Book - Financial Shenanigans

Question 1

What was the problem in Waste Management, and how did one-time gains come into the picture?

Answer 1

Waste management: Investors cannot trust auditors, with one-time charges connected to acquisitions being so frequent, and by investors not agreeing on the practice but still allowing it. Also netted one-time gains against special charges and did not disclose this.

Question 2

How did Enron manage to inflate revenue 10-fold?

Answer 2

The revenue grew “too” fast, it was unprecedented. They counted trading activities as sales, which created modest profit but huge revenues (hypergrowth).
if it looks too good to be true, it probably is, and should be investigated further.

Question 3

In World Com, what was the problem with the accounting for so-called “line costs”?

Answer 3

fees paid to third-party telecom network providers for the right to access their network, these should be expensed and not capitalised, which they did not follow and inflated their earnings.

Question 4

How did the management in Valeant managed to fool investors?

Answer 4

Making acquisitions, writing off too much of the costs immediately, and creating reserves which were released when needed. If companies have a strategy relying on aggressive acquisitions and accounting, one should be particularly thorough.

Question 5

There are seven financial Shenanigans recognised in the book, relating to earnings manipulations. How many of them relate to revenue accounting or gains, and which are they?

Answer 5

3: Recording revenue too soon, Recording bogus revenue, Boosting income using one-time or unsustainable activities

Question 6

How many relates to expense accounting or losses?

Answer 6

4: Shifting current expenses to a later period, Employing other techniques to hide expenses or losses, Shifting current income to a later period, Shifting future expenses to the current period

Question 7

Which are the shenanigans relating to cash flow? How many of them relates to the operating section of the cash flow statement?

Answer 7

Shifting Financing cash inflows to the operating section, Moving cash outflows from the operating section to other sections, Boosting operating cash flow using unsustainable activities

Question 8

Explain how Key Metrics Shenanigans are created.

Answer 8

Business results are presented to cater to a wider range of company- and industry-specific measures (ROIC etc.), and since they are often non-GAAP, companies have more freedom to calculate and report them.

Question 9

What are the Acquisitions Accounting Shenanigans?

Answer 9

3: Artificially boosting revenue and earnings, Inflating reported cash flow, manipulating key metrics

Question 10

By what does the authors mean when they state “the auditors can be either a friend or a foe to investors”?

Answer 10

A friend is competent, independent, and fastidious in sniffing out problems, a foe is incompetent, lazy, or a rubber stamp for the management (high fees and relationship might be an issue)

Question 11

There are four techniques to record revenue too soon; which?

Answer 11

Recording revenue before completing material obligations under the contract, Recording revenue far in excess of work completed on the contract, Recording revenue before the buyer’s final acceptance of the product, Recording revenue when the buyer’s payment remains uncertain or unnecessary

Question 12

What are the key lessons for investors in the “boomerang” transactions in MSTR?

Answer 12

1) funds flowing back and forth between a customer and seller should raise suspicions about the legitimacy of both transactions
2) the suspicious timing of press releases announcing new sales should raise questions about whether revenue might have been recognised too early

Question 13

Explain in general terms, the background to the percentage of completion (POC) method?

Answer 13

It was introduced so that firms working on long-term construction-type contracts could report business activity each period, even if a product was not delivered to the customer. Have to estimate how large portion of the project that has been completed.

Question 14

What is a “bill-and-hold” arrangement and when do accounting guidelines allow revenues to be recognized?

Answer 14

When the seller bills the customer and recognizes revenue but continues to hold the product. For most sales, revenue recognition requires shipment of the product to the customer.

Question 15

Explain how Sunbeam managed to record revenue too soon.

Answer 15

They sold products six months before they were needed, in exchange for major discounts and longer payment terms.

Question 16

What is a consignment arrangement and how does it affect the recognotion of revenue?

Answer 16

Products are shipped to an intermediary, who has the task of finding a buyer, and it should not be recorded as revenue, bur Sunbeam did.

Question 17

Explain what the risk might be if the seller accepts an exceptionally long time to pay or if the seller provides the financing for the sale. What key-ratio might be useful in spotting too aggressive accounting?

Answer 17

May indicate the acceleration of revenue into the current period, tepid customers interest in the product or the buyer’s ability to pay. Can use DSO as a measure of this.

Question 18

Which are the four techniques, involving recording bogus revenue?

Answer 18

Recording revenue from transactions that lack economic substance, Recording revenue from transactions that lack reasonable arm-length process, Recording revenue on receipts from non-revenue-producing transactions, Recording revenue from appropriate transactions, but at inflated amounts

Question 19

How did the “finite insurance” issued by AIG, work in the case of Brightpoint.

Answer 19

If they did not reach a target, a revenue to AIG could be recorded (insurance), This was not a real transaction, since it was only a financing arrangement - bright point deposited cash at AIG which was refunded as insurance claim payments eventually.

Question 20

What part of the balance sheet could have been used as a warning signal to spot problems in Peregrines “parking” of transactions?

Answer 20

High accounts receivables. They counted transactions as revenue when customers still could withdraw

Question 21

What is a Barter transaction in in what way is it risky, when it comes to revenue recognition?

Answer 21

It is a non monetary arrangement, where no money switch hands, it is risky since they can inflate the value easily

Question 22

How did Enron managed to record rapidly expanding revenue by the help of commodity brokerage transactions?

Answer 22

They counted the full value of the transaction as revenue, instead of recording the results only. Hereby they recorded 101 million on a 100 mill transaction instead of the 1 “profit”.

Question 23

Which are the two techniques described in the chapter? (boosting income using one-time/unsustainable act.)

Answer 23

Boosting income using one-time events and boosting income through misleading classifications

Question 24

Large discrepancies between revenue and operating earnings growth, is a warning sign. How did IBM managed to have a 30.2 per cent growth in operating earnings on only 7.2 per cent revenue growth?

Answer 24

They included a gain from selling a business in the S&Am which boosted operating earnings.

Question 25

Describe the technique used for turning the sale of a business in to recurring revenue stream.

Answer 25

By selling it and at the same time enter into an agreement to buy back products from the sold BU, they can thus take less money to get a good future deal on the purchases.

Question 26

How did Softbank managed to increase future revenue when selling the modem rental business?

Answer 26

entered into an agreement to service the buyer in the future, they consider part of the purchase price as future revenue which could be utilised later.

Question 27

Which are the three types of financial classifications that could inflate operating (above-the-line) income?

Answer 27

1 - shifting normal open to non operating section 2 - shifting non operating or nonrecurring income to operating section 3 - using questionable management decisions regarding BS classification to help offload bad stuff or upload good stuff

Question 28

What is the most common way to shift normal operating expenses below the line?

Answer 28

one-time write-offs of costs that would normally appear in the operating section

Question 29

In what way can the recording of restructuring charges be an abuse?

Answer 29

By doing it many times, and bundling normal open in these

Question 30

Give an example of how companies can shift losses to the presentation of discontinued operations.

Answer 30

they can put nonprofitable divisions below the line and look more profitable above the line.

Question 31

In what way can consolidated subsidiaries with a minority interest produce misleadingly strong growth in revenue growth and operating earnings?

Answer 31

They will look more profitable since full revenue and expenses is included above the operating part, while the deduction is put below.

Question 32

Which are the four techniques used to shift current expenses to a later period?

Answer 32

Excessively capitalising normal opex Amortising costs too slowly Failing to write down asetts with impaired value Failing to record expenses for uncollectible receivables and devalued investments

Question 33

What are the two main categories of assets, explained in the Accounting capsule?

Answer 33

1 those that produce future benefit (inventory) | 2 tase that are ultimately expected to be exchanged for another asset (cash)

Question 34

Which are the three warning signs of improper use of capitalization?

Answer 34

- Unwarranted improvement in profit margins and a large jump in certain assets - A big unexpected decline in FCF, with an equally sizeable increase in CFFO - Unexpected increases in capex that belie the company's normal guidance and market conditions

Question 35

How did AOL managed to increase operating earnings by changing the soliciting costs for new customers?

Answer 35

They treated it as an asset, called deferred membership acquisition costs.

Question 36

Describe how the accounting of software costs can increase earnings.

Answer 36

By capitalising this development costs are understated.

Question 37

Describe how improper capitalization has an effect on operating cash flow.

Answer 37

capitalised costs are normally presented in the capex, in the investment section of the CF

Question 38

How can a change in depreciations be used to inflate earnings and how can you spot if this technique is being used?

Answer 38

BY increasing the depreciation period, the costs are reduced and earnings inflated.

Question 39

How can the allowance for doubtful accounts be used as a warning sign?

Answer 39

a sharp decline in the allowance coupled with a rise in receivables often signals that a company has failed to record enough bad debts expense and has therefore overstated profit.

Question 40

How are credit losses recognized in a bank – as they occur or in advance? What might be the problem with the approach that is used?

Answer 40

they must estimate the portion that cannot be collected, if management fail to reserva a sufficient amount, profits will be overstated.

Question 41

The first subprime mortgage company to collapse in the financial crisis was New Century Financial. In what way can the company’s account in 2006 be criticized?

Answer 41

they decreased their reserves despite having more bad loans.

Question 42

Which are the three major areas within which companies can hide expenses or losses?

Answer 42

Failing to record an expense at the appropriate amount from a current transaction Recording inappropriately low expenses by using aggressive accounting assumptions Reducing expenses by realising reserves from previous charges

Question 43

In the Accounting capsule, non-accrued loss contingencies are discussed. What is the problem and the warning sign?

Answer 43

Some obligations are not required to be put on the BS, and thus footnotes about these can be more important than existing debt

Question 44

Explain how Sunrise Medical managed to increase earnings by $1 million.

Answer 44

They paid a 1 mill lower price now in exchange of paying 1 mill too much the next year

Question 45

How did Marvell managed to escape the cost increase/earnings decrease that should have occurred in the deal with Intel (which recognised a too low gain on the transaction with Marvell and instead bought products from Marvell at too low prices, inflating Intel’s earnings).

Answer 45

The difference was recorded as a liability which could be considered a cookie jar and utilised whenever they see fit.

Question 46

Describe the problems relating to warranty reserves that were detected in Dell Computer 2003 to 2007.

Answer 46

Some liabilities were kept on the BS and not moved to the IS, and thus overstated profit.

Question 47

There are three “watch for...” areas described in the book related to pension accounting - which?

Answer 47

Changes in pension estimates and assumptions, in the measurement date, and for outsized pension income

Question 48

How did Navistar International Corp managed to reduce its pension expense and inflate income?

Answer 48

by changing the estimated life participants of the plan from 18 to 12, which created unrecognised losses over o longer period and reducing pension expense.

Question 49

In the Accounting capsule, problems with inflating liabilities is described. What is the problem?

Answer 49

When inflating the liability, the release of it will overstate profit for the period.

Question 50

How did the management in Sunbeam use restructuring reserves to inflate earnings?

Answer 50

They used many improper restructuring and other cookie jar reserves as part of the plan, when realised into income inflated profit and looked like successful restructuring

Question 51

What are the four techniques used in these accounting irregularities? (shifting income to a later period)

Answer 51

Creating reserve and releasing them into income in a later period Smoothing income by improperly accounting for derivatives Creating reserves in conjunction with an acquisition and realising them into income in a later period Recording current-period sales in a later period

Question 52

Describe how the account “deferred revenue” can be used to shifting earnings to a later period?

Answer 52

By considering it being related to the next period, it can be released at a later period when it is needed

Question 53

How did Microsoft managed to shift current revenues to future periods?

Answer 53

They delayed revenue by creating large amounts of unearned revenue, and then utilised it when they were not as scrutinised

Question 54

Which are the two techniques described in the chapter? (shifting future expenses to the current period)

Answer 54

Improperly writing off assets in the current period to avoid expenses in a future period

Question 55

How did AOL switch accounting for the “deferred subscriber acquisition costs” (described in an earlier chapter)? How did that affect earnings in the present and following quarters?

Answer 55

They did a huge write off of this, and thus escaped future expenses.

Question 56

NVIDIA took an impairment charge to write down the value of its inventory. What was the problem with the write down?

Answer 56

They overstated the write-down and thus could present higher profits the following quarters

Question 57

In the Accounting capsule, it is explained how restructuring charges can create two sets of benefits. Which?

Answer 57

Intraperiod - fewer expenses in the future | Interperiod - often classified as non-recurring and thus no effect on operating earnings

Question 58

What should investors watch out for after a restructuring period?

Answer 58

dramatic improvements in the numbers, they could infer that it was overstated

Question 59

What is a “Big Bath”?

Answer 59

When a new CEO comes in and records all expenses previous management was reluctant to, which makes it easier to present higher profit in the future.

Question 60

Which are the three cash flow shenanigans?

Answer 60

Shifting financing cash inflows to the operating section Moving operating cash outflows to other sections Boosting operating cash flow using unsustainable activities

Question 61

Which key-ratio relating to the cash flow statement and the income statement is often calculated by investors? What is the warning sign?

Answer 61

They usually test the CFFO against the net income, if there is a large difference, one should start asking questions.

Question 62

Explain what the authors mean by a “Robin Hood” trick, when it comes to the cash flow statement.

Answer 62

Stealing from the rich sections to the poor, in this case from the investment/financing part to the operating

Question 63

Which are the three techniques to shift financing cash flow to the operating section?

Answer 63

Recording bogus CFFO from normal bank borrowing Boosting CFFO by selling receivables before collection date Inflating CFFO by faking the sale of receivables

Question 64

Explain how Delphi Corporation managed to escape negative cash flow from operations (CFFO) using Bank One?

Answer 64

They sold large parts of their inventory, with the addition that they could buy it back in a few weeks, and recorded it as a sale, while it clearly was a loan.

Question 65

How did Enron managed to present a misleadingly strong CFFO by using an off- balance sheet vehicle?

Answer 65

They created such a vehicle which they helped being able to take loans, and the money from it was used to "buy" commodities from Enron which boosted revenue

Question 66

How can receivables be used to inflate CFFO?

Answer 66

They sell it before it is due, to a buyer that is interested in them, which leads to cash flow today

Question 67

What is the difference between factoring and securitizations? (inventory)

Answer 67

Factoring: The simple sale of receivables to a third party, often bank or special-purpose entity Securitization: sale to a third party, for the purpose of creating a new financial instrument by repackaging the receivables inflow

Question 68

Why was the sale of receivables in Peregrine a fake sale?

Answer 68

They transferred receivables to a bank for cash, but the risk of collection loss still remained at Peregrine, thus no transaction

Question 69

Which are the four techniques used to ship cash outflows to other sections?

Answer 69

Inflating CFFO with boomerang transactions Improperly capitalising normal operating costs Recording the purchase of inventory as an investing outflow Shifting operating cashflows off the statement of cash flows

Question 70

Explain the “boomerang scheme” in place in Global Crossing. How did it affect the CFFO?

Answer 70

They sold large blocks of future network capacity to telecom customers, and bought a similar amount of future capacity from them, the cash they received was recorded as CFFO and paid as investment.

Question 71

How did WorldCom managed to inflate the CFFO by the help of capitalization?

Answer 71

They accounted normal opex as capital equipment purchases and thus enhanced the CFFO

Question 72

How did Netflix Inc managed to improve the CFFO?

Answer 72

They considered the purchase of inventory as a capital asset

Question 73

Which are the four techniques explained in the chapter? (Inflating operating cash flow using unsustainable activities)

Answer 73

Boosting CFFO: - by paying vendors more slowly - by collecting from customers more quickly - by purchasing less inventory - with one time benefits

Question 74

How is the CFFO helped by paying vendors more slowly?

Answer 74

By postponing the payments, the cash flow generated will look higher

Question 75

What key-ratio might be helpful in spotting the CFFO being inflated by paying vendors more slowly?

Answer 75

Days of accounts payables, and the accounts payables in the BS.

Question 76

Which are the two key metrics shenanigans mentioned in the chapter?

Answer 76

Showcasing misleading metrics that overstate performance | Distorting BS metrics to avoid showing deterioration

Question 77

In the chapter three key metrics of “surrogates” for revenue are mentioned, and for three different sectors; which?

Answer 77

Cable operator - subscriber count Airline - load factor (% seats filled) Internet portal - paid clicks

Question 78

Which five surrogates for earnings are mentioned?

Answer 78

Pro forma earnings, EBITDA, non-GAAP earnings, constant-currency earnings, and organic earnings growth

Question 79

Which are the three metrics mentioned in the chapter? (Showcasing misleading metrics that overstate performance.)

Answer 79

Highlighting a misleading metric as a surrogate for: - revenue - earnings - cash flow

Question 80

Explain the phrase “same-store-sales” and how it is used?

Answer 80

It shows a more correct growth in revenue for stores if a company is in an expansion phase, for example might only include stores open for at least one year

Question 81

What is ARPU and give an example of how it can be defined differently among companies?

Answer 81

Average revenue per user - differed between two radio station, one only included revenue while one included marketing costs and similar.

Question 82

What is “churn” and how is it used, and normally in which companies?

Answer 82

The level of cancellation=churn, it can be used to assess if the growth is good in a subscription based company.

Question 83

What is the difference between “bookings” and “book-to-bill”?

Answer 83

Bookings - amount of new business booked during the period | Book-to-bill - compares current period bookings to current period revenue (bookings/rev)

Question 84

What are the problems with “bookings”, “backlog” and similar key metrics?

Answer 84

they are non-GAAP and thus companies have a lot of ways to tamper with them, need to understand the measures before trusting them.

Question 85

Explain how Sabre Corporation managed to inflate EBITDA by the help of its up-front payments?

Answer 85

They excluded this, since they considered it to be relevant for many years and thus amortised, but hard to understand since they paid monthly.

Question 86

Why is not “EBITDA” the same as cash flow?

Answer 86

It excludes changes in WC, and includes other non-cash flow items (than A/D).

Question 87

Which are the four techniques mentioned in the chapter? ( Distorting balance sheet metrics to avoid showing deterioration.)

Answer 87

Distorting: - accounts receivable metrics to hide revenue problems - inventory metrics to hide profitability problems - financial asset metrics to hide impairment problems - debt metrics to hide liquidity problems

Question 88

Explain how selling accounts receivables can distort the warning sign the increase in day’s sales outstanding (DSO) creates.

Answer 88

It lowers DSO, and looks like the company is getting paid faster, if DSO decrease and CFFO increase, be careful

Question 89

Explain why investors generally view an increase in inventory as something negative?

Answer 89

They view this as a sign of upcoming margin pressure (markdowns or write-offs) or falling product demand.

Question 90

What was the problem with the inventory in Symbol Technologies, relating to return rights?

Answer 90

Many customers returned their products, which drastically increased the inventory, they tried to reduce this problem by selling part of inventory and then repurchasing as well as not accounting it as inventory.

Question 91

How did New Century Financial Corp managed to disguise a reduction in its loan loss reserve in 2006?

Answer 91

They did not present it on a stand-alone basis as they had done before, but rather grouped it with another reserve, which made it same as if the reserve had increased.

Question 92

Which are the three reasons acquisitions often fail to live up to expectations?

Answer 92

- Widespread overconfidence in the magic of synergies - Reckless transactions motivated by intense fear or greed - Deals driven by artificial accounting and reporting benefits rather than business logic

Question 93

In chapter 15 (Releasing deal related reserves...) “earn-outs” and “contingent consideration liability” is referred to. Explain what it is and how the two are related.

Answer 93

Earn-out - if the acq company achieves certain targets, have to pay more Contingent consideration liability - reserve for this

Question 94

What happens with the two factors in b) if the acquired business performs below expectations?

Answer 94

If one has to pay a lower fee, it will be realised as income on the income statement, and henceforth might be risky and companies will be reluctant to make a smaller liability

Question 95

Which are the three techniques, described in chapter 16, related to acquisitions, in artificially boost cash flow from operations?

Answer 95

- Inheriting operating inflows in normal business acquisition - Acquiring contracts or customers rather than developing them internally - Bosting CFFO by creatively structuring the sale of a business

Question 96

Chapter 16 an example is presented. If a company expands by selling more products and increase sales, the CFFO is immediately affected negatively because it increases inventory and customer receivables. Explain why an acquisition of a company do not have the same effect on CFFO.

Answer 96

Since when you buy a new company it will affect the investing part of the CF, while it will have a positive effect on the CFFO through the revenues in te acquired company

Question 97

In chapter 17 (Determining representative sales growth...) the use of “pro forma” accounting is discussed. How may it be used in an acquisition?

Answer 97

this divides the company to two entities instead of one, which might make it easier to analyse

Question 98

In chapter 17, the company Affiliated Computer Systems (ACS) defined organic growth as “internal growth”. What was the difference, compared to the most common definition?

Answer 98

they just took their revenue and deducted a fixed amount based on the previous years sales of the acquired company, thus any large deals attained before acquisitions could be counted for as organic growth.