Financial Shenanigans EM

8/18/2019 Financial Shenanigans EM

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Financial Shenanigans- Earnings Manipulation Shenanigans

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Objective of the Session

• To learn the techniques of Accountinganalysis

• To learn to mae a!justments to the

reporte! numbers to see the trueeconomic reality

• "n!erstan!ing Earning Management

from t#o perspectives – Aggressive accounting practice follo#e!

by the company that fall #ithin $n!ian%AA&

– Frau!ulent accounting practice that violate'


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&urpose of Accounting Analysis

• To evaluate the !egree to #hich the (rms)accounting captures its un!erlying business reality

• To i!entify areas #here managers can e*erciseaccounting +e*ibility

• $!entify re! +ags an! investigate it !eeper, Mayreveal earnings management techniques EMS.applie! by the management

• Assess reasonableness an! appropriateness of the

Firm)s accounting policies an! estimates• "n!o !istortions in reporte! numbers to the e*tent

possible an! to improve the reliability of theconclusions !ra#n from Financial statement analysis

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FS0Financial Misrepresentations

• Financial shenanigans are actionstaen by management that mislea!about a company)s (nancialperformance or economic health – $nvestors0len!ers0regulators are often

trice! into believing that a company)s

earnings are stronger its cash +o#smore robust an! its 2alance Sheetposition more secure than are really thecase

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Earning Manipulation ShenanigansEMS.

• All of the earnings manipulation trics are!ivi!e! into t#o major subgroups – Infating current-period earnings - $n or!er to

in+ate current-perio! earnings managementeither push more revenue or gains into thecurrent perio! or shift e*penses to a later one

– Infating uture-period earnings - To in+ate

tomorro#)s income management #oul!simply hol! bac to!ay)s revenue or gains an!accelerate tomorro#)s e*penses or losses intothe current perio!

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5hy Earnings Manipulation•

6igher reporte! revenue0pro(ts lea!s to – 6igher stoc price an! goo! image for the company

– 6igher e*ecutive compensation #hen compensations are line! toperformance #hich is measure! in terms of pro(tability

– To appear as a much larger company than its economic reality si7ematters88.

– To comply #ith (nancial !ebt covenants

– To avoi! the hostile taeover by competitors

• Shifting revenue to future perio! is usually resorte! to – to smooth out volatile earnings in or!er to portray a more stea!y

business

– To re!uce ta* payments for the current perio!

– 5hen facing "nion contract negotiations companies resort to lo#erpro(tability reporting

– 9evenue0pro(ts can be recor!e! in later perio! or cost push toearlier perio! to hi!e any major slump0!o#nfall observe! in the

revenue0pro(ts :


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9evenue recognition - %AA&

• AS-; 9evenue recognition gui!elinesun!er follo#ing events – Sale of goo!s

– 9en!ering of services

– "se by others of entity assets yiel!inginterest royalties an! !ivi!en!s

• AS-< =onstruction contracts

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Earning ManipulationShenanigans

• EM Shenanigan >o, 1? 9ecor!ing revenue too soon

• EM Shenanigan >o, '? 9ecor!ing bogus revenue

• EM Shenanigan >o, /? 2oosting income using one-timeor unsustainable activities #ithout proper !isclosure.

• EM Shenanigan >o, 3? Shifting current e*penses to alater perio!

• EM Shenanigan >o, 4? Employing other techniques tohi!e e*penses or losses

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EM Shenanigan >o, :? Shifting current income to a laterperio!

• EM Shenanigan >o,


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EMS-1 9ecor!ing 9evenue Too Soon

• Techniques to record revenues to soon

– 9ecor!ing revenue before completing anyobligations un!er the contract

– "p-front revenue recognition on long-termcontracts

– "se of aggressive assumptions on long-termleases or percentage-of-completion accounting

– 9ecor!ing revenue before the buyer)s (nalacceptance of the pro!uct in case of project

(nance infrastructure projects. if revenuerealisation is base! on quality chec by thecustomer one shoul! chec the actual certi(cateof acceptance from the buyer.

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EMS-1 –

=hannel stuBng C pushing sales up by stuBng the !istributors#ith goo!s even #hen there are no real or!ers =ase- Sunbeampg :' Dbill an! hol! transactions.

• "n!erstan! that some in!ustries follo# Sell-in recor!ing scheme i,e,recor!s revenue #hen goo!s are shippe! to !istributors as against sell-through in #hich revenue is recor!e! #hen goo!s are sol! by the!istributor to (nal consumer, Sell-in is consi!ere! aggressive accountingcompare! to

– 9ecor!ing revenue at the point of shipment

• 9ecor!ing revenue upon shipment to someone other than thecustomer i,e, to a consignee or sales agent, 9evenue shoul!not be recogni7e! until sales agent consummate a transaction

#ith an en! customer – 9ecor!ing revenue #hen the buyer)s payment remains uncertain

or lacs ability to pay

• $f the !ebtor is unable to pay for the cre!it sales ma!e to hima!equate provision for ba! an! !oubtful !ebts shoul! be ma!e

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=ases C EM-1

• =omputer Associates C &g 41 - "p-front recognition of a long-termlicense contract

• Hero* C pg 4< - 9ecor!ing 9evenuefrom Assets Iease! to =ustomers Cplaying #ith the !iscount rate

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EMS-' 9ecor!ing 2ogus9evenues

• 9ecor!ing revenue from transactions that laceconomic substance case C &eregrine Systems pg


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EMS-/ 2oosting $ncome "sing One- Time or "nsustainable Activities• 2oosting income using one-time events

– 9ecor!ing income from sale of business segment inappropriatelyas a re!uction from e*penses accounting for !iscontinue!operations- AS '3.

– =ase C $2M $2M booe! a "SL 3,G4< billion gain from selling its

%lobal >et#or business to ATT an! curiously inclu!e! that gainas a re!uction in the S%A e*pense pg C ;4.

• 2oosting income through mislea!ing classi(cations – =lassify one-time gain by #ay of re!uction of e*pense or as a part of

other income

– 9ecor!ing interest income or gain on sale of asset as revenue an! putit un!er the hea! other income >o !isclosures8.

– Some companies constantly recor! restructuring charges one-oNitems. virtually every year thus masing normal operating e*pensesin to these charges belo# the line e*penses. an! unethically boost

the operating pro(ts 1/


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EMS-/ 2oosting $ncome "sing One- Time or "nsustainable Activities

– =lassi(cation of investment on balance sheet to boostoperating income

• $f a company hol!s 'G or more of the equity sharecapital of other company it is !eeme! that the

company E*ercises Signi(cant $n+uence over theother company unless it can be clearlydemonstrated that this is not the case – Thisclause provides management with an optionwhether to account for the associate usingequity method or treat it as investment availablefor sale

• Case – Oracle and its associate Liberate (OracleChanges Its Accounting for a truggling A!liate– "age #$% and #$&'

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Indicators of EM• 9eporte! sales gro#th far e*cee!s the normal pattern "se peer

comparison technique to un!erstan! #hether it is a legitimate increase.

– Are the e*planations given by the client un!erpinne! by !ata an! support #hichevi!ences a competitive a!vantageP

• 9eceivables especially long-term an! unbille!. gro#ing faster than sales

• Lays Sales Outstan!ing receivable hol!ing perio!. increasing!ramatically

• $n cases of channel stuBng companies have entere! into promissory

note contracts #ith their !ebtors an! have manage! to shift the !ebtorbalances to >otes receivables, Thereby achieving the re!uction in LSO,>otes receivable balances shoul! be investigate!

• =ash +o# from operations lagging far behin! net income in!icatespremature revenue recognition

• Accelerating sales by changing the revenue recognition policy

• $nappropriate use of bill-an!-hol! accounting case C Sunbeam.

• =hanges in revenue recognition assumptions or liberali7ing customercollection terms, This overly generous terms may eNectively shift salesthat originally #ere slate! for future perio!s into the current one

• Frequent restatement of numbers C Follo# quarter-on-quarter (gures

closely an! investigate the changes if foun! to be material 14

Ch k f EM


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Checks for EM• Au!itor)s report giving quali(e! opinion on change in

revenue recognition policy or uncollectible receivables or

!iscrepancies highlighte! by the stoc au!it report• >on accounting for cre!it notes issue! !uring the perio! or

booing them as purchases correct entry C Sales return A0cC Lr, To Lebtor a0c return of goo!s from customer.misleading entry C &urchase A0c CLr, To Lebtor A0c #rong

!ebit to purchase a0c.• Surprise visit by the ban oBcials for investigation taing

stoc at least of major stoc items

• As for Ta* returns (le! #ith $T !epartment, At times this

may reveal !iNerences in statements (le! #ith the ban• Stu!y the statement of boo !ebts submitte! major

customers an! amounts outstan!ing chec bulgingreceivables as if any e*ten!e! payment terms allo#e! toa particular party an! reasons thereof

• 9eference checs 1:


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9esources

• Financial Shenanigans by 6o#ar! M, Schilit an! Jeremy &erler

• Accounting Stan!ar!s issue! by $=A$

•

9esearch papers from Journal of Accounting• The Serious Frau! $nvestigation OBce S$FO.

• http?00###,#atchoutinvestors,com - Site forme!by Ministry of =orporate ANairs %overnment of

$n!ia $nvestor protection an! e!ucation fun!an! SE2$

• http?00###,#atchoutinvestors,com0compin!e*,aspP(n!#or!QA

C list of companies allege! on !iNerent groun!s1

Financial Shenanigans EM

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