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CFA Level 1 - Red Flags

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10.1 - Introduction
We conclude our five section discussion on financial
statements with a brief, yet important chapter on red
flags. Although companies are required to follow
Generally Accepted Accounting Principals (GAAP),
many companies find loopholes and ways to fudge their
numbers. These items are crucial for analysts to recognize
in order to avoid recommending poor investments to their
clients. Prime examples of recent bad apples are Enron
and Worldcom.

The following articles are great resources on spotting the


signs of earnings manipulation, learning telltale signs of

corporate misdeeds, and how off-balance sheet


entities can be misleading:

• Cooking the Books


• Putting Management Under the Microscope
• Off-Balance-Sheet Entities: The Good, the
Bad and the Ugly

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


Earnings manipulation can be classified into one of
four categories:

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. Sometimes they do well and sometimes they do
not. 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 takes place 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 takes place when a company is having a really bad year and the income
reserves are not enough to offset the bad results they are about to report. That said, management knows
that its stock will drop 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 - What are 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
These two basic shenanigan strategies can be classified into seven categories of techniques:

1. 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
- Reporting revenues (gross) that do not include appropriate reserves for returns

2.Recording fictional revenues, such as:


- Recording sales for no reason
- Misclassifying income from investments as revenue
- Recording the cash received from a lending transaction as revenues
- Recording supplier rebates as revenues

3.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

4.Not recording or reducing liabilities improperly, such as:


- Excluding expenses and the related liability
- Modifying accounting assumptions in an effort to decrease the reported liabilities
- Failure to record unearned revenues (customer prepayments) and recording these amounts as revenues

5.Shifting current expenses to past or future periods, such as:


- Reclassifying previously capitalized costs as operating expenses
- Increasing the life of an asset to reduce the amortization expense
- Reducing asset reserves
- Failing to record impaired assets
- Changing accounting practices in an effort to shift current expenses to an earlier period
- Modifying accounting assumptions in an effort to decrease the reported liabilities
- Failure to record unearned revenues (customer prepayments) and recording these amounts as revenues

6.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

7.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
- Capitalizing startup costs
- Amortizing costs slowly
- Recording investment income as revenue
- Capitalizing normal operating costs
- Not accounting for or allocating a small amount for returns, warranties, allowance for bad debt and allowance
for doubtful accounts
- Extensive use of off-balance-sheet financing (joint ventures, operating leases and take-or-pay and throughput
contracts)

Conservative Accounting Policies


- 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 - Why Do Shenanigans Exist?


Shenanigans exist because 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, although it may not exercise that option.
So why would management want to use financial shenanigans to cook the books? Because it pays to do so; it’s
easy, and the discovery of shenanigans is difficult and unlikely.

1. It pays
Displaying a good financial performance can be very
beneficial monetarily for the current management,
especially if its short-term compensation is based on the
company’s current performance. Managers who have a
significant position in a public company stock (stock-
option program) will most likely want to defer reporting
losses or cook the book until they sell their current
holdings. There are also non-monetary incentives for
management, such as keeping their job.

2. It’s easy
Financial accounting standards are broad. It is easy for
management to use the accounting rules that best fit its
needs rather than those of the stockholders or lenders.

3. Discovery is difficult and unlikely


Though there have been several advancements in the area of discovering accounting frauds - due in part to the
Enron scandal - they remain difficult to identify, and it’s unlikely that the managers will get caught. In the past,
the potential penalties for companies that engage in financial shenanigans were small. Fortunately, this has
changed, and the penalties can be severe for both managers and board members.

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.

Likely Candidates for Shenanigans


There are certain types of companies that have a higher probability for performing shenanigans.

1.Fast-growth companies whose real growth is beginning to slow


Growth companies command a premium over slower-growth companies. If a company is no longer classified as
a growth company, its valuation can be severely affected.

2. Basket-case companies trying to survive


These are companies that have a weak management. Management may resort to financial shenanigans in an
effort to make investors believe that the company’s problems are not significant.

3.Newly public companies (IPO)


These have been known to have weak internal controls, making them susceptible to earnings manipulation.

4.Private companies.
Private companies that are closely held do not need to produce audited financial statements, and are likely to
use financial shenanigans.

10.5 - Finding Shenanigans


Finding Shenanigans
There are four sources of information an analyst should use to detect financial shenanigans:

1.Press releases
Press releases can provide an analyst with useful
information. That said, they must be used and analyzed
diligently.

2.Securities Exchange Commission filings


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 auditors 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 directors
- Footnotes to financial statements – Red flags include:
- Abnormalities found in the accounting-policy descriptions
- Pending lawsuits or other contingent liabilities
- 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

3.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.

4.Commercial databases
Analysts can also make use of commercial databases such as LexisNexis and Compustat to screen for
companies displaying potential warning sings of operating and accounting problems.

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