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1-Page Summary of Financial Shenanigans
Telling Tall Tales
Economists and accountants aren’t usually thought of as storytellers, but they can tell whoppers that cost investors billions. The Center for Financial Research and Analysis (CFRA) has identified 30 techniques grouped into seven categories that are used to dupe investors.
All accounting trickery involves manipulating either revenue or expenses. This can be accomplished by inflating current sales, or underestimating costs. Companies can also manipulate earnings by deflating them, which means to underestimate revenues and/or overestimate expenses in order to shift profits into the future when they’re needed. There are three reasons why companies do this:
It is easy for unscrupulous executives to take advantage of the system. They can structure transactions or announce reporting moves that help them achieve their accounting goals. For example, they could use operating leases to keep debt off the books.
It can be very beneficial, especially if you work for a company that has financial problems. Managers are motivated to do well financially because they get bonuses based on the company’s performance. They also have less of a chance of getting caught because unaudited reports don’t usually go through an independent CPA review.
When you’re evaluating a company, be aware of any misguided management incentives. These are not uncommon and can cause people to cheat on their numbers.
When to Be on the Lookout
Certain factors can lead to accounting fraud. If a company has an oversight board that’s not independent, or if it doesn’t have a competent auditor, be on guard. The same goes for companies facing high competitive pressure and those with questionable management integrity. These situations could indicate fraudulent activity within the business. Watch out for previously successful companies that are suddenly going through tough times—and ones struggling just to stay alive in general—as well.”
Audit Your Auditor
Auditors spend weeks going through a company’s financial records. They will usually give the company a clean bill of health in their report, but if they have any serious reservations about the accuracy or fairness of the financial statement, they will qualify their opinion. If you get a qualified opinion and it notes “going concern” issues, that should raise some red flags for investors.
In addition, look for a situation where the audit committee is not independent. The purpose of an audit committee is to act as a go-between between the outside auditor and executives. Companies that are listed on the New York Stock Exchange are required to have an audit committee. Other companies do not have this requirement.
The Seven Financial Shenanigans
Here’s how it works: 1. Recording bogus revenue – This is the worst type of deception and can be done in many ways, such as recording sales that have no economic substance or counting rebates from suppliers that should not be counted as revenue. Another common trick is to record investment income as operating revenue. 2. The company may also try to pull a fast one by holding back money before a merger and then releasing it after the merger has taken place.
Revenue from services that have not yet been provided should not be counted. Revenue should never be recorded before the item being sold has actually shipped and been accepted by the customer. A company should not record revenue if the customer isn’t required to pay. Sales to an affiliated company are also dubious, as is grossing up revenue.
Sometimes, companies will count their one-time gains as revenue. This is a dirty little trick because it’s only the company making money once and they’re counting it over and over again. Similarly, some companies reclassify accounts on their balance sheets in a way that makes them appear to have more income than they actually do.
