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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.
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.
• 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:
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)
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.
4.Private companies.
Private companies that are closely held do not need to produce audited financial statements, and are likely to
use financial shenanigans.
1.Press releases
Press releases can provide an analyst with useful
information. That said, they must be used and analyzed
diligently.
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.