how to detect financial shenanigans

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Knowing how to catch manipulative companies is one of the best ways to protect yourself as investor. There is no insurance policy for the money youve invested in the stock market. It only makes sense to protect yourself by equipping yourself with valuable knowledge on accounting red flags and fraudulent techniques. Here are the lessons from one of the best books out there.

Financial Shenanigans Watch for:

executive incentives which encourage managing financial statements

poor internal controls quarterly 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)

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The Seven Shenanigans 1. Recording Revenue Too Soon

shipping goods before the sale is finalized recording revenue when important uncertainties exist recording revenues when future services are still due

2. Recording Bogus Revenues recording income on the exchange of similar assets recording refunds from suppliers as revenues using bogus estimates on interim financial reports

3. Boosting Income With One Time Gains 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 non-continuing operations

4. Shifting Current Expenses to a Later Period improperly capitalizing costs depreciating or amortizing costs too slowly failing to write off worthless assets

5. Failing to Record or Disclose All Liabilities 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

6. Shifting Current Income to a Later Period creating reserves to shift sales revenue to a later period

7. Shifting Future Expenses to the Current Period accelerating discretionary expenses into the current period writing off future years depreciation or amortization

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Rule 1: Recording Revenue Too Soon Revenue should be recorded after the earnings process has been completed and an exchange has occurred.

earnings process should be substantially complete arms length exchange

Three Typical Scenarios 1. Shipping Goods Before a Sale is Finalized

goods must be exchanged for cash or reliable promise to pay before revenue recognized

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 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

2. Recording Revenue When Important Uncertainties Exist

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

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does right of return exist the buyer may not pay for the goods

does buyer have financing to pay for goods is buyers purchase contingent on his ability to resell

product is buyer obligated to pay

3. Recording Revenue When Future Services are Still Due

should only recognize revenue earned to date; remainder of receipts are a liability

often the case with franchisers recognize revenue while still promising future services area development rights to have exclusive right to open

franchises in area these should not be considered to be current income

(defer until franchises open)

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Rule 2: Recording Bogus Revenues Revenue should be recorded after the earnings process has been completed and an exchange has occurred. Three Typical Scenarios 1. Recording Income on the Exchange of Similar Assets

no gain should be recorded on the exchange of similar property 2. Recording Refunds from Suppliers as Revenue

retailers often receive refunds from suppliers. This is not revenue.

3. Using Bogus Estimates on Interim Financial Reports

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 gross profit rate

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Rule 3: Boosting Income with One-Time Gains Revenue should be recorded after the earnings process has been completed and an exchange has occurred. Similarly, gains should be reported only after an exchange has taken place. Four Common Techniques 1. Boosting Profits by Selling Undervalued Assets

these are nonrecurring gains typical examples include:

selling assets acquired in a pooling transaction company that uses LIFO (especially with many inventory

pools, which allow management to especially manage cost of goods sold)

e.g., separate inventory into three pools. Each pool has inventory purchased in each of the last three years (higher prices each year). Use all of one pool to get to the lower priced inventory and increase earnings.

real estate (or other assets) acquired long ago 2. Boosting Profits by Retiring Debt

this is especially interesting when new debt is issued at higher rates

such gains do not recur 3. Failing to Segregate Unusual and Nonrecurring Gains or Losses From

Recurring Income 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

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i.e., income from operations, as opposed to revenue from ancillary services (such as interest and rental income)

4. Burying Losses Under Noncontinuing Operations

noncontinuing operations include discontinued operations, extraordinary gains / losses, and the cumulative effect on income from changing accounting principles

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Rule 4: Shifting Current Expenses to a Later Period An enterprise should capitalize costs incurred that produce a future benefit and expense those that produce no such benefit. If the asset is immaterial or the benefit will be received over a short period of time, expense the item. Expenses should be charged against income in the period in which the benefit is received. As an enterprise realizes 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. Three Common Scenarios 1. Improperly Capitalizing Costs

shifts expense to a later period improper capitalization often includes start-up 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)

2. Depreciating or Amortizing Costs Too Slowly

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 amortization periods for intangibles and

leasehold improvements

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leasehold improvements such as carpet or theater seats should be amortized over the shorter of:

the remaining life of lease the useful life of the improvements

watch for slow amortization of inventory costs in certain industries, it is difficult to determine inventory

expense (COGS) e.g., film expense capitalized and matched against

projected revenues; life of film revenues and amount of revenues are crucial assumptions

be concerned when the depreciation or amortization period increases

often times, this is clear manipulation to increase earnings

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3. Failing to Write Off Worthless Assets

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). This 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 realizable 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 adjusted 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

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Rule 5: Failing to Record or Disclose All Liabilities An 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 off balance sheet financing. Four Primary Techniques 1. Reporting Revenue Rather Than a Liability When Cash is Received

(Future Services Still Due) e.g., franchisers, magazines, 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) 2. Failing to Accrue Expected or Contingent Liabilities

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)

3. Failing to Disclose Commitments and Contingencies

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 (SFAS No. 106)

transition costs can be immediately recognized or deferred this is the difference between the obligations to

which the company has committed and the fmv of

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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 4. Engaging in Transactions to Keep Debt Off the Books

examine any debt for equity swaps as stock prices rise, a company might give bondholders

equity. This reduces debt and interest expense. It increases equity. Also 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

majority 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 Treasury bonds.

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Rule 6: Shifting Current Income to a Later Period (companies that have had better than expected years sometimes shift income to a later period) Revenue should be recorded in the period in which it is earned. One Primary Technique: 1. Creating Reserves to Shift Sales Revenue to a Later Period

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. They dont realize that investors and creditors should be using all available information to make decision.

be critical of successful companies with large reserves

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Rule 7: Shifting Future Expenses to the Current Period Expenses should be charged against income in the period in which the benefit is received. Two Primary Techniques 1. Accelerating Discretionary Expenses Into the Current Period

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 amortization period decreases

e.g., fixed assets, intangibles, leasehold assets 2. Writing Off Future Years Depreciation or Amortization

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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Cash is King: Study the Statement of Cash Flows Accounting profit is result of accrual accounting (and subject to manipulation). Must look at cash flow statement and income statement together. Cash Flow from Operations

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 CFFO with Net Income

if NI is positive, while CFFO is negative, (year after year) might be problem

similarly, if CFFO is continually less than NI 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 CFFO negative for years while income positive.

May result from booming accounts receivable. Additional Measures of Quality of Earnings Quality of Income = CFFO / Operating Income Interest Coverage = CFFO before Interest and Taxes / Interest Return on Assets = CFFO before Interest and Taxes / Assets

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Keeping Everything in Balance: Inventory, Sales, and Receivables Signs of Misleading Financial Statements That May Appear on the Balance Sheet 1. Overstating assets or showing balances at amounts in excess of their net

realizable values 2. Understating assets where companies attempt to smooth income by

shifting future expenses into the current fiscal year 3. Understating liabilities, either by excluding them entirely from the

balance sheet or by recording overly conservative estimates of future obligations

4. Overstating liabilities using reserves to smooth income by shifting current year revenue to the future

5. Misstating owners equity Watch the amount of capital.

how quickly is it growing or shrinking Overstated assets often indicate future declines in earnings

in particular, watch inventory and accounts receivable Compare growth in inventory to growth in sales

they should match Compare 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

Compare 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 Signs for Uncollectibility of Receivables

large amount of overdue receivables large increase in receivables with flat sales

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exaggerated dependence on one or two customers related party receivables slow receivable turnover receivables consisting largely of goods that customers may return

Warning Signs of Inadequate Salability of Inventory

slow inventory turnover large increase when sales are flat faddish inventory collateralized inventory insufficient insurance change of corporate inventory valuation methods increase in number of LIFO pools inclusion of inflation profits in inventory large, unexplained increase in inventory inclusion of improper costs in inventory

Warning Signs of Improper Valuation of Investments

switching between current and noncurrent categories investments recorded in excess of cost risky investments that must be written off

Warning Signs of Obsolescence of Fixed Assets

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 Signs of Overstatement of Intangibles

slow amortization period lengthening amortization period high ratio of intangibles to total assets and capital large balance in goodwill even though profits are weak

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Warning Signs For Liabilities warranties amortized quickly arbitrary adjustments over-reserve warranties (smoothing income)

Signs of Misleading Financial Statements

liberal accounting policies unjustified changing of accounting policies deferring expenses (overstating income) income smoothing (understating profits) recognizing 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)

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Profitability Ratios Gross Profit Margin = Gross Profit / Sales

margin available to cover expenses and yield a profit

Operating Margin = Operating Profit / Sales profitability from main operations

Net Profit Margin = NI / Sales earnings from each dollar of sales

ROA = NI / Assets return on investment of both stockholders and creditholders

ROE = NI / Equity return on investment for shareholders

EPS = NI / Number of Shares profitability to shareholders on a per share basis

Liquidity Ratios Current Ratio = Current Assets / Current Liabilities

extent to which claims by short term creditors are covered by current (short term) assets

Working Capital = Current Assets - Current Liabilities

cushion to meet unforeseen cash requirements Quick Ratio = (Current Assets - Inventory) / Current Liabilities

extent to which claims of short term creditors are covered without the need for an inventory sell off

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Inventory to Net Working Capital = Inventory / (Current Assets - Current Liabilities)

extent to which companys working capital is tied up in inventory

Solvency Ratios Debt to Assets = Total Debt / Total Assets

extent to which a company borrows money to finance its operations

Debt to Equity = Total Debt / Total Equity

the creditors funds as a percentage of stockholders funds Long Term Debt to Equity = Long Term Debt / Total Equity

balance between a companys debt and its equity measures level of risk in meeting principal and/or interest on debt

Interest Coverage Ratio = Operating Income / Interest Expense

measures the multiple by which operating income exceeds the fixed interest expenses

indicates the chance of defaulting on the payment

Activity Ratio Inventory Turnover = Cost of Sales / Average Inventory

number of times a company turns over all its inventory in a year how quickly inventory is selling

Accounts Receivable Turnover = Sales / Average Accounts

number of times a company turns over all its receivables during a year

how quickly customers are paying bills

how to detect financial shenanigans

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