Financial Fraud Case Book

June 23, 2012

Holistic approach to detecting financial shenanigans

Use checks and balances from all three statements as well as notes

• WorldCom: Boosted income by capitalising operating costs. Warning sign: SCF: Capex surged
• Transactions Systems Architect: Recorded revenue too soon. Warning sign: BS: Rapid increase in long-term and unbilled receivables
• IBM: Boosted income with one-time gain. Warning sign: SCF: Gain on investment sale in Operating section
• AOL: Boosted income by capitalising operating costs. Warning sign: BS: Deferred marketing costs exploded

Overview of shenanigan-prone companies:

• Absence of checks and balances among senior mgt
• An extended streak of meeting or beating Wall Street expectations
• A single family dominating mgt, ownership, or board of directors
• Presence of related-party transactions
• An inappropriate compensation structure that encourages aggressive financial reporting
• Inappropriate members placed on the board
• Inappropriate business relationships between the company and board members
• An unqualified auditing firm
• An auditor lacking objectivity and the appearance of independence
• Attempts by management to avoid regulatory or legal scrutiny

Earnings Manipulation Shenanigans

Inflate current period income or future period incomes.

Warning sign 1: Recording revenue too soon

• Recording revenue before completing any obligations under contract
• Recording revenue far in excess of work completed on a contract
• Upfront revenue recognition on long-term contracts
• Use of aggressive assumptions on long-term leases or %-of-completion accounting
• Recording revenue before the buyers final acceptance of the product
• Recording revenue when buyers payment remain uncertain or unnecessary
• Cash flow from operations lagging behind net income
• Receivables (especially long-term and unbilled) growing faster than sales
• Accelerating sales by changing revenue recognition policy
• Using an appropriate accounting method for an unintended purpose
• Inappropriate use of mark-to-market or bill-and-hold accounting
• Changes in revenue recognition assumptions or liberalising customer collection terms
• Seller offering extremely generous extended payment terms

Warning sign 2: Recording bogus revenue

• Recording revenue from transactions that lack economic substance
• Recording revenue from transactions that lack a reasonable arms-length process
• Lack of risk transfer from seller to buyer
• Transactions involving sales to a related party, affiliated party, or joint venture partner
• Boomerang (two-way) transactions to a nontraditional buyer
• Recording revenue on receipts from non-revenue-producing transactions
• Recording cash received from a lender, business partner, or vendor as revenue
• Use of an inappropriate or unusual revenue recognition approach
• Inappropriately using gross rather than net method of revenue recognition
• Receivables (especially long-term and unbilled) growing much faster than sales
• Revenue growing much faster than accounts receivable
• Unusual increases and decreases in liability reserve accounts

Warning sign 3: Boosting income using one-time or unsustainable activities

• Boosting income using one-time events
• Turning proceeds from the sale of a business into a recurring revenue stream
• Commingling future product sales with buying a business
• Shifting normal operating expenses below the line
• Routinely recording restructuring charges
• Shifting losses to discont. operations
• Including proceeds received from selling a subsidiary as revenue
• Operating income growing much faster than sales
• Suspicious or frequent use of JVs when unwarranted
• Misclassification of income from JVs
• Using discretion regarding Balance Sheet classification to boost operating income

Warning sign 4: Shifting current expenses to a later period

• Improperly capitalising operating expenses
• Changes in capitalisation policy or accelerated capitalisation of costs
• New or unusual asset accounts
• Jump in soft assets relative to sales
• Unexpected increase in capex
• Amortising or depreciating costs too slowly
• Stretching out depreciable asset life
• Improper amortisation of costs associated with loans
• Failing to record expenses for impaired assets
• Jump in inventory relative to COGS
• Failure by lenders to adequately reserve for credit losses
• Decrease in loan loss reserve relative to bad loans
• Decline in bad debt expense or obsolescence expense
• Decrease in reserves related to bad debts or inventory obsolescence

Warning sign 5: Employing other techniques to hide expenses or losses

• Failing to record an expense from a current transaction
• Unusually large vendor credits or rebates
• Unusual transactions in which vendors send out cash
• Failing to record an expense for a necessary accrual or reversing a past expense
• Unusual declines in reserve for warranty or warranty expense
• Declining accruals, reserves, or soft liability accounts
• Unexpected and unwarranted margin expansion
• Unusually lucky timing of issuance of stock options
• Failing to accrue loss reserves
• Failing to highlight off-balance-sheet obligations
• Changing pension, lease, or self-insurance assumptions to reduce expenses
• Outsized pension income

Warning sign 6: Shifting current income to a later period

• Creating reserves and releasing them into income in a later period
• Stretching out windfall gains over several years
• Improperly accounting for derivatives to smooth income
• Holding back revenue just before an acquisition closes
• Creating acquisition-related reserves and releasing them into income in a later period
• Recording current-period sales in a later period
• Sudden and unexplained declines in deferred revenue
• Changes in revenue recognition policy
• Unexpectedly consistent earnings during volatile times
• SIgns of revenue being held back by the target just before an acquisition closes

Warning sign 7: Shifting future expenses to an earlier period

• Improperly writing off assets in current period to avoid expenses in future periods
• Improperly recording charges to establish reserves used to reduce future expenses
• Large write-offs accompanying the arrival of a new CEO
• Restructuring charges just before an acquisition closes
• Gross margin expansion shortly after an inventory write-off
• Repeated restructuring charges that serve to convert ordinary expenses to one-time expenses
• Unusually smooth earnings during volatile times

Cash Flow Shenanigans

Ways that companies use to inflate CFFO

Warning sign 1: Shifting financing cash inflows to operating section

• Recording bogus CFFO from a normal bank borrowing
• Boosting CFFO by selling receivables before the collection date
• Disclosures about selling receivables with recourse
• Inflating CFFO by faking sale of receivables
• Changes in wording of key disclosure items in financial reports
• Providing less disclosure than in prior period
• Big margin expansion shortly after an inventory write-off

Warning sign 2: Shifting normal operating cash outflows to investing section

• Inflating operating cash flow with boomerang transactions
• Improperly capitalising normal operating costs
• New or unusual asset accounts
• Jump in soft assets relative to sales
• Unexpected increase in capex
• Recording purchase of inventory as an investing outflow
• Investing outflows that sound like a normal cost of business
• Purchasing patents, contracts, and development-stage technologies

Warning sign 3: Inflating operating cash flow using acquisitions or disposals

• Inheriting operating cash inflows in a normal business acquisition
• Companies that make numerous acquisitions
• Declining FCF while CFFO appears to be strong
• Acquiring contracts or customers rather than developing them internally
• Boosting CFFO by creatively structuring the sale of a business
• New categories appearing on SCF
• Selling a business, but keeping related receivables

Warning sign 4: Boosting operating cash flow using unsustainable activities

• Boosting CFFO by paying vendors more slowly
• Accounts payable increasing faster than COGS
• Increases in other payables accounts
• Large positive swings in SCF
• Evidence of accounts payable financing
• New disclosure about prepayments
• Offering customers incentives to pay invoices early
• Boosting CFFO by purchasing less inventory
• Disclosure about timing of inventory purchases
• Dramatic improvements in CFFO
• CFFO benefit from one-time items

Key Metrics Shenanigans

Warning sign 1: Showcasing misleading metrics that overstate performance

• Changing the definition of a key metric
• Highlighting a misleading metric as a surrogate for revenue
• Unusual definition of organic growth
• Divergence in trend between SSSS and revenue per store
• Inconsistencies between earnings release and 10-Q
• Highlighting a misleading metric as a surrogate for earnings
• Pretending that recurring charges are non-recurring in nature
• Pretending that one-time gains are recurring in nature
• Highlighting misleading metrics as a surrogate for cash flow
• Headlining a misleading metric on the earnings release

Warning sign 2: Distorting balance sheet metrics to avoid showing deterioration

• Distorting accounts receivable metrics to hide revenue problems
• Failing to prominently disclose the sale of accounts receivable
• Converting accounts receivable into notes
• Increases in receivables other than accounts receivable
• A huge decline in DSO following several quarters of growing receivables
• Inappropriate or changing methods of calculating DSO
• Distorting inventory metrics to hide profitability problems
• Moving inventory to another part of the balance sheet
• Distorting financial asset metrics to hide impairment problems
• Stopping the reporting of certain key metrics
• Distorting debt metrics to hide liquidity problems