Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (8 page)

Earnings Manipulation Shenanigans

Chapter 3 EM No. 1: Recording Revenue Too Soon

Chapter 4 EM No. 2: Recording Bogus Revenue

Chapter 5 EM No. 3: Boosting Income Using One-Time or Unsustainable Activities

Chapter 6 EM No. 4: Shifting Current Expenses to a Later Period

Chapter 7 EM No. 5: Employing Other Techniques to Hide Expenses or Losses

Chapter 8 EM No. 6: Shifting Current Income to a Later Period

Chapter 9 EM No. 7: Shifting Future Expenses to an Earlier Period

Management may use a variety of techniques to give investors the mistaken impression that its company is performing better than the underlying economic reality. We have categorized all of these earnings manipulation tricks into two major subgroups: inflating current-period earnings and inflating future-period earnings.

Inflating Current-Period Earnings

Quite simply, in order to inflate current-period earnings, management must either push more revenue or gains into the current period or shift expenses to a later one. Shenanigans No. 1, 2, and 3 push revenue or one-time gains into current-period operations, and No. 4 and 5 shift expenses to a later period.

Inflating Future-Period Earnings

Conversely, to inflate tomorrow’s operations, management would simply hold back today’s revenue or gains and accelerate tomorrow’s expenses or losses into the current period. Shenanigan No. 6 describes techniques to improperly hold back revenue, and Shenanigan No. 7 accelerates expenses into an incorrect earlier period.

Earnings can be
improperly inflated
by inappropriately including revenues or gains and by excluding rightful expenses or losses of that period. Conversely, earnings can be
improperly deflated
by inappropriately excluding revenues or gains of that period and by including expenses or losses that really pertain to another period. Of course, when management deflates current-period earnings, it plans to “release” those pent-up earnings into another (and more advantageous) period.

Of the seven Earnings Manipulation Shenanigans identified to distort earnings, the first five inflate earnings, and the last two deflate them. For most readers, the desire to use Shenanigans No. 1 through 5 to exaggerate earnings might seem logical or intuitive. After all, higher reported profits often lead to a higher stock price and higher executive compensation. The logic of using Shenanigans No. 6 and 7 may be less intuitive in that a company that chooses to report less than its actual profits does not stand to gain any sort of obvious advantage. Management’s scheme, quite simply, would be to shift earnings from one period (with excess profits) to another (in need of profits). Alternatively, management may simply be attempting to smooth out volatile earnings in order to portray a more steady business.

3 – Earnings Manipulation Shenanigan No. 1: Recording Revenue Too Soon

Thirty days has September,

April, June, and November;

Of twenty-eight there is but one,

And all the rest have thirty-one.

—A modern version of the fifteenth-century medieval British rhyme

As young children, many of us were taught this useful rhyme by parents and teachers to help us remember the number of days in each month. Frankly, it still comes in handy as a reminder well into our adult years. Only fairly recently did we learn that February was not necessarily the only exception to the 30- or 31-day rule. In fact, every month could be the exception for companies that wish to inflate their revenue. Computer Associates has become the poster child for this revenue inflation trick, regularly stretching out its months to 35 days on the books. That scheme worked well for a while—or at least until the company was caught and CEO Sanjay Kumar was sent to jail.

Stretching out the number of days in a month is but one of the creative techniques that management may use to improperly record revenue too early. Chapter 3 describes a variety of ways in which management attempts to accelerate revenue to earlier periods and how investors can spot signs of this transgression.

Techniques to Record Revenue Too Soon

1. Recording Revenue Before Completing Any Obligations under the Contract

2. Recording Revenue Far in Excess of Work Completed on the Contract

3. Recording Revenue Before the Buyer’s Final Acceptance of the Product

4. Recording Revenue When the Buyer’s Payment Remains Uncertain or Unnecessary

1. Recording Revenue Before Completing Any Obligations under the Contract

Some companies go to great lengths to record sales before the clock strikes midnight on the last day of the quarter. Sometimes they get creative in how they mark the quarter’s end and push a future period’s sale into the current period.

Computer Associates and the Endless Month

Executives at Computer Associates regularly stretched out the last month of the quarter to as much as 35 days and both backdated and forged sales contracts to trick their auditor and their investors into believing the company’s fictitious sales growth.

But, Boy, Did They Have a Billion Good Reasons.
What may have led management to embark with such great zeal on pushing sales and Computer Associates’ stock price higher and higher? The obvious answer would be oversized bonuses and stock options; however, the extent of this compensation defies the imagination. Let’s go back to the terms of the company’s 1995 Key Employee Stock Ownership Plan (KESOP), which would reward Computer Associates’ top three executives with millions of additional shares if the share price reached certain levels and remained above those levels for at least 30 consecutive days.

The August 1995 plan initially authorized the grant of up to 6 million shares to three senior executives: Chief Executive Officer Charles Wang (60 percent), Chief Operating Officer Sanjay Kumar (30 percent), and Executive Vice President Russell Artzt (10 percent). After a certain amount of time (and a certain number of stock splits), more than 20 million shares were actually issued. Then finally it happened—drum roll, please! On one not-so-ordinary day in 1998, they hit the $1.1 billion jackpot when the company’s share price closed at just over $55, with Wang receiving 12.15 million shares, Kumar 6.075 million, and Artzt 2.025 million (worth $669.8, $334.9, and $111.6 million, respectively).

But They Must Have Done an Unbelievable Job.
Well, not really. The price
did
appreciate significantly, but remember that this occurred within the great bull market of the late 1990s. From the date of the plan in 1995, the annual return looked impressive; however, the appreciation was not much greater than that of the S&P 500 during this raging bull market. Good results, sure, but certainly not All Star or Hall of Fame worthy. Oh, and one other small point—the results were achieved through cheating!

Let’s go back to the terms of this bizarre plan. If management can figure out a way to produce good news so that the stock price jumps to the designated level and remains at that new higher level for a month, the house pays out. In the end, these executives split more than a billion dollars in bonuses. If investors had read about the bizarre arrangement in the 1995 Securities and Exchange Commission (SEC) filing, they surely would have realized that temptation existed for the company to use every trick in the book to manipulate earnings and inflate the stock price.

Accounting Capsule: Revenue Recognition

According to accounting guidelines, four conditions must be met in order for revenue to be recognized: (1) evidence of an arrangement exists, (2) delivery of the product or service has occurred, (3) the price is fixed or determinable, and (4) the collectibility of the proceeds is reasonably assured. Failure to meet any one of these conditions requires deferral of revenue until all requirements have been satisfied.

Be Wary of Companies That Extend Their Quarter End Date.
Not surprisingly, Computer Associates was not alone in improperly accelerating revenue by stretching its quarter end date. During the mid-1990s, “Chainsaw Al” Dunlap and his minions at Sunbeam changed the company’s quarter end from March 29 to March 31 to make up for a revenue shortfall. The two additional days permitted Sunbeam to record another $5 million in sales from its operations and $15 million from the newly acquired Coleman Corporation.

Not to be outdone by Computer Associates and Sunbeam, San Diego–based software maker Peregrine also routinely kept its books open well after the official quarter ended. The practice became so common at the company that officers joked about this ploy, characterizing these late transactions as having been completed on “
the thirty-seventh of December
.”

2. Recording Revenue Far in Excess of Work Completed on the Contract

The first technique reveals how companies improperly recognize revenue before the sale even happens. Next, we discuss revenue recognition in situations in which the seller has started to deliver on the contract; however, management records a far greater amount than is warranted. Our friends at Computer Associates were savvy at playing both tricks. Not only did the company extend its quarter to capture more revenue, but it also pulled forward license sales that would not actually be earned for many years to come.

Up-Front Recognition of a Long-Term License Contract

Computer Associates sold long-term licenses allowing customers to use its mainframe computer software. Customers paid an upfront licensing fee for the software, as well as an annual charge to renew the license in subsequent years. Despite the long-term nature of these agreements (some contracts lasted as long as seven years), the company would recognize the present value of all licensing revenue for the entire contract immediately. Since all licensing revenue was recorded at the beginning of the contract, and cash was not collected for many years to come, Computer Associates recorded large amounts of long-term receivables on its Balance Sheet.

A November 1998 report by the Center for Financial Research and Analysis (CFRA) disagreed with Computer Associates management and deemed it aggressive for a company to record all this revenue up front. Economic reality dictates that revenue should be deferred until the billing period for each installment sale.

RED FLAG!
A sharp jump in accounts receivable, especially long-term and unbilled ones.

Regulators Also Strongly Disagreed with the Approach. The SEC charged that from at least January 1998 through October 2000, Computer Associates prematurely recognized
over $3.3 billion
in revenue from at least 363 software contracts with customers.

Computer Associates’ bulging long-term receivables should have alerted investors to the company’s aggressive revenue recognition. The CFRA report highlighted the firm’s surging long-term and total receivables at September 1998. Investors should use a measure called days’ sales outstanding (DSO) to evaluate whether customers are paying their bills on time. A higher DSO could indicate aggressive revenue recognition in addition to simply poor cash management. With the company’s long-term installment receivables soaring at September 1998, its DSO reached an unsettling 247 days (based on product revenue)—a year-over-year increase of 20 days. Furthermore,
total
receivables, including both current and long-term, increased to 342 days—a jump of 31 days.

Accounting Capsule: Days’ Sales Outstanding (DSO)

Days’ sales outstanding (DSO) is generally calculated as follows:

Ending receivables/revenue × number of days in the period

(
for quarterly periods, 91.25 days is a normal approximation
)

Since DSO is a metric outside of generally accepted accounting principles, companies may present their DSO calculated in a different way (for example, by using average receivables instead of the ending balance). However, for financial shenanigan detection purposes, we advise using our calculation. We will discuss DSO in greater detail, including its uses and abuses by management, in Part 4, “Key Metrics Shenanigans.”

Changing the Revenue Recognition Policy to Record Revenue Sooner

Like Computer Associates, software maker Transaction Systems Architects, Inc., jump-started its sluggish revenue growth by shifting future-period sales into earlier periods. Reported sales growth in 1999 excited investors; however, several cautionary signs were emerging. The company changed its revenue recognition policy to record the entire value of five-year customer contracts up front, as compared to its previous approach of spreading the revenue over the five-year contract period. And, did this ever change the results.