FINANCIAL SHENANIGANSFINANCIAL SHENANIGANS Detecting Accounting Gimmicks g g

that Torpedo Investments

Howard M. SchilitFinancial Shenanigans Detection Group, LLCFinancial Shenanigans Detection Group, LLC

Howard.Schilit@theFSDgroup.com

CFA InstituteMay 2010

Seven Earnings Manipulation (EM) Shenanigans

EM # 1 R di R T SEM # 1: Recording Revenue Too Soon

EM # 2: Recording Bogus Revenue

EM # 3: Boosting Income Using One-Time or Unsustainable Activities

EM # 4: Shifting Current Expenses to a Later Period

EM # 5: Employing Other Techniques to Hide Expenses or Losses

EM # 6: Shifting Current Income to a Later Period

EM # 7 Shifti F t E t E li P i dEM # 7: Shifting Future Expenses to an Earlier Period

2

EM # 1: Recording Revenue Too Soon

Recording Revenue before Completing Any ObligationsComputer Associates 35 day monthsComputer Associates – 35-day months

Recording Revenue Far in Excess of Work Completed on Contract Transaction Systems Architect – push greater amount to front-endXerox – select inappropriately low discount rate to accelerateXerox select inappropriately low discount rate to accelerate revenueEnron – use of mark-to-market to accelerate revenue to early years

Recording Revenue before Buyer’s Final Acceptance of ProductSunbeam – use of bill-and-hold to accelerate revenueKrispy Kreme – shipped to someone other than customerMcData – switched revenue time from “sell-through” to “sell-in”

R di R Wh B ’ P t R i U t iRecording Revenue When Buyer’s Payment Remains Uncertain or UnnecessaryKendall Square – recorded revenue although customer unable to payp ySystem Software – customers offered 14-month extended payment term 3

EM # 2: Recording Bogus Revenue

Recording Revenue from Transactions Lacking Economic SubstanceSubstanceBrightpoint – reported revenue from bogus finite insurance contractAIG – reported bogus insurance reserves on receipts from Gen Re

Recording Revenue from Transactions Lacking a ReasonableRecording Revenue from Transactions Lacking a Reasonable Arm’s-Length ProcessSyntax-Brillian – reported bogus sales to related partiesGlobal Crossing – reported bogus revenue on “round-trip” sales

Recording Revenue on Receipts from Non-Revenue-Producing TransactionsLehman– tried to “dress-up” bank borrowing as a sales transactionMolten Metal recorded funds received from partner as revenueMolten Metal – recorded funds received from partner as revenue

Recording Revenue from Appropriate Transactions, but at Inflated AmountsEnron – recorded “agent-type” activities as if a “principal”g yp p pOverstock.com – changed from the “net method” to “gross method”

4

EM # 3: Boosting Income Using One-Time or Unsustainable ActivitiesU susta ab e ct t es

Boosting Income Using One-Time EventsIBM inflated operating income by including big gain fromIBM – inflated operating income by including big gain from asset saleFPA Medical – inflated income by including asset sale rebate

Boosting Income through Misleading ClassificationsEnron – inflated income by pushing losses from ventures to balance sheetL t h d l ti i t ti hLucent - pushed normal operating expenses into one-time chargeToys R Us – treated normal inventory write-down as non-recurringBoston Chicken – treated interest income from franchisees as revenuerevenueOracle – boosted income by changing structure of affiliated company

5

EM # 4: Shifting Current Expenses to a Later PeriodPeriod

Improperly Capitalizing Normal Operating ExpensesW ldC d i billi i liWorldCom – started treating billions in line costs as an assetAOL – inflated income by capitalizing marketing costs

Amortizing Costs Too SlowlyAOL changed its 12 month amortization period to 24 monthsAOL – changed its 12-month amortization period to 24 monthsTime Warner Telecom – changed depreciable life from 15 to 20 yearsFannie Mae – failed to amortize loan origination costs changes g gproperly

Failing to Write Down Costs with Impaired ValueOrion Pictures – failed to write off costs of money-losing filmsVit S i d t f il d t d i t b lVitesse Semiconductor – failed to record inventory obsolescence charge

Failing to Record Expenses for Uncollectible Receivables and Devalued InvestmentsNew Century Financial – reduced loan loss reserves to boost income 6

EM # 5: Employing Other Techniques to Hide E LExpenses or Losses

Failing to Record an Expense from a Current TransactionRent Way toward end of period stopped recording vendorRent-Way – toward end of period, stopped recording vendor invoicesUnited Healthcare – failed to record expense on backdated options

Failing to Record an Expense for a Necessary Accrual or g p yReversing a Past ExpenseDell – inflated income by failing to accrue sufficient warranty reserves

Failing to Record or Reduce Expenses by Using AggressiveFailing to Record or Reduce Expenses by Using Aggressive Accounting AssumptionsDelphi – inflated profits using improper expected return on pension assetsXerox – inflated income by changing residual value on leases

Reducing Expenses by Releasing Bogus Reserves from Previous ChargesSunbeam released bogus restructuring reserves into incomeSunbeam – released bogus restructuring reserves into incomeWorldCom – regularly used acquisition-related reserves to inflate income 7

EM # 6: Shifting Current Income to a Later PeriodPeriod

Creating Reserves and Releasing Them into Income in a Later PeriodPeriodMicrosoft – big buildup of unearned income benefited future period profitsW.R. Grace – Medicare reimbursement receipt shifted to future pperiodEnron – released huge trading gains deferred into future periods

Improperly Accounting for Derivatives in Order to Smooth IncomeF ddi M i l d f d d i ti i t thFreddie Mac – improperly deferred derivative gains to smooth incomeFannie Mae – shifted billions in derivative gains to later periodsGE – used derivative contracts to improperly smooth incomeGE used derivative contracts to improperly smooth income

Creating Reserves in Conjunction with an Acquisition and Releasing Them into Income in a Later PeriodU.S. Robotics – held back income to be released after deal closedComputer Associates – inflates profits with target company income

Recording Current Period Sales in a Later Period 8

EM # 7: Shifting Future Expenses to an Earlier Period

Improperly Writing Off Assets in the Current Period to Avoid Expenses in a Future PeriodExpenses in a Future PeriodAOL – inflated operating income by writing off deferred marketing costsCisco – gross margins benefited from big earlier period inventory g g g p ywrite-offToys R Us – included “repositioned” inventory as part of restructuringSunbeam took big restructuring charge when CEO Al DunlopSunbeam – took big restructuring charge when CEO Al Dunlop arrived

Improperly Recording Charges to Establish Reserves Used to Reduce Future ExpensesFreddie Mac – reduced previous reserves to inflate incomeSymbol – created reserves in conjunction with acquisitionWorldCom – regularly created reserves in conjunction with acquisitionacquisitionXerox – created reserves for “unknown risks”

9

Four Cash Flow (CF) Sh iShenanigans

CF #1: Shifting Financing Cash Inflows to the Operating Section

CF #2: Shifting Normal Operating Cash Outflows to the Investing Section

CF #3: Inflating Operating Cash Flow Using Acquisitions or DisposalsDisposals

CF #4: Boosting Operating Cash Flow Using Unsustainable ActivitiesActivities

10

CF #1: Shifting Financing Cash Inflows to the Operating Section

Recording Bogus CFFO from a Normal Bank BorrowingD l hi d f ll l b k l l fDelphi – accounted for collateral on bank loan as sale of assetEnron – included borrowing for related party in CFFO

Boosting CFFO by Selling Receivables Before Collection DateBoosting CFFO by Selling Receivables Before Collection DateCardinal Health – boosted CFFO by selling receivablesSanmina-SCI – boosted CFFO with “stealth” sale of receivablesGlobal Crossing – tried to hide cash crunch selling receivablesGlobal Crossing tried to hide cash crunch selling receivablesXerox – was cited by the U.S. SEC for failing to disclose sale of receivables

Inflating CFFO by Faking the Sale of ReceivablesPeregrine – used “fake” sale of receivables to bank to cover up fraudVitesse – never offloaded risk of default on receivables “sold” to bankbank

11

CF #2: Shifting Normal Operating Cash Outflows to the Investing Section

Inflating CFFO with Boomerang TransactionsGl b l C i “ d i ” l d d flGlobal Crossing – on “round-trip” sales, recorded outflows as investing

Improperly Capitalizing Normal Operating CostsImproperly Capitalizing Normal Operating CostsWorldCom – treated outflows for line costs as investing

Recording the Purchase of Inventory as an Investing Outflowg y gNetflix – treated outflows to purchase inventory as investingCephalon – treated cash outflows for acquiring R&D technologies as investingBi il t t d h h f d t i ht i tiBiovail – treated non-cash purchases of product rights as investing

12

CF #3: Inflating Operating Cash Flow Using Acquisitions or Disposals

Inheriting Operating Inflows in a Normal Business AcquisitionT CFFO i fl d f i i iTyco – CFFO inflated from numerous acquisitionsWorldCom– CFFO inflated from numerous acquisitions

Acquiring Contracts or Customers Rather than Developing ThemAcquiring Contracts or Customers Rather than Developing Them InternallyTyco – inflated CFFO by outsourcing sales force and treated as investing

Boosting CFFO by Creatively Structuring the Sale of a BusinessSoftbank – inflated CFFO with a service agreement with buyer of businessbusinessTenet Healthcare – inflated CFFO to retain receivables when business sold

13

CF #4: Boosting Operating Cash Flow Using Unsustainable Activities

Boosting CFFO by Paying Vendors More SlowlyH D t i fl t d CFFO b i dHome Depot – inflated CFFO by squeezing vendorsAutoZone – treated bank loans to pay vendors as operating increase

Boosting CFFO by Collecting from Customers More Quicklyg y g yEDS – renegotiated contract with customer to accelerate cash receiptSilicon Graphics – provided deep discounts to accelerate cash receipt

Boosting CFFO by Purchasing Less InventoryBoosting CFFO by Purchasing Less InventoryHome Depot – inflated CFFO by purchasing less inventorySilicon Graphics – purchased inventory only at beginning of period

Boosting CFFO with One-Time BenefitsSun Microsystems – included big litigation-related windfall in CFFO

14

Two Key Metrics (KM) Sh iShenanigans

KM #1: Showcasing Misleading Metrics that Overstate Performance

KM #2: Distorting Balance Sheet Metrics to Avoid Showing g g

Deterioration

15

KM #1: Showcasing Misleading Metrics that Overstate Performance

Highlighting a Misleading Metric as a Surrogate for RevenueG d di l i b f ld i hGateway – stopped disclosing number of computers sold in tough periodAOL – inflated subscriber count on bulk sales to companiesAdelphia – inflated subscriber count by including unconsolidatedAdelphia inflated subscriber count by including unconsolidated affiliatesPegasus – inflated subscriber count by including former customers on list

Hi hli hti Mi l di M t i S t f E iHighlighting a Misleading Metric as a Surrogate for EarningsSpansion – excluded normal expenses to inflate EBITDA metricOpenwave – created and twice changed definition of earnings metric

Highlighting a Misleading Metric as a Surrogate for Cash FlowHighlighting a Misleading Metric as a Surrogate for Cash FlowRent-A-Center – abnormal accounting for inventory and sales distorted EBITDADelphi – presented a confusing metric labeled “operating cash flow” p p g p gAmerican Financial Realty – used unusual definition of funds from operation 16

KM #2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration

Distorting Accounts Receivable Metrics to Hide Revenue ProblemsProblemsPeregrine – tried to hide fraud by faking sale of receivables to bankSymbol – tried to hide fraud by turning receivables into a noteTellabs – tried to hide problem by changing calculation of days salesTellabs tried to hide problem by changing calculation of days sales outstanding

Distorting Inventory Metrics to Hide Profitability ProblemsMerck – hid inventory build by reclassifying some to non-current

Distorting Financial Asset Metrics to Hide Impairment ProblemsNew Century Financial – misled investors with loan loss reserves shownEast West Bancorp stopped providing investors info on problemEast West Bancorp – stopped providing investors info on problem loans

Distorting Debt Metrics to Hide Liquidity ProblemsParmalat – debt metrics distorted by absence of unreported loansy pLehman– debt metrics distorted by absence of unreported loans

17

Breeding Ground for ShenanigansBreeding Ground for ShenanigansManagement Issues

C l f f d i i id i “ k b ”Culture of fear and intimidation to “make numbers at any cost”Absence of checks and balances among executive ranksUnusual or inappropriate compensation structure

Board of Director IssuesBoard of Director IssuesLack of independence in fact or in behaviorAbsence of “investor-centric” members

Auditor IssuesAuditor IssuesChanges in auditor or signs of lack of independence

Operating in Environment of Flux and Rapid ChangeKey change in business or regulatory environmenty g g yFrequent changes in key personnelCompany changes accounting principles, estimates, or presentationVery acquisitive companyCompany requires frequent equity or debt infusions

18

Tell-Tale Sign of Financial Shenanigans –Pressure from CEO

"The most important thing we do is meet ourThe most important thing we do is meet our numbers. It’s more important than any individual product, it’s more important than any individual philosophy, it’s more important than any individual cultural change

’ ki W t thi l hwe’re making. We stop everything else when we don’t make the numbers.“

– Joe Nacchio CEO QwestJoe Nacchio, CEO, Qwest

19