Book: Financial Shenanigans
Author: Howard Schilit
What Should Make Your Ears Perk Up?
- Steady and predictable performance (esp. during a recession) ala Symbol Technology
- Unusually large one-time charges (as this might be building a bogus reserve to use later)
- Boastful and/or promotional management
- Boards lacking competence or independence, and providing services to the company
- Merging into an existing company to avoid the regulatory scrutiny before an IPO ala Chinese reverse-mergers
Earnings Manipulation
Look for the following items that may be being used to record revenues too soon –
- Revenue recognition policies and any changes (sell-in vs. sell-through etc.)
- DSO
- OCF vs. NI
- Un-billed receivables (not really receivables; customers haven’t been billed, and these accounts are still in the production period), long-term receivables (beyond B/S date)–this is more likely to happen in %age-of-completion projects, bill-and-hold, consignment
- Seller-provided financing
- Revenues from related 3rd party / JVs has the added risk of simply bogus revenues
- Financing / special agreements with customers that actually are uneconomic, but create revenue right away
- Commingling sale of a business with sale of a product: this allows the company to book a smaller one-time gain and create a revenue stream
If the company has a lot of subs that have some ownership by other non-controlling entities, then make sure not to focus solely on the operating income as it would include 100% of the income from the subsidiary and would ignore the portion of the earnings owed to the non-controlling entities. It’s also worth nothing when the company starts counting certain subs as controlled vs. not as that may depend on the economics of the subsidiary.
The following items may be used to shut expenses to a later period –
- Certain assets growing in an unusual way (esp. ones that are new and previously unused) as this may signal capitalization of costs
- Depreciating these assets slowly than usual
- DOI
- inventory obsolescence expense and related reserves (this may signal aggressive capitalization of expenses in inventory)
- Self-insurance reserves (this is where the co. creates a mini insurance company within to insure certain health-care or disability risks)
- Use of derivatives (categorization of hedges as “in-effective” leads to immediate recognition of earnings, whereas effective hedges don’t impact earnings). “Hedges” that move in the same direction as the underlying asset/liability may signal that the company is using the hedges to speculate (instead of hedging).
Cash Flow Manipulation
The following items can be used to shift financial cash inflows to the operating section –
- Mis-representing loans as sale of inventory
- Selling accounts-receivables
- Complicated off-balance sheet transactions
The following items can be used to shift operating cash outflows to the financial section –
- Boomerang transactions ala Global Crossing
- Recording the purchase of inventory as capex
In case of frequent acquisitions, the company may ask its targets to pay all its vendors early and hold off receiving cash from its customers, which would deliver a nice OCF boost to the acquiring company (this will often work as most cos. have a +ve net working capital.
In case of frequent dispositions, the company may sell the assets but keep the receivables to get a short boost from the cash generated from the receivables (ala THC).
Prasad Capital 