Financial Shenanigans Ch 1-5 Flashcards
Enron used what kind of accounting to give the illusion that it had larger sales than in reality?
Mark to market accounting
When reported sales growth far exceeds any normal patterns…
Revenue recognition shenanigans may likely have fueled the increase
Earnings manipulation shenanigans…4
1 recording revenue too soon
2 recording bogus revenue
3 boosting income using one time/unsustainable activities
4 use techniques to hide expenses or losses
Cash flow shenanigans:
Shifting financing cash inflows…
To operating section
Cash flow shenanigans:
Shifting normal operating cash outflows to…
The investing section
Cash flow shenanigans:
Inflating operating cash flow using…2
1 acquisitions or
2 disposals
Cash flow shenanigans:
Boosting operating cash flow using…
Unsustainable activities
Key metrics shenanigans 2
1 showcasing misleading metrics that overstate performance
2 distorting balance sheet metrics to avoid showing deterioration
Acquisition driven companies offer investors some of the…
Greatest challenges and risks
Aggressive accounting by worldcom involved…4
1 making acquisitions
2 writing off much of the costs immediately
3 creating reserves
4 releasing reserves into income as needed
Acquisition driven companies often lack internal engined of growth such as…3
1 product development
2 sales
3 marketing
On the statement of cash flows line costs were placed in…
Instead of…
The investing section
Operating section
Free cash flow equation
Free cash flow =
cash flow from operations - capital expenditures
When free cash flow suddenly plummets…
Expect big problems
Red flag is companies profits do not…
Do not grow in proportion to company’s sales
Operating cash flow is inflated when acquisitions are…
Recorded in the investing section of statement of cash flows
Financial shenanigans
Actions taken by management to mislead investors about financial performance or economic health
Management is devoid of checks and balances 2
Good when members of management disagree
Bad when one manager runs the show
It is bad, when company management consists of…
Family and friends
CEOs who push a culture of win at all costs can lead to…
Aggressive accounting
It’s bad when management…
Boasts about continuously beating earnings
You should question the auditor’s opinion when…
Auditor’s fees are astronomical
How can management avoid the regulatory scrutiny of going public?
By merging into an already public company
Red flag when management boasts about being…
Ethical
Ethical people rarely brag about such virtues
Madoff’s investment firm did not have a…
Third party custodian to safeguard cash and securities
For investors to prevent theft
Warning signs: breeding ground for shenanigans
Absence of checks and balances…
Among senior management
Warning signs: breeding ground for shenanigans
An extended streak of…
Meeting or beating Wall Street expectations
Warning signs: breeding ground for shenanigans
Single family dominating…3
1 management
2 ownership or
3 board of directors
Warning signs: breeding ground for shenanigans
Presence of…
Related party transactions
Warning signs: breeding ground for shenanigans
Inappropriate compensation structure that encourages…
Aggressive financial reporting
Warning signs: breeding ground for shenanigans
Inappropriate members placed on…
Board of directors
Warning signs: breeding ground for shenanigans
Inappropriate business relationships between…
Company and board members
Warning signs: breeding ground for shenanigans
An unqualified…
Auditing firm
Warning signs: breeding ground for shenanigans
An auditor lacking…
Objectivity and independence
Warning signs: breeding ground for shenanigans
Attempts of management to avoid…2
Regulatory or legal scrutiny
4 requirements for revenue recognition that must be met
1 evidence of an arrangement exists
2 delivery of product or service has occurred
3 price is fixed or determinable
4 collectibility of proceeds is reasonably assured
For capital leases, by using a low discount rate management could…
Aggressively accelerate revenue recognition
Be aware of acceptable accounting methods that are meant for different industries, ex.
Mark to market used by Enron for premature rev recognition
Percentage completion used for premature rev recognition
Bill and hold is considered…
Where can it be found if the company used bill and hold?
Premature revenue recognition
Found in the 10-K foot note for revenue
Consignment arrangements can be used for…
Prematurely recording revenue
Sell in
2) sell through
Sell in = manufacturer sells to distributor
Sell through = products are purchased by the end user
When a company switches from a sell in to a sell through model this is a…
More aggressive way to recognize revenue
Be mindful of sellers recording revenue before the lapse of the…
Right to return
Look for revenue recognition changes in…
The footnotes
Watch for an increase in…
Seller provided financing
A company is riskier when they have looser…
Financing plans
Record revenue from transactions that lack economic substance
Customer is under no obligation to pay for product
For legitimate insurance contracts there must be…
A transfer of risk
Bogus reserves will often lead to…
Bogus revenue or income
A rapid increase in accounts receivable is often an indication of…
Deteriorating financial health
Most related party transactions and joint ventures that lack an arms length exchange produce…
Phony revenue
If a company has 36 employees, chances are the company is committing fraud by stating…
$300 million in revenue
If you spot signs of a questionable accounting approach test it by…
Comparing results and practices to a similar larger company
A principal (owner of inventory) should recognize revenue using…
2) an agent should recognize revenue using…
The gross method
2) the net method (fee only)
Turning a sale of a business into a recurring revenue stream (ex. Technology companies commonly do this)
Company Sells a business unit and agrees to buy it back
When a company sells a business unit that it will use future services from, a common shenanigan is…
Under reporting the gain from sale in order to over report revenue
Companies often try to over report…
How?
Operating income
By shifting nonrecurring income to operating income and operating expenses to nonrecurring expenses
If an investor possesses significant influence of a company (over 20% ownership), it’s proportionate share of profits should be included as…
Non operating income (not as revenue)
Switching from the equity method to the available for sale method means…
Periodic results of the subsidiary would not affect earnings of the parent
If an investment is designated as trading security, changes in fair value are…
Reflected on the statement of income
If an investment is designTed at available for sale, changes in fair value are…
Presented as an offset to equity with no impact to earnings
Under the equity method for an investment, a company reports…
Proportional share of investment’s earnings on income statement
For an over 50% ownership investment in a company…
The parent consolidates sub’s financial statements into its own
