Financial Shenanigans 3rd Edition

The lure of accounting gimmickry is particularly strong at companies that are struggling to keep up with their investors expectations or their competitors performance. Investors should assume that the urge to exaggerate the positive side and hide the negative will never disappear Key Lesson #1 When reported sales growth far exceeds any normal patterns, revenue recognition shenanigans may likely have fueled the increase Key Warning #1 : Acquisitive Companies financial shenanigans often lurk at companies that grow predominantly by making acquisitions. Moreover, acquisitiondriven companies often lack internal engines of growth, such as product development, sales, and marketing. Key Lesson #2 When free cash flow suddenly plummets, expect big problems PWS comment maybe you can screen based on these lessons using software to screen for short candidates Since over valuation is not usually enough to take an intelligent short as timing is an issue, starting with earnings quality and then looking at valuation might be a better approach. For acquisitive companies, however, we suggest computing and adjusted free cash flow that removes total cash outflow (CFI??) for acquisitionscall this Free Cash Flow after Acquisitions. Acquisitions present numerous opportunities for companies to inflate earnings and both operating and free cash flow. Key Takeaway Watch out for aggressive accounting practices Analytical Tools - Allowance for doubtful accounts as % of receivables 3 Broad categories of shenanigans: Earnings Manipulation, Cash Flow, and Key Metrics Earnings Manipulation Shenanigans: 1) Record Revenues Too Soon 2) Recording Bogus Revenue 3) Boosting Income Using One-Time or Unsustainable Activities 4) Shifting Current Expenses to a Later Period 5) Employing Other Techniques to Hide Expenses or Losses 6) Shifting Current Income to a Later Period 7) Shifting Future Expenses to an Earlier Period

Cash Flow Shenanigans: 1) Shifting Financing Cash Inflows to the Operating Section 2) Shifting Normal Operating Cash Outflows to the Investing Section 3) Inflating Operating Cash Flow Using Acquisitions or Disposals 4) Boosting Operating Cash Flow Using Unsustainable Activities Key Metrics Shenanigans: 1) Showcasing Misleading Metrics That Overstate Performance 2) Distorting Balance Sheet Metrics to Avoid Showing Deterioration Corporate Governance Oversight Checklist: 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? Be alert for Companies that lack checks and balances among management Be particularly alert when a single family dominates management and the board Watch out for senior executives who push for winning at all costs Be skeptical of boastful promotional management Boards lacking competence or independence Inappropriate or inadequately prepared board members Failure to challenge management on related-party transactions Failure to challenge management on inappropriate compensation plans Need for outside directors to avoid inappropriate actions that lessen their independence o We believe that independent directors should not be involved in such related-party arrangements, as they may impair their objectivity and the appearance of independence on important decisions Auditor lacking objectivity and the appearance of independence Astronomical fees lead to a conflicted independent auditor Too long and close a relationship prevents a fresh look at the picture

Investors should demand auditor rotation every few years Incompetent auditors can serve as shills for management Management schemes to avoid regulatory scrutiny Lack of usual regulatory scrutiny before going public

Earnings Shenanigan #1: Recording Revenue Too Soon

Techniques to record revenue too soon: 1) Recording revenue before completing any obligations under the contract -Watch out for the endless month extending their qtr end date 2) Recording revenue far in excess of work completed on the contract -Upfront recognition of a long-term license contract -Changing the revenue recognition policy to record revenue sooner -Watch for CFO to start lagging NI -Be alert for a jump in unbilled receivables -Watch for long term receivable that grow faster than sales -When you artificially bring revenue forward you create a huge problem in terms of being able to meet future comps -Look out for companies inappropriately using POC accounting and using aggressive assumptions including low discount rates, changing terms of existing leases, long term arrangements w/multiple deliverables, and utility contracts using mark to market accounting 3) Recording revenue before the buyers final acceptance of the product -Seller records revenue before shipment (bill-and-hold) this is only allowed if beneficial and requested by the buyer (i.e. lack of warehouse storage). -Seller records Revenue upon shipment to someone other than the customer -Be wary of consignment sales (middle man), they should not be recognized until final buyer has purchased goods -Seller records revenue but can still reject sale -Be alert to seller shipping product before the agreed upon shipping date (channel stuffing) 4) Recording revenue when the buyers payment remains uncertain/unnecessary -Buyer lacks the ability or necessary approval to pay -Watch for companies that change their assessment of customers ability to pay -Seller induces sale by allowing an exceptionally long time to pay -Watch for seller provided financing -Watch for companies that offer extended or flexible payment terms -Be wary of extended payment terms on new products -Sound the alarm when the new extended payment terms are disclosed and DSO jumps 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, 4) the collectibility of the proceeds is reasonably assured. Failure to meet any one of these conditions requires deferral of revenue until all requirements are satisfied.

Red Flag- A sharp jump in accounts receivable, especially long-term and unbilled ones Tip Use DSO (days sales outstanding) metric to look for aggressive revenue recognition DSO = Ending receivables/revenue * number of days in the period (91.25 for qtr) An increase in DSO can be an indicator that a product was shipped late in the qtr Warning of premature revenue recognition: Cash flow from operations materially lags behind net income Potential problems using the percentage of completion accounting: Companies may use POC when it is not appropriate Companies may make aggressive assumptions to accelerate revenue Revenues may be inflated simply because honest estimates are off the mark Lease accounting relies heavily on management estimates Selecting low discount rates for capital leases lets you recognize more upfront revenue Warning of Premature revenue recognition: Companies adopting an acceptable methodology (such as POC) that was intended for other industriesthis is in essence the same as using a non-GAAP method because it distorts the economics of the business **In many cases an accounting change, even a GAAP permissible one, is an attempt to hide an operational deterioration

Earnings Manipulation Shenanigan #2: Recording Bogus Revenue

This is even more serious, and nefarious, than recognizing revenue early. Techniques to record bogus revenue: 1) Recording revenue from transactions that lack economic substance a. Bogus reserves will often lead to bogus revenue or income 2) Recording revenue from transactions that lack a reasonable arms-length process a. Transactions involving sales to an Affiliated Party b. Be wary of related-party customers and joint venture partners c. Watch for unusual sources of revenue at the time of an acquisition d. Be alert of two-way transactions with a nontraditional buyer 3) Recording revenue on receipts from non-revenue producing transactions a. Question revenue records when cash is received in lending transactions i. Never confuse money received from your banker with money received from a customer b. Challenge advances received from a partnership that are classified as revenue c. Be wary of revenue recorded on receipts from vendors

d. Consider how retailers account for returned goods 4) Recording revenue from appropriate transactions, but at inflated amounts a. Using an inappropriate methodology to recognize revenue b. Grossing up revenue to appear to be a larger company Accounting Capsule: Legitimate insurance contracts require a transfer of risk In order to be considered an insurance policy for accounting purposes, an arrangement must involve a transfer of risk from the insured to the insurer. Accounting Capsule: Revenue recognition for Principals vs Agents Principals recognize sales revenue at the gross amount of the transaction (i.e. the cost of the product plus mark-up). In contrast, agents simply recognize the revenue at the net amount, (i.e. the agents fee, which is the difference between the cost of the product and the sales price paid by a customer). Tip: If you spot signs of a questionable accounting approach, test it by comparing the results and practices to those of a similar company that is much larger.

Earnings Manipulation Shenanigan #3: Boosting Income Using OneTime or Unsustainable Activities
One time items are like pulling a rabbit out of a hat to magically meet earnings expectations Techniques to Boost Income Using One-Time or Unustainable Activities: 1) Boosting Income Using One-Time Events a. Turning a sale of a business into a recurring revenue stream b. Beware of commingling the sale of a business with the sale of product 2) Boosting Income through Misleading Classifications a. Shifting normal expenses below the line b. Watch for companies that constantly record re-structuring charges i. Move these costs above the line if frequent c. Watch for companies that shift losses to discontinued operations d. Shifting nonoperating and nonrecurring income above the line i. Including a one time gain above the line generally harder to do e. Watch for companies that include investment income as revenue, particularly if that is not normal for that companies industry f. Be suspicious of inflated operating income related to subsidiaries g. Pay attention to where companies classify joint venture income h. Using discretion regarding balance sheet classification to boost operating income i. Watch for shifting losses to non-consolidated joint ventures to boost op inc

Tip: Be sure to always review both parties disclosures on the sale of businesses to best grasp the true economics of the transactions. Warning Sign: Commingling future product sales with buying a business Accounting Capsule: Above-the-line and below-the-line Income Above-the-line: income from core business (revenues operating expenses) Below-the-line: non core or nonrecurring gains or losses Accounting Capsule: Accounting for investments in other companies For a small investment in a company (typically under 20%), the owner presents the investment at fair value in its balance sheet. If the investment is designated as trading security, changes in fair value are reflected on the statement of income. If it is instead designated as available for sale, changes in fair value are presented as an offset to equity, with no impact on earnings (unless permanent impairment exists). For a medium-sized investment in a company (typically 20-50%), the owner reports its proportional share of the investments earnings as a single line on the statement of income. This is called the equity method. For a large investment in a company (>50%), the owner fully merges the investments financial statements into its own. This is called consolidation