Kenny Yang

Financial Shenanigans- A Deep Look At The Tricks A Company Can Play With Its Accounting

June 19, 2014

The source for this discussion comes from a book titled "Financial Shenanigans" by Howard M. Schilit. The discussion is aimed at explaining accounting tricks public companies use to inflate their financial numbers in order to meet the expectation of analysts. Management of public companies are often pressured by analysts and investors to "make the numbers" every quarter. Therefore, some may cheat to meet a net income target for a certain quarter. A little cheating during one quarter can snowball into a lot of cheating (i.e. Enron is a famous example). How does these corporate executives cook the books? One may think they are rocket scientists but with a little accounting knowledge you learned from Ms. Hopwood-Jones's class, you too can detect accounting frauds.

Earnings[1] (Income Statement) Manipulations:

Investors often scrutinize a public company's quarterly earnings report very carefully. They often cheer when a company can meet or beat the consensus earnings (net income) estimate. If a company failed to meet the consensus estimate, the share price often declines. How do corporate executives create "fake" earnings? They often just play around with the fundamental income statement equation as listed below.

Revenue - Expenses = Net Income

Since net income is calculated by subtracting expenses from revenue, corporate management can manipulate net income by inflating revenues or making expenses disappear.

Trick #1: Recording Revenue Too Soon

A common trick is to record revenue early before it is actually earned. In accounting, the revenue recognition rule is used to determine if revenue is actually earned (see table 1 below for more details).

A common trick is to recognize revenues that belong to a future accounting period. For example, if company A is a magazine publisher that collected \$100 for a 4-year subscription fee from a customer, how much revenue can the company recognize in year 1? The answer is only \$25 because the other \$75 should go into "unearned/deferred revenue" (a liability account) since the \$75 does not meet the GAAP revenue recognition rule. Nonetheless, corporate executives often trick their auditors by using fancy wording to convince auditors that these 4-year subscriptions are actually 1 year subscriptions. Therefore, it is vital for investors to read the footnotes to financial statements. Read the footnotes carefully!

One interesting method to boost revenue is by billing the customer for work not completed yet. In the real world, most transactions are not black and white as you see in accounting textbooks and revenue is often recognized over several accounting periods (construction industry is the common example). Since revenue is a credit account, they need a debit account to balance the books. Since customers generally don't pay cash unless the required work is completed, a common account to debit is account receivables. Therefore, be wary of any abnormal increases in accounts receivables or any receivable accounts. Also, if the accounts receivable turnover ratio (revenue/accounts receivables) starts to slow while revenues are still growing, it is a red flag and the company is probably inflating revenue by borrowing future revenue.

Table 1: Revenue Recognition under IFRS and US GAAP[2]

 IFRS Revenue Recognition Criteria US GAAP Revenue Recognition Criteria (1) The amount of revenue can be measured reliably (1) There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end (2) It is probable that the economic benefits associated with the transaction will flow to the entity (2) The product has been delivered or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risk and rewards have not actually passed to the buyer (3) The stage of completion of transaction at the balance sheet date can be measured reliably (3) The price is determined or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency (4) The costs incurred for the transaction and the costs to complete the transaction can be measured reliably (4) The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay

Source: IASB and FASB

As shown in table 1, a company cannot recognize revenue unless the risk and rewards (economic benefits) is transferred from the seller to the buyer. A trick used in the 1990s by Sunbeam is to use a technique called "bill and hold." In essence, Sunbeam bills the customers and recognizes revenue despite the products were held in Sunbeam's warehouses. Although this trick is difficult to detect, a closer look at the revenue recognition footnote can discover aggressive revenue recognition. Below is the paragraph disclosed in Sunbeam's annual report:

"In limited circumstances, at the customers' request the company may sell seasonal products on a bill-and-hold basis provided that goods are completed, packaged and ready for shipment, such goods are segregated and the risks of ownership and legal title have been passed to the customer."

With the grills sitting at Sunbeam's warehouses, there is no doubt that the economic benefits have not been passed onto the buyers despite Sunbeam tried using the words "risk of ownership and legal title have been passed to the customer." Also, customers often do not request goods on a bill-and-hold basis. Always be suspicious when the words "bill-and-hold" comes up in the financial footnotes.

Finally, another trick is to inflate revenues is to extend generous terms to buyers despite low creditworthiness, which fails criteria (4) listed in table 1 since the probability of collection is low. An acceleration of revenue along with growth in accounts or note receivable is a red flag. Although not all red flags imply revenue manipulation, investors should be careful when these red flag appear. If the company is showing abnormal growth in accounts or note receivable while also disclosing that it is extending credit to customers with generous terms, watch out!

Trick # 2: Boosting Income Using One Time Items

One-time items, also known as "extraordinary items", are often used to boost net income. By definition one-time items should occur infrequently such as gain/loss from sale of equipment[3] or damage incurred from a natural disaster.

Corporate management often tell investors to ignore one-time items because they do not reflect the continuous business operations. They tell investors to focus on normalized income, which is often called "operating income." You will often see a corporate income statement organized as follows:

Table 2: Sample Corporate Income Statement[4]

 Revenue XXX COGS XXX Gross Profit XXX Operating Expenses XXX Operating Income XXX One-time Items XXX Earnings Before Tax XXX Income Tax Expense XXX Net Income XXX

Investors do pay more attention to operating income than the net income number. Therefore, management has the opportunity to inflate operating income by shifting positive benefits from one-time items above the operating income line and shifting normal expenses below the operating line. The former outcome can be achieved by shifting a gain from the sale of an asset above the operating income line as reduction to operating expenses. For example in 1999, IBM sold a business to AT&T but instead of disclosing the gain on the sale in the one-time items line on the income statement, IBM decided to book the \$4.06 billion gain on sale as a contra expense. The effect of IBM's accounting decision significantly reduced operating expense by \$4.06 billion (reducing the \$18.8 billion operating expenses to only \$14.7 billion!). Investors thought IBM found a magic way to reduce operating expenses and decided to give a higher valuation[5] for the stock only to find out later that those expense reductions didn't continue into future periods. Savvy investors reading the financial footnote would have noticed this trick because the company, by law, had to disclose how the sale of a business is accounted for. Companies often bury these unwanted disclosures deep in the footnotes since they know most investors never bother to read 100 pages of financial footnotes. However, it pays to goes through the footnotes of financial statements!

Another genius method is to create a continuous stream of income from the sale of an asset. Because income from a one-time sale is less impressive than a continuous stream of income, corporate management will aim to create a continuous stream of income from the sale of an asset. Let's use the traditional debits and credits to explain this trick. Assuming an asset owned by company I is valued at \$1,000,000 (fair-value). Instead of selling it at \$1,000,000, company I sells the asset to company M at only \$800,000. However, company I requires company M to pay for future products at above market prices to make up for the \$200,000 difference. Table 3 shows the correct way to account for this transaction while table 4 shows the inflated approach.

Table 3: Correct way to account the transaction by company I

 Cash \$800,000 Receivable (from Company M) \$200,000 Asset Sold (Book Value)[6] \$700,000 Gain on Sale of Asset \$300,000

When the inflated prices are paid by company M in the future, the following should occur:

 Cash \$200,000 Receivable (from Company M) \$200,000

Table 4: How to Create A Revenue Stream From One-Time Sale

 Cash \$800,000 Asset Sold (Book Value) \$700,000 Gain on Sale of Asset \$100,000

When the inflated prices are paid by company M in the future, company I records:

 Cash \$200,000 Revenue \$200,000

Magically, company I created \$200,000 of revenue that should have been recorded as a gain on sale from a prior accounting period. To create a continuous revenue stream, the company could have recognized the \$200,000 more slowly, such as \$20,000 for 10 reporting periods.

This example is actually real. Company I was Intel and company M was Marvell Technology and this transaction took place back in November 2006. Again, the only way to have detected this fraud was to look in the footnotes when Marvell disclosed that it will pay above market prices for Intel's products in future periods. When analyzing any transaction, always try to understand the underlying economics and consider which accounts are affected. It's critical for investors to understand their debits and credits.

Trick #3: Shifting Current Expenses to a Later Period

Two examples will be illustrated for this trick. The first example is capitalizing expenses. In order to understand the nature of this action, let's review the fundamental accounting equation:

Assets = Liabilities + Shareholder's Equity[7] (1)

Now we can expand equation (1) above by expanding the Shareholder's Equity section as follows:

Assets = Liabilities + Beginning Shareholder's Equity + Revenue - Expense (2)[8]

In order to decrease expenses, the asset side must increase in order for equation (2) to remain in balance. How can a company increase assets to reduce expenses? Let's step back and revisit the accounting rules for a fixed asset. When a fixed asset is purchased, is the entire amount expensed on the income statement? The answer is obviously "no" since that action would distort the trend in net income by having years with high net income when there are no purchases of fixed assets and years with low net income when there are purchases of fixed assets. Accounting rule states that a fixed assets must be capitalized (put on the balance sheet) and the cost of the asset is allocated, by reporting costs in the income statement, over its useful life. However, only assets that provide economic benefits for more than one accounting period can be capitalized. Normal operating expenses should be expensed on the income statement. Nonetheless, managers who wish to reduce expenses will often capitalize normal operating expenses in order to boost net income.

Let's use debits and credits to explain this trick. To account for \$1 million of normal operating expenses, the following should be recorded:

 Operating Expense \$1,000,000 Cash/Accounts Payable \$1,000,000

To defer a portion of the \$1 million expense, consider what happens if the \$1 million is capitalized and recognized over 2 accounting period instead of 1.

 Fixed Asset \$1,000,000 Cash/Accounts Payable \$1,000,000
 Depreciation Expense \$500,000 Accumulated Depreciation \$500,000

By recognizing the \$1 million expense over 2 periods, net income is overstated in the 1st period by \$500,000. Because the effect reverses in the 2nd period, a company that capitalize expenses is often forced to repeat the trick over and over again until it goes bust. This was the case with WorldCom in 2002.

Capitalizing expenses is a simple trick, but shrewd investors can detect this fraud by looking at the balance sheet instead of focusing exclusively on the income statement. If any fixed asset is growing out of control and there is no good explanation in the footnotes, management is probably capitalizing normal operating expenses. For those grade 12 students who understand the cash flow statement, another method to detect this fraud is look at free cash flow, which is defined as cash flow from operations minus purchases of fixed assets, a line located in the cash flow from investing section. If free cash flow declines rapidly, it is a red flag.

Another method to defer expense is to recognize them more slowly. Recall that depreciation/amortization expense should be recognized by an amount equaling to [(cost-salvage)/useful life] if the straight line method is used. The useful life number is often an estimate and accounting rules allow management to use its best estimate as a proxy. Therefore, management can record a lower expense by simply assuming a longer useful life of its asset. The only way to detect this fraud is to compare the useful life (estimated by cost/annual depreciation expense) one company compared to the industry average. If the assumed useful life of a particular asset is significantly higher than the industry average, the company is probably making an aggressive assumption regarding the useful life of its assets.

Trick #4: Hiding Expenses

Similar to how a magician makes a rabbit disappear, corporate management often employ tricks to make expenses disappear. The most simple trick to hide expenses is simply failing to record accrued expenses. Let's apply what you learned in Ms. Hopwood-Jones class on accrued expenses in the following example: company X repaired a machine for company Y and bills company Y for \$100. If company Y does not pay in the current accounting period, an accrued expenses must be recorded in Y's books.

 Maintenance Expense \$100 Accounts Payable \$100

However, to avoid the recognition of an expense, company Y simply ignores this adjusting entry, which would boost income (by reducing expenses) for the current accounting period. Although outside investors cannot detect this fraud without looking at the internal books, the expense recognition footnote may provide clues about aggressive accounting for expenses.

Another method to hide expenses is making aggressive assumption on "soft expenses" like warranty expenses. Soft expenses often require the significant use of management's judgement in determining the amount booked in the financials. Let's illustrate with an example of warranty expense. Under GAAP, the company must record a warranty expense for each accounting period using past experience as a proxy, similar to the accounting for bad debt.

To illustrate with an example of warranty accounting. Let's see the following entries:

 Warranty Expense \$1,000 Warranty Liability \$1,000
 Warranty Liability \$900 Cash \$900

The first entry records the \$1,000 expense incurred while the second entry books the \$900 actual claim during the period. The figures should be similar for the two entries. Nevertheless, a company wishing to reduce current expenses may book a lower warranty expense, such as booking only \$500 in the prior example instead of the \$1,000 justified using past experience. The easiest method to hide expenses is to assume a lower expense figure for these "soft expenses" like warranty expense or bad debt expense.

Trick #5: Shifting Future Expenses to an Earlier Period

This trick is to incur the pain today while lowering expenses in future periods. Table 5 shows a two-step process for expense recognition for balance sheet items. By accelerating the expense recognition process, a company can recognize future expenses upfront and incur zero expense in the future. Let's illustrate with an example of an inventory write-down.

Table 5: Cost Recognition under a two-step progress

 Step 1: Asset Step 2: Expense Prepaid Insurance Insurance Expense Inventory COGS Property, Plant & Equipment Depreciation/Amortization Expense

Under GAAP, inventories on the balance sheet are accounted for using the LCM (lower of cost or market) approach. If the market value (market price less estimated costs incurred to sell) is lower than the book value on the balance sheet, the difference must be written down as an expense (often through COGS) on the income statement. However, the market value used in the write-down is estimated by management and they could use an unrealistically low number so the expense recognized is higher than it should be. By writing down inventories close to zero, similar to how Cisco wrote down \$2.25 billion in 2001, companies can report very low COGS numbers in the future and inflate their profit margins significantly.

Another creative method to overload current expenses is to book a large "restructuring expense." This is a common trick used by companies during difficult times. By booking a large restructuring expense today, companies can release the excessive amount into net income through a reduction of operating expenses. Again, let's demonstrate with the use of debits and credits. Assuming company R decides to fire 100 workers and need to pay \$10,000 to each worker as a severance expense, which will paid in a future period. The proper method to account for the transaction is shown below.

(1) Current period to recognize the expense:

 Restructuring Expense (Wages) \$1,000,000 Wage Payable \$1,000,000

(2) When Severance is paid at a later period:

 Wage Payable \$1,000,000 Cash \$1,000,000

However, because the \$10,000 per worker is a "soft expense" estimated by management, there is a strong incentive to overestimate, such as using \$20,000 per worker.

(1) Current period to recognize the expense:

 Restructuring Expense (Wages) \$2,000,000 Wage Payable \$2,000,000

(2) When Severance is paid at a later period and only \$1,000,000 is paid:

 Wage Payable \$2,000,000 Cash \$1,000,000 Wage Expense \$1,000,000

By booking an extra \$1,000,000 of restructuring expense in the current period, the company can reduce wage expense by \$1,000,000 in a future period when the restructuring liability is extinguished. This is a creative method but fails to conform to the basic matching rule under GAAP.

Conclusion:

Despite real world accounting is more complicated than what you learned in Ms. Hopwood-Jones's class, I believe everyone has the necessary tools to detect accounting frauds. As stated many times in this article, the key is to read the footnotes carefully so that you can detect aggressive accounting assumptions, whether it is related to revenue, expenses or one-time items.

[1] The word "earnings" is often used in place of "net income" when discussion financials of public traded companies (ones that trade on a public exchange such as the TSX or NYSE).

[2] When an accounting textbook uses the word "GAAP", it is referring to the old Canadian GAAP rules. IFRS, the international standard, replaced Canadian GAAP in 2011. Nonetheless, IFRS is quite different and US GAAP is closer to the old Canadian GAAP.

[3] Recall that a gain/loss is recorded from the sale of a fixed asset when the sale price is higher/lower than the net book value (historical cost - accumulated depreciation)

[4] When you read financial statements of public companies, the income statement is commonly called the "statement of operations" or "statement of earnings."

[5] Stocks valuation can be explained by the P/E ratio which is market price of stock divided by its earnings. Usually investors would use operating earnings (income) as the denominator as those earnings are continuous in nature. Therefore, IBM's action of moving a gain from sale of an asset above the operating income line inflates operating income and increase the "E" in the P/E ratio, result in a higher stock price.

[6] The net book value is credited for the sake of simplicity. In reality, the asset account (historical cost) is credited while the accumulated depreciation is debited.

[7] "Shareholder Equity" is the equivalent of "Owner's Equity" and it is used for the equity account of a public traded company

[8] Assuming no dividends (Owner's withdrawals) or share issuance (Owner's deposit)

[9] Salvage value is ignored because it usually a negligible amount

Kenny Yang
I'm a value investor who loves to read and learn more. I'm an avid follower of Buffett's advice of reading as much as I can. I strive to gain a little wisdom everyday. My investment portfolio is heavily concentrated in a few names similar to how Munger positions his portfolio. I often find great opportunities and sit on them for a long time.

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Nhsu_75 - 3 years ago    Report SPAM

Great article. Thanks for writing!