Financial Shenanigans: Detecting Accounting Gimmicks That Destroy InvestmentsVW Staff
Financial Shenanigans: Detecting Accounting Gimmicks That Destroy Investments by CFA Institute
Howard M. Schilit
Founder and CEO
Financial Shenanigans Detection Group, LLC
Key Biscayne, Florida
Good companies as well as bad can turn to financial shenanigans if management sets the wrong example. Most companies leave telltale signs of their fraudulent behavior, but auditors and analysts must be independent, imaginative, and skeptical in their examination of company accounts if they expect to find these signs.
During the past few years, I have been shocked and disappointed by the way corporations have increased the use of manipulative accounting gimmicks when their management presents information to investors. Such behavior occurs in both reputable and disreputable companies. In fact, many of the companies that I cite in my examples are highly regarded companies, so I am not pointing fingers at any particular type of company. But all of the companies I cite have at least one thing in common: Their management sets a tone that encourages the use of tricked-up accounting. For example, consider the words spoken at an employee meeting at Qwest Communications International by Joseph Nacchio, the CEO at the time:
The most important thing we do is meet our numbers. It’s more important than any individual product. It’s more important than any individual philosophy. It’s more important than any individual cultural change we’re making. We stop everything else when we don’t make the numbers.
Companies that play games with their accounting mirror this philosophy that nothing is more important than meeting and beating Wall Street’s numbers, and that philosophy begins at the top.
The intention of this presentation, therefore, is not only to share insights about the accounting tricks used by management to manipulate corporations’ apparent earnings and cash flow but also to identify some of the telltale signs and behaviors that can indicate such shenanigans are happening.
Earnings Manipulation Shenanigans
The accounting gimmicks used to manipulate earnings can be organized into seven categories:
- Recording revenue too soon,
- Recording bogus revenue,
- Boosting income by using one-time or unsustainable activities,
- Shifting current expenses to a later period,
- Employing other techniques to hide expenses or losses,
- Shifting current income to a later period, and
- Shifting future expenses to an earlier period.
Categories 1–5 represent earnings manipulation (EM) techniques for inflating profits during a given period, which can be done either by overstating revenue or by hiding expenses. Businesses are most likely to use these five categories. Sometimes, however, businesses want to do just the opposite, particularly when they want to cheat on their taxes. In these instances, they turn to Categories 6 and 7, which represent EM techniques for understating revenue and inflating expenses. Lower income and higher expenses lead to lower taxes.
I will discuss several, but not all seven, of these techniques.
Recording Revenue Too Soon. In this EM technique, a company does not fabricate revenue out of thin air; it simply reports revenue sooner than it should. For example, if a company is having difficulty meeting Wall Street’s estimate, it may start signing contracts or shipping out its product during the last few days of the quarter to get additional revenue booked in the current period.
- Recording revenue before completing any obligations. Computer Associates was particularly persistent at recording revenue before any obligations were complete. Its specific technique was to keep open the last month of any given quarter until it was able to produce enough revenue to satisfy Wall Street. Computer Associates was infamous for its 35-day months.
Furthermore, Computer Associates showed billions of dollars of long-term receivables in its accounts, which is a sure sign that something odd is going on. Generally, a receivable is recorded at the same time as the revenue, and one would expect the customer to pay within 30–60 days, not 365 days later. When a company shows long-term receivables, auditors and analysts should scrutinize the data and determine when the revenue for the receivables was recorded. For example, if a software company signs a five-year licensing deal, the company will receive payment over that 60-month period and should not be picking up all of the revenue in the first month. But that is exactly what Computer Associates was doing.
- Recording revenue far in excess of work completed on the contract. Companies can use this technique in several different ways, one of which is through a contract with several deliverables. Software companies often use this kind of contract. For example, when Apple sells an iPhone, part of its revenue is from selling hardware and part is from the two-year contract for iPhone service. Certainly, this is a legitimate way of doing business, but it can also lead to accounting shenanigans.
Consider the software company Transaction Systems Architects, which became increasingly aggressive at picking up ever larger portions of its revenue at the front end and smaller portions at the back end. One sign that helped me discover this behavior was that new accounts began appearing on the balance sheet. When I see a new account, only two explanations seem logical: The company is creating a new business, or it has decided to account for things in a different way. The second explanation is not a good sign. Such accounts as unbilled receivables and receivables in excess of billing began to show up on the balance sheet of Transaction Systems Architects, a telltale sign of accounting tricks.
Two more brief examples are Xerox Corporation’s tendency to select an inappropriately low discount rate to accelerate revenue and, more notoriously, Enron Corporation’s use of mark-to-market accounting to accelerate revenue into early years.
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