Thursday 20 August 2020

Earnings Manipulation Shenanigans: Part 2.

This part introduced seven Earnings Manipulation (EM) Shenanigans used to trick investors. 

  • The first five inflate current period income, and
  • the last two inflate that of future periods. 

The boxes given here show various techniques that management uses for each of the seven shenanigans. 


Warning Signs: Recording Revenue Too Soon (EM Shenanigan No. 1) 

  • Recording revenue before completing any obligations under contract 
  • Recording revenue far in excess of work completed on a contract 
  • Up-front revenue recognition on long-term contracts 
  • Use of aggressive assumptions on long-term leases or percentage-of-completion accounting 
  • Recording revenue before the buyer’s final acceptance of the product 
  • Recording revenue when the buyer’s payment remains uncertain or unnecessary 
  • Cash flow from operations lagging behind net income 
  • Receivables (especially long-term and unbilled) growing faster than sales 
  • Accelerating sales by changing the revenue recognition policy 
  • Using an appropriate accounting method for an unintended purpose 
  • Inappropriate use of mark-to-market or bill-and-hold accounting 
  • Changes in revenue recognition assumptions or liberalizing customer collection terms 
  • Seller offering extremely generous extended payment terms 

Warning Signs: Recording Bogus Revenue (EM Shenanigan No. 2) 

  • Recording revenue from transactions that lack economic substance 
  • Recording revenue from transactions that lack a reasonable arm’s-length process 
  • Lack of risk transfer from seller to buyer 
  • Transactions involving sales to a related party, affiliated party, or joint venture partner 
  • Boomerang (two-way) transactions to nontraditional buyers 
  • Recording revenue on receipts from non-revenue-producing transactions 
  • Recording cash received from a lender, business partner, or vendor as revenue 
  • Use of an inappropriate or unusual revenue recognition approach 
  • Inappropriately using the gross rather than the net method of revenue recognition 
  • Receivables (especially long-term and unbilled) growing much faster than sales 
  • Revenue growing much faster than accounts receivable 
  • Unusual increases or decreases in liability reserve accounts


Warning Signs: Boosting Income Using One-Time or Unsustainable Activities (EM Shenanigan No. 3) 

  • Boosting income using one-time events 
  • Turning proceeds from the sale of a business into a recurring revenue stream 
  • Commingling future product sales with buying a business 
  • Shifting normal operating expenses below the line 
  • Routinely recording restructuring charges 
  • Shifting losses to discontinued operations Including proceeds received from selling a subsidiary as revenue 
  • Operating income growing much faster than sales 
  • Suspicious or frequent use of joint ventures when unwarranted 
  • Misclassification of income from joint ventures 
  • Using discretion regarding Balance Sheet classification to boost operating income


Warning Signs: Shifting Current Expenses to a Later Period (EM Shenanigan No. 4) 

  • Improperly capitalizing normal operating expenses 
  • Changes in capitalization policy or accelerated capitalization of costs 
  • New or unusual asset accounts 
  • Jump in soft assets relative to sales 
  • Unexpected increase in capital expenditures 
  • Amortizing or depreciating costs too slowly 
  • Stretching out depreciable asset life 
  • Improper amortization of costs associated with loans 
  • Failing to record expenses for impaired assets 
  • Jump in inventory relative to cost of goods sold 
  • Failure by lenders to adequately reserve for credit losses 
  • Decrease in loan loss reserve relative to bad loans 
  • Decline in bad debt expense or obsolescence expense 
  • Decrease in reserves related to bad debts or inventory obsolescence


Warning Signs: Employing Other Techniques to Hide Expenses or Losses (EM Shenanigan No. 5) 

  • Failing to record an expense from a current transaction 
  • Unusually large vendor credits or rebates 
  • Unusual transactions in which vendors send out cash Failing to record an expense for a necessary accrual or reversing a past expense
  • Unusual declines in reserve for warranty or warranty expense 
  • Declining accruals, reserves, or “soft liability” accounts 
  • Unexpected and unwarranted margin expansion 
  • Unusually “lucky” timing on the issuance of stock options 
  • Failing to accrue loss reserves 
  • Failing to highlight off-balance-sheet obligations 
  • Changing pension, lease, or self-insurance assumptions to reduce expenses 
  • Outsized pension income


Warning Signs: Shifting Current Income to a Later Period (EM Shenanigan No. 6) 


  • Creating reserves and releasing them into income in a later period 
  • Stretching out windfall gains over several years 
  • Improperly accounting for derivatives in order to smooth income 
  • Holding back revenue just before an acquisition closes 
  • Creating acquisition-related reserves and releasing them into income in a later period 
  • Recording current-period sales in a later period 
  • Sudden and unexplained declines in deferred revenue 
  • Changes in revenue recognition policy 
  • Unexpectedly consistent earnings during a volatile time 
  • Signs of revenue being held back by the target just before an acquisition closes 


Warning Signs: Shifting Future Expenses to an Earlier Period (EM Shenanigan No. 7) 

  • Improperly writing off assets in the current period to avoid expenses in a future period 
  • Improperly recording charges to establish reserves used to reduce future expenses 
  • Large write-offs accompanying the arrival of a new CEO 
  • Restructuring charges just before an acquisition closes 
  • Gross margin expansion shortly after an inventory write-off 
  • Repeated restructuring charges that serve to convert ordinary expenses to a one-time expense 
  • Unusually smooth earnings during volatile times

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