Analyzing Financial Report:Detecting Accounting Fraud

Analyzing Financial Report:
Detecting Accounting Fraud
Arthik Davianti

Analisis laporan keuangan, kinerja,
dan kepatuhan atas entitas komersial,
nirlaba, dan ETAP dengan focus pada
accounting gimmick and fraud

What has been will be again, what has
been done will be done again;
There is nothing new under the sun
Ecclesiastes 1:9

SHENANIGANS
Shenanigans:
Secret or dishonest activity or
manoeuvring (Oxford
Dictionary)
Financial shenanigans:
Actions taken by management
that mislead investors about a
company’s financial
performance or economic
health (Schilit and Perler,
2010)

FINANCIAL SHENANIGANS
Awards for Most Outrageous Financial Shenanigans
Category Company
Most Imaginative Fabrication of Revenue Enron
Most Brazen Creation of Fictitious Profit
and Cash Flow
WorldCom
Most Shameless Heist by Senior Manager Tyco
Most Ardent and Prolific Use of Numerous
Shenanigans
Symbol Technologies

1. Earnings
Manipulation
Shenanigans
2. Cash Flow
Shenanigans
3. Key Metrics
Shenanigans

Companies with structural weakness or
inadequate oversight.
Ask these basic questions:
1. Do appropriate check and balances exist
among senior executives to snuff out corporate
misdeeds?
2. Do outside members of the board play a
meaningful role in protecting investors?
3. Do the auditors possess the independence,
knowledge, and determination to protect
investors?
4. Has the company improperly taken circuitous
steps to avoid regulatory scrutiny?

Warnings signs – ground for shenanigans:
1. Absence of checks and balances among senior
management.
2. An extended streak of meeting or beating Wall
Street expectations.
3. A single family dominating management,
ownership, or the BOD.
4. Presence of related-party transactions.
5. Inappropriate members placed on the BOD.
6. Inappropriate business relationship between
company and board members.

Warnings signs – ground for shenanigans
(continues):
7. An unqualified auditing firm.
8. An auditor lacking objectivity and the
appearance of independence.
9. Attempts by management to avoid regulatory
or legal scrutiny.

EARNINGS MANIPULATION
Investor judge corporate executives harshly when
they fail to meet Wall Street’s earnings
expectations when reporting each quarter.
• Inflating current-period earnings.
• Inflating future-period earnings.

1. Recording revenue too soon.
2. Recording bogus revenue.
3. Boosting income using one-time or
unsustainable activities.
4. Shifting current expenses to a later period.
5. Employing other techniques to hide expenses
or losses.
6. Shifting current income to a later period.
7. Shifting future expenses to an earlier period.

Techniques:
1. Recording revenue before completing any
obligations under the contract.
2. Recording revenue far in excess of work
completed on the contract.
3. Recording revenue before the buyer’s final
acceptance of the product.
4. Recording revenue when the buyer’s payment
remains uncertain or unnecessary.

Warning signs (p. 73):
1. Up-front revenue recognition on long-term
contracts.
2. Cash flow from operation lagging behind net
income.
3. Accelerating sales by changing the revenue
recognition policy.
4. Seller offering extremely generous extended
payment terms.

Techniques:
1. Recording revenue from transaction that lack
economic substance
2. Recording revenue from transaction that lack a
reasonable arm’s length process.
3. Recording revenue on receipt from non-
revenue-producing transactions.

Warnings (p. 91):
1. Recording revenue from transaction that lack a
reasonable arm’s length process.
2. Recording cash received from a lender,
business partner, or vendor as revenue.
3. Revenue growing much faster than account
receivables.
4. Unusual increases or decreases in liability
reserves account.

Techniques:
1. Boosting income using one-time events.
2. Boosting income through misleading
classifications.

Warnings signs (p. 108):
1. Shifting normal operating expenses below the
line.
2. Routinely recording restructuring charges.
3. Including proceeds received from selling a
subsidiary as revenue.
4. Operating income growing much faster than
sales.

Techniques (p. 111):
1. Improperly capitalizing normal operating
expenses.
2. Amortizing cost too slowly.
3. Failing to write down assets with impaired
value.
4. Failing to record expenses for uncollectible
receivables and devalued investments.

Warnings signs (p. 134):
1. Improperly capitalizing normal operating
expenses.
2. Changes in capitalization policy or accelerated
capitalization of costs.
3. New or unusual assets accounts.
4. Jump in soft assets relative to sale
5. Stretching out depreciable asset life.
6. Improper amortization of cost associated with
loans.

or losses
Technique (p. 137):
1. Failing to record an expense from a current
transaction.
2. Failing to record an expense for a necessary
accrual or revising a past expense
3. Failing to record or reducing expense by using
aggressive account assumptions.
4. Reducing expenses by realising bogus reserves
from previous charges.

or losses
1. Unusually large vendor credits or rebates.
2. Unusual transactions in which vendors send
out cash.
3. Failing to record an expense for a necessary
accrual or revising a past expense.
4. Unusual declines in reserves for warranty or
warranty expense.

Techniques (p. 159-160):
1. Creating reserves and realising them into
income in a later period.
2. Improperly accounting for derivatives in order
to smooth income.
3. Creating reserves in conjunction with an
acquisition and realising them into income in a
later period.
4. Recording current-period sales in a later
period.

Warning signs (p. 171-172):
1. Creating reserves and releasing them into
income in a later period.
2. Stretching out windfall gains over several
years.
3. Improperly accounting for derivatives in order
to smooth income.
4. Holding back revenue just before an
acquisition closes.

1. Improperly writing off assets in the current
period to avoid expenses in a future period.
2. Improperly recording charges to establish
reserves used to reduce future expenses.

Warnings signs (p. 187-188):
1. Improperly writing off assets in the current
period to avoid expenses in a future period.
2. Improperly recording charges to establish,
reserves used to reduce future expenses.
3. Large write-offs accompanying the arrival of a
new CEO.

CASH FLOW SHENANIGANS
Increasingly, investors have expanded their focus
to include the Statement of Cash Flows and, more
specifically, the section that highlights cash flow
from operation (CFFO).
• Accrual versus cash-based accounting.

1. Shifting financing cash inflows to the operating
section.
2. Shifting normal operating cash outflows to
investing section.
3. Inflating operating cash flow using acquisitions
or disposal.
4. Boosting operating cash flow using

section
1. Reporting bogus CFFO from a normal bank
borrowing.
2. Boosting CFFO by selling receivables before
collection date.
3. Inflating CFFO by faking the sale of receivables.

section
1. Recording bogus CFFO from a normal bank
borrowing.
2. Boosting CFFO by selling receivables before the
collection date.
3. Providing less disclosure than in the prior
period.

investing section
Techniques (p. 213-214):
1. Inflating CFFO with boomerang transactions.
2. Improperly capitalizing normal operating cost.
3. Recording the purchase of inventory as an
investing outflow.

investing section
1. Inflating operating cash flow with boomerang
transactions.
2. Improperly capitalizing normal operating costs.
3. New or unusual assets accounts.
4. Jump in soft assets relative to sales.
5. Unexpected increase in capital expenditures.

or disposal
1. Inheriting operating inflows in a normal
business acquisition.
2. Acquiring contracts or customers rather than
developing them internally.
3. Boosting CFFO by creating structuring the sale
of a business.

or disposal
1. Declining free cash flow while CFFO appears to
be strong.
2. Acquiring contracts or customers rather than
developing them internally.
3. Boosting CFFO by creatively structuring the
sale of a business.
4. Selling a business, but keeping the related
receivables.

1. Boosting CFFO by paying vendors more slowly.
2. Boosting CFFO by collecting from customers
more quickly.
3. Boosting CFFO by purchasing less inventory.
4. Boosting CFFO with one-time benefit.

Example of boosting CFFO with one-time benefit:
Microsoft Corp doled out billions of dollars –
settle antitrust litigation.
Sun Microsystem (one of the recipient) – received
$2 billion from Microsoft in 2004 ($1.6 billion
recognized as income), presented as
“settlement income” – non recurring and
unrelated to its normal operation.

1. Boosting CFFO by paying vendors more slowly.
2. Account payable increasing faster than cost of
goods sold.
3. Increase in other payables accounts.
4. New disclosure about prepayments.
5. Offering customers incentives to pay invoices
early.

KEY METRICS SHENANIGANS
Management, naturally, faces some restriction
under accounting rules – GAAP.
To by pass many such restrictions and put on a
positive spin, management has become more
active and deceptive in creating and manipulating
key non-GAAP metrics to impress investors.
The use of other “key metric” to evaluate a
company’s performance and economic health.

KEY MATRICS SHANANIGANS
1. Showcasing
misleading
metrics that
overstate
performance.
2. Distorting
balance sheet
metrics to avoid
showing
deterioration.

KEY MATRICS SHANANIGANS
1. Surrogates for revenue: same-store sales,
backlog and bookings, subscriber count,
average revenue per customer, and organic
revenue growth.
2. Surrogates for earnings: pro forma earnings,
EBITDA), non-GAAP earnings, constant-
currency earnings, and organic earnings
growth.
3. Surrogates for cash flow: a retail chain may
present cash flow excluding a substantial one-
time cash payment for a legal settlement.

Showcasing misleading metrics that overstate
performance.
1. Highlighting a misleading metric as a surrogate
for revenue.
for earnings.
for cash flow.

performance.
Examples (p. 272):
General Motors (GM) recorded $259 million after
tax gain on the sale of an equity interest in a
regional homebuilder in June 2006.
The gain from the homebuilder investment would
not be excluded from ‘adjusted income’ (20%
more than the adjusted income).

performance.
for revenue.
2. Divergence in trend between same-store sales
and revenue per store.
3. Pretending that recurring charges are
nonrecurring in nature.

Distorting balance sheet metrics to avoid showing
deterioration.
1. Distorting account receivable metric to hide
revenue problems.
2. Distorting inventory metrics to hide
profitability problems.
3. Distorting financial assets metrics to hide
impairment problems.
4. Distorting debt metrics to hide liquidity
problems

deterioration.
Example – selling accounts receivable (p. 282):
• Lowers the days’ sales outstanding reported to
investors.
• It appears that customers have been paying
more quickly.

deterioration.
Warning signs (p. 295-296):
1. Failing to prominently disclose the sale of
accounts receivable.
2. A huge decline in DSO following several
quarters of growing receivables.
3. Moving inventory to another part of the
balance sheet.
4. Stopping the reporting of certain key metrics.

Source:
Schilit, H. and Perler, J., 2010,
Financial Shenanigans: How to Detect
Accounting Gimmicks & Fraud in Financial
Reports, 3rd Edition,

Analyzing Financial Report:Detecting Accounting Fraud

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