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