Incentives to Manipulate Earnings =
Overstate net income: meet earnings expectations, remain in compliance with lending covenants, higher incentive compensation
Understate net income: obtain trade relief (quotas, protective tariffs), favourable terms from creditors, favourable labor union contracts
Managing BS: manipulate appearance of solvency (less or more through adjusting assets/liabilities), performance ratios (lower assets = higher ROA, asset turnover)
Low Quality Earnings =
firm exploits GAAP to 'meet the spirit, not the letter' of the standards - earnings quality usually deteriorates. Activities:
- Selecting acceptable accounting principles that misrepresent a transaction
- Structuring transactions to achieve a specific outcome
- Using aggressive or unrealistic estimates and assumptions
- Exploiting the intent of an accounting principle
3 Conditions for Fraud =
SAS #99, by AICPA
Opportunity (weakness in internal controls), Incentives & Pressure, Attitudes/Rationalization
Incentives and Pressures (x4) =
Threats to financial stability or profitability (as a result of economic, industry, or firm conditions)
Excessive third party pressures on management
Personal net worth of management or the BOD is threatened
Excessive pressure on management or operating personnel to meet internal financial goals
Opportunities for Fraud (x4) =
The nature of the firm's industry or operations involve: grey areas around transactions, auditing, terms and conditions, estimates, overseas transactions/bank accounts/related parties
Ineffective manageent monitoring from: ineffective oversight by BOD/audit committee, single person/group dominates management.
Complex/unstable organizational structure (including unusual legal entities/authority lines, high turnover)
Deficient internal controls (ineffective systems, high turnover of relevant personnel)
Attitudes and Rationalizations (x9) =
inappropriate ethical standards
Excessive infuence of nonfinancial management in the selection of accounting standards/estimates
History of being a badass (BOD/mgmt)
Mgmt obsession with increasing stock price
Making commitments to third parties to achieve agressive results
Failing to correct known reportable conditions in a timely manner
inappropriately minimizing earnings for tax purposes
Mmgt's use of MATERIALITY to justify questionable accounting methods
Strained rship between management and auditors
Agressive revenue recognition =
recognizing revenue too soon.
- bill-and-hold arrangements - RR before goods are shipped
- Sales-type leases whereby the lessor recognizes sale/profit at the start of the lease
- RR before fulfilling all terms of sale
- RR from swaps/barter transactions from third party
Different growth rates of OCF and earnings =
relationship should be STABLE.
Growing earnings and negative/declining OCF may show RR too soon or delayed expense recognition.
Rship can be measured with CASH FLOW EARNINGS INDEX (OCF/Net Income) - consistently less than 1 or declining over time is fuckin suspicious.
Abnormal sales growth =
compared to peers, industry, economy.
may be from superior management or products, or accounting irregularities.
Receivables growing faster than sales, indicated by an increasing average collection period, may be a sign of agressive revenue recognition.
Abnormal Inventory growth (compared to sales growth) =
may indicate obselete products or poor inventory management, or overstating inventory, decreasing COGS and thus increasing increasing gross and net profit.
note: ending inventory = starting inventory + purchases - COGS
So if it is too high either purchases are overstated or COGS is understated
Boosting Rev w/ non operating income and nonrecurring gains =
some firms try and classify these as revenue - moving them 'up' the income statement.
net income is the same BUT revenue growth is higher
Delaying expense recognition =
by capitalizing operating expenditures the firm delays expense recognition.
Increase in assets with unusual names like 'deferred marketing charges' or 'deferred customer acquisition costs'
*Abnormal use of leases by lessees =
can be used to reduce ratios and reduce perceived leverage (through off balance operating leases)
compare use of leasing as a financing source to industry peers - consider treating operating leases as capital leases.
Hiding Expenses by classifying them as extraordinary or non recurring =
this moves expenses down the balance sheet - boosting income from continuing operations.
LIFO Liquidations =
If a LIFO firm sells more inventory than it purchases when prices are rising = COGS decreases, profit increases, taxes increase.
These profits are not sustainable as the firm will RUN OUT OF INVENTORY
LIFO Reserve : difference in inv. between FIFO and LIFO - if declining this signals Lifo Liquidation.
This must be disclosed by LIFO firms, and should disclose the effects of liquidation in footnotes.
Abnormal gross margin/operating margin compared to industry peers =
could be from superior management and cost controls.
OR accounting irregularities: how conservative is the firm? What principles are disclosed in the footnotes?
Extending the useful lives of LT Assets =
Depreciating or amortizing cost of an asset of more periods results in higher reported earnings
Compare to peers.
Agressive Pension Assumptions -
high discount rates, low compensation growth rates, high expected rate of return on pension assets.
Will lead to lower pension expense and higher reported earnings.
Compare with industry peers.
Year end surprises =
Higher earnings in the fourth quarter that cannot be explained by seasonality may be from manipulation.
*Equity method investments and off balance sheet special purpose entities -
Equity method investments are not consolidated.
Pro-rata share of investee's earnings are included in net income.
Watch for frequent use of non consolidated special purpose entities.
Other off-balance sheet financing arrangements including debt guarantees =
Firms must disclose these arrangements in the financial statement footnotes.
For analytical purposes consider increasing balance sheet liabilities for these arrangements.