Part One
- Does company’s revenue growth make sense? Sales growth far exceeds normal patterns while income growth does not follow
- Be careful with companies that grow predominately by making acquisitions
- Some companies perpetrate fraud by capitalizing losses instead of accounting for them as operating losses, use cash flow statements to identify irregularities
- When free cash flow suddenly plummets expect BIG problems
Part Two: Warnings Signs
- Absence of checks and balances among senior management
- An extended streak of meeting or beating Wall Street expectations
- A single family dominating management, ownership, or the board of directors
- Presence of related party transactions
- Inappropriate compensation structure that encourages aggressive financial reporting, inappropriate members on board of directors, inappropriate business relationships between company and board members
- An unqualified auditing firm, an auditor lacking objectivity, and attempts by management to avoid regulatory or legal scrutiny
Earnings Manipulation: Recording Revenue Too Soon
- Be wary of companies that extend their quarter end date. Management may have an incentive to record more current revenue than future revenue (stock options awards)
- Companies should not record future revenue as current revenue (long term licensing contracts). Be wary of a sharp jump in accounts receivable. Use DSO to calculate how long it’s taking companies to get paid for their services
- Take notice when: companies change their revenue recognition policy, cash flow from operations materially lags behind net income, a jump in unbilled receivables and long term receivables (longer than a year)
- Percentage-of-completion contracts allow companies to record a percentage of completed revenue dependent upon the percentage of total costs incurred
- When recording revenue from capital leases the seller can recognize the present value of a large portion of future payments as current revenue. Care must be taken to determine how companies are calculating that present value
- Long term arrangements with multiple deliverables can also result in aggressive accounting practices
- When Enron used marked-to-market accounting to value its service agreements it was able to record massive amounts of upfront revenue recognition. However, marked-to-market accounting was not meant for the utility industry but for the financial services industry
- Bill-and-hold transactions initiated by the buyer are allowed, and revenue recognition can take place for the seller. However, they may not be initiated by the seller.
- Other ways that companies can prematurely record revenue include: offering overly generous payment terms or financing, seller records revenue before shipment, consignment arrangements, moving to sell-in from sell-through, and when the seller deliberately ships incorrect or incomplete products.
Chapter 4: Creating Bogus Revenue
- Companies may try to create revenue from transactions that lack economic substance. As when AIG created fake insurance policies where no risk was transferred, Peregrine and its non-binding sales, and Symbol with their bribery
- Investors should be wary of transactions that lack a reasonable arm’s length process. Be sure to scrutinize sales to a related party or joint venture partner
- Investors should be sure companies are not recording revenue from non-revenue producing transactions. Companies should not be recording financing transactions as revenue or credits as revenue
- Anytime revenue growth or amount seems unbelievable you might want to investigate if that company is inflating revenue
- Agents should only record the net (commission) amount as revenue, not the gross amount of the transaction
- Investors should keep an eye on accounts receivable. AR should grow proportionately to sales and vice versa
Chapter 5: Boosting Income Using One-Time or Unsustainable Activities
- Companies may try to boost income by stuffing one-time events in operating results (IBM 1999)
- Be sure to review both parties’ disclosures on the sale of businesses.( Marvel bought a business of Intel and then contracted to buy wafers at inflated prices). Intel then recorded these revenue streams from Marvel to boost profits
- Companies can boost operating income by shifting operating expenses below the line to non-operating expenses and bring non-operating revenue above the line to inflate operating revenue
- Investors should investigate companies who record “one-time” or “restructuring” charges frequently over multiple years. Some of these companies may be trying to hide operating expenses
- Companies should not be including interest or investment income in operating revenue
- Under accounting rules majority owned subsidiaries share 100 percent of the revenue and cost above the line (operating) and then subtract out the portion not owned below the line (non operating) this drastically inflates operating incomes
- In equity method accounting if a company owns a “significant influence” in another company (20% or so) it can push the proportion of income earned to income statement or if not a significant influence than it just adjusts its balance sheet line item related to the investment
Chapter 6: Shifting Current Expenses to a Later Period
- Investors must watch for companies that attempt to capitalize costs on the balance sheet as an asset instead of expensing them immediately. One way an investor can identify this is by examining cap ex on the statement of cash flows and whether it matches up with company and industry expectations
- Companies may also try to capitalize marketing costs instead of expensing them immediately (AOL)
- Investors should investigate whenever a company changes its accounting policy. Any growth related to the policy will not occur unless it results in improved operational performance
- Any time a company reports a new and unusual asset account, especially one that is increasing rapidly, this may signal improper capitalization
- Some operating costs can be capitalized like late-stage software development costs
- Once companies capitalize costs they can stretch out the amortization period to boost income
- Any time a company changes its accounting policy to extend the depreciable life of an asset this should be a red flag
- Financial institutions must amortize the premium/discount and origination costs when purchasing a loan over the life of the loan. If prepayment occurs financial institutions must make “catch-up” charges for the remaining amount (Fannie Mae undervalued this catch up charge to boost pretax income)
- Companies often fail to write off impaired assets, obsolete and excessive inventory.
- Use Days Inventory Outstanding to calculate inventory buildup. Compare inventory increases with revenue increases to see if it is proportionate
- Companies should write off uncollectable accounts receivable by creating a bad debts expense on the income statement and decreasing the value of AR on the balance sheet
- When examining financial institutions loan loss reserves should increase relative to non-performing loans
Chapter 7: Employing Other Techniques to Hide Expenses or Losses
- Companies will delay paying invoices until after quarter end to hide expenses and increase income
- Always question any cash receipt from a vendor. Be wary of vendor credits or rebates
- Stock option backdating allowed management to award themselves stock options that had already increased in value. They would use stock chart to pinpoint the day where the stock was lowest and backdate the options to this day, instantly creating hundreds of millions of dollars in value
- Companies may fail to record an expense for a necessary accrual. Since these costs rely on management assumptions it is easy for them to tweak these assumptions and inflate earnings. A decline in warranty expense or warranty reserve relative to revenue may signal that earnings are being inflated through underaccruing for warranty obligations.
- Companies must also properly accrue employee bonuses and expenses for loss contingencies
- Investors should always review the purchase agreements in the footnotes to get a better understanding of a company’s true obligations
- Investors should monitor the expected return of pension plan assets to see if companies are attempting to hide expenses
- Investors must read the pension footnote for any company with a large pension plan
- A decline in self-insurance expense is also a warning sign for investors
- Investigate soft liability accounts (accrued expenses and other current liabilities) and flag any sharp declines relative to revenue
Chapter 8: Shifting Current Income to a Later Period
- Management may try to push current revenue to a later period in order to show smooth consistent earnings over time
- Firms can easily create a deferred revenue account on the balance sheet and release it into earnings at a later time
- Firms with windfall gains could create reserve accounts to stretch out earnings into future periods.
- Derivative accounting rules allow gains and losses on hedges deemed “ineffective” to have an impact on current earnings, while gains and losses on hedges deemed “effective” to have no impact on earnings. However, it was under management’s discretions to deem a hedge “effective” or “ineffective”
- Gains/losses on hedges should be proportionate to gains/losses on the underlying asset or liability
- Companies involved in mergers may ask the target company to hold back revenue so that the buyer can release it as its own once the merger goes through
Chapter 9: Shifting Future Expenses to an Earlier Period
- Companies may attempt to make one-time impairment or “write-offs” to be rid of deferred expenses in one swoop
- Firms may improperly write off inventory and then sell this inventory to deliver strong profits and high margins (Cisco)
- Restructuring and “one-time” charges are reported below operating income and thus do not impact operating income. That is why it is advantageous for management to hide future expenses this way
- New CEOs may seek to write down a large amount of assets (big bath) in order to improve future profits. This reduces future period amortization and depreciation expense and increases net income.
- Just before an acquisition closes targets may take a “merger related” charge which reduces expenses for the merged company
- Firms create these “cookie jar” reserves to reduce future costs or inflate future earnings
Chapter 10: Cash Flow Shenanigans – Shifting Financing Cash Inflows to the Operating Section
- Delphi sold mental inventory and bought it back from Bank One (short term loan), this increased cash flow from operations by increasing revenue and decreasing inventory. However this should have been a financing cash flow
- If an investor suspects a company of recording bogus revenue, the investor should also suspect the company is also recording bogus cash flow from operations
- Investors should be skeptical when management puts an intense focus on a company-created cash flow metric
- Complicated off-balance structures raise the risk of inflated cash flow from operations. This occurred when Enron would sell itself commodities and only record one side of the transaction.
- When a company sells its receivables (factoring) this is considered a cash flow from operations inflow because they are collecting from past sales. However this is not sustainable in the long term as future period cash flows are pushed to the current quarter.
- Peregrine built up a huge receivable base after quarters of bogus revenue and reciprocal transactions. To cover up the receivables they entered into an agreement with their bank to purchase the receivables but they still held all the collection risk. They began offering financing terms to buyers which also was a sign they were having trouble getting paid.
Chapter 11: Shifting Normal Operating Cash Outflow to the Investing Section
- Firms may use boomerang transactions to sell and simultaneously buy the same amount of goods and services. They then record the cash received as revenue but also the cash spent as an investment. This will increase CFFO and show a cash outflow from investments.
- It is easy for companies to capitalize normal operating expenses. This allows them to shift large cash outflows from the operating to investing section. The most common operating costs that are capitalized are generally those related to long-term arrangements
- By calculating Free Cash Flow (Cash Flow From Operations – minus capital expenditures) investors can get a better view of a company’s cash flow situation
- Many companies that purchase goods and then lease or rent them to customers record inventory purchased as capital expenditure (Netflix) thereby inflating CFFO
- Companies that readily acquire patents and rights agreements for growth (pharma and tech) often consider these costs as “acquisitions” and dump them into the investment section of the SCF, where they most like belong is in CFFO
- Investors should be sure to read the “Supplemental Cash Flow Information” disclosure to see what a company is including in its cashflows.
Chapter 12: Inflating Operating Cash Flow Using Acquisitions or Disposals
- In an acquisition accounting the acquirer inherits the operating assets from the target which leads to automatic cash inflows from operations. This is because when the assets are purchased it is through an investing cash outflow.
- Investors should analyze “free cash flow after acquisitions” when investigating a serial acquirer (CFFO – Net Cap Ex – cash paid for acquisitions)
- Tyco recorded payments to third party dealers for security contracts as “acquisitions” allowing it to shift operating expenses to the balance sheet as an investment cash outflow. It also charged a fraudulent dealer connection fee that allowed it to increase operating cash inflows at the same time
- Companies can boost CFFO by creatively structuring the sale of a business. Traditionally the sale of a business would be an investing cash inflow. However, they can structure it in a way to boost CFFO as well.
- Investors should look for new categories on the statement of cash flows (especially CFFO). This could be a product of cash flow shenanigans as companies are structuring sales in funny ways.
- When a company sells a business but not its AR it is hoping to receive a cash inflow from CFFO when it eventually collects on the AR
Chapter 13: Boosting CFFO Using Unsustainable Activities
- Extending Day’s Payable will only result in a one-time boost to CFFO and is not a lasting way to generate more cash. Investors should analyze DPO to determine if its growth is an unsustainable boost
- Accounts payable financing arrangements should be considered financing and should not have an impact on CFFO
- Investors should watch for swings in other payables accounts as increases in these also do not have lasting impacts to CFFO
- Prepayments that allow companies to collect from customers more quickly are not a sustainable way to increase cash flow. Investors should watch for new disclosures about prepayments.
- Another way companies can collect money more quickly is by offering discounts to customers. This is usually not sustainable and can be an indication of poor financial health.
- Firms may time cash flows in order to present the healthiest picture during quarterly or yearend filings
- Companies can improve CFFO by decreasing inventory. However, like other aggressive working capital strategies, this is not sustainable
- The “Liquidity and Capital Resources” section is an essential read for any investor
- Nonrecurring boosts to CFFO are often not disclosed in SCF. Whenever an investor spots a one-time earnings benefit he/she should wonder how it affects SCF.
Chapter 14: Showcasing Misleading Metrics that Overstate Performance
- Management may use revenue surrogates to mislead investors. Many retailers and restaurants use same store sales (SSS) as a way to show revenue growth. However, this falls outside of GAAP coverage and some firms may be dishonest in how they represent this. Investors should compare SSS to revenue growth/store to identify any divergence and spot shenanigans
- Investors should scrutinize the internal “organic” grow calculation of acquisitive companies as it may include spill over revenue from the target
- Look for inconsistencies on how companies report key metrics. Also compare how competitors are reporting key metrics and what is being included
- Bookings and backlog can be useful metrics to determine future revenue growth ( beginning backlog + net bookings – revenue = ending backlog)
- Investors should be wary of “one-time charges” companies exclude from their costs in an attempt to show profitability
- On the flip side companies may try to show that “one-time gains are recurring.
- Investors should be wary when companies repeatedly change their definition of adjusted earnings
- EBITDA and cash earnings are poor representatives of cash flow. Working capital and Capex must also be considered
- Investors must look out for pro forma cash flow metrics. They should compare these to their own calculations of CFFO and free cash flow
- REITS use Funds from Operations (FFO) as a measure of performance. The industry definition is net income excluding depreciation, gains or losses from the sale of property, and income from unconsolidated joint ventures. Some REITS may use their own FFO metric and these should be adjusted to standard FFO
- In Summary, any time a company reports and important non-GAAP metric, investors need to read and monitor the definition to ensure they understand exactly what it conveys
Chapter 15: Distorting Balance Sheet Metrics to Avoid Showing Deterioration
- Management can distort a firm’s accounts receivable balance by 1. Selling it 2. Converting them into notes receivable 3. Moving them somewhere else on the balance sheet
- To calculate DSO on an apples to apples basis, add back sold receivables that remain outstanding at quarter end for all periods
- Companies may seek to convert AR into notes receivable hoping investors do not notice. Check in the foot notes for a disclosure regarding this conversion. Also, look out for any large decrease in DSO especially following large increases.
- Changes in DSO calculation by companies can be very concerning as they are likely trying to hide some deterioration in operational metrics from investors
- Companies may distort inventory metrics to hide profitability problems. Check in the footnotes for disclosures about inventory being moved to another part of the balance sheet. Be cautious about new company-created inventory metrics especially when a company is seeing a surge in inventory
- Firms that hold financial assets like loans, investments, and securities may try to hide the true value of their assets. Investors need to watch for changes in the way companies present the metrics and balances in question. Be extremely cautious when key metrics disappear entirely.
- Firms must abide by certain debt covenants made by lenders. Anytime management cannot meet these covenants or artificially engineers a way to do so, this should be very worrying for investors
- Any time a company has a public disagreement with an auditor (Parmalat) they should run for the hills
Related Book Notes
