Notes on Financial Shenanigans

- Sudhir Kulaye, CFA

"Financial Shenanigans", How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard M. Schilit, Jeremy Perler, Yoni Engelhart is an essential book for anyone who wants to become a better analyst or investor. The book is a comprehensive guide that teaches readers how to identify accounting gimmicks and fraudulent financial reporting. Schilit’s writing style is clear and engaging. The book provides real-life examples and case studies that demonstrate how corporate fraudsters use tricks to hide their operations. I hope you find my notes helpful for your study and quick reference. I am happy to assist you with your learning.

Forensic Mindset

  1. Skepticism is a competitive advantage
    1. Capital Markets are designed to circulate good news
    2. Corporate issuers are incentivized to announce good news, sell-side firms to spread such news, and investors to believe it. This dynamic is part of what occasionally creates asset bubbles and boom/bust cycles. Investors who can remain objective and skeptical, while the herds echo and amplify each other's excitement, have a better chance of profiting from the more blatant disconnects from reality
  2. Pay close attention to changes-always ask "why?" and "why now?"
    1. After noticing an important change (e.g. changes in accounting practices, policy disclosure, balance sheet trends, key matrix, customer payment terms, executive departure, auditors, etc.), asking "why" the change happened is an important question, but an even more insightful one is "why now" which often leads investors to probe deeper into how results would have looked absent of the change.
  3. Look past "accounting problems" to see if business problems are being covered up
    1. Do not view "Accounting Problems" are mere technical issues.
    2. Focus on the question: "To what extent have these incorrect applications of accounting served to hide problems in the business"
  4. Pay attention to corporate culture and watch for breeding grounds of bad behavior
    1. Weak checks and balances, an autocratic CEO, and a culture of meeting targets at all costs are among the elements that increase the risk of shenanigans
  5. Never blindly adopt the company's profitability framework
    1. While evaluating a non-GAAP profitability matric, stop to consider what question it is that the measure answers, and then assess whether the question itself is a worthwhile one.
  6. Incentives matter: pay close attention to how executives are compensated
    1. Conventional wisdom links executive compensation to performance against established targets.
    2. Valeant's CEO incentive plan, focused on "cash earnings per share," shaped the company's strategy by excluding M&A-related expenses.
  7. Even in financial disclosures: location, location, location
    1. Companies can strategically highlight positive information in widely read documents, while burying unflattering disclosures in less visible sections of regulatory filings.
    2. Skepticism is crucial when encountering technical or less engaging sections of financial reports, as this is where management may attempt to conceal concerning information.
    3. Identifying buried disclosures, often found in small type or footnotes, can provide valuable insights into information that management may be trying to hide.
  8. Like in golf, every shot counts
    1. Golf's emphasis on every shot parallels GAAP accounting, where all expenses must be accounted for without exceptions.
    2. Excluding certain expenses from financial reporting, as seen with Whirlpool's exclusion of annual restructuring charges, is akin to seeking a "mulligan" and raises ethical concerns.
  9. Patterns of behavior provide a reliable signal
    1. By understanding the persistent patterns in executives' behavior, investors can gain insights into their decision-making, such as recognizing the likelihood of a CFO using aggressive accounting methods across different companies and identifying historical trends that may impact future financial performance.
  10. Be humble and curious, and never stop learning
    1. Pursuit of learning, humility despite expertise, and the commitment to solving complex problems, recognizing mistakes, and sharing valuable knowledge in the field of forensic accounting. 

1. 25 Years of experience

  1. Struggling companies usually try to do shenanigans
  2. Cannot rely on the auditor 
  3. The acquisition may not solve the problem of slow growth or a struggling company 
  4. Unbelievable numbers should not be believed 
  5. Focus on free cash flow to the firm then EPS 
  6. The balance sheet may not reflect the trend  
  7. Management-favoured numbers need scrutiny 

2. Touch-up 

  1. Need scrutiny of footnotes 
  2. Four Questions for Analysis: 
    1. Checks & balances among senior management
    2. Meaningful role of the board of directors 
    3. Auditor's independence & determination to protect Investors  
    4. Avoiding regulatory scrutiny  

3. EMS 1: Recording revenue too soon → DSO will spike 

  1. Before completing material obligation → Boomerang transaction, Extended Quarter  
  2. Recording excess revenue of work completed → POC (percentage-of-completion method) Assumptions, long term contract, software licensing fee 
  3. Recording revenue before buyer's acceptance → Bill & hold, after shipment (sell-in v/s sell-through), channel stuffing  
  4. Recording revenue when buyer's payment is uncertain → Approval required for purchase (especially universities, govt. offices), customer financing, liberal assessment of buyer’s credit score 

4. EMS 2: Recording bogus revenue 

  1. Lack of economic substance → AIG's Finite Insurance  
  2. Lack of arm's length → Related party transactions, JV controlled by the firm 
  3. Non-revenue-producing transaction → Borrowing or sale of asset or inventory, vendor rebate  
  4. Appropriate transaction but at inflated value → Grossing up e.g., Enron 

5. EMS 3: Boosting income using one-time accounting activity

  1. Boosting income using one-time event 
    1. IBM gained from selling AT&Tbusiness to reduce SG&A 
    2. Intel & Marvell - sold at a discounted value and assured future revenue
    3. Co-mingling selling with the sale of business or product rights (e.g., Soft Bank) 
    4. Dunkin's change in the policy to recognize unused balances on Dunkin card 
  2. Boosting income through misleading classification 
    1. Shifting normal expenses below the line e.g., Whirlpool's restructuring charges 
    2. Shifting non-operating, non-recurring income above the line - Boston Chicken recognized interest income as a revenue  
    3. Balance sheet reclassification → discretion in case of JV or subsidiaries, off-balance sheet debt

6. EMS 4: Shifting current period expenses to a later period (signs: Unwarranted ↑ OPM, ↑ Certain Assets, ↑ CFO But ↓ FCF) 

  1. Excess capitalization of routine expenses 
    1. Capitalizing marketing expenses e.g., AOL 
    2. This creates unusual assets on the balance sheet 
    3. Capitalizing permissible items but in too great amount e.g., software development cost 
    4. Growing advances of pre-payments  
  2. Amortizing cost too slowly → Stretching amortization period, depreciable lives, slow amortization of inventory cost e.g., airplane manufacturing industry   
  3. Failing to write down assets with impaired value (e.g., plant, inventory)  
  4. Failing to record expenses for devalued investments → e.g., banks' provision for NPAs or uncollected receivables e.g., allowance for a doubtful account [A/c Receivable ↑]  

7 EMS 5: Employing other techniques to hide expenses or losses

  1. Failing to Record expenses at the appropriate amount 
    1. Invoices received late in the quarter e.g., electricity bill  
    2. Cash received from vendor or advance rebate 
    3. Failing to accrue expenses for outside dispute or loss contingency  
    4. Off-balance sheet purchase commitments (read footnotes) 
  2. Recording low expenses by using aggressive accounting assumptions e.g., changing lease assumption, self-insurance assumption, or pension assumption 
  3. Reducing expenses by releasing reserves from previous charges 
    1. Reverting bonus  
    2. Release of the restructuring reserve 
    3. Marvell's cookie jar reserve (creating a reserve for future expenses and then releasing them) 
    4. Too low warrants → high EPS, too high warrants → low EPS  

8 EMS 6: Shifting current income to later period 

  1. Creating reserves and releasing them into income in the latter period → e.g., Microsoft's  ↑ in unearned or deferred revenue (saving for a rainy day), Enron's stretching out gain over several period 
  2. Smoothing income by improperly accounting for derivatives → e.g., "Steady Freddie" volatile income due to fluctuating interest rates  
  3. Creating Reserve in conjunction with Acquisition → "2 Month Stub Period" by Us Robotics & 3Com (i.e., purchasing a failure business)  
  4. Recording current period sales in a later Period → To retain performance bonus for the next period (very difficult to track though) 

9 EMS 7: Shifting future expenses to current period 

  1. Improperly writing off assets in current period to avoid expenses in future period  
    1. AOL → First did excess capitalization of regular advertorial expenses to appear more profitable; then one-time charges to write off entire amount to look profitable in future  
    2. NVIDIA → In 2016 wrote down Inventory & then sold the same to boost gross margin 
    3. Toys R Us → Included inventory in the restructuring charges 
    4. New CEO's tough" decisions 
    5. Pre-Merger write-off by child company → Parent's "Stub Period" to boost revenue plus child's pre-merger write off so expenses related to depreciation are low and overall acquisition look attractive 
    6. Restructuring at the tough economic time → Frequency of restructuring 
  2. Improperly recording charges to establish reserve used to reduce future expenses  
    1. Creating larger than needed restructuring reserve → Plan to lay off 100 people but take restructuring charges for 200 people 
    2. Watch for companies that creates reserve at the time of acquisition  

10 CFS 1: Shifting financial cash flow to the operating section 

  1. Recording bogus CFFO from bank borrowing (As if selling Inventory) 
    1. Delphi Corp → Borrowed $200m & showed as CFFO by crafting agreement as a sell 
    2. Bogus revenue → Bogus CFFO 
    3. Borrowing though SPE or subsidiaries e.g., Enron → missing Arm's length 
  2. Boosting CFFO by selling Receivables before the collection date 
    1. Normal practice 
    2. Cardinal Health sold receivables worth $800m, transparent but created hole for future 
    3. Sanmina Inc. was not even transparent 
    4. Watch for sudden ↑ in CFFO & ↓ in receivables 
  3. Faking the sale of receivable 
    1. Peregrines → bogus revenue → Bogus receivable → Fake sale of receivable 
    2. Watch for disclosure statement change 
    3. Non-Recourse → Risk of default is passed on to third party; Recourse → Risk of default is NOT passed on to third party 

11 CFS 2: Moving operating cash outflow to other sections 

  1. Inflating CFFO by boomerang transaction → e.g., Global Crossing showed cash received as CFFO but cash paid as CFFI 
  2. Improperly capitalizing normal operating cost 
    1. Both profit & CFFO get inflated. So, pay attention to net CFO (e.g., WorldCom) 
    2. Most common but legal capitalization → Long term R&D, software development and cost to win customer 
    3. Aggressive capitalization mainly in prepaid expenses, other assets, and software license fee (e..g., Salesforce)
  3. Recording purchasing of inventory as investing outflow 
    1. Netflix Vs Blockbuster → DVD purchases as cash flow of investing activity 
    2. Fully developed drug whose FDA approval is near (e.g., Calphalon Inc.) or developed R&D product (e.g., Nuance Communications Inc.) 
    3. Purchasing drug rights through a non cash & then cash pay as CFFI e.g., Biovail Corp 
  4. Shifting operating cash outflow off the cash flow statement → e.g., Diago's aging whiskey, IBM's Treasury Securities 

12 CFS 3: Boasting CFFO using unsustainable activities 

  1. Boosting CFO by paying vendors slowly → e.g., Home Depot. ↑ in days payable outstanding Watch ↑ account payable relative to ↑ in COGS & large swing in account payable or CFO, Accounting payable financing e.g., T-Mobile 
  2. Boosting CFO by collecting from customers more quickly → e.g., Tesla, Silicon Graphics  
  3. Boosting CFO by purchasing less Inventory → e.g., Home Depot or Purchasing inventory at the beginning of the quarter → e.g., Silicon Graphics 
  4. Boosting CFO by one-time benefit → e.g., Sun Microsystem's litigation income as CFO without plain disclosure 

13 KMS 1: Showcasing misleading metrics that overstate performance  

  1. Misleading metrics as a surrogate for revenue 
    1. Same-store-Sale (SSS)  
      1. Valuable if reported in a logical & consistent manner 
      2. No universally accepted definition, sometime not consistent from one quarter to another  
      3. Compare SSS with Revenue per store → Any divergence means struggling new stores or change in definition 
      4. Watch for change in definition   
        1. Length & time of inclusion (12 months Ve 18 months) 
        2. Type of stores included (e.g., geography, modelling) 
      5. Coach Inc. (fashion company) in 2014 or Reuter's "Ongoing Business" definition 
    2. Average Revenue. Per User (ARPU) → Sirius Vs XM Radio → One included subscriber activation + advertisement revenue 
    3. Subscriber Addition & Churn → e.g., AOL in 2001 included "Bulk Subscription" before user activation  
    4. Bookings & Backlog 
      1. First Solar included bookings after quarter ended till Earning Release
      2. ACI World Wide’s "Wishful thinking backlog" → licence agreements were assumed would be renewed 
  2. Misleading metrics as a surrogate for earnings 
    1. EBITDA variation → Global Crossing's "Adjusted Cash EBITDA" in which regular maintenance charges were considered as One-Time along with customer default etc. Another example is Whirlpool & Groupon 
    2. Inclusion or exclusion of one-time gain in "Adjusted EBITDA" while comparing two quarters  
    3. Upfront expenses → Capitalization → And removing amortization as non-cash expenses 
  3. Misleading metric as a surrogate for cash flow  
    1. Less common but they do exist 
    2. Illusionary Sense of Profitability → "Cash Earnings", "Cash EBITDA" most common. But cash flow is not just net income plus non-cash expenses. Ignoring working capital change, accrual of bad debt, impairments, warranty exp. will give an illusionary sense of profitability. Especially capital-intensive business. e.g., Go-Go Inc's inflight internet access (non-GAAP) 
    3. Non-GAAP CF metrics to confuse → e.g., Delphis Non-GAAP "Operating CF" 
    4. Non-GAAP metrics in Energy Industry → e.g., Linn Energy's "Distributable Cash Flow" which involves discretion in classifying maintenance capital & growth capital i.e., Higher classification to growth → Higher "Distributable CF". Paying out enormous dividends while generating negative Free CF is not sustainable   

14 KMS 2: Distorting balance sheet metrics to avoid showing deterioration 

  1. Distorting account receivable metrics to hide revenue problem 
    1. Selling account receivable → showing lower DSO e.g., Sanmina & Peregrine [fake sale of account receivable]
    2. Turning account receivable into notes receivable e.g., Symbol Tech, UTStar.com → Watch for increase in receivables other than account receivable especially notes receivable
    3. Watch for varying company DSO Calculations → DSO = [End Receivable / Revenue] x 91.25 → End Receivable is preferred than Average Receivable
    4. Watch for change in end receivable to average receivable (e.g., Tellabs Inc.)
  2. Distorting Inventory metrics to hide profitability problems 
    1. Unexpected rise in inventory → sign of upcoming margin pressure / falling product demand
    2. Inventory reduction plan → Symbol Tech's covering up the cover → Fictional accounting entries to reduce inventory → product delivery to receiving docks → Selling inventory to third party but agreeing to repurchase
    3. Moving inventory to another part of the balance sheet e.g., Pharma giant Merck & Co.’s "OtherAsset” → Inventories not expected to be sold within one year
    4. New company created metrics → e.g., Tween Brand's "In Store" Inventory per sq. ft. is compared with total inventory
  3. Distorting financial asset metrics to hide impairment problems
    1. Exposure to subprime borrowers → It is crucial to know the bank's loan portfolio is weighted towards dicey subprime borrowers
    2. Managements dress up or conceals important metrics → Banks might report delinquency rate,non-performing loan & loan loss reserve. However, sometimes managements dress up or conceals important metrics
    3. Changes in reporting presentation → e.g., New Currency Fin Corp which used to report loan loss reserve on standalone basis. In Sep. 2006, company group the loan loss reserve with other reserve (allowance for real estate) & presented those two together. 
  4. Distorting debt metrics to hide liquidity problems
    1. Large near-term debt obligations may prevent company from funding its growth initiative or worst spiralling toward bankruptcy 
    2. Europe's Enron → e.g., Parmalat, Italian-based dairy producer company used offshore entities to hide fictitious or impaired assets, fabricated the reduction of the debt and created fake income 

15 AAS 1: Artificially boosting revenue & earnings 

  1. Make or buy
    1. Apple's iPhone V/s Google's Android 
    2. Acquisition, by contrast, appears to provide a more attractive risk profile.
    3. However, in some respect it is an illusion. Long term success rate is low. 
  2. Failure reasons of acquisition
    1. Widespread confidence on magic of "Synergies" → e.g., Sears attempt to become Financial Super Market 
    2. Reckless transaction motivated by fear or greed → e.g., Valent's CEO's stock-based compensation
    3. Deals driven by artificial accounting & reporting benefits rather than business logic e.g., Olympus
  3. Natural consequences of acquisition
    1. Cost that should reflect as expenses on income statement are shifted to balance sheet as goodwill or intangibles
    2. Certain cashout flow typically reflected as reduction in CFO are classified as CFI
    3. So, acquisitive company logically report higher profit than organic grower as R&D expenses spent by someone else
    4. Similarly acquisitive company appears to generate more CFO than organic grower
  4. Inflating profit through tricks at target co" before" deal close 
    1. Valent's acquisition of Salix → Channel Stuffing to boost deal price & then "stub period" to boost revenue post deal. 
    2. Krispy Kreme's acquired one of its franchises & as a deal "sold" equipment than offsetting deal price. (clear lack of arm's length)
  5. Inflating profit by hiding losses "at" the deal → e.g. Olympus's "Tobashi" (fly away), $2b Acquisition → Fees to middleman to hide bad investments
  6. Creating dubious new revenue stream "After" closing the deal → e.g., FPA Medical’s rebate as a revenue or Intel and Marvel deal or Valent and Médicis where Médicis changed policy from "sell through" to "sell in" 
  7. Inflating profit by releasing suspicious reserve "Before/After" deal
    1. High earnout reserve to pay acquired company if certain target is achieved by the acquired company  

16 AAS 2: Inflating reported cash flow 

  1. Inheriting operating inflow  
    1. Most acquisitions are positive net working capital i.e. receivables greater than payable, so by liquidating and not by replenishing assets (inventory etc.) unsustainable benefit to cash flow can be shown.
    2. This boost to cash flow may cause "Quality of Earnings" measures to improve
    3. Serial acquirers get the boost repeatedly by "rolling up" the acquisitions → e.g., Tyco and WorldCom
    4. Tricks like holding cash received and expediting cash payments before acquisition and normalizing after acquisition gives boost to CFFO post acquisition.
    5. Tyco mother of all roll ups → e.g., Tyco bought more than 700 companies for total $29 billion during 1999 to 2002, considered as immaterial and choose to disclose nothing at all about them
    6. Consider free cash flow after acquisition to assess cash flow generation of acquisitive company and if available review the balance sheet of acquired company
  2. Acquiring contract or customer 
    1. Aggressive accounting → Tyco considered payment to dealer (which is normal customer solicitation cost) as a payment to purchase price of "acquisition" of contract and thus classified as investing cashflow rather operating cash outflow
    2. Aggressive accounting to fraud → Tyco's dealer connection fee sham transaction fraudulently generated $719 million CFFO. For every contract Tyco collected $200 from dealers as a dealer connection fee and paid $200 more for the contract acquisition. Thus net result caused no change in the economics of the transactions but gave a boost to CFFO by considering dealer connection fee as a inflow to CFFO.
  3. Boosting CFFO by creatively structuring the sell of a business
    1. Recording CFFO for proceeds from sale of a business → In 2005, Softbank sold its modem rental business to Gemini, classified received 85 billion Yen, into two categories - 45 billion as a sale of business (investing CF) and 40 billion as "advance" on the future royalty revenue (operating CF)
    2. Watch for new categories on statement of cash flow → In 2006, Softbank added a new line "Increased in deferred revenue" on its operating CF statement.
    3. Sell the business but keep some of the good stuff → To improve its liquidity and profitability, Tenet Healthcare sold some of its hospitals but kept receivables. This, of course, lowers the eventual sale price of the hospital by receivable amount. And collected receivable became a part of operating cash inflow.
    4. Buy the business but not any of the bad stuff → In 2016, Treehouse Food bought everything but payable
    5. Buy controlling interest in a business but use restricted cash to hide outflows → When Whirlpool bought Chinese appliance manufacturer Hefei Sanyo used restricted account to cover working capital and ongoing research need
    6. Fuzzy line between operating and investing outflow → e.g. MDC Partners - NY city based advertisement agency   

 

17 AAS 3: Manipulating Key Metrics 

  1. Inflating sales growth at the core business  
    1. No GAAP definition of "Organic Growth", thereby allowing management to come up with there own or not disclose at all
    2. Search footnotes disclosure that shows sales on a "pro-forma" basis, or contribution of target company and compute growth rate for legacy business, acquired business and the combined business
    3. Look for strange definition of organic or pro-forma sales growth. e.g. ACS's "Internal Growth" which included part of the revenue from acquired company as a part of a legacy business
    4. Starbucks's SSG ratio was not comparable after acquiring its strongest licencee.
    5. Acquisition of Companies with competing products. e.g. 3D Printing Manufacturer 3D System's acquisition of Z-Corp. After acquisition, 3D System discontinued some of Z-Corp's products. Naturally, Z-Corp Revenue fell and 3D System reported strong organic growth.
  2. Highlighting inflated earnings 
    1. Classifying normal expenses below the line along with substantial deal-related costs, especially in case of serial acquisition
    2. Be skeptical when GAAP earnings materially lag "Adjusted Earnings". e.g. Valeant's 2013-2016 GAAP based net earning vs its Non GAAP "Cash Earnings"

 

18 Case Studies 

  1. Hertz Global Holdings 
    1. Hertz Global Holdings, a car rental company, was bought by private equity (PE) firms in 2005 for $15 billion.
    2. Red Flag : PE firms paid themselves a dividend with a $1 billion loan before going public in 2006.
    3. Hertz suffered during the 2008 financial crisis, but recovered gradually until 2013.
    4. PE firms exited their investment in early 2013.
    5. Red Flag : CFO resigned abruptly in Sep-2013, raising doubts about the company’s financial health.
    6. New CFO delayed filing annual report in Mar-2014, claiming no material impact from accounting errors.
    7. TIP: Don’t trust management’s reassurances when accounting problems arise. They often understate the severity of the issue.
    8. Hertz’s stock price plummeted as the restatement process dragged on. Value investors who bought the dip lost money as the restatement (from 2011 to 2013) revealed significant losses and poor performance.
    9. TIP: Avoid investing in companies that are correcting accounting errors until you have a clear picture of their true performance. You may find unpleasant surprises.
  2. Toshiba Corporation 
    1. 2015: Toshiba confronted a major accounting scandal involving revenue recognition.(percentage-of-completion accounting)
    2. Initial announcement of internal investigation raised concerns; stock fell mildly.
    3. TIP: Assume issues are worse than imagined, avoid optimism, and stay on the investment sidelines.
    4. Toshiba's stock dropped further after revealing exacerbated revenue recognition problems. Similar to Hertz, management sugarcoated the initial disclosures about accounting problems.
    5. September 2015: Final report revealed a cumulative overstatement of pretax profits, reaching $1.9 billion. Restatements covered 2008 to 2014, indicating systemic problems in revenue recognition.
    6. Toshiba's stock plummeted by 60% by December 2015.
  3. Valeant Pharmaceuticals 
    1. Valeant Pharmaceuticals, founded in 1960, experienced a meteoric rise and fall from 2007 to 2017.
    2. McKinsey & Company's radical strategy, led by CEO Michael Pearson, focused on acquisitions and price increases, leading to a $90 billion market value peak in 2015.
    3. Valeant relied on misleading non-GAAP metrics to present a favorable narrative despite tepid organic growth and regular GAAP-based net losses.
    4. Unorthodox strategy involved acquiring established companies, raising drug prices, and shunning traditional R&D.
    5. Valeant's stock plummeted to $3 billion by 2017, wiping out $87 billion in equity value.
    6. Warning signs included reliance on acquisitions for growth, questionable targets with accounting scandals (e.g., Biovail, Medicis, Salix), and a hostile approach towards deals.
    7. Valeant's aggressive pursuit of Allergan in 2014, in partnership with Bill Ackman, raised ethical concerns and led to legal issues.
    8. Failed hostile deals, media scrutiny, and ethical concerns contributed to a loss of reputation.
    9. Valeant's biggest acquisition, Salix Pharmaceuticals, involved serious accounting issues and internal control weaknesses.
    10. Valeant's share price reached $263 in August 2015 but collapsed to under $9 by April 2017.
    11. The downfall was triggered by allegations of price gouging, media exposés on fraudulent practices, and government scrutiny.
    12. Valeant's business unraveled, former executives faced criminal investigations, and the share price declined by 96% from its peak.
    13. Astute investors understood the inevitability of Valeant's collapse due to false financial representations and accounting gimmickry.
    14. Lessons learned include the importance of scrutinizing financial representations, recognizing warning signs, and understanding the risks associated with aggressive M&A-driven growth strategies.