10.

2 - Managerial Discretion

Under U.S. GAAP, a company’s management is given some discretion as to the timing and
classification of certain items. Unfortunately, a company’s management can use this allotted
discretion to manipulate reported earnings.

Types of Earnings Manipulation_______________________________

1.    Classification of good news/bad news – Since analysts and investors tend to focus on income
from continuing operations, a reporting company will tend to include good news in this category and
keep bad news out (report it below the net-income-from-operations line). If a company sells a
subsidiary for a gain, it will most likely be included in the net income from continuing operations. If
the company sells the subsidiary for a loss, the company will most likely want to classify it as a
discontinued operation (extraordinary or unusual or infrequent event) and report the loss below the
line.

2.    Income Smoothing – Companies go through cycles of good years and bad years. During the
good years some companies will create accounting reserves so when they are no longer doing well,
they can increase their net income and effectively smooth out their reported net income over time.
Income smoothing can be classified as one of two types:

a.    Inter-temporal smoothing takes place when a company alters the timing of expenditures or
chooses an accounting method that smoothes out earnings. One example is choosing to capitalize or
expense R&D expenditures.

b.    Classification smoothing occurs when a company chooses the category of an item based on the
reporting implication it will have (i.e. it will be above or below the net-income-from-continuing-
operations line). An example is the selling of a subsidiary or asset as if it were a gain or loss from
continuing operations or not.

3.    Big-Bath Behavior - This often takes place when a company is having what they think their
investors will interpret as a really bad year and their previous income reserves are not enough to
offset the bad results they are about to report. Management knows that its stock will drop because of
this news, and investors will not be happy. As a result, management figures that it is the best time to
get rid of all of the inconsistencies that will have a negative impact on the financial statements
(impairment of assets etc.). This will create two benefits for a company: first, most of the bad news
will be reported below the line, and second, in the future the company will appear to be more
profitable than in the past.

4.    Accounting Changes – A company can change its accounting methods, such as change its
inventory-accounting methodology (LIFO to FIFO), capitalize instead of expense decisions and
change its depreciation methodology. Since accounting changes are accounted for below the line
(net income from operations), they can be used to manipulate the reported income from continuing
operations.

10.3 - Shenanigans

Shenanigan Strategies_________________________________________
Financial shenanigans are actions or omissions (tricks) intended to hide or distort the real financial
performance or financial condition of an entity. They range from minor deceptions to more serious
misapplications of accounting principles.

There are two basic strategies underlying accounting shenanigans:

 Inflating current reported income - A company can inflate its current income by inflating
current revenues and gains, or deflating current expenses.
 Deflating current reported income - A company can deflate current revenues by deflating
current revenues or gains, or inflating current expenses.

Shenanigans aimed at inflating current reported income are considered more serious, because they
make the company look much better than it is. Furthermore, over time, the inflation of current
income will most likely be discovered in the future and will make the company stock plummet. On
the other hand, deflating current reported income will only serve as an income-smoothing
mechanism and will not have as serious of an impact on common shareholders.

Methods of Inflating or Deflating Income__________________________

Stretching out payables:

 This is one of the easiest methods to inflate income while reducing costs and one of the most
difficult to spot.
 Basically the company picks and chooses some or all of its payables and instead of recording
them in the current period they extend the payables to a future period.

Financing of payables:

 Similar to stretching out payables, a company may choose to finance a portion of their
payables so they can record the smaller interest expense instead of the principle amount of
the payable as an expense.

Securitization of receivables:

 Just like the decision to securitize a leasing agreement, a company may attempt to securitize
their receivables with similar effects
 Instead of recognizing the receivables when they should be reported, securitizing them will
give the company the ability to manipulate their reported earnings though an amortization
schedule that will have lower interest costs in the earlier years.

Using stock buybacks to offset dilution of earnings:

 While many investors may welcome a company’s decision to buyback shares, others may
not.
 The immediate effects of a share buyback is to reduce the dilution of earnings by reducing
the number of shares outstanding.
  This allows the company to report future earnings in relation to less shares outstanding with
multiple positive looking effects; higher reported EPS, potentially lowering a company’s p/e
ratio  (among other ratios) and potentially increasing the company’s share price.

Other Shenanigans for investors to look out for:

Recording revenues prematurely and/or of questionable quality, such as:

 Recording revenues when a substantial portion of the service has not been delivered
 Recording revenues of unshipped items
 Recording revenues of items that have not yet been accepted by the client
 Recording revenues of items for which the client has no obligation to pay (consignment)
 Recording sales that were made to an affiliate

Recording fictional revenues:

 Recording sales for no reason

 Misclassifying income from investments as revenue
 Recording the cash received from a lending transaction as revenue
 Recording supplier rebates as revenues

Creating special transactions or one-time transactions to generate a gain, such as:

 Selling undervalued assets for a profit

 Selling investments for a gain and recording it as revenue, or using it to reduce current
operating expenses
 Reclassifying certain balance sheet accounts to create income
 Failure to record unearned revenues (customer prepayments) and recording these amounts as
revenues 

Deferring current revenues to a future period, such as:

 Refraining from recording revenues before a merger or acquisition

 Increasing allowance for bad debt
 Increasing other reserves such as warranties and returns

Recognizing future expenses in current expenses as a special one-time charge, such as:

 Inflating one-time charges

 Increasing expenses such as R&D, advertising, etc.
 Recognizing expenses that will continue to provide the company with a future economic
benefit, such advertising, R&D and maintenance expenses, among others.

Aggressive Accounting Policies______ ____________________________

  Increasing the useful file of an asset beyond its estimated useful life
 Using FIFO versus average cost or LIFO
 Accruing losses associated with contingencies
 Capitalizing all software development and R&D costs, or aggressively capitalizing any costs
 Amortizing costs slowly thus reducing recognized expenses  
 Recording investment income as revenue
 Not accounting for or allocating a small amount for returns, warranties, allowance for bad
debt and allowance for doubtful accounts

Describe the accounting warning signs related to the Enron accounting scandal.

 Extensive use of off-balance-sheet financing (joint ventures, improperly classifying leases

and take-or-pay and throughput contracts).
 Purposely providing non-transparent financial statements.
 Use of a “merchant model” of recording trading revenues where instead of the reporting the
trading fees as income they chose to record the entire trade as income not accounting for the
corresponding cost of the asset being traded.
 A wide scale cooperation: while many of the leading levels of management claimed to have
no knowledge of less than honest accounting practices, the final outcomes proved that this
could not have been undertaken by just one person.
 Presenting inflated assets and undervalued liabilities by taking some to “off balance sheet”
methods. They then chose to provide little or no information as to the actual values of these
projects which were typically in the form of limited partnerships with little footnoting.
 Marking to market valuing their long-term contracts: Instead of using the more conservative
matching principles or recording revenue with costs, they chose to aggressively value the
present value of long term contracts as revenue in the current reporting periods allowing
them to show what was perceived as phenomenal growth.
 Misaligning compensation: while it is common for companies to tie part of employee’s
compensation to the profitability of the company and reward them with stock, Enron chose
to make this a much bigger part of their comp plan. In this case, so much emphasis was
placed on the stock’s performance that some employees were driven to inflate the stock at
any cost.       

Weblink 10.4             Enron's Collapse: The Fall Of A Wall Street Darling

In contrast to aggressive accounting policies and lessons learned from Enron, here are some more
conservative accounting policies that would more accurately affect both the financial condition of a
company and the quality of their earnings.

 Rapid write-off of fixed assets (DDM)

 Using a conservative estimate of assets useful lives
 Minimal capitalization of software and startup costs
 Adequate provision for contingent liabilities
  Impaired assets written off quickly
 The use of completed-contract method for long-term projects
 Little use of off-balance-sheet financing
 Net income closely resembles cash flow from operations
 Adequate reserves allocated to returns, warranties, allowance for bad debt and allowance for
doubtful accounts

10.4 - What Causes Shenanigans And Manipulation?

Under GAAP a company’s management has many options from which to choose to record certain
economic events. These options are called “accounting rules” and, when used are referred to as
“accounting events.” Because the various choices will have differing effects on reported earnings
management has the opportunity to manipulate its financial results.

 Incentives and pressures: when compensation is heavily tied to the overall company’s
performance and the escalation of the stock price, pressure can be created to increase those
incentives

Opportunities: While it may be instinctual, if the opportunity presents itself, those with less
than ethical practices may steer toward taking them if they feel they will not get caught or
the effects on the company will be minimal
 Attitudes and rationalizations: this is often considered to come from the top down, but it can
be engrained in a company’s culture for long periods of time. Those who follow the lead of
senior management can easily rationalize their improper behavior with the justification that
the attitudes of their superiors are the same way.

 The implementation of SOX in 2002 was prompted by the wide spread abuse that was occurring in
the reporting and financial markets. Whether or not it has proven successful remains to be seen.
Sarbanes-Oxley Act Of 2002 - SOX
 

Weblink 10.5  - To spot the signs of earnings manipulation, you need to know the different ways
companies can inflate their figures, read Cooking The Books 101, or check out the definition for
Sarbanes-Oxley Act Of 2002 - SOX.

Even with more strict regulations, the incentive to cook the books remains because it   pays to do so.
,In the right hands it can be relatively easy. Shenanigans and manipulation are often unearthed, but it
sometimes does not occur until well after the fact. A good example of this is when companies go
back and restate earnings for prior periods once their less than proper accounting decisions are
uncovered.

Other Motives Behind Financial Shenanigans

Another aim of financial shenanigans is to improve liquidity. By inflating revenues or hiding debt,
companies can obtain funding with lower borrowing costs and fewer restrictive financial covenants
when they issue bonds; they may also get preferred lower rates from financial institutions for short-
and long-term loans, and if they are able to issue private placement debt the unsuspecting investors
should make due diligence a priority.
10.5 - Finding Shenanigans

The first place to start to investigate red flags or shenanigans is the company’s reported income
statement, balance sheet and statement of cash flows and changes in owners’ equity.  Some red flags
to be aware of are the following:

 Large swings year-over-year, signifying some sort of event of change in accounting

methods.
 Any ambiguities noticed in reporting functions that look out of place.
 A change in auditors, especially if the previous auditor was on board for an extended period
of time.
 An increase in footnotes or a combination of all the above.

Keep in mind that while these changes may not signify manipulation, these anomalies need to be
adjusted when comparing one company to another.  

Besides reported financial results from the company, here are other sources used to investigate
potential red flags and shenanigans.

 Press releases
Press releases can provide an analyst with useful information. That said, they must be used
and analyzed diligently.
 Securities Exchange Commission fillings
Securities filings are forms such as the Form 10-K (annual), 10-Q (quarterly), 8-K (special
events) and 144 (corporate insider activity), and annual reports, proxy statements and
registration statements.

Armed with these documents analysts should look in:

The Auditor’s Report

Red flags include:
Inclusion of a qualified opinion
No audit committee, or audit committee comprises mostly of related parties

Proxy Statement
Red flags include:
pending lawsuits or other contingent liabilities, special compensation plans or perks for
officers and directorsOff-balance-sheet transactions

Footnotes to Financial Statements

Red flags include:
abnormalities found in the accounting-policy descriptions and unbilled receivables
Off-balance-sheet transactions
Changes in accounting principles and estimations

Management Discussion and Analysis (MD&A)

Red flags include:
Large planned expenses
 Decreased liquidity
Abnormal need for working capital

Form 8-K
This will provide information on:
The company’s acquisition and divestitures
Change in auditor – If a company changes auditors, it could be because the previous auditor
did not want to sign off on the financial statements.

Form 144
Red flags include:
Insiders selling a large portion of their holdings
 Interviews with the Company
Company interviews are also a good way to get close and personal with a company’s
management and ask some more targeted questions. Individual investors typically do not
take this extra step unless they own a significant amount of stocks. They instead rely on
analysts’ reports and opinions where it should be verified that the analyst has met with the
company and preferably visited the company on site.
 Commercial Databases
Analysts can also make use of commercial databases such as LexisNexis and Compustat to
screen for companies displaying potential warning signs of operating and accounting
problems.