HurricaneCapital

BusinessAnalysis&Investing

FinancialShenanigansChecklist
ONNOVEMBER4,2014NOVEMBER4,2014 / BY
/ INBOOKS,CHECKLISTS,FRAUD
Whathasbeenwillbeagain,whathasbeendonewillbedoneagain;
Thereisnothingnewunderthesun.Ecclesiastes1:9

HURRICANECAPITAL

(hp://www.amazon.com/Financial
ShenanigansAccounting
Gimmicks

Reports/dp/0071703071hps://hurricanecapital.les.wordpress.co
m/2014/11/fs1.jpg)FinancialShenanigans:HowtoDetect
AccountingGimmicks&FraudinFinancialReports
Financialshenanigansareactionstakenbymanagementthat
misleadinvestorsaboutacompanysnancialperformanceor
economichealth.Asaresult,investorsareoftentrickedinto
believingthatacompanysearningsarestronger,itscashows
morerobust,anditsBalanceSheetpositionmoresecurethanare
reallythecase.
Someshenaniganscanbedetectedinthenumberspresentedby

Someshenaniganscanbedetectedinthenumberspresentedby
carefullyreadingacompanysBalanceSheet,StatementofIncome,
andStatementofCashFlows.Proofofothershenanigansmightnot
beexplicitlyprovidedinthenumbersandthereforerequires
scrutinizingthenarrativescontainedinfootnotes,quarterly
earningsreleases,andotherpubliclyavailablerepresentationsby
management.Weclassifynancialshenanigansintothreebroad
groups:EarningsManipulationShenanigans(Part2),CashFlow
Shenanigans(Part3),andKeyMetricsShenanigans(Part4).
EarningsManipulationShenanigans
Investorsjudgecorporateexecutivesharshlywhentheyfailto
meetWallStreetsearningsexpectationswhenreportingeach
quarter.Sharepricesoftensuerdramaticdeclineswhen
disappointingearningsarereported.Notsurprisingly,then,in
ordertosteertheshareprice(andtheexecutivescompensation
package)higher,somecompaniesengageinavarietyof
shenaniganstomanipulateearnings.Wehaveidentiedthe
followingsevenEarningsManipulation(EM)Shenanigansthat
resultinmisrepresentationsofacompanyssustainableearnings.
EMNo.1:RecordingRevenueTooSoon
EMNo.2:RecordingBogusRevenue
EMNo.3:BoostingIncomeUsingOneTimeorUnsustainable
Activities
EMNo.4:ShiftingCurrentExpensestoaLaterPeriod
EMNo.5:EmployingOtherTechniquestoHideExpensesor
Losses
EMNo.6:ShiftingCurrentIncometoaLaterPeriod
EMNo.7:ShiftingFutureExpensestoanEarlierPeriod
CashFlowShenanigans
Theplethoraofnancialreportingscandalsandearnings
restatementsinrecentyearshasleftmanyinvestorsquestioning
whetherreportedearningscaneverbefreeofmanagement
manipulation.Increasingly,investorshaveexpandedtheirfocusto
includetheStatementofCashFlowsand,morespecically,the
sectionthathighlightscashowfromoperations(CFFO).
Investorsarebeginningtoharboratroublingsuspicionabout
corporatenancialreporting:thatmanagementnowplaystricksto
pollutecashowfromoperations.Sadly,thesesuspicionsarewell
founded.Investorscannolongertrustthatmanagementwillreport
itscashowhonestlyandwithoutdiscretion.Tohelpinvestors
navigatethroughthecashowdeception,wehaveidentiedthe
followingfourCashFlow(CF)Shenanigansthatmayresultin

followingfourCashFlow(CF)Shenanigansthatmayresultin
misrepresentationsofacompanysabilitytogeneratecashow
fromitsoperations.
CFNo.1:ShiftingFinancingCashInowstotheOperating
Section
CFNo.2:ShiftingNormalOperatingCashOutowstothe
InvestingSection
CFNo.3:InatingOperatingCashFlowUsingAcquisitionsor
Disposals
CFNo.4:BoostingOperatingCashFlowUsingUnsustainable
Activities
KeyMetricsShenanigans
Sofarwehaveaddressedshenanigansthatinvestorscan
generallyidentifybyacarefulreadingofthenumbersinthe
nancialreports.Management,naturally,facessomerestrictions
undertheaccountingrules(calledGAAP,orgenerallyaccepted
accountingprinciples)onhowitpresentsnancialresultsto
investors.Tobypassmanysuchrestrictionsandputonapositive
spin,managementhasbecomemoreactiveanddeceptivein
creatingandmanipulatingkeynonGAAPmetricstoimpress
investors.Suchnancialreportingmisrepresentationstendto
improperlyhighlightstrongorconsistentgrowthandrobust
health.Part4introducestwocategoriesofKeyMetrics(KM)
Shenanigans.
KMNo.1:ShowcasingMisleadingMetricsThatOverstate
Performance
KMNo.2:DistortingBalanceSheetMetricstoAvoidShowing
Deterioration
FinancialShenanigansChecklist
WarningSigns:BreedingGroundforShenanigans
Absenceofchecksandbalancesamongseniormanagement
AnextendedstreakofmeetingorbeatingWallStreet
expectations
Asinglefamilydominatingmanagement,ownership,orthe
boardofdirectors
Presenceofrelatedpartytransactions
Aninappropriatecompensationstructurethatencourages
aggressivenancialreporting
Inappropriatemembersplacedontheboardofdirectors
Inappropriatebusinessrelationshipsbetweenthecompanyand
boardmembers
Anunqualiedauditingrm

Anunqualiedauditingrm
Anauditorlackingobjectivityandtheappearanceof
independence
Aemptsbymanagementtoavoidregulatoryorlegalscrutiny
EarningsManipulation(EM)Shenanigans
WarningSigns:RecordingRevenueTooSoon(EMShenaniganNo.1)
1.Recordingrevenuebeforecompletinganyobligationsunder
contract
2.Recordingrevenuefarinexcessofworkcompletedona
contract
3.Upfrontrevenuerecognitiononlongtermcontracts
4.Useofaggressiveassumptionsonlongtermleasesor
percentageofcompletionaccounting
5.Recordingrevenuebeforethebuyersnalacceptanceofthe
product
6.Recordingrevenuewhenthebuyerspaymentremains
uncertainorunnecessary
7.Cashowfromoperationslaggingbehindnetincome
Receivables(especiallylongtermandunbilled)growingfaster
thansales
8.Acceleratingsalesbychangingtherevenuerecognitionpolicy
9.Usinganappropriateaccountingmethodforanunintended
purpose
10.Inappropriateuseofmarktomarketorbillandhold
accounting
11.Changesinrevenuerecognitionassumptionsorliberalizing
customercollectionterms
12.Selleroeringextremelygenerousextendedpaymentterms
WarningSigns:RecordingBogusRevenue(EMShenaniganNo.2)
1.Recordingrevenuefromtransactionsthatlackeconomic
substance
2.Recordingrevenuefromtransactionsthatlackareasonable
armslengthprocess
3.Lackofrisktransferfromsellertobuyer
4.Transactionsinvolvingsalestoarelatedparty,aliatedparty,
orjointventurepartner
5.Boomerang(twoway)transactionstonontraditionalbuyers
6.Recordingrevenueonreceiptsfromnonrevenueproducing
transactions
Recordingcashreceivedfromalender,businesspartner,or
vendorasrevenue
7.Useofaninappropriateorunusualrevenuerecognition
approach

7.Useofaninappropriateorunusualrevenuerecognition
approach
8.Inappropriatelyusingthegrossratherthanthenetmethodof
revenuerecognition
9.Receivables(especiallylongtermandunbilled)growingmuch
fasterthansales
10.Revenuegrowingmuchfasterthanaccountsreceivable
11.Unusualincreasesordecreasesinliabilityreserveaccounts
WarningSigns:BoostingIncomeUsingOneTimeorUnsustainable
Activities(EMShenaniganNo.3)
1.Boostingincomeusingonetimeevents
2.Turningproceedsfromthesaleofabusinessintoarecurring
revenuestream
3.Comminglingfutureproductsaleswithbuyingabusiness
4.Shiftingnormaloperatingexpensesbelowtheline
5.Routinelyrecordingrestructuringcharges
6.Shiftinglossestodiscontinuedoperations
7.Includingproceedsreceivedfromsellingasubsidiaryas
revenue
8.Operatingincomegrowingmuchfasterthansales
9.Suspiciousorfrequentuseofjointventureswhenunwarranted
10.Misclassicationofincomefromjointventures
11.UsingdiscretionregardingBalanceSheetclassicationtoboost
operatingincome
WarningSigns:ShiftingCurrentExpensestoaLaterPeriod(EM
ShenaniganNo.4)
1.Improperlycapitalizingnormaloperatingexpenses
2.Changesincapitalizationpolicyoracceleratedcapitalizationof
costs
3.Neworunusualassetaccounts
4.Jumpinsoftassetsrelativetosales
5.Unexpectedincreaseincapitalexpenditures
6.Amortizingordepreciatingcoststooslowly
7.Stretchingoutdepreciableassetlife
8.Improperamortizationofcostsassociatedwithloans
9.Failingtorecordexpensesforimpairedassets
10.Jumpininventoryrelativetocostofgoodssold
11.Failurebylenderstoadequatelyreserveforcreditlosses
12.Decreaseinloanlossreserverelativetobadloans
13.Declineinbaddebtexpenseorobsolescenceexpense
14.Decreaseinreservesrelatedtobaddebtsorinventory
obsolescence
WarningSigns:EmployingOtherTechniquestoHideExpensesor

WarningSigns:EmployingOtherTechniquestoHideExpensesor
Losses(EMShenaniganNo.5)
1.Failingtorecordanexpensefromacurrenttransaction
2.Unusuallylargevendorcreditsorrebates
3.Unusualtransactionsinwhichvendorssendoutcash
4.Failingtorecordanexpenseforanecessaryaccrualorreversing
apastexpense
5.Unusualdeclinesinreserveforwarrantyorwarrantyexpense
6.Decliningaccruals,reserves,orsoftliabilityaccounts
7.Unexpectedandunwarrantedmarginexpansion
8.Unusuallyluckytimingontheissuanceofstockoptions
9.Failingtoaccruelossreserves
10.Failingtohighlightobalancesheetobligations
11.Changingpension,lease,orselfinsuranceassumptionsto
reduceexpenses
12.Outsizedpensionincome
WarningSigns:ShiftingCurrentIncometoaLaterPeriod(EM
ShenaniganNo.6)
1.Creatingreservesandreleasingthemintoincomeinalater
period
2.Stretchingoutwindfallgainsoverseveralyears
3.Improperlyaccountingforderivativesinordertosmooth
income
4.Holdingbackrevenuejustbeforeanacquisitioncloses
5.Creatingacquisitionrelatedreservesandreleasingtheminto
incomeinalaterperiod
6.Recordingcurrentperiodsalesinalaterperiod
7.Suddenandunexplaineddeclinesindeferredrevenue
8.Changesinrevenuerecognitionpolicy
9.Unexpectedlyconsistentearningsduringavolatiletime
10.Signsofrevenuebeingheldbackbythetargetjustbeforean
acquisitioncloses
CashFlowShenanigans
WarningSigns:ShiftingFinancingCashInowstotheOperating
Section(CFShenaniganNo.1)
1.RecordingbogusCFFOfromanormalbankborrowing
2.BoostingCFFObysellingreceivablesbeforethecollectiondate
3.Disclosuresaboutsellingreceivableswithrecourse
4.InatingCFFObyfakingthesaleofreceivables
5.Changesinthewordingofkeydisclosureitemsinthenancial
reports
6.Providinglessdisclosurethaninthepriorperiod

6.Providinglessdisclosurethaninthepriorperiod
7.Bigmarginexpansionshortlyafteraninventorywriteo
WarningSigns:ShiftingNormalOperatingCashOutowstothe
InvestingSection(CFShenaniganNo.2)
1.Inatingoperatingcashowwithboomerangtransactions
2.Improperlycapitalizingnormaloperatingcosts
3.Neworunusualassetaccounts
4.Jumpinsoftassetsrelativetosales
5.Unexpectedincreaseincapitalexpenditures
6.Recordingpurchaseofinventoryasaninvestingoutow
7.Investingoutowsthatsoundlikeanormalcostofbusiness
8.Purchasingpatents,contracts,anddevelopmentstage
technologies
WarningSigns:InatingOperatingCashFlowUsingAcquisitions
orDisposals(CFShenaniganNo.3)
1.InheritingOperatingcashinowsinanormalbusiness
acquisition
2.Companiesthatmakenumerousacquisitions
3.DecliningfreecashowwhileCFFOappearstobestrong
4.Acquiringcontractsorcustomersratherthandevelopingthem
internally
5.BoostingCFFObycreativelystructuringthesaleofabusiness
6.NewcategoriesappearingontheStatementofCashFlows
7.Sellingabusiness,butkeepingtherelatedreceivables
WarningSigns:BoostingOperatingCashFlowUsing
UnsustainableActivities(CFShenaniganNo.4)
1.BoostingCFFObypayingvendorsmoreslowly
2.Accountspayableincreasingfasterthancostofgoodssold
3.Increasesinotherpayablesaccounts
4.LargepositiveswingsontheStatementofCashFlows
5.Evidenceofaccountspayablenancing
6.Newdisclosureaboutprepayments
7.Oeringcustomersincentivestopayinvoicesearly
8.BoostingCFFObypurchasinglessinventory
9.Disclosureaboutthetimingofinventorypurchases
10.DramaticimprovementsinCFFO
11.CFFObenetfromonetimeitems
KeyMetricsShenanigans

WarningSigns:ShowcasingMisleadingMetricsThatOverstate

WarningSigns:ShowcasingMisleadingMetricsThatOverstate
Performance(KMShenaniganNo.1)
1.Changingthedenitionofakeymetric
2.Highlightingamisleadingmetricasasurrogateforrevenue
3.Unusualdenitionoforganicgrowth
4.Divergenceintrendbetweensamestoresalesandrevenueper
store
5.Inconsistenciesbetweentheearningsreleaseandthe10Q
6.Highlightingamisleadingmetricasasurrogateforearnings
7.Pretendingthatrecurringchargesarenonrecurringinnature
8.Pretendingthatonetimegainsarerecurringinnature
9.Highlightingamisleadingmetricasasurrogateforcashow
10.Headliningamisleadingmetricontheearningsrelease
WarningSigns:DistortingBalanceSheetMetricstoAvoidShowing
Deterioration(KMShenaniganNo.2)
1.Distortingaccountsreceivablemetricstohiderevenue
problems
2.Failingtoprominentlydisclosethesaleofaccountsreceivable
3.Convertingaccountsreceivableintonotes
4.Increasesinreceivablesotherthanaccountsreceivable
5.AhugedeclineinDSOfollowingseveralquartersofgrowing
receivables
6.InappropriateorchangingmethodsofcalculatingDSO
7.Distortinginventorymetricstohideprotabilityproblems
8.MovinginventorytoanotherpartoftheBalanceSheet
9.Distortingnancialassetmetricstohideimpairmentproblems
10.Stoppingthereportingofcertainkeymetrics
11.Distortingdebtmetricstohideliquidityproblems
ConcludingThoughts

(hp://www.amazon.com/Financial
ShenanigansAccounting
Gimmicks
Reports/dp/0071703071)The
prefaceofthisbookquoteda
proverbfromtheBible(Ecclesiastes
1:9):
Whathasbeenwillbeagain,whathas
beendonewillbedoneagain;thereis
nothingnewunderthesun.
Corporatenancialscandalshave
beenaroundaslongascorporations
andinvestorsthemselves.Dishonest
managementhaspreyedon
unsuspectinginvestors,anditistimeforsuchinvestorstoredouble
theireortstobealertforsuchnancialshenaniganssothatthey
canprotectthemselves.
Sinceshenanigansattheirmostbasiclevelrepresentmanagements
aempttoputapositivespinonacompanysnancial
performanceandeconomichealth,ouruniversalmessageisthat
investorsshouldassumethattheurgetoexaggeratethepositive
andhidethenegativewillneverdisappear.Andwheretemptation
exists,shenanigansoftenwillfollow.
Disclosure:Iwrotethisarticlemyself,anditexpressesmyown
opinions.Iamnotreceivingcompensationforit.Ihavenobusiness
relationshipwithanycompanyorindividualmentionedinthis
article.Ihavenopositionsinanystocksmentioned.

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