by decline Personal factors bonus, promotions, job retention Signals in Current Year Signals that should be checked in company reports Read the audit report Reduction in managed costs such as advertising in relation to sales Changes in accounting policies towards more liberal applications Unexpected increase in accounts receivable Extension of trade payables longer than normal credit Unusual increase in intangible assets One time sources of income 11

12 Signals in Current Year (Cont d) Decline in gross margins Reduction in reserves Reliance on income sources other than core business Nor reserving for future probable losses Unusual increase in borrowings Increase in deferred taxes Increase in unfunded pension liability Low cash and marketable securities at year end Peak short borrowings at year end Slowdown of inventory turnover ratio Cash Flow Shenanigans 8. Shifts to operating cash increases 9. Shifts to investing cash decreases 10. Misuse of mergers 11. Unsustainable generation of cash flow 12

13 Key Metrics Shenanigans 12. Overstating performance metrics 13. Distorting performance metrics Numbers Game Arthur Levitt Speech (1998) on accounting hocus-pocus Cookie jar reserves Use unrealistic assumptions to estimate sales returns, loan losses or warranty costs, thus stashing accruals in cookie jars during the good times and reach into them when needed in the bad times. Materiality Intentionally record errors with specified ceiling and then argue that the errors are not material 13

14 Revenue recognition Numbers Game Recognize a sale before it is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale. New SAB rules now exist to record revenue Transparency is the Key Are the # s telling the story or making the story? Is the company managing the business or managing the # s? What is, is? versus What is. Is! 14

15 Detecting Earnings Management using Multi-period Analysis A longer- term perspective, looking for recurring patterns or negative trends Quarterly patterns than may signal intra-year earnings management Balance sheet issues Income statement issues Balance Sheet Issues Low liquidity, especially negative working capital Relationship of inventories & receivables to sales (esp. relative growth & changes) Excessive use of operating leases & other off-balance-sheet items Warranties, commitments, contingencies & other obligations that may understate true liabilities Long-term debt levels (especially is growing) Excessive & growing treasury stock levels 15

16 Income Statement Issues Trends in revenues, gross margin, operating margin, etc. Operating expense issues, including SG & A, R & D spending, special charges, etc. Effective tax rates & other tax issues Non-recurring charges these should be rare Net income & other bottom line measures Cash Flow Issues CFO trends, especially related to net income Free cash flows & relative capital expenditures Relationships of CFO, CFI & CFF & comparisons to cash balances 16

17 Stock Price & Other Market Analysis Long-term stock charts (5 years is common) indicate the longer-term trends in investor reactions Reasons for large rises & dips should be explainable; if not, they may signal potential concerns Relationship of stock prices to EPS & 5-year forecast earnings growth rates Earnings surprises, actual to analyst forecast estimates Financial Shenanigans Book By Howard Schilit 3 rd Edition published in 2010 McGraw Hill Ryerson 17