CFA Level 1

Reference: Standards of Practice Handbook U. 10th ed.: CFA Institute, 2010

Investopedia

RED FLAGS

Introduction

We conclude our discussion on financial statements with a brief yet important chapter on red flags. Although companies
are required to follow generally accepted accounting principles (GAAP), some companies find loopholes and ways to
manipulate their numbers. Part of the SOX concept is to have those who create and sign off on financial statements be
held responsible for misrepresentation.

These items are crucial for analysts to recognize in order to avoid recommending poor investments to their clients. Prime
examples from the last decade were some bad apples like Enron and Worldcom.

The following articles are great resources on spotting the signs of earnings manipulation, learning telltale signs of
corporate misdeeds, and how off-balance sheet entities can be misleading:

A. Managerial Discretion

Under U.S. GAAP, a company's management is given some discretion as to the timing and classification of certain items.
Unfortunately, a company's management can use this allotted discretion to manipulate reported earnings.

Types of Earnings Manipulation

1. Classification of good news/bad news – Since analysts and investors tend to focus on income from continuing
operations, a reporting company will tend to include good news in this category and keep bad news out (report it below
the net-income-from-operations line). If a company sells a subsidiary for a gain, it will most likely be included in the net
income from continuing operations. If the company sells the subsidiary for a loss, the company will most likely want to
classify it as a discontinued operation (extraordinary or unusual or infrequent event) and report the loss below the line.

2. Income Smoothing – Companies go through cycles of good years and bad years. During the good years, some companies
will create accounting reserves so when they are no longer doing well, they can increase their net income and effectively
smooth out their reported net income over time. Income smoothing can be classified as one of two types:

a. Inter-temporal smoothing takes place when a company alters the timing of expenditures or chooses an
accounting method that smoothes out earnings. One example is choosing to capitalize or expense R&D
expenditures.

b. Classification smoothing occurs when a company chooses the category of an item based on the reporting
implication it will have (i.e. it will be above or below the net-income-from-continuing-operations line). An example
is the selling of a subsidiary or asset as if it were a gain or loss from continuing operations or not.

3. Big-Bath Behavior - This often takes place when a company is having what they think their investors will interpret as a
really bad year and their previous income reserves are not enough to offset the bad results they are about to report.
Management knows that its stock will drop because of this news, and investors will not be happy. As a result, management
figures that it is the best time to get rid of all of the inconsistencies that will have a negative impact on the financial
statements (impairment of assets etc.). This will create two benefits for a company: first, most of the bad news will be
reported below the line, and second, in the future the company will appear to be more profitable than in the past.

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4. Accounting Changes – A company can change its accounting methods, such as change its inventory-accounting
methodology (LIFO to FIFO), capitalize instead of expense decisions and change its depreciation methodology. Since
accounting changes are accounted for below the line (net income from operations), they can be used to manipulate the
reported income from continuing operations.

B. Shenanigans

Shenanigan Strategies

Financial shenanigans are actions or omissions (tricks) intended to hide or distort the real financial performance or
financial condition of an entity. They range from minor deceptions to more serious misapplications of accounting
principles

There are two basic strategies underlying accounting shenanigans:

 Inflating current reported income - A company can inflate its current income by inflating current revenues and
gains, or deflating current expenses.
 Deflating current reported income - A company can deflate current income by deflating current revenues or gains,
or inflating current expenses.

Shenanigans aimed at inflating current reported income are considered more serious, because they make the company
look much better than it is. Furthermore, over time, the inflation of current income will most likely be discovered in the
future and will make the company stock plummet. On the other hand, deflating current reported income will only serve
as an income-smoothing mechanism and will not have as serious of an impact on common shareholders.

Methods of Inflating or Deflating Income

Stretching out payables:

 This is one of the easiest methods to inflate income while reducing costs and one of the most difficult to spot.
 Basically the company picks and chooses some or all of its payables and instead of recording them in the current
period they extend the payables to a future period.

Financing of payables:
 Similar to stretching out payables, a company may choose to finance a portion of their payables so they can record
the smaller interest expense instead of the principle amount of the payable as an expense.

Securitization of receivables:
 Just like the decision to securitize a leasing agreement, a company may attempt to securitize their receivables
with similar effects.
 Instead of recognizing the receivables when they should be reported, securitizing them will give the company the
ability to manipulate their reported earnings though an amortization schedule that will have lower interest costs
in the earlier years.

Using stock buybacks to offset dilution of earnings:

 While many investors may welcome a company's decision to buyback shares, others may not.
 The immediate effects of a share buyback is to reduce the dilution of earnings by reducing the number of shares
outstanding.
 This allows the company to report future earnings in relation to less shares outstanding with multiple positive
looking effects; higher reported EPS, potentially lowering a company's p/e ratio (among other ratios) and
potentially increasing the company's share price.
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Other Shenanigans for investors to look out for:

Recording revenues prematurely and/or of questionable quality, such as:

 Recording revenues when a substantial portion of the service has not been delivered
 Recording revenues of unshipped items
 Recording revenues of items that have not yet been accepted by the client
 Recording revenues of items for which the client has no obligation to pay (consignment)
 Recording sales that were made to an affiliate

Recording fictional revenues:

 Recording sales for no reason

 Misclassifying income from investments as revenue
 Recording the cash received from a lending transaction as revenue
 Recording supplier rebates as revenues

Creating special transactions or one-time transactions to generate a gain, such as:

 Selling undervalued assets for a profit

 Selling investments for a gain and recording it as revenue, or using it to reduce current operating expenses
 Reclassifying certain balance sheet accounts to create income
 Failure to record unearned revenues (customer prepayments) and recording these amounts as revenues

Deferring current revenues to a future period, such as:

 Refraining from recording revenues before a merger or acquisition

 Increasing allowance for bad debt
 Increasing other reserves such as warranties and returns

Recognizing future expenses in current expenses as a special one-time charge, such as:

 Inflating one-time charges

 Increasing expenses such as R&D, advertising, etc.
 Recognizing expenses that will continue to provide the company with a future economic benefit, such advertising,
R&D and maintenance expenses, among others.

Aggressive Accounting Policies

 Increasing the useful life of an asset beyond its estimated useful life
 Using FIFO versus average cost or LIFO
 Accruing losses associated with contingencies
 Capitalizing all software development and R&D costs, or aggressively capitalizing any costs
 Amortizing costs slowly thus reducing recognized expenses
 Recording investment income as revenue
 Not accounting for or allocating a small amount for returns, warranties, allowance for bad debt and allowance for
doubtful accounts

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Describe the accounting warning signs related to the Enron accounting scandal.

 Extensive use of off-balance-sheet financing (joint ventures, improperly classifying leases and take-or-pay and
throughput contracts).
 Purposely providing non-transparent financial statements.
 Use of a "merchant model" of recording trading revenues where instead of the reporting the trading fees as
income they chose to record the entire trade as income not accounting for the corresponding cost of the asset
being traded.
 A wide scale cooperation: while many of the leading levels of management claimed to have no knowledge of less
than honest accounting practices, the final outcomes proved that this could not have been undertaken by just one
person.
 Presenting inflated assets and undervalued liabilities by taking some to "off balance sheet" methods. They then
chose to provide little or no information as to the actual values of these projects which were typically in the form
of limited partnerships with little footnoting.
 Marking to market valuing their long-term contracts: Instead of using the more conservative matching principles
or recording revenue with costs, they chose to aggressively value the present value of long-term contracts as
revenue in the current reporting periods allowing them to show what was perceived as phenomenal growth.
 Misaligning compensation: while it is common for companies to tie part of employee's compensation to the
profitability of the company and reward them with stock, Enron chose to make this a much bigger part of their
comp plan. In this case, so much emphasis was placed on the stock's performance that some employees were
driven to inflate the stock at any cost.

In contrast to aggressive accounting policies and lessons learned from Enron, here are some more conservative accounting
policies that would more accurately affect both the financial condition of a company and the quality of their earnings.

 Rapid write-off of fixed assets (DDM)

 Using a conservative estimate of assets useful lives
 Minimal capitalization of software and startup costs
 Adequate provision for contingent liabilities
 Impaired assets written off quickly
 The use of completed-contract method for long-term projects
 Little use of off-balance-sheet financing
 Net income closely resembles cash flow from operations
 Adequate reserves allocated to returns, warranties, allowance for bad debt and allowance for doubtful accounts

C. What Causes Shenanigans And Manipulation?

Under GAAP a company's management has many options from which to choose to record certain economic events. These
options are called "accounting rules" and, when used are referred to as "accounting events." Because the various choices
will have differing effects on reported earnings management has the opportunity to manipulate its financial results.

 Incentives and pressures: when compensation is heavily tied to the overall company's performance and the
escalation of the stock price, pressure can be created to increase those incentives

 Opportunities: While it may be instinctual, if the opportunity presents itself, those with less than ethical practices
may steer toward taking them if they feel they will not get caught or the effects on the company will be minimal

 Attitudes and rationalizations: this is often considered to come from the top down, but it can be engrained in a
company's culture for long periods of time. Those who follow the lead of senior management can easily rationalize
their improper behavior with the justification that the attitudes of their superiors are the same way.

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The implementation of SOX in 2002 was prompted by the wide spread abuse that was occurring in the reporting and
financial markets. Whether or not it has proven successful remains to be seen. Sarbanes-Oxley Act Of 2002 – SOX

Even with more strict regulations, the incentive to cook the books remains because it pays to do so. ,In the right hands it
can be relatively easy. Shenanigans and manipulation are often unearthed, but it sometimes does not occur until well
after the fact. A good example of this is when companies go back and restate earnings for prior periods once their less
than proper accounting decisions are uncovered.

Other Motives Behind Financial Shenanigans

Another aim of financial shenanigans is to improve liquidity. By inflating revenues or hiding debt, companies can obtain
funding with lower borrowing costs and fewer restrictive financial covenants when they issue bonds; they may also get
preferred lower rates from financial institutions for short- and long-term loans, and if they are able to issue private
placement debt the unsuspecting investors should make due diligence a priority.

D. Finding Shenanigans

The first place to start to investigate red flags or shenanigans is the company's reported income statement, balance sheet
and statement of cash flows and changes in owners' equity. Some red flags to be aware of are the following:

 Large swings year-over-year, signifying some sort of event of change in accounting methods.
 Any ambiguities noticed in reporting functions that look out of place.
 A change in auditors, especially if the previous auditor was on board for an extended period of time.
 An increase in footnotes or a combination of all the above.

Keep in mind that while these changes may not signify manipulation, these anomalies need to be adjusted when
comparing one company to another.

Besides reported financial results from the company, here are other sources used to investigate potential red flags and
shenanigans.

 Press releases
Press releases can provide an analyst with useful information. That said, they must be used and analyzed diligently.

 Securities Exchange Commission filings

Securities filings are forms such as the Form 10-K (annual), 10-Q (quarterly), 8-K (special events) and 144
(corporate insider activity), and annual reports, proxy statements and registration statements.

Armed with these documents analysts should look in:

The Auditor's Report

Red flags include:
Inclusion of a qualified opinion.
No audit committee, or audit committee comprises mostly of related parties.

Proxy Statement
Red flags include:
Pending lawsuits or other contingent liabilities, special compensation plans or perks for officers and directors
Off-balance-sheet transactions.

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 Footnotes to Financial Statements
Red flags include:
Abnormalities found in the accounting-policy descriptions and unbilled receivables.
Off-balance-sheet transactions.
Changes in accounting principles and estimations.

Management Discussion and Analysis (MD&A)

Red flags include:
Large planned expenses.
Decreased liquidity.
Abnormal need for working capital.

Form 8-K
This will provide information on:
The company's acquisition and divestitures.
Change in auditor – If a company changes auditors, it could be because the previous auditor did not want to sign
off on the financial statements.

Form 144
Red flags include:
Insiders selling a large portion of their holdings.

 Interviews with the Company

Company interviews are also a good way to get close and personal with a company's management and ask some
more targeted questions. Individual investors typically do not take this extra step unless they own a significant
amount of stocks. They instead rely on analysts' reports and opinions where it should be verified that the analyst
has met with the company and preferably visited the company on site.

 Commercial Databases
Analysts can also make use of commercial databases such as LexisNexis and Compustat to screen for companies
displaying potential warning signs of operating and accounting problems.