Financial Shenanigans

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