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
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