Financial Shenanigans

- Earnings Manipulation Shenanigans EM4, 5, 6 & 7

EMS-4 Shifting Current Expenses to

a Later Period
AS-10 Accounting for Fixed assets, AS-16 Borrowing costs
and AS-26 Accounting for Intangible assets permit
Capitalization of expenses subject to certain conditions being met
on the grounds that the expense will produce future economic
benefits
Capitalize until the asset is ready for its intended use

As per Matching Concept of accounting (GAAP), cost

should be recognized over the period during which revenue
is expected to be realized.
Companies record transactions based on Accrual system e.g.
wages to employees are reported as an expense in the week when
the employees worked and not in the week when the employees
are paid.
Estimate of revenue realization can lead to slow write off of the
costs (case Orion pictures, pg 125)
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EM-4 Shifting Current Expenses to

Later period
This technique can be used inappropriately by the management to
inflate/deflate the income as it is based on managements estimate of
certain conditions
Improperly capitalizing normal operating expenses (software development cost,
advertising expense, research and development expense, interest cost etc)
Amortizing costs too slowly
Change in estimates of useful life of assets will lead to slower recognition of expense through
depreciation or amortization
Compare depreciation policies used by players in the industry to get an fair idea of useful life
of asset

Failing to write down assets with Impaired value (AS 28 Impairment of assets)
Failure to write off obsolete inventory Increase in inventory levels whether on
account of estimation of increased future sales or due to no market/ slackening
demand for the product . Inventory holding period will signal the problem (case
Coldwater creek, pg 128)
Failing to record expenses for uncollectible receivables and devalued investments
Failing to record Allowance for bad and doubtful debt leads to overstating of earnings

EMS-4 Shifting Current Expenses to

a Later Period
Improperly capitalizing normal operating expense
Generally those costs related to long-term arrangements, such as
research and development, labor and overhead related to a long-term
project, software development, and costs to win contracts or
customers are more privy to this shenanigan

Capitalizing Software Development Costs (Technology

companies)
Be aware of the practice followed by the technology companies to
capitalize the software cost before the technical feasibility is
established
Developing software being the main business; sudden jump in
software capitalized should be viewed cautiously as the software
development costs for the client should be expensed as cost of
sales unless
technical and commercial feasibility of project is demonstrated,
cost can be measured reliably,
future economic benefits are probable, and
the company has intention and ability to complete and use or sell the software
4

EMS-4 Shifting Current Expenses to

a Later Period
Capitalisation of Research and Development cost (AS-26)
Costs incurred during Research phase should be expensed
Costs incurred during development phase should be capitalized only
if the 4 conditions mentioned before are met (i.e. technical feasibility,
intention and ability to use/sale, measured reliably, probable future
economic benefits, etc)

Borrowing costs (AS 16)

The amount of interest and other borrowing costs that are directly
attributable to the acquisition, construction or production of a
qualifying asset should be capitalised as part of the cost of that asset
Capitalisation of borrowing costs should cease when substantially all
the activities necessary to prepare the qualifying asset for its
intended use or sale are complete
While calculating the vital ratios like Interest cover or DSCR; interest
expense capitalized should also be considered as it is nothing but the
interest obligation on borrowings that is capitalised instead of being
charged against profits
5

Indicators
Be wary of the change in policy from expensing costs to capitalizing them
and the impact on earnings
Be cautious about large jump in capital expenditure (capex) vis--vis
planned/committed commitments
Prepare common size statement (expense as % of sales), see the trend, find
reason for sudden drop in expenses
Free cash flow (OCF less capex) deteriorating at a much higher rate than
before (as capital expenditure will increase due to capitalization of expense)
New and unusual/unexplained asset account
Stretching out depreciable assets life
Amortizing or depreciating costs too slowly can be checked by comparing
policies followed by the companies in same industry
Study the Auditors complete report
Study the stock and receivables audit report
Surprise visit to the clients premises in suspicious circumstances
Compare budgeted figures (submitted at the time of sanctioning limits) with
actual figures for the quarter/year and find the deviations
6

EM-5 Falling to Record or Conceal

Expenses
Falling to record Warranty provisions in the statement of income in
the period when sales are made
Management has to make some estimate of warranty claims that might be
raised in respect of products sold during the year by deciding the failure rate
(warranty liability estimation process)
Decline in warranty expense relative to revenue may signal that earnings
are being inflated (case Dell Computer, pg- 146)

Falling to record loss from contingencies which meets the following

criteria's
The loss is probable and
The amount of loss can be estimated reasonably
If both the conditions are met; provision for this otherwise contingent
liability should be made in the books. Failure to record will led to overstating
profits and understating liability.
Look for material contingent liability in notes to accounts, say on account
of litigations or disputed liabilities (e.g. 2G license scam) that are more likely
to devolve on the company. Seek expert advice from legal department,
reference can also be made to similar past judgments in like cases
7

EM-5
Closely monitor the foot notes to see future purchase
agreement that signal heavy burden of the company's
earnings thus negating the lending decision
Case- Columbia Gas Systems CGS signed Take or Pay
agreements to purchase substantial amounts of Natural Gas
at above market price. Gas price plummeted and it could not
sell the gas at a price anywhere near its cost. CGS had to
honor the commitments to its suppliers while its utility
customers were free to purchase gas from cheaper sources.
CGS filed for bankruptcy thereafter
While modeling future periods for a borrower; look critically
at the movement in the prices of products and any such
binding agreements that may lead to questions on
sustainability.
8

EM-5
Boosting income by changing pension
assumptions (will be covered in session on
pension liability)
Pension expense is recorded based on certain
assumptions made by the management
True economic cost of post retirement obligation
can be concealed by the company, if estimate of
expected rate of return on plan asset is taken
higher than the reasonable estimate of market
return
Indicator Check for the return rates used by peers

EM-5
Reduce expenses by releasing reserves
from previous charge
Companies indulge into creation of bogus
liability/provision during the period of good
earnings
These provisions can be written back (reserve
for the rainy day!) as a reduction from expense
thus boosting the reported profits
Indicators watch for sudden drop in liabilities
(at times masked as other liabilities) and read
notes to accounts carefully
Case Sunbeam Corporation (pg-155)
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Indicators
Always prepare common-size
statements to find out major
deviations
Study Auditors report
Critically check the write-back of
provisions
Read notes to accounts carefully to
see whether any contingent liability
has a probability of devolvement the
provision for which has not been

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Purpose of using EM-6 and 7

To project smooth earnings
Shift income from a particularly
strong period to a weaker one
Clear the deck of troublesome
expenses to produce future-period
earnings

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EMS-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
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 increase and declines in deferred revenue
(case Microsoft, pg-162)
Changes in revenue recognition policy
Unexpectedly consistent earnings during a volatile time
Signs of revenue being held back by the target just before an
acquisition closes
Key point to remember while modeling numbers post acquisition is to
assess whether the merger synergies as portrayed by the management
are possible/reasonable
It may take years for merger related benefits/synergies to flow

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EM-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
Large write-offs accompanying the arrival of
a new CEO (Case-Sunbeam)
Restructuring charges just before an
acquisition closes
Unusually smooth earnings during volatile
times
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Warning Signs: Breeding Ground for

Shenanigans
Absence of checks and balances among senior management
A single family dominating management, ownership, or the
board of directors
Presence of related-party transactions
An inappropriate compensation structure that encourages
aggressive financial reporting
Inappropriate members placed on the board of directors
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
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Sources
Financial Shenanigans by Howard M. Schilit and
Jeremy Perler
Accounting Standards issued by ICAI
Research papers from Journal of Accounting
The Serious Fraud Investigation Office (SIFO)
http://www.watchoutinvestors.com - Site formed
by Ministry of Corporate Affairs, Government of
India, Investor protection and education fund and
SEBI
http://www.watchoutinvestors.com/compindex.asp
?findword=A
list of companies alleged on different grounds
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