Shenanigan Strategies

CFA Level 1 - Red Flags

Shenanigan Strategies

Financial shenanigans are actions or omissions (tricks) intended to hide or distort the real financial performance or financial condition of an entity. They range from minor deceptions to more serious misapplications of accounting principles.

There are two basic strategies underlying accounting shenanigans:

• Inflating current reported income - A company can inflate its current income by inflating current revenues and gains, or deflating current expenses.
• Deflating current reported income - A company can deflate current revenues by deflating current revenues or gains, or inflating current expenses.

Shenanigans aimed at inflating current reported income are considered more serious, because they make the company look much better than it is. Furthermore, over time, the inflation of current income will most likely be discovered in the future and will make the company stock plummet. On the other hand, deflating current reported income will only serve as an income-smoothing mechanism and will not have as serious of an impact on common shareholders.

Methods of Inflating or Deflating Income

Stretching out payables:

• This is one of the easiest methods to inflate income while reducing costs and one of the most difficult to spot.
• Basically the company picks and chooses some or all of its payables and instead of recording them in the current period they extend the payables to a future period.

Financing of payables:

• Similar to stretching out payables, a company may choose to finance a portion of their payables so they can record the smaller interest expense instead of the principle amount of the payable as an expense.

Securitization of receivables:

• Just like the decision to securitize a leasing agreement, a company may attempt to securitize their receivables with similar effects
• Instead of recognizing the receivables when they should be reported, securitizing them will give the company the ability to manipulate their reported earnings though an amortization schedule that will have lower interest costs in the earlier years.

Using stock buybacks to offset dilution of earnings:

• While many investors may welcome a company’s decision to buyback shares, others may not.
• The immediate effects of a share buyback is to reduce the dilution of earnings by reducing the number of shares outstanding.
• This allows the company to report future earnings in relation to less shares outstanding with multiple positive looking effects; higher reported EPS, potentially lowering a company’s p/e ratio  (among other ratios) and potentially increasing the company’s share price.

Other Shenanigans for investors to look out for:

Recording revenues prematurely and/or of questionable quality, such as:

• Recording revenues when a substantial portion of the service has not been delivered
• Recording revenues of unshipped items
• Recording revenues of items that have not yet been accepted by the client
• Recording revenues of items for which the client has no obligation to pay (consignment)
• Recording sales that were made to an affiliate

Recording fictional revenues:

• Recording sales for no reason
• Misclassifying income from investments as revenue
• Recording the cash received from a lending transaction as revenue
• Recording supplier rebates as revenues

Creating special transactions or one-time transactions to generate a gain, such as:

• Selling undervalued assets for a profit
• Selling investments for a gain and recording it as revenue, or using it to reduce current operating expenses
• Reclassifying certain balance sheet accounts to create income
• Failure to record unearned revenues (customer prepayments) and recording these amounts as revenues 

Deferring current revenues to a future period, such as:

• Refraining from recording revenues before a merger or acquisition
• Increasing allowance for bad debt
• Increasing other reserves such as warranties and returns

Recognizing future expenses in current expenses as a special one-time charge, such as:

• Inflating one-time charges
• Increasing expenses such as R&D, advertising, etc.
• Recognizing expenses that will continue to provide the company with a future economic benefit, such advertising, R&D and maintenance expenses, among others.

Aggressive Accounting Policies

• Increasing the useful file of an asset beyond its estimated useful life
• Using FIFO versus average cost or LIFO
• Accruing losses associated with contingencies
• Capitalizing all software development and R&D costs, or aggressively capitalizing any costs
• Amortizing costs slowly thus reducing recognized expenses  
• Recording investment income as revenue
• Not accounting for or allocating a small amount for returns, warranties, allowance for bad debt and allowance for doubtful accounts

Describe the accounting warning signs related to the Enron accounting scandal.

• Extensive use of off-balance-sheet financing (joint ventures, improperly classifying leases and take-or-pay and throughput contracts).
• Purposely providing non-transparent financial statements.
• Use of a “merchant model” of recording trading revenues where instead of the reporting the trading fees as income they chose to record the entire trade as income not accounting for the corresponding cost of the asset being traded.
• A wide scale cooperation: while many of the leading levels of management claimed to have no knowledge of less than honest accounting practices, the final outcomes proved that this could not have been undertaken by just one person.
• Presenting inflated assets and undervalued liabilities by taking some to “off balance sheet” methods. They then chose to provide little or no information as to the actual values of these projects which were typically in the form of limited partnerships with little footnoting.
• Marking to market valuing their long-term contracts: Instead of using the more conservative matching principles or recording revenue with costs, they chose to aggressively value the present value of long term contracts as revenue in the current reporting periods allowing them to show what was perceived as phenomenal growth.
• Misaligning compensation: while it is common for companies to tie part of employee’s compensation to the profitability of the company and reward them with stock, Enron chose to make this a much bigger part of their comp plan. In this case, so much emphasis was placed on the stock’s performance that some employees were driven to inflate the stock at any cost.       

Weblink 10.4             Enron's Collapse: The Fall Of A Wall Street Darling

In contrast to aggressive accounting policies and lessons learned from Enron, here are some more conservative accounting policies that would more accurately affect both the financial condition of a company and the quality of their earnings.

• Rapid write-off of fixed assets (DDM)
• Using a conservative estimate of assets useful lives
• Minimal capitalization of software and startup costs
• Adequate provision for contingent liabilities
• Impaired assets written off quickly
• The use of completed-contract method for long-term projects
• Little use of off-balance-sheet financing
• Net income closely resembles cash flow from operations
• Adequate reserves allocated to returns, warranties, allowance for bad debt and allowance for doubtful accounts

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