Spotting Accounting Manipulation (from Detecting Accounting Fraud: Analysis and Ethics, Global Edition)
Telltale signs of fraud: growing accounts receivable and mounting inventory.
- Increase in accounts receivable as a percentage of sales
- Sudden change in gross margin percentage
- Cash flow from operations lags the reported profits.
- Large one time charges
- Rapid decrease in reserve together with increase in reported profit
- Precisely meeting analyst expectation
- Fixed cost remains a constant percentage of sales (especially when fixed cost is high percentage of expense)
- Large amount of goodwill when acquiring other company, without super-normal return on assets
- Decrease in sales to asset ratio, increase in capex vs decrease in sales
1. Channel Stuffing - persuading customers to place a later period’s orders in the current period [E.g. Sunbeam]
- Offering deep discount & extended payment terms to get customers to place future orders early.
- Consignment sales allow customers to return unsold products, sometimes including shipping & storage at company's expense.
- Sales are billed, but items never shipped / held until customers needed them, at company's expense.
- Customers given right to return goods, yet reserves for returns are not recorded.
- Discontinued income reported as continued income (one time gain)
- Fictitious sales agreement.
- Rebates on future purchase deducted from current accounting period.
2. Improper Use of restructuring reserves [E.g. Sunbeam]
- Initially over-accruing a liability when creating a reserve (for legal, restructuring, special charges etc), later “discovered” that these reserves were not needed and releases those reserves back into earnings.
- Over state inventory write downs, recognize profits when inventory is sold at normal price.
- Write down property, plant, and equipment values to reduce future depreciation expenses.
3. Holding Books Open after the Close of a reporting period [E.g. Sensormatic]
- Counting sales made a few hours / days after the end of reporting period as those made in current quarter
4. Shipment manipulation [E.g. Sensormatic]
- false recognition of early Shipments, shipping to own warehouse before to customer
- delay shipment process with shipping company to avoid goods from arriving too early
- Recognizing revenue on shipment, instead of on reaching destination
5. Improper use of multiple-element Contracts or Bundled Contracts [E.g. Xerox]
- Recording revenue meant to be recognized over the lifetime of a contract immediately (servicing / financing contract)
- Sales of lease (accounts receivables) causes operating income to shoot up, but any future benefit lost is not reported.
6. Estimates of discount rates and residual values [E.g. Xerox]
- Leasing companies discount future cash flows when they recognize the amounts in current income
- Assumed a fixed percent return despite significant volatility in the returns actually earned by leasing companies
- Increase earnings by changing estimated residual value of leased assets
7. Fictitious revenue via top-Side adjustments (Adjustments made in financial statement, not general ledger) [E.g. CUC]
- Outright lying - subsidiary sends financial statement, holding company adjusts figure in final presentation
- Unsupported entries
- Deferred revenue (club memberships) shifted to current revenue
8. Improper use of merger reserves [E.g. WorldCom]
- acquire numerous companies and pretend to be paying for large amounts of goodwill by overstating liability, understating net asset.
- Increasing good will to use as false reserves.
- reverse liabilities reserves into profits as it was “discovered” that the reserves weren’t really needed
- Uses stock to take over other companies, thus the need to maintain high share prices with inflated profits.
- Founder also use his own stock as collateral to take on private debts, which could lead to a crash if forcefully sold.
9. Improper Capitalization of expenses [E.g. WorldCom]
- Record cash expenses as money spend on assets, capex (Cash becomes fixed asset, total asset doesn't drop)
10. Expense roll [E.g. Livent]
- removal of certain expenses and liabilities from ledger at the end of each quarter, re-entered in the next quarter.
11. Amortization roll [E.g. Livent]
- Transfer cost from an activity to another that has yet to begin production, or with a longer amortization period to reduce cost.
- Stretching amortization period over 40 years, when it should have been 5.
12. Overstating earnings via understating cost of goods sold.
- Boost ending inventory value by failing to write down full shrinkage (loss due to theft etc)
13. Understating bad Debts over long period of time instead of writing it off in one shot when discovered.
14. Failure to record asset value impairment in one shot, instead choosing to write off over a period of time.
15. Abuse of Mark-to-Market accounting [Everyone's favorite, E.g. Enron]
- mark-to-market accounting allowed Enron to look at an asset — be it a merchant asset or a contract or publicly traded stocks—and revalue it to its “fair” value.
- This process involved increasing the asset’s value on the balance sheet and increasing the profit on the income statement.
- Private company (illiquid), specialized in highly speculative deepwater exploration, was valued at Enron according to their own internal “models.”
- Enron had acquired Mariner Energy for $185 million and by “the second quarter of 2001, Enron had Mariner on its books for $367.4 million”
16. Abuse of special purpose entity (SPE) - [E.g. Enron]
- business entity such as a partnership, trust, or joint venture created as legally separate from a company in order to conduct “special” or specific kinds of business transactions that are not part of the company’s normal operating activities.
- debt not added into the company’s consolidated balance sheet - keeps debts off
- Enron guarantees the debts of their SPE
- via equity accounting, the company’s share of the SPE’s earnings is accounted for in the company’s income statement - company can record SPE's earnings
- sales of poorly performing Enron assets to the SPEs at inflated prices, thereby overstating Enron’s earnings.
17. Prepay transactions - debt hidden as revenue, disguised loans [E.g. Enron]
- Enron would enter into a contract with a party to deliver a commodity, such as gas, in the future at a specified price.
- Sell the contract to a financial institution for the amount of the total future cash selling price, less a discount, and Enron would get the cash up front.
- agree to guarantee the repayment of all the cash received, plus interest, at some point in the future.
- this "Loan" was treated as a sale, increasing profit yet balance sheet remains unchanged (increase in both asset and liability)
- Under report debt, increase profit, artificially inflates Cashflow
18. improper use and misleading disclosure of related-party transactions [E.g. Adelphia]
- hide debt, boost earnings, and loot the company in favor of the major shareholders, directors, or officers.
- intermingling of a company’s assets or liabilities with the personal assets or liabilities of its major shareholders, officers, or directors is a signal of poor internal control.
19. Inappropriate Accounting for Round-Trip Transactions. [E.g. Krispy Kreme]
- simultaneous pre-arranged sales transactions, often of the same product, in order to create a false impression of business activity or revenue
- ”Krispy Kreme increased the price it paid for the franchise by $800,000, i.e., from $65,000,000 to $65,800,000 in return for the franchise purchasing from Krispy Kreme $800,000 worth of doughnut making equipment”