Catch the trend! Its all about analyzing,interpreting and evaluating (Part-1)

Financial Shenanigans to be traced over the years (Part-1)

Link for Part-2:https://myweekendspot.blogspot.com/2020/01/checklist-to-understand-recording-of.html

Link for Part-3:https://myweekendspot.blogspot.com/2020/01/understanding-details-of-cashflow.html

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While most companies act ethically and follow prescribed accounting rules when reporting their financial performance, some take advantage of gray areas in the rules (or worse, ignore the rules altogether) in order to portray their financial results in a misleadingly positive way. Management’s desire to put a positive spin on financial results has been around as long as corporations and investors themselves. Dishonest companies have long used these tricks to prey on unsuspecting investors, and it is unlikely that they will ever cease to do so.

The lure of accounting gimmickry is particularly strong at companies that are struggling to keep up with their investors’ expectations or their competitors’ performance. And while investors have become more savvy to these gimmicks over the years, dishonest companies continue to find new
tricks (and recycle old favorites) to fool investors.

What Are Financial Shenanigans?
Financial shenanigans are actions taken by management that mislead investors about a company’s financial performance or economic health. As a result, investors are often tricked into believing
that a company’s earnings are stronger, its cash flows more robust, and its Balance Sheet position more secure than are really the case.
Some shenanigans can be detected in the numbers presented by carefully reading a company’s Balance Sheet, Statement of Income, and Statement of Cash Flows. Proof of other shenanigans
might not be explicitly provided in the numbers and therefore requires scrutinizing the narratives contained in footnotes, quarterly earnings releases, and other publicly available representations
by management.
So here I classify financial shenanigans into three broad groups: Earnings Manipulation Shenanigans
Cash Flow Shenanigans, and Key Metrics Shenanigans

Earnings Manipulation Shenanigans
Investors judge corporate executives harshly when they fail to meet benchmark earnings expectations when reporting each quarter. Share prices often suffer dramatic declines when disappointing earnings are reported. Not surprisingly, then, in order to steer the share price (and the executives’ compensation package) higher,some companies engage in a variety of shenanigans to manipulate earnings. We have identified the following seven Earnings Manipulation Shenanigans that result in misrepresentations of a company’s sustainable earnings.

Cash Flow Shenanigans
The plethora of financial reporting scandals and earnings restatements in recent years has left many investors questioning whether reported earnings can ever be free of management manipulation.
Increasingly, investors have expanded their focus to include the Statement of Cash Flows and, more specifically, the section that highlights cash flow from operations (CFFO).
Investors are beginning to harbor a troubling suspicion about corporate financial reporting: that management now plays tricks to pollute cash flow from operations. Sadly, these suspicions are
well-founded. Investors can no longer trust that management will report its cash flow honestly and without discretion. To help investors navigate through the cash flow deception, we have identified
the following four Cash Flow (CF) Shenanigans may result in misrepresentations of a company’s ability to generate cash flow from its operations.

Key Metrics Shenanigans
So far we have addressed shenanigans that investors can generally identify by a careful reading of the numbers in the financial reports.
Management, naturally, faces some restrictions under the accounting rules (called GAAP, or generally accepted accounting principles) on how it presents financial results to investors. To bypass
many such restrictions and put on a positive spin, management has become more active and deceptive in creating and manipulating key non-GAAP metrics to impress investors. Such financial reporting
misrepresentations tend to improperly highlight strong or consistent growth and robust health.

Example:  The Enron Fraud Revealed The  first  signs  of  a  massive  fraud  were  revealed  when  an  Enron  committee and the firm’s auditor, Arthur Andersen, reviewed the accounting  for  several  unconsolidated  (“off-balance-sheet”)  partnerships  in October  2001  and  concluded  that  Enron  should  have  consolidated some  of  these  partnerships  and  included  them  as  a  part  of  the  company’s  financial  results.  Things  went  from  bad  to  worse  the  following month  when  Enron  disclosed  a  $586  million  reduction  in  previously reported  net  income  and  took  a  $1.2  billion  reduction  in  its  stockholders’  equity.  Investors  began  to  flee,  and  Enron’s  stock  price  sank  like  a boulder.  Before  Enron’s  final  descent,  credit  rating  agencies  cut  its  rating  and  virtually  all  borrowing  froze.  In  early  December  2001,  Enron filed  for  bankruptcy  with  assets  of  about  $65  billion.  It  was  the  largest  corporate  bankruptcy  in  U.S.  history—until  WorldCom  declared bankruptcy  seven  months  later  (WorldCom  was  subsequently  surpassed  by Lehman Brothers in 2008). In  the  end,  most  shareholders  suffered  staggering  losses  as  Enron’s  stock  price  in  2000  plunged  from  over  $80  per  share  (with a  market  capitalization  exceeding  $60  billion)  to  $0.25  nine  short but  painful  months  later.  Some  insiders,  however,  sold  large  parts of their holdings before  the  collapse.  Enron’s  chairman  and  former CEO,  Ken  Lay,  and  other  top  officials  sold  hundreds  of  millions  of dollars worth of stock in the months leading up to the  crisis.

Example: The Collapse of WorldCom Meanwhile,  in  early  2002,  a  small  team  of  internal  auditors  at WorldCom,  working  on  a  hunch,  were  secretly  investigating  what they  thought  could  be  fraud.  After  finding  $3.8  billion  in  inappropriate  accounting  entries,  they  immediately  notified  the  company’s board  of  directors,  and  events  progressed swiftly.  The  CFO  was fired,  the  controller  resigned,  Arthur  Andersen  withdrew  its  audit  opinion  for  2001,  and  the  Securities  and  Exchange  Commission (SEC) launched an investigation.
Reported Cash Flow from Operations Looked Solid As shown in Table, WorldCom cleverly hid its problems from investors, as the cash flow from operations (CFFO) regularly exceeded net income.

 Free cash flow measures the cash generated by a company,  including the impact of cash paid to maintain or expand its asset base (i.e., purchases of capital equipment). Free cash flow typically would be calculated as follows: Cash flow from operations  minus  capital expenditures  equals free cash flow

Some of the important and mostly traced shenanigans:

Earnings Manipulation Shenanigans 
reveals how companies manipulate
the Statement of Income to report higher revenue, inflated
profits, or improperly smoothed income.

Cash Flow Shenanigans 
discusses tricks used by companies to report
misleadingly high cash flow measures, including cash flow
from operations and free cash flow.

Key Metrics Shenanigans
exposes how companies fool investors by
showcasing misleading metrics that are being billed as key measures
of business performance or economic health.

Universal Message about Financial Shenanigans:

While most companies report their results honestly to investors, a significant number use accounting or financial reporting tricks to hide the truth. Since they are likely to be unaware of management’s
integrity level, smart investors would do well to maintain a healthy skepticism and perform rigorous due diligence with regard to financial reports. Additionally, financial shenanigans occur in every industry and know no geographic borders. Our universal message is that investors should assume that the urge to exaggerate the positive and hide the negative will never disappear. And where temptation exists, shenanigans often follow.

Some of the basic metrics to be kept in mind while analyzing annual reports are as follows:
When reported sales growth far exceeds any normal patterns, revenue recognition shenanigans may likely have fueled the increase.

Earnings Manipulation Shenanigans
Recording Revenue Too Soon
Recording Bogus Revenue
Boosting Income Using One-Time or Unsustainable Activities
Employing Other Techniques to Hide Expenses or Losses
Shifting Future Expenses to an Earlier Period
Shifting Current Income to a Later Period
Shifting Current Expenses to a Later Period

Cash Flow Shenanigans
Shifting Financing Cash Inflows to the Operating Section
Shifting Normal Operating Cash Outflows to the Investing Section
Inflating Operating Cash Flow Using Acquisitions or Disposals
Boosting Operating Cash Flow Using Unsustainable Activities

Key Metrics Shenanigans
Showcasing Misleading Metrics That Overstate Performance
Distorting Balance Sheet Metrics to Avoid Showing Deterioration

For Acquisition Companies
Key Warning: Acquisitive Companies—Financial shenanigans often lurk at companies that grow predominantly by making acquisitions. Moreover, acquisition-driven companies often lack
internal engines of growth, such as product development, sales, and marketing.

Important Checklist for analyzing companies:

1.Be Alert for Companies That Lack Checks and Balances Among Management.
2.Be Particularly Alert When a Single Family Dominates Management and the Board.
3.Watch for Senior Executives Who Push for Winning at All Costs.
4.Be Skeptical of Boastful or Promotional Management.
Boards Lacking Competence or Independence Inappropriate or Inadequately Prepared Board Members.
5.Failure to Challenge Management on Related-Party Transactions.
6.Failure to Challenge Management on Inappropriate
Compensation Plans.
7.Need for Outside Directors to Avoid Inappropriate Actions That Lessen Their Independence.
8.Auditor Lacking Objectivity and the Appearance
of Independence, Astronomical Fees Lead to a Conflicted Independent Auditor.
9.Too Long and Close a Relationship Prevents a Fresh Look at the Picture.
10.Incompetent Auditors Can Serve as Shills for Management.
11.Management Schemes to Avoid Regulatory Scrutiny
12.Lack of Usual Regulatory Scrutiny before Going Public.
13.Techniques to Detect Investment Manager Shenanigans.
14.Understand the Business to Assess whether the
Numbers Make Sense.
15.Assess the Competence and Ethics of Management
Evaluate the Adequacy of Checks and Balances.

Sources: Financial Frauds
                 Accounting for Financial Accounts
                 Financial Shenanigans
                 Financial recordings

Disclaimer: The information provided on Shuchi Nahar’s Weekend Blog is for educational purposes only. The articles  may contain external links , references and compilation of various publicly available articles. Hence all the authors are given due credit for the same. All copyrights and trademarks of images belong to their respective owners and are used for Fair Educational Purpose only. 

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