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Financial Shenanigans: Earnings Manipulation (Part 2)

Financial Shenanigans: Earnings Manipulation (Part 2)
https://www.toonpool.com/cartoons/Cooking%20the%20books_211296#

In my previous post I mentioned the brief summary of accounting shenanigans identified by Howard Schilit in his book Financial Shenanigans used by management to manipulate earnings, cash flow and key metrics.
Below is the summary of various methods management uses to manipulate the earnings through the 7 Earnings manipulation shenanigans.


1. Recording revenue too soon:

  • Recording revenue before completing any obligations under the contract
  • Recording revenue far in excess of work completed on the contract
    – Up-front recognition of long-term contracts
    – Inappropriate use of percentage of completion method
    – Improper recording of revenue from assets leased to customers
  • Recording revenue before the buyer’s final acceptance of the product
    – Seller records revenue before shipment
    – Seller records revenue upon shipment to someone other than the customer
    – Seller records revenue, but buyer can still reject the sale
  • Recording revenue when the buyer’s payment remains uncertain or unnecessary
    – Buyer lacks the ability or the necessary approval to pay
    – Seller induces sale by allowing an exceptionally long time to pay

2. Recording bogus revenue:

  • Recording revenue from transactions that lack economic substance
  • Recording revenue from transactions that lack a reasonable arm’s-length process
  • Recording revenue on receipts from non-revenue-producing transactions like borrowings from banks, refund from suppliers, etc.
  • Recording revenue from appropriate transactions, but at inflated amounts

3. Boosting income using one time or unsustainable activities:

  • Boosting income using one-time events like selling of a division or an asset
  • Boosting income through misleading classifications
    – Shifting normal expenses below the line by one time write-offs of cost that would normally appear in operating section. Like taking one-time write-off of inventory or restructuring charges

4. Shifting current expenses to later period:

  • Improperly capitalizing normal operating expenses
  • Amortizing costs too slowly
  • Failing to write down assets with impaired value

5. Employing other techniques to hide expenses or losses:

  • Failing to record an expense from a current transaction
    – Failure to record invoices received late in the period
    – Unusual transaction in which vendor sends out cash
    – Unusually large vendor credits or rebates
    – Failing to account for stock options backdating expense
  • Failing to record an expense for a necessary accrual or reversing a past expense
    – Decline in warranties reserve of warranty expense
    – Fail to accrue for loss contingencies
  • Failing to record or reducing expenses by using aggressive accounting assumptions
    – Boosting income by changing lease assumptions
  • Reducing expenses by releasing reserves from previous charges

6. Shifting current income to later period:

  • Creating reserves and releasing them into income in a later period
  • Creating reserves in conjunction with an acquisition and releasing them into income in a later period
  • Recording current period sales in a later period

7. Shifting future expenses to an earlier period:

  • Improperly writing off assets in the current period to avoid expenses in a future period
  • Improperly recording charges to establish reserves used to reduce future expenses

Few red flags associated with earnings manipulation:

  • Cash flow from operations (CFFO) lagging behind net income
  • Receivables (especially long-term and unbilled) growing faster than sales
  • Operating income growing much faster than sales
  • Jump in inventory relative to cost of goods sold
  • Boomerang (two-way) transactions to non-traditional buyers
  • Unexpected increase in capital expenditures
  • Use of an inappropriate or unusual revenue recognition approach
  • Unexpectedly consistent earnings during a volatile time
  • Signs of revenue being held back by the target just before an acquisition closes
  • Large write-offs accompanying the arrival of a new CEO

Edit 1: Link to Financial Shenanigans: Cash Flow & Key Metrics Shenanigans (Part 3)