Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (5 page)

• Recording Revenue Too Soon

• Recording Bogus Revenue

• Boosting Income Using One-Time or Unsustainable Activities

• Shifting Current Expenses to a Later Period

• Employing Other Techniques to Hide Expenses

• Shifting Current Income to a Later Period

• Shifting Future Expenses to an Earlier Period

Cash Flow Shenanigans

• Shifting Financing Cash Inflows to the Operating Section

• Shifting Normal Operating Cash Outflows to the Investing Section

• Inflating Operating Cash Flow Using Acquisitions or Disposals

• Boosting Operating Cash Flow Using Unsustainable Activities

Key Metrics Shenanigans

• Showcasing Misleading Metrics That Overstate Performance

• Distorting Balance Sheet Metrics to Avoid Showing Deterioration

Looking Ahead

Many investors in Enron, WorldCom, Tyco, and Symbol Technologies paid heavy prices for failing to spot early signs of operating problems that had been camouflaged by financial shenanigans. Fortunately, investors, auditors, and other stakeholders can learn lessons from these debacles and better arm themselves with the knowledge of how to detect similar warning signs in the future.

Chapter 2 establishes the foundation for understanding the three categories of financial shenanigans: Earnings Manipulation (Part 2), Cash Flow (Part 3), and Key Metrics (Part 4), and where they are most likely to occur.

2 – Just Touch Up the X-Rays

I can’t afford the operation, but would you accept a small payment to touch up the X-rays?

—Warren Buffett, CEO of Berkshire Hathaway

Legendary investor Warren Buffett generously uses his annual letter to investors as a vehicle to educate all interested parties about the art of investing. In one such letter, the Oracle from Omaha, as he is affectionately known, gave a particularly poignant lesson concerning a subject that is near and dear to us: companies that use financial shenanigans to hide the unpleasant truth from investors. This letter described a conversation between a seriously ill patient and his doctor, just after an X-ray revealed the bad news about his condition. Rather than accept the information about his deteriorating health, the patient’s immediate response to the dreadful news was to ask the doctor to touch up the X-rays. Buffett uses this story to warn investors about managements that try to hide the truth about a deteriorating business’s economic health by
touching up
the financial statements. Buffett then prophetically adds, “In the long run, however, trouble awaits managements that paper over operating problems with accounting maneuvers. Eventually, managements of this kind achieve the same result as the seriously-ill patient.”

No doubt, a company’s use of financial shenanigans to paper over its poor economic health would be no more effective than a doctor touching up X-rays to improve a patient’s physical health. Such gimmicks are pointless, as the truth of the company’s deterioration will remain unchanged and will ultimately come to light one day.

This book provides readers with the skills necessary to identify companies that are simply papering over their financial performance and economic health problems. Chapter 2 establishes the foundation for development of these skills by answering basic questions, including what financial shenanigans are and where they are most likely to occur.

What Are Financial Shenanigans?

Financial shenanigans are actions taken by management that mislead investors about a company’s financial performance or economic health. As a result, investors are often tricked into believing that a company’s earnings are stronger, its cash flows more robust, and its Balance Sheet position more secure than are really the case.

Some shenanigans can be detected in the numbers presented by carefully reading a company’s Balance Sheet, Statement of Income, and Statement of Cash Flows. Proof of other shenanigans might not be explicitly provided in the numbers and therefore requires scrutinizing the narratives contained in footnotes, quarterly earnings releases, and other publicly available representations by management. We classify financial shenanigans into three broad groups: Earnings Manipulation Shenanigans (Part 2), Cash Flow Shenanigans (Part 3), and Key Metrics Shenanigans (Part 4).

Earnings Manipulation Shenanigans (Part 2)

Investors judge corporate executives harshly when they fail to meet Wall Street’s earnings expectations when reporting each quarter. Share prices often suffer dramatic declines when disappointing earnings are reported. Not surprisingly, then, in order to steer the share price (and the executives’ compensation package) higher, some companies engage in a variety of shenanigans to manipulate earnings. We have identified the following seven Earnings Manipulation (EM) Shenanigans that result in is representations of a company’s sustainable earnings.

EM Shenanigan No. 1: Recording Revenue Too Soon

EM Shenanigan No. 2: Recording Bogus Revenue

EM Shenanigan No. 3: Boosting Income Using One-Time or Unsustainable Activities

EM Shenanigan No. 4: Shifting Current Expenses to a Later Period

EM Shenanigan No. 5: Employing Other Techniques to Hide Expenses or Losses

EM Shenanigan No. 6: Shifting Current Income to a Later Period

EM Shenanigan No. 7: Shifting Future Expenses to an Earlier Period

Cash Flow Shenanigans (Part 3)

The plethora of financial reporting scandals and earnings restatements in recent years has left many investors questioning whether reported earnings can ever be free of management manipulation. Increasingly, investors have expanded their focus to include the Statement of Cash Flows and, more specifically, the section that highlights cash flow from operations (CFFO).

Investors are beginning to harbor a troubling suspicion about corporate financial reporting: that management now plays tricks to pollute cash flow from operations. Sadly, these suspicions are well founded. Investors can no longer trust that management will report its cash flow honestly and without discretion. To help investors navigate through the cash flow deception, we have identified the following four Cash Flow (CF) Shenanigans that may result in misrepresentations of a company’s ability to generate cash flow from its operations.

CF Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section

CF Shenanigan No. 2: Shifting Normal Operating Cash Outflows to the Investing Section

CF Shenanigan No. 3: Inflating Operating Cash Flow Using Acquisitions or Disposals

CF Shenanigan No. 4: Boosting Operating Cash Flow Using Unsustainable Activities

Key Metrics Shenanigans (Part 4)

So far we have addressed shenanigans that investors can generally identify by a careful reading of the numbers in the financial reports. Management, naturally, faces some restrictions under the accounting rules (called GAAP, or generally accepted accounting principles) on how it presents financial results to investors. To bypass many such restrictions and put on a positive spin, management has become more active and deceptive in creating and manipulating key non-GAAP metrics to impress investors. Such financial reporting misrepresentations tend to improperly highlight strong or consistent growth and robust health. Part 4 introduces two categories of Key Metrics (KM) Shenanigans.

KM Shenanigan No. 1: Showcasing Misleading Metrics That Overstate Performance

KM Shenanigan No. 2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration

Using a Holistic Approach to Detect Financial Shenanigans

Importance of “Checks and Balances”

What began in June 1972 as a bungled burglary of the Democratic National Committee office located in the Watergate Hotel in Washington culminated in the unprecedented resignation of a U.S. president in August 1974. The fact that President Nixon was driven out of office confirmed that our system of checks and balances really does work. Both the judicial and legislative branches played important roles in stopping a chief executive who abused his constitutional powers. The Supreme Court ruled unanimously that President Nixon could not plead executive privilege to prevent investigators from gaining access to White House tapes that were believed to contain damaging evidence, and the Judiciary Committee of the House of Representatives recommended impeachment to the full House. Facing the likely prospect of losing the impeachment votes in the House and the Senate, Nixon resigned the presidency.

More recently, in 1999, President Bill Clinton brought the executive office to the brink with another constitutional crisis over poor presidential behavior. The House of Representatives voted to impeach Clinton for lying under oath about his relations with a White House intern, stating that the president “willfully corrupted and manipulated the judicial process of the United States for his personal gain and exoneration.” However, with Supreme Court Chief Justice William Rehnquist presiding, the Senate had trouble finding an impeachable offense under “high crimes and misdemeanors,” and Clinton was found not guilty.

Whether the goal is preserving a democracy or upholding the integrity of financial reporting, a system of checks and balances is paramount for preventing, uncovering, and punishing improper behavior. And much like the U.S. government, financial reporting has three separate “branches”: a Statement of Income, a Statement of Cash Flows, and a Balance Sheet. When one of these financial statements contains shenanigans, warning signs generally appear on the other ones. Thus, Earnings Manipulation tricks can often be detected indirectly through unusual patterns on the Balance Sheet and the Statement of Cash Flows. Similarly, deciphering certain changes on the Statement of Income and the Balance Sheet often can help investors sniff out Cash Flow Shenanigans. (Part 5, “Putting It All Together,” summarizes how various checks and balances could have helped investors detect many of the shenanigans illustrated in this book.)

What Environment Breeds Shenanigans?

Clearly, not all companies use tricks in reporting to investors. Indeed, we believe that the vast majority of companies report honestly. Nevertheless, when researching companies, investors must always be vigilant and actively search for warning signs of problems, since shenanigans occur with sufficient frequency and cause significant pain if left undetected.

Companies with structural weaknesses or inadequate oversight provide a fertile breeding ground for shenanigans. Investors should probe a company’s governance and oversight by asking these basic questions:

(1) 
Do appropriate checks and balances exist among senior executives to snuff out corporate misdeeds?

(2) 
Do outside members of the board play a meaningful role in protecting investors from greedy, misguided, or incompetent management?

(3) 
Do the auditors possess the independence, knowledge, and determination to protect investors when management acts inappropriately?

(4) 
Has the company improperly taken circuitous steps to avoid regulatory scrutiny?

Let’s assume that a deceitful management team wishes to raise capital and prepares misleadingly glowing financial reports with inflated profits intended to trick investors. To successfully dupe investors, corporate management often tries to avoid unnecessary scrutiny and remain below the radar. Such management will create an organizational structure that avoids unwanted scrutiny by other corporate executives, board members, auditors, and regulators, who typically must sign off on offerings sold to investors. Here are some important red flags.

Management Teams Devoid of Checks and Balances

In the best companies, senior executives can freely criticize and disagree with one another—sort of like a good marriage. In undesirable companies, a single dictatorial leader runs roughshod over the others—not unlike a bad marriage. Investors face great risks if that dictatorial leader is also bent on creating misleading financial reports. Who can stop him when a culture of fear and intimidation exists? (No marriage analogies here, as our wives will be reading this book.) It is important for investors that sufficient checks and balances exist among senior management to prevent bad behavior.

Be Alert for Companies That Lack Checks and Balances Among Management.
Investors are best served when the senior management team includes strong, confident, and (hopefully) ethical members who will thwart a dishonest CEO or CFO and report improper behavior to the board of directors and the auditor. Too often, though, financial shenanigans arise when no such checks and balances exist. For example, an organizational structure in which a small group of family and friends hold key executive positions may embolden management to engage in financial reporting trickery. Additionally, a powerful and bullying CEO, such as Sunbeam’s Al Dunlap or HealthSouth’s Richard Scrushy, along with weak complicit or conflicted underlings, raises the risk profile for investors.