financial shenanigans em 4 5

8/18/2019 Financial Shenanigans EM 4 5

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Financial Shenanigans- Earnings Manipulation Shenanigans – EM-

4, 5, 6 & 7

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2/16

EMS-4 Shifting Current Expenses toa ater !erio"

• #S-1$ #ccounting for Fixe" assets, #S-16 %orroing costsan" #S-'6 #ccounting for (ntangi)le assets per*it – Capitali+ation of expenses su)ect to certain con"itions )eing *et

on the groun"s that the expense ill pro"uce future econo*ic)enets

– Capitali+e until the asset is rea". for its inten"e" use

• #s per /Matching Concept0 of accounting 2##!3, costshoul" )e recogni+e" oer the perio" "uring hich reenueis expecte" to )e reali+e" –

Co*panies recor" transactions )ase" on /#ccrual s.ste*0 egages to e*plo.ees are reporte" as an expense in the ee henthe e*plo.ees ore" an" not in the ee hen the e*plo.eesare pai"

– Esti*ate of reenue reali+ation can lea" to slo rite o of thecosts case – 8rion pictures, pg 1'53

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3/16

EM-4 Shifting Current Expenses toater perio"

•

9his techni:ue can )e use" inappropriatel. ). the *anage*ent toin;ate


4/16


–(*properl. capitali+ing nor*al operating expense• 2enerall. those costs relate" to long-ter* arrange*ents, such as

research an" "eelop*ent, la)or an" oerhea" relate" to a long-ter*proect, softare "eelop*ent, an" costs to in contracts orcusto*ers are *ore pri. to this shenanigan

– Capitali+ing Softare @eelop*ent Costs 9echnolog.co*panies3 –• %e aare of the practice folloe" ). the technolog. co*panies to

capitali+e the softare cost )efore the /technical feasi)ilit.0 isesta)lishe"

• @eeloping softare )eing the *ain )usinessA su""en u*p in

softare capitali+e" shoul" )e iee" cautiousl. as the softare"eelop*ent costs for the client shoul" )e expense" as /cost ofsales0 unless technical an" co**ercial feasi)ilit. of proect is "e*onstrate",

cost can )e *easure" relia)l.,

future econo*ic )enets are pro)a)le, an"

the co*pan. has intention an" a)ilit. to co*plete an" use or sell the softare4


5/16


– Capitalisation of Besearch an" @eelop*ent cost #S-'63• Costs incurre" "uring Besearch phase shoul" )e expense"

• Costs incurre" "uring "eelop*ent phase shoul" )e capitali+e" onl.if the 4 con"itions *entione" )efore are *et ie technical feasi)ilit.,intention an" a)ilit. to use


6/16

(n"icators

• %e ar. of the change in polic. fro* expensing costs to capitali+ing the*an" the i*pact on earnings

• %e cautious a)out large u*p in capital expen"iture capex3 is-D-isplanne"


7/16

EM-5 Falling to Becor" or ConcealExpenses

• Falling to recor" /arrant.0 proisions in the state*ent of inco*e inthe perio" hen sales are *a"e – Manage*ent has to *ae so*e esti*ate of arrant. clai*s that *ight )e

raise" in respect of pro"ucts sol" "uring the .ear ). "eci"ing the failure ratearrant. lia)ilit. esti*ation process3

– Decline in warranty expense relative to revenue may signal that earnings

are being infated (case –Dell Computer, pg- 14!

• Falling to recor" loss fro* contingencies hich *eets the folloingcriteriaGs – 9he loss is pro)a)le an"

– 9he a*ount of loss can )e esti*ate" reasona)l.

–

(f )oth the con"itions are *etA proision for this otherise contingentlia)ilit. shoul" )e *a"e in the )oos Failure to recor" ill le" to oerstatingprots an" un"erstating lia)ilit.

– "oo# $or %material contingent liability in notes to accounts&, say on accounto$ litigations or disputed liabilities (e'g' ) license scam! that are more li#elyto devolve on the company' *ee# expert advice $rom legal department,

re$erence can also be made to similar past +udgments in li#e cases 7


8/16

EM-5

• Closel. *onitor the foot notes to see future purchaseagree*ent that signal hea. )ur"en of the co*pan.Gsearnings thus negating the len"ing "ecision – Case- Colu*)ia 2as S.ste*s – C2S signe" /9ae or !a.0

agree*ents to purchase su)stantial a*ounts of atural 2asat a)oe *aret price 2as price plu**ete" an" it coul" notsell the gas at a price an.here near its cost C2S ha" tohonor the co**it*ents to its suppliers hile its utilit.custo*ers ere free to purchase gas fro* cheaper sourcesC2S le" for )anruptc. thereafter

– hile modeling $uture periods $or a borrower loo# criticallyat the movement in the prices o$ products and any suchbinding agreements that may lead to .uestions onsustainability'

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9/16

EM-5

• %oosting inco*e ). changing pensionassu*ptions ill )e coere" in session onpension lia)ilit.3 – !ension expense is recor"e" )ase" on certain

assu*ptions *a"e ). the *anage*ent

– 9rue econo*ic cost of post retire*ent o)ligationcan )e conceale" ). the co*pan., if esti*ate ofexpecte" rate of return on /plan asset0 is taen

higher than the reasona)le esti*ate of *aretreturn

– /ndicator – Chec# $or the return rates used by peers

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10/16

EM-5

• Be"uce expenses ). releasing reseresfro* preious charge – Co*panies in"ulge into creation of )ogus

lia)ilit.


11/16

(n"icators

• #la.s prepare co**on-si+estate*ents to n" out *aor"eiations

• Stu". #u"itor=s report

• Criticall. chec the rite-)ac ofproisions

• Bea" notes to accounts carefull. tosee hether an. contingent lia)ilit.has a pro)a)ilit. of "eole*ent the

proision for hich has not )een 11


12/16

!urpose of using EM-6 an" 7

• 9o proect s*ooth earnings

• Shift inco*e fro* a particularl.strong perio" to a eaer one

• Clear the "ec of trou)leso*eexpenses to pro"uce future-perio"earnings

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13/16

EMS-6 Shifting Current (nco*e to aater !erio"

1?

• Creating reseres an" releasing the* into inco*e in a later perio"

• Stretching out in"fall gains oer seeral .ears

• Jol"ing )ac reenue ust )efore an ac:uisition closes

• Creating ac:uisition-relate" reseres an" releasing the* intoinco*e in a later perio"

• Becor"ing current-perio" sales in a later perio"

• Su""en an" unexplaine" increase an" "eclines in "eferre" reenuecase – Microsoft, pg-16'3

• Changes in reenue recognition polic.

• Knexpecte"l. consistent earnings "uring a olatile ti*e

• Signs of reenue )eing hel" )ac ). the target ust )efore anac:uisition closes – Le. point to re*e*)er hile *o"eling nu*)ers post ac:uisition is to

assess hether the *erger s.nergies as portra.e" ). the *anage*entare possi)le


14/16

EM-7 Shifting Future Expenses to anEarlier !erio"

• (*properl. riting o assets in the currentperio" to aoi" expenses in a future perio"

• (*properl. recor"ing charges to esta)lish

reseres use" to re"uce future expenses• arge rite-os acco*pan.ing the arrial of

a ne CE8 Case-Sun)ea*3

• Bestructuring charges ust )efore an

ac:uisition closes• Knusuall. s*ooth earnings "uring olatile

ti*es

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15/16

arning Signs %ree"ing 2roun" forShenanigans

• #)sence of checs an" )alances a*ong senior *anage*ent

• # single fa*il. "o*inating *anage*ent, onership, or the)oar" of "irectors

• !resence of relate"-part. transactions

•

#n inappropriate co*pensation structure that encouragesaggressie nancial reporting

• (nappropriate *e*)ers place" on the )oar" of "irectors

• (nappropriate )usiness relationships )eteen the co*pan.an" )oar" *e*)ers

•

#n un:ualie" au"iting r*• #n au"itor lacing o)ectiit. an" the appearance of

in"epen"ence

• #tte*pts ). *anage*ent to aoi" regulator. or legal scrutin.

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16/16

Sources

• Financial Shenanigans ). Joar" M Schilit an" Nere*. !erler

• #ccounting Stan"ar"s issue" ). (C#(

•

Besearch papers fro* Nournal of #ccounting• 9he Serious Frau" (nestigation 8Oce S(F83

• http

financial shenanigans em 4 5

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