Financial Shenanigans: Concluding Thoughts

This third edition of Financial Shenanigans updates investors with lessons gleaned from examining many of the deceptive financial reporting practices employed during the last decade. Since we published the original edition of Financial Shenanigans in 1993, corporate management has continued to concoct new ways to manipulate its financial reports in order to inflate company stock prices and other compensation-related metrics. And, looking to the future, as management works to create newfangled tricks, diligent investors must continue to learn to detect new financial shenanigans. 

The preface of this book quoted a proverb from the Bible (Ecclesiastes 1:9): 

What has been will be again, what has been done will be done again; there is nothing new under the sun. 

Corporate financial scandals have been around as long as corporations and investors themselves. Dishonest management has preyed on unsuspecting investors, and it is time for such investors to redouble their efforts to be alert for such financial shenanigans so that they can protect themselves. 

Since shenanigans at their most basic level represent management’s attempt to put a positive spin on a company’s financial performance and economic health, our universal message is that investors should assume that the urge to exaggerate the positive and hide the negative will never disappear. And where temptation exists, shenanigans often will follow.

Reference:

Financial Shenanigans  Third Edition 

by Howard M. Schilit & Jeremy Perler

Key Metrics Shenanigans: Part 4.

Part 4 introduces readers to a group of shenanigans that stretches management’s creativity in deception to the limit. 

This section of the book shows Key Metrics (KM) Shenanigans used to distort an investor’s understanding of the economic performance and health of that company. The accompanying boxes summarize exactly how it is done and how investors can spot these devices. 

Warning Signs: Showcasing Misleading Metrics That Overstate Performance (KM Shenanigan No. 1) 

• Changing the definition of a key metric 
• Highlighting a misleading metric as a surrogate for revenue 
• Unusual definition of organic growth
• Divergence in trend between same-store sales and revenue per store 
• Inconsistencies between the earnings release and the 10-Q 
• Highlighting a misleading metric as a surrogate for earnings 
• Pretending that recurring charges are nonrecurring in nature 
• Pretending that one-time gains are recurring in nature 
• Highlighting a misleading metric as a surrogate for cash flow 
• Headlining a misleading metric on the earnings release

Warning Signs: Distorting Balance Sheet Metrics to Avoid Showing Deterioration (KM Shenanigan No. 2) 

• Distorting accounts receivable metrics to hide revenue problems 
• Failing to prominently disclose the sale of accounts receivable 
• Converting accounts receivable into notes 
• Increases in receivables other than accounts receivable 
• A huge decline in DSO following several quarters of growing receivables 
• Inappropriate or changing methods of calculating DSO 
• Distorting inventory metrics to hide profitability problems 
• Moving inventory to another part of the Balance Sheet 
• Distorting financial asset metrics to hide impairment problems 
• Stopping the reporting of certain key metrics 
• Distorting debt metrics to hide liquidity problems

Cash Flow Shenanigans: Part 3.

This part expands the discussion to the Statement of Cash Flows. Since investors have started placing more emphasis on cash flow from operations (CFFO), not surprisingly, management has tried to perfect a new class of shenanigans—those that inflate the CFFO. 

Four general Cash Flow (CF) Shenanigans are used to inflate CFFO, and they are reflected in the accompanying boxes. 

Warning Signs: Shifting Financing Cash Inflows to the Operating Section (CF Shenanigan No. 1)

• Recording bogus CFFO from a normal bank borrowing 
• Boosting CFFO by selling receivables before the collection date 
• Disclosures about selling receivables with recourse 
• Inflating CFFO by faking the sale of receivables 
• Changes in the wording of key disclosure items in the financial reports 
• Providing less disclosure than in the prior period 
• Big margin expansion shortly after an inventory write-off 

Warning Signs: Shifting Normal Operating Cash Outflows to the Investing Section (CF Shenanigan No. 2) 

• Inflating operating cash flow with boomerang transactions Improperly capitalizing normal operating costs 
• New or unusual asset accounts 
• Jump in soft assets relative to sales 
• Unexpected increase in capital expenditures 
• Recording purchase of inventory as an investing outflow 
• Investing outflows that sound like a normal cost of business 
• Purchasing patents, contracts, and development-stage technologies 

Warning Signs: Inflating Operating Cash Flow Using Acquisitions or Disposals (CF Shenanigan No. 3) 

• Inheriting Operating cash inflows in a normal business acquisition 
• Companies that make numerous acquisitions 
• Declining free cash flow while CFFO appears to be strong 
• Acquiring contracts or customers rather than developing them internally 
• Boosting CFFO by creatively structuring the sale of a business 
• New categories appearing on the Statement of Cash Flows 
• Selling a business, but keeping the related receivables 

Warning Signs: Boosting Operating Cash Flow Using Unsustainable Activities (CF Shenanigan No. 4) 

• Boosting CFFO by paying vendors more slowly 
• Accounts payable increasing faster than cost of goods sold Increases in other payables accounts 
• Large positive swings on the Statement of Cash Flows 
• Evidence of accounts payable financing 
• New disclosure about prepayments 
• Offering customers incentives to pay invoices early 
• Boosting CFFO by purchasing less inventory 
• Disclosure about the timing of inventory purchases 
• Dramatic improvements in CFFO 
• CFFO benefit from one-time items

Breeding Grounds for Shenanigans: Part 1.

The following box summarizes the key warning signs that investors should consider as creating a higher likelihood that shenanigans will be present. 

Warning Signs: Breeding Ground for Shenanigans 

• Absence of checks and balances among senior management 
• An extended streak of meeting or beating Wall Street expectations  
• A single family dominating management, ownership, or the board of directors 
• Presence of related-party transactions 
• An inappropriate compensation structure that encourages aggressive financial reporting 
• Inappropriate members placed on the board of directors 
• Inappropriate business relationships between the company and board members 
• An unqualified auditing firm 
• An auditor lacking objectivity and the appearance of independence 
• Attempts by management to avoid regulatory or legal scrutiny

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

Financial Shenanigans: A Holistic Approach to Detecting Financial Shenanigans

What to look for when reviewing financial statements and searching for financial shenanigans. 

 A Holistic Approach to Detecting Financial Shenanigans 

Just as the three branches of government rein in bad behavior by government officials, the three financial statements help to protect investors from misbehaving corporate executives. 

• Specifically, investors can sniff out Earnings Manipulation Shenanigans by scrutinizing the Balance Sheet and the Statement of Cash Flows. 
• Similarly, they can detect signs of misleading operating cash flow by finding unusual or troubling changes on the Statement of Income and the Balance Sheet. 
• Additionally, investors can use the supplementary disclosures and key metrics provided by management as another form of “checks and balances.”

Examples

Company 

Financial Shenanigan 

Warnings on Other Financial Statements 

Earnings Manipulation Shenanigans 

WorldCom 

Boosted income by capitalizing operating costs 

SCF: Capital expenditures surged 

Transaction Systems Architects 

Recorded revenue too soon 

BS: Rapid increase in long-term and unbilled receivables 

IBM 

Boosted income with one-time gain 

SCF: Gain on investment sale in Operating section 

AOL 

Boosted income by capitalizing operating costs 

BS: Deferred marketing costs exploded 

Cash Flow Shenanigans 

Tyco 

Inflated CFFO using acquisitions 

BS: Receivables increase differs on BS and SCF 

Home Depot 

Boosted CFFO with unsustainable gain 

BS: Accounts payable surged 

Sun Microsystems 

Boosted CFFO with unsustainable gain 

IS: One-time litigationrelated gain