This blog covers the general topic of financial markets.

Financial Shenanigans

first posted: 2023-10-26 13:22:41.013987

Financial Shenanigans is a 95 book updated to 3rd edition in 2010 by Howard Shilit. There is a 4th edition published in 2018.

  • actions that intentionally distort a company financial performance and financial condition
  • either to inflate current earnings (inflating revenue or deflating expenses) or deflating earnings
  • inflate earning: going public soon, needs loan, or board feels threatened. Deflating: rainy day fund, make merger look fruitful, big bath

Usual Suspects:

greater incentives for

  • serial acquirers especially from weak corp
  • dumb incentives to mgt (bonuses capped if reaching certain threshold )
  • private: no audited financial statements
  • company about to IPO: early shareholder exit
  • changing business model: red flag if no longer viable,
  • operational problem: declining sales or profits, receivable increase, or operating cashflow decreasing compared to earnings

Seven Shenanigans

  • recording revenue too soon or of questionable quality
  • recording bogus revenue, like sales from person not paying, lend as revenue, rebated as revenue (red flag)
  • recording business sale as revenue
  • shifting business expense to a later or earlier period, capitalisation of cost with no future benefits
  • failing to record or improperly reduce liab: example fiddling with pension plan assumption
  • shifting current revenue to a later period: to create reserves
  • shifting future expenses as special charge, writing down merger cost too quickly

Recording revenue too soon:

  • recording revenue before completing obligations under contract
  • recording revenue far in excess of work completed
  • upfront recognition of long-term contracts
  • use of aggressive assumptions on long term lease or percentage of completion accounting
  • recording revenue before buyer's final acceptance of the product
  • recording revenue when buyer's payment is uncertain or unnecessary
  • cashflow from operations lagging behind net income
  • receivables growing faster than sales
  • accelerating sales by change of revenue recognition policy
  • using an appropriate accounting method for an unintended purpose
  • mark to market or bill to hold accounting
  • change in revenue recognition or liberalisation of customer collection terms
  • offering extending extremely generous payment terms

Recording Bogus Revenue:

  • revenue from txn that lack economic substance
  • txn with no arms-length process
  • no risk transfer from seller to buyer
  • txn with affilliated party
  • boomerang txn
  • revenue on receipts from non revenue producing txn
  • cash from lender, business partner or vendor as revenue
  • inappropriate or unusual revenue recognition
  • receivables growing faster than sales
  • unusual decrease in liability reserve account

Boosting Operating Income using One-Time or Unsustainable activities

  • boosting income using one-time events
  • turning proceeds from sales into recurring profit
  • commingling future product sales with buying a business
  • shifting operating expenses below the line
  • routinely recording restructuring charges
  • shifting losses to discontinued operations
  • including proceeds from subsidiary sale to revenue
  • operating income growing much faster than sales
  • frequent use of JV when unwarranted
  • using discretion regarding balance sheet classification to boost operating income

Hide Expenses or losses:

  • unusually high vendor credits
  • vendor sending cash (unusual)
  • failing to record an accrual or reversing past expense
  • declining reserves, accruals and other soft liability accounts
  • unexpected margin expansion
  • unusually luck timing of stock options
  • no accrual of loss reserves
  • hiding off-balance sheet obligations
  • changing pension, self-insurance, lease assumptions
  • outsize pension income

Shifting Future Expenses to an Earlier Period

  • improperly writing off asserts in the current period to avoid later expense
  • recording charges to establish reserves and reduce future expenses
  • large write-offs with new CEO
  • restructuring charges just before aquisition closes
  • gross margin expansion after inventory write-off
  • repeated restructuring charges converting ordinary expenses into one-time charges
  • unusually smooth earnings during volatile times

Shifting financing inflow to operating cashflow

  • bogus cffo from bank borrowing
  • boosting cffo by selling receivables before due date
  • disclosures about selling receivables with recourse
  • inflating cffo by faking sale of receivables
  • change in wording of key disclosures
  • providing less disclosure than in previous reports
  • big margin expansion after an inventory write-off

Shifting normal operating cash outflow to investing

  • inflating operating cashflow with boomerang transactions
  • improperly capitalizing expenses
  • new or unusual asset accounts
  • jump in soft assets relative to sales
  • unexpected increase in capex
  • recording purchase of inventory as investing outflow
  • investing outflow that sounds like a normal cost of business
  • purchasing patents, contracts, and dev stage tech

Inflating operating cashflow through constant aquisitions

  • inheriting operating cashflow from aquired business instead of growing it organically
  • making numerous aquisitions
  • declining free cashflow while operating cashflow appears strong
  • acquiring contracts and customers instead of developping them internally
  • boosting CFFO by creatively structuring the sale of a business
  • new categories appearing on cashflow statement
  • selling a business but keeping receivables

Boosting Operating CF using Unsustainable activities

  • increasing days of collection for payables
  • accelerating receipts
  • lowering inventory
  • large positive swings on casflow
  • account payable financing
  • new disclosure about prepayments
  • disclosure about inventory purchases
  • CFFO benefiting from one time items

Company Report

  • auditors absence of opinion or qualified opinion
  • proxy: mgt comp, related party txn, lawsuits
  • footnote: change in acct policy, long term commitments
  • president's letter: read comments with grain of salt, watch out for "challenging" word
  • MD&A in 10k 10Q
  • Form 8k for major events: change in auditors
  • can call them

Common Size Analysis

  • vertical analysis: rescale by revenue for IS and CS or assets for BS
  • find top 5 competitors of the company and compare
  • horizontal for change between years

Typical case

  • Enron: miraculous revenue growth of x10 over 5 years brings company in top 7. Net income did not follow
  • Wolrdcom: net income overstated as expense is classified as capex, FCF=operating cf - capex tells the story
  • Tyco: expenses become as investing cashflow in aquisitions
  • symbol technology: always make analyst targets, op cf always fall short of net income