analyzing financial report:detecting accounting fraud

Analyzing Financial Report:Detecting Accounting Fraud

Arthik Davianti

Analisis laporan keuangan, kinerja, dan kepatuhan atas

entitas komersial, nirlaba, dan ETAP dengan focus pada

accounting gimmick and fraud

What has been will be again, what has been done will be

done again;There is nothing new under

the sunEcclesiastes 1:9

SHENANIGANS

Shenanigans:Secret or dishonest activity or

manoeuvring (Oxford Dictionary)

Financial shenanigans:Actions taken by management that mislead investors about a

company’s financial performance or economic

health (Schilit and Perler, 2010)

FINANCIAL SHENANIGANS

Awards for Most Outrageous Financial Shenanigans

Category CompanyMost Imaginative Fabrication of Revenue EnronMost Brazen Creation of Fictitious Profit and Cash Flow

WorldCom

Most Shameless Heist by Senior Manager TycoMost Ardent and Prolific Use of Numerous Shenanigans

Symbol Technologies


1. Earnings Manipulation Shenanigans

2. Cash Flow Shenanigans

3. Key Metrics Shenanigans


Companies with structural weakness or inadequate oversight.Ask these basic questions:1. Do appropriate check and balances exist among

senior executives to snuff out corporate misdeeds?2. Do outside members of the board play a

meaningful role in protecting investors?3. Do the auditors possess the independence,

knowledge, and determination to protect investors?

4. Has the company improperly taken circuitous steps to avoid regulatory scrutiny?


Warnings signs – ground for shenanigans:1. Absence of checks and balances among senior

management.2. An extended streak of meeting or beating Wall

Street expectations.3. A single family dominating management,

ownership, or the BOD.4. Presence of related-party transactions.5. Inappropriate members placed on the BOD.6. Inappropriate business relationship between

company and board members.


Warnings signs – ground for shenanigans (continues):7. An unqualified auditing firm.8. An auditor lacking objectivity and the

appearance of independence.9. Attempts by management to avoid regulatory

or legal scrutiny.

EARNINGS MANIPULATION

Investor judge corporate executives harshly when they fail to meet Wall Street’s earnings expectations when reporting each quarter.• Inflating current-period earnings.• Inflating future-period earnings.


1. Recording revenue too soon.2. Recording bogus revenue.3. Boosting income using one-time or

unsustainable activities.4. Shifting current expenses to a later period.5. Employing other techniques to hide expenses

or losses.6. Shifting current income to a later period.7. Shifting future expenses to an earlier period.


1. Recording revenue too soon.

Techniques:1. Recording revenue before completing any

obligations under the contract.2. Recording revenue far in excess of work

completed on the contract.3. Recording revenue before the buyer’s final

acceptance of the product.4. Recording revenue when the buyer’s payment

remains uncertain or unnecessary.


1. Recording revenue too soon.

Warning signs (p. 73):1. Up-front revenue recognition on long-term

contracts.2. Cash flow from operation lagging behind net

income.3. Accelerating sales by changing the revenue

recognition policy.4. Seller offering extremely generous extended

payment terms.


2. Recording bogus revenue.

Techniques:1. Recording revenue from transaction that lack

economic substance2. Recording revenue from transaction that lack a

reasonable arm’s length process.3. Recording revenue on receipt from non-

revenue-producing transactions.


2. Recording bogus revenue.

Warnings (p. 91):1. Recording revenue from transaction that lack a

reasonable arm’s length process.2. Recording cash received from a lender,

business partner, or vendor as revenue.3. Revenue growing much faster than account

receivables.4. Unusual increases or decreases in liability

reserves account.


3. Boosting income using one-time or unsustainable activities.

Techniques:1. Boosting income using one-time events.2. Boosting income through misleading

classifications.


3. Boosting income using one-time or unsustainable activities.

Warnings signs (p. 108):1. Shifting normal operating expenses below the

line.2. Routinely recording restructuring charges.3. Including proceeds received from selling a

subsidiary as revenue.4. Operating income growing much faster than

sales.


4. Shifting current expenses to a later period.

Techniques (p. 111):1. Improperly capitalizing normal operating

expenses.2. Amortizing cost too slowly.3. Failing to write down assets with impaired

value.4. Failing to record expenses for uncollectible

receivables and devalued investments.


4. Shifting current expenses to a later period.

Warnings signs (p. 134):1. Improperly capitalizing normal operating

expenses.2. Changes in capitalization policy or accelerated

capitalization of costs.3. New or unusual assets accounts.4. Jump in soft assets relative to sale5. Stretching out depreciable asset life.6. Improper amortization of cost associated with

loans.

EARNINGS MANIPULATION5. Employing other techniques to hide expenses or losses

Technique (p. 137):1. Failing to record an expense from a current

transaction.2. Failing to record an expense for a necessary

accrual or revising a past expense3. Failing to record or reducing expense by using

aggressive account assumptions.4. Reducing expenses by realising bogus reserves

from previous charges.

EARNINGS MANIPULATION5. Employing other techniques to hide expenses or losses

Warning signs (p. 155):1. Unusually large vendor credits or rebates.2. Unusual transactions in which vendors send

out cash.3. Failing to record an expense for a necessary

accrual or revising a past expense.4. Unusual declines in reserves for warranty or

warranty expense.


6. Shifting current income to a later period.

Techniques (p. 159-160):1. Creating reserves and realising them into

income in a later period.2. Improperly accounting for derivatives in order

to smooth income.3. Creating reserves in conjunction with an

acquisition and realising them into income in a later period.

4. Recording current-period sales in a later period.


6. Shifting current income to a later period.

Warning signs (p. 171-172):1. Creating reserves and releasing them into

income in a later period.2. Stretching out windfall gains over several years.3. Improperly accounting for derivatives in order

to smooth income.4. Holding back revenue just before an

acquisition closes.


7. Shifting future expenses to an earlier period.

Techniques (p. 175):1. Improperly writing off assets in the current

period to avoid expenses in a future period.2. Improperly recording charges to establish

reserves used to reduce future expenses.


7. Shifting future expenses to an earlier period.

Warnings signs (p. 187-188):1. Improperly writing off assets in the current

period to avoid expenses in a future period.2. Improperly recording charges to establish,

reserves used to reduce future expenses.3. Large write-offs accompanying the arrival of a

new CEO.

CASH FLOW SHENANIGANS

Increasingly, investors have expanded their focus to include the Statement of Cash Flows and, more specifically, the section that highlights cash flow from operation (CFFO).• Accrual versus cash-based accounting.


1. Shifting financing cash inflows to the operating section.

2. Shifting normal operating cash outflows to investing section.

3. Inflating operating cash flow using acquisitions or disposal.

4. Boosting operating cash flow using unsustainable activities.


1. Shifting financing cash inflows to the operating section

Techniques (p. 197):1. Reporting bogus CFFO from a normal bank

borrowing.2. Boosting CFFO by selling receivables before

collection date.3. Inflating CFFO by faking the sale of receivables.


1. Shifting financing cash inflows to the operating section

Warning signs (p. 211):1. Recording bogus CFFO from a normal bank

borrowing.2. Boosting CFFO by selling receivables before the

collection date.3. Providing less disclosure than in the prior

period.


2. Shifting normal operating cash outflows to investing section

Techniques (p. 213-214):1. Inflating CFFO with boomerang transactions.2. Improperly capitalizing normal operating cost.3. Recording the purchase of inventory as an

investing outflow.


2. Shifting normal operating cash outflows to investing section

Warning signs (p. 226):1. Inflating operating cash flow with boomerang

transactions.2. Improperly capitalizing normal operating costs.3. New or unusual assets accounts.4. Jump in soft assets relative to sales.5. Unexpected increase in capital expenditures.


3. Inflating operating cash flow using acquisitions or disposal

Techniques (p. 228):1. Inheriting operating inflows in a normal

business acquisition.2. Acquiring contracts or customers rather than

developing them internally.3. Boosting CFFO by creating structuring the sale

of a business.


3. Inflating operating cash flow using acquisitions or disposalWarning signs (p. 240):1. Declining free cash flow while CFFO appears to

be strong.2. Acquiring contracts or customers rather than

developing them internally.3. Boosting CFFO by creatively structuring the sale

of a business.4. Selling a business, but keeping the related

receivables.



Techniques (p. 241):1. Boosting CFFO by paying vendors more slowly.2. Boosting CFFO by collecting from customers

more quickly.3. Boosting CFFO by purchasing less inventory.4. Boosting CFFO with one-time benefit.



Example of boosting CFFO with one-time benefit:Microsoft Corp doled out billions of dollars –

settle antitrust litigation.Sun Microsystem (one of the recipient) – received

$2 billion from Microsoft in 2004 ($1.6 billion recognized as income), presented as “settlement income” – non recurring and unrelated to its normal operation.



Warning signs (p. 251):1. Boosting CFFO by paying vendors more slowly.2. Account payable increasing faster than cost of

goods sold.3. Increase in other payables accounts.4. New disclosure about prepayments.5. Offering customers incentives to pay invoices

early.

KEY METRICS SHENANIGANS

Management, naturally, faces some restriction under accounting rules – GAAP.To by pass many such restrictions and put on a positive spin, management has become more active and deceptive in creating and manipulating key non-GAAP metrics to impress investors.The use of other “key metric” to evaluate a company’s performance and economic health.

KEY MATRICS SHANANIGANS

1. Showcasing misleading metrics that overstate performance.

2. Distorting balance sheet metrics to avoid showing deterioration.

KEY MATRICS SHANANIGANS

1. Surrogates for revenue: same-store sales, backlog and bookings, subscriber count, average revenue per customer, and organic revenue growth.

2. Surrogates for earnings: pro forma earnings, EBITDA), non-GAAP earnings, constant-currency earnings, and organic earnings growth.

3. Surrogates for cash flow: a retail chain may present cash flow excluding a substantial one-time cash payment for a legal settlement.


Showcasing misleading metrics that overstate performance.

Techniques (p. 262):1. Highlighting a misleading metric as a surrogate

for revenue.2. Highlighting a misleading metric as a surrogate

for earnings.3. Highlighting a misleading metric as a surrogate

for cash flow.



Examples (p. 272):General Motors (GM) recorded $259 million after tax gain on the sale of an equity interest in a regional homebuilder in June 2006.The gain from the homebuilder investment would not be excluded from ‘adjusted income’ (20% more than the adjusted income).



Warning signs (p. 277):1. Highlighting a misleading metric as a surrogate

for revenue.2. Divergence in trend between same-store sales

and revenue per store.3. Pretending that recurring charges are

nonrecurring in nature.


Distorting balance sheet metrics to avoid showing deterioration.Techniques (p. 281):1. Distorting account receivable metric to hide

revenue problems.2. Distorting inventory metrics to hide profitability

problems.3. Distorting financial assets metrics to hide

impairment problems.4. Distorting debt metrics to hide liquidity problems


Distorting balance sheet metrics to avoid showing deterioration.

Example – selling accounts receivable (p. 282):• Lowers the days’ sales outstanding reported to

investors.• It appears that customers have been paying

more quickly.


Distorting balance sheet metrics to avoid showing deterioration.

Warning signs (p. 295-296):1. Failing to prominently disclose the sale of

accounts receivable.2. A huge decline in DSO following several

quarters of growing receivables.3. Moving inventory to another part of the

balance sheet.4. Stopping the reporting of certain key metrics.

Source:Schilit, H. and Perler, J., 2010,

Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial

Reports, 3rd Edition,

analyzing financial report:detecting accounting fraud

Business

shenanigans shenanigans

financial shenanigans

cash flow shenanigans

key metrics shenanigans

bogus revenue

currentperiod earnings

financial report

upfront revenue recognit