Financial Shenanigans, Fourth Edition

1. Financial shenanigans distort reality and mislead investors

Above all, do no harm.

Deceptive practices abound. Companies employ various accounting tricks to present a rosier picture of their financial health and performance. These shenanigans range from aggressive interpretations of accounting rules to outright fraud. Common tactics include prematurely recognizing revenue, understating expenses, manipulating cash flow statements, and abusing non-GAAP metrics.

Motivations drive deception. Executives face intense pressure to meet Wall Street expectations and boost stock prices. This pressure, combined with misaligned incentives like stock-based compensation, can lead to unethical behavior. In some cases, a culture of deception becomes ingrained in a company's DNA, perpetuating the use of shenanigans across multiple reporting periods.

Investors bear the cost. When shenanigans are eventually exposed, the consequences can be severe. Stock prices plummet, reputations are destroyed, and in extreme cases, companies collapse entirely. High-profile failures like Enron, WorldCom, and more recently, Valeant Pharmaceuticals, serve as cautionary tales of the damage wrought by financial deception.

2. Revenue manipulation tricks inflate top-line performance

Did consumers really want to buy socks and stocks under the same roof?

Premature recognition is common. Companies often record revenue before it's truly earned, such as booking sales for undelivered products or recognizing long-term contract revenue upfront. Channel stuffing – pushing excess inventory to distributors – artificially inflates current period sales at the expense of future periods.

Fictitious revenue creation. In more egregious cases, companies manufacture fake sales through various schemes:

• Recording revenue on non-binding agreements
• Engaging in "round-trip" transactions with no economic substance
• Misclassifying loan proceeds or investment income as revenue

Manipulating key metrics. Companies may distort revenue-related metrics to paint a more favorable picture:

• Changing the definition of "same-store sales" to include non-comparable data
• Altering calculations for metrics like average revenue per user (ARPU)
• Presenting misleading "organic growth" figures that include acquisition-related revenue

3. Expense manipulation tactics artificially boost profits

The sun will come out tomorrow.

Delaying expense recognition. Companies push costs into future periods through various means:

• Aggressively capitalizing normal operating expenses
• Extending depreciation schedules for assets
• Failing to write down impaired assets or uncollectible receivables

Creating and releasing reserves. "Cookie jar" reserves allow companies to smooth earnings:

• Taking large restructuring charges that can be released later
• Over-accruing for liabilities, then reversing the excess
• Manipulating inventory reserves or loan loss provisions

Misclassifying expenses. Shifting costs to different parts of the financial statements can improve perceived profitability:

• Moving normal operating expenses to the "non-recurring" category
• Burying costs in acquisition-related charges
• Classifying overhead costs as part of inventory to delay recognition

4. Cash flow shenanigans mask true operational health

Did we mention the word "chutzpah" before?

Operating vs. investing classification abuse. Companies exploit the Statement of Cash Flows structure:

• Classifying normal operating costs (like customer acquisition) as investing outflows
• Recording proceeds from asset sales as operating inflows
• Manipulating working capital to boost operating cash flow

Acquisition-related distortions. M&A activity creates opportunities to inflate operating cash flow:

• Inheriting acquired company's receivables collections without the associated cash outflows
• Structuring deals to retain high-cash-generating assets while divesting cash-consuming ones
• Using "acquisition accounting" to bury normal operating costs in purchase price allocation

Unsustainable cash flow boosts. Companies employ short-term tactics that sacrifice future performance:

• Aggressively collecting receivables or delaying payables
• Selling receivables (factoring) to accelerate cash inflows
• Reducing inventory levels below sustainable amounts

5. Acquisition accounting creates opportunities for deception

More value is destroyed by acquisitions than any other single action taken by companies.

Deal structures hide problems. Acquisitive companies can use M&A to obscure underlying issues:

• Using purchase accounting to write off ongoing expenses
• Creating inflated goodwill that can be gradually written down
• Burying underperforming assets within larger acquisitions

Manipulating post-acquisition metrics. Companies exploit the complexities of combining businesses:

• Presenting misleading "pro forma" or "organic" growth figures
• Changing accounting policies of acquired companies to boost reported performance
• Using acquisition-related charges to hide normal operating expenses

Serial acquirers raise red flags. Frequent M&A activity should heighten investor scrutiny:

• Unsustainable "rollup" strategies that mask weak organic growth
• Increasing reliance on acquisition accounting benefits to meet targets
• Deteriorating free cash flow despite reported earnings growth

6. Non-GAAP metrics can be misleading without context

Warren Buffett has long poked fun at management teams that create dishonest pro forma metrics.

Customized metrics lack standardization. Companies create bespoke financial measures:

• "Adjusted EBITDA" that excludes real, recurring costs
• "Cash earnings" that ignore important non-cash expenses
• Constantly changing definitions of key performance indicators

Reconciliation is crucial. Investors must understand the bridge between GAAP and non-GAAP figures:

• Large, persistent differences between GAAP and adjusted metrics are concerning
• Watch for exclusions of normal, recurring operating expenses
• Be wary of metrics that always paint a rosier picture than GAAP

Industry-specific measures require scrutiny. Sector-wide non-GAAP metrics can be misleading:

• REITs' "funds from operations" may ignore real estate depreciation
• SaaS companies' "customer acquisition costs" calculations vary widely
• E-commerce firms' definitions of "active users" or "gross merchandise value" lack consistency

7. Red flags and warning signs precede financial unraveling

When first signs point to accounting problems, don't take management's assurances at face value.

Divergences raise alarms. Look for disconnects between different financial statements and metrics:

• Revenue growth outpacing cash collection
• Earnings increases despite deteriorating margins
• Working capital ratios moving in unexpected directions

Sudden changes warrant investigation. Abrupt shifts in accounting policies or management practices are concerning:

• Switching auditors, especially outside the normal rotation cycle
• Altering revenue recognition policies
• Unexplained departures of key executives, particularly in finance roles

Disclosure quality matters. Pay attention to how companies communicate:

• Increasing complexity or opacity in financial statement footnotes
• Shifting focus to obscure or constantly changing non-GAAP metrics
• Delays in filing required reports or announcing restatements

8. A forensic mindset is crucial for detecting shenanigans

Just as the Sheriff of Nottingham could not prevent Robin Hood from stealing from the rich and giving to the poor, the current accounting rules often seem inadequate to prevent companies from engaging in such cash flow shenanigans.

Skepticism is fundamental. Question management's narrative and dig deeper:

• Analyze trends over multiple periods, not just year-over-year changes
• Compare a company's practices to industry peers and historical norms
• Look beyond headline numbers to understand the underlying drivers

Context is key. Understand the broader picture surrounding financial reports:

• Consider management incentives and corporate culture
• Evaluate industry dynamics and competitive pressures
• Assess macroeconomic factors that could influence performance

Continuous learning is essential. Stay informed about evolving shenanigans:

• Study past accounting scandals and frauds
• Keep up with changes in accounting standards and regulatory focus
• Develop a network of professionals to share insights and best practices

Last updated: October 24, 2024