Financial Shenanigans

- Earnings Manipulation Shenanigans

Objective of the Session

To learn the techniques of Accounting
analysis
To learn to make adjustments to the
reported numbers to see the true
economic reality
Understanding Earning Management
from two perspectives
Aggressive accounting practice followed
by the company that fall within Indian
GAAP
2
Fraudulent accounting practice that violate

Purpose of Accounting Analysis

To evaluate the degree to which the firms
accounting captures its underlying business reality
To identify areas where managers can exercise
accounting flexibility
Identify red flags and investigate it deeper. May
reveal earnings management techniques (EMS)
applied by the management
Assess reasonableness and appropriateness of the
Firms accounting policies and estimates
Undo distortions in reported numbers to the extent
possible and to improve the reliability of the
conclusions drawn from Financial statement analysis
3

FS/Financial Misrepresentations
Financial shenanigans are actions
taken by management that mislead
about a companys financial
performance or economic health
Investors/lenders/regulators are often
tricked into believing that a companys
earnings are stronger, its cash flows
more robust and its Balance Sheet
position more secure than are really the
case
4

Earning Manipulation Shenanigans

(EMS)
All of the earnings manipulation tricks are
divided into two major subgroups
Inflating current-period earnings - In order to
inflate current-period earnings, management
either push more revenue or gains into the
current period or shift expenses to a later one
Inflating future-period earnings - To inflate
tomorrows income, management would
simply hold back todays revenue or gains and
accelerate tomorrows expenses or losses into
the current period
5

Why Earnings Manipulation

Higher reported revenue/profits leads to
Higher stock price and good image for the company
Higher executive compensation when compensations are linked to
performance which is measured in terms of profitability
To appear as a much larger company than its economic reality (size
matters!!)
To comply with financial debt covenants
To avoid the hostile takeover by competitors

Shifting revenue to future period is usually resorted to

to smooth out volatile earnings in order to portray a more steady
business
To reduce tax payments for the current period
When facing Union contract negotiations, companies resort to lower
profitability reporting
Revenue/profits can be recorded in later period or cost push to
earlier period to hide any major slump/downfall observed in the
revenue/profits
6

Revenue recognition - GAAP

AS-9 Revenue recognition guidelines
under following events
Sale of goods
Rendering of services
Use by others of entity assets yielding
interest, royalties and dividends

AS-7 Construction contracts

Earning Manipulation
Shenanigans
EM Shenanigan No. 1: Recording revenue too soon
EM Shenanigan No. 2: Recording bogus revenue
EM Shenanigan No. 3: Boosting income using one-time
or unsustainable activities (without proper disclosure)
EM Shenanigan No. 4: Shifting current expenses to a
later period
EM Shenanigan No. 5: Employing other techniques to
hide expenses or losses
EM Shenanigan No. 6: Shifting current income to a later
period
EM Shenanigan No. 7: Shifting future expenses to an
earlier period
8

EMS-1 Recording Revenue Too Soon

Techniques to record revenues to soon
Recording revenue before completing any
obligations under the contract
Up-front revenue recognition on long-term
contracts
Use of aggressive assumptions on long-term
leases or percentage-of-completion accounting
Recording revenue before the buyers final
acceptance of the product (in case of project
finance (infrastructure projects) if revenue
realisation is based on quality check by the
customer; one should check the actual certificate
of acceptance from the buyer)
9

EMS-1
Channel stuffing pushing sales up by stuffing the distributors
with goods even when there are no real orders (Case- Sunbeam,
pg 62 _bill and hold transactions)
Understand that some industries follow Sell-in recording scheme i.e.
records revenue when goods are shipped to distributors as against sellthrough in which revenue is recorded when goods are sold by the
distributor to final consumer. Sell-in is considered aggressive accounting
compared to

Recording revenue at the point of shipment

Recording revenue upon shipment to someone other than the
customer i.e. to a consignee or sales agent. Revenue should
not be recognized until sales agent consummate a transaction
with an end customer
Recording revenue when the buyers payment remains uncertain
or lacks ability to pay
If the debtor is unable to pay for the credit sales made to him,
adequate provision for bad and doubtful debts should be made
10

Cases EM-1
Computer Associates Pg 51 - Upfront recognition of a long-term
license contract
Xerox pg 57 - Recording Revenue
from Assets Leased to Customers
playing with the discount rate

11

EMS-2 Recording Bogus

Revenues

Recording revenue from transactions that lack

economic substance (case Peregrine Systems; pg 79)
Recording revenue from transactions that lack a
reasonable arms-length
transactions with JVs or business associates or group
companies can be of accommodating nature

Agents, middleman, commission agents, travel agents,

etc it is important to recognize just the commission or
fees as revenue and not the actual amount of sale
made (Case - Education Alternatives, pg - 87)
Recording of purchase return or cash received from
vendor as sales transaction instead of reducing the
amount of purchases of material/inventory
12

EMS-3 Boosting Income Using OneTime or Unsustainable Activities

Boosting income using one-time events
Recording income from sale of business segment inappropriately
as a reduction from expenses (accounting for discontinued
operations- AS 24)
Case IBM; IBM booked a USD 4.057 billion gain from selling its
Global Network business to AT&T and curiously included that gain
as a reduction in the SG&A expense (pg 95)

Boosting income through misleading classifications

Classify one-time gain by way of reduction of expense or as a part of
other income
Recording interest income or gain on sale of asset as revenue and put
it under the head other income (No disclosures!)
Some companies constantly record restructuring charges (one-off
items) virtually every year thus masking normal operating expenses
in to these charges (below the line expenses) and unethically boost
the operating profits
13

EMS-3 Boosting Income Using OneTime or Unsustainable Activities

Classification of investment on balance sheet to boost
operating income
If a company holds 20% or more of the equity share
capital of other company, it is deemed that the
company Exercises Significant Influence over the
other company unless it can be clearly
demonstrated that this is not the case This
clause provides management with an option
whether to account for the associate using
equity method or treat it as investment available
for sale
Case Oracle and its associate Liberate (Oracle
Changes Its Accounting for a Struggling Affiliate
Page 106 and 107)
14

Indicators of EM
Reported sales growth far exceeds the normal pattern ( Use peer
comparison technique to understand whether it is a legitimate increase)
Are the explanations given by the client underpinned by data and support which
evidences a competitive advantage?

Receivables (especially long-term and unbilled) growing faster than sales

Days Sales Outstanding (receivable holding period) increasing
dramatically
In cases of channel stuffing, companies have entered into promissory
note contracts with their debtors and have managed to shift the debtor
balances to Notes receivables. Thereby achieving the reduction in DSO.
Notes receivable balances should be investigated
Cash flow from operations lagging far behind net income indicates
premature revenue recognition
Accelerating sales by changing the revenue recognition policy
Inappropriate use of bill-and-hold accounting (case Sunbeam)
Changes in revenue recognition assumptions or liberalizing customer
collection terms. This overly generous terms may effectively shift sales
that originally were slated for future periods into the current one
Frequent restatement of numbers Follow quarter-on-quarter figures
closely and investigate the changes if found to be material
15

Checks for EM
Auditors report giving qualified opinion on change in
revenue recognition policy or uncollectible receivables or
discrepancies highlighted by the stock audit report
Non accounting for credit notes issued during the period or
booking them as purchases (correct entry Sales return A/c
Dr. To Debtor a/c (return of goods from customer),
misleading entry Purchase A/c Dr. To Debtor A/c (wrong
debit to purchase a/c)
Surprise visit by the bank officials for investigation; taking
stock at least of major stock items
Ask for Tax returns filed with IT department. At times this
may reveal differences in statements filed with the bank
Study the statement of book debts submitted; major
customers and amounts outstanding, check bulging
receivables, ask if any extended payment terms allowed to
a particular party and reasons thereof
Reference checks
16

Resources
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.a
sp?findword=A
list of companies alleged on different grounds
17