Understanding Accounting Frauds (Part-2)

Checklist to understand Recording of Revenue in Financial Statement (Part-2)

In continuation of my previous blog post...
https://myweekendspot.blogspot.com/2020/01/catch-trend-its-all-about.html?m=1

Investors  rely  on  the  information  that  they  receive  from  corporate executives  to  make  informed  and  rational  securities  selection  decisions.  This  information  is  assumed  to  be  accurate,  whether  the news  is  good  or  bad.  While  most  corporate  executives  respect  investors  and  their  needs,  some  dishonest  ones  hurt  investors  by  misrepresenting  the  actual  company  performance  and  manipulating the  company’s  declared  earnings.

Below mentioned are some of the shenanigans done by companies to attract investors and cheat them by manipulating numbers.
All the below described pointers cover the frauds that take place due to manipulating Revenue line item in the financials of the companies.

RECORDING REVENUE TOO SOON

Techniques to Record Revenue Too Soon
1.  Recording  Revenue  Before  Completing  Any  Obligations  under the Contract
2.  Recording  Revenue  Far  in  Excess  of  Work  Completed  on  the Contract
3.  Recording  Revenue  Before  the  Buyer’s  Final  Acceptance  of the Product
4.  Recording  Revenue  When  the  Buyer’s  Payment  Remains  Uncertain or Unnecessary

RED  FLAG!  A  sharp  jump  in  accounts  receivable,  especially long-term and unbilled ones.
Warning  of  Premature  Revenue Recognition:  Cash  flow  from operations materially lags behind net income.
Warning  of  Premature  Revenue  Recognition:  Companies  adopting  an  acceptable  methodology  (such  as  percentage-of-completion or  mark to market) that  was intended for  other  industries.

Warning Signs: Recording Revenue Too Soon

• Recording  revenue  before  completing  any  obligations  under the contract. 
• Recording  revenue  far  in  excess  of  work  completed  on  a  contract Up-front revenue recognition on long-term contracts. 
• Use  of  aggressive  assumptions  on  long-term  leases  or  percentage-of-completion accounting. 
• Recording  revenue  before  the  buyer’s  final  acceptance  of  the product. 
• Recording  revenue  when  the  buyer’s  payment  remains  uncertain or unnecessary Cash flow from operations lagging behind net income. 
• Receivables  (especially  long-term  and  unbilled)  growing faster than sales. 
• Accelerating  sales  by  changing  the  revenue  recognition  policy. 
• Using  an  appropriate  accounting  method  for  an  unintended purpose. 
• Inappropriate  use  of  mark-to-market  or  bill-and-hold  accounting. 
• Changes  in  revenue  recognition  assumptions  or  liberalizing customer collection terms. 
• Seller offering extremely generous extended payment terms. 

The following four techniques used to recognize revenue prematurely: 

 (1) recording revenue before completing any obligations under the contract, 

 (2) recording revenue far in excess of the work completed on the contract, 

 (3) recording revenue before the buyer’s final acceptance of the product, and 

 (4) recording revenue when the buyer’s payment remains uncertain or unnecessary.
The following pointers will describe four techniques that companies employ to create bogus revenue and some warning signs for investors to spot this nefarious shenanigan.

RECORDING OF BOGUS REVENUE

Techniques to Record Bogus Revenue
1.  Recording  Revenue  from  Transactions  That  Lack  Economic Substance
2.  Recording  Revenue  from  Transactions  That  Lack  a  Reasonable Arm’s-Length Process
3. Recording Revenue on Receipts from Non-Revenue-Producing Transactions
4. Recording Revenue from Appropriate Transactions, but at Inflated Amounts

Warning Signs: Recording Bogus Revenue 

• Recording revenue from transactions that lack economic substance. 
• Recording revenue from transactions that lack a reasonable arm’s-length process Lack of risk transfer from seller to buyer. 
• Transactions involving sales to a related party, affiliated party, or joint venture partner. 
• Boomerang (two-way) transactions to nontraditional buyers. Recording revenue on receipts from non-revenue-producing transactions. 
• Recording cash received from a lender, business partner, or vendor as revenue. 
• Use of an inappropriate or unusual revenue recognition approach Inappropriately using the gross rather than the net method of revenue recognition. 
• Receivables (especially long-term and unbilled) growing much faster than sales. 
• Revenue growing much faster than accounts receivable. 
• Unusual increases or decreases in liability reserve accounts.

RECORDING INCOME USING ONE TIME ACTIVITIES
Boosting Income Using One-Time or Unsustainable Activities

• Warning signs: Boosting income using one-time or unsustainable activities. 
• Boosting income using one-time events. 
• Turning proceeds from the sale of a business into a recurring revenue stream. 
• Commingling future product sales with buying a business. 
• Shifting normal operating expenses below the line. Routinely recording restructuring charges. 
• Shifting losses to discontinued operations.
• Including proceeds received from selling a subsidiary as revenue. 
• Operating income growing much faster than sales.
• Suspicious or frequent use of joint ventures when unwarranted
• Missclassification of income from joint ventures.
• Using discretion regarding Balance Sheet classification to boost operating income. 

Companies account for their costs and expenditures in a similar two-step accounting dance. Step 1 occurs at the time of the expenditure—when the cost has been paid, but the related benefit has not yet been received. 

At Step 1, the expenditure represents a future benefit to the company, and is therefore recorded on the Balance Sheet as an asset. 

Step 2 happens when the benefit is received.
At this point, the cost should be shifted from the Balance Sheet to the Statement of Income and recorded as an expense. This accounting two-step is danced at different tempos, depending on whether the cost is related to a benefit with a long- or a short-term horizon.

RECORDING OF IMPROPERLY CAPITALIZING NORMAL OPERATING EXPENSES
Warning Signs of Improperly Capitalizing Normal Operating Expenses 

• Unwarranted improvement in profit margins and a large jump in certain assets. 
• A big unexpected decline in free cash flow, with an equally big drop in cash flow from operations. 
• Unexpected increases in capital expenditures that belie the company’s original guidance and market conditions.
• Warning Sign: A new or unusual asset account  (particularly  one that is increasing rapidly) may signal improper capitalization.
• Warning: When all reserve accruals are moving in the wrong direction (i.e., declining), head for the hills!

RECORDING CURRENT EXPENSES TO A LATER PERIOD
Warning Signs: Shifting Current Expenses to a  later Period. 

1. Improperly capitalizing normal operating expenses Changes in capitalization policy or accelerated capitalization of costs. 
2. New or unusual asset accounts Jump in soft assets relative to sales Unexpected increase in capital expenditures. 
3. Amortizing or depreciating costs too slowly Stretching out depreciable asset life.
4. Improper amortization of costs associated with loans.
5. Failing to record expenses for impaired assets Jump in inventory relative to cost of goods sold.
6. Failure by lenders to adequately reserve for credit losses.
7. A decrease in loan loss reserve relative to bad loans.
8. The decline in bad debt expense or obsolescence expense.
9. Decrease in reserves related to bad debts or inventory obsolescence.

SHIFTING CURRENT EXPENSES TO A LATER PERIOD
Techniques to Shift Current Expenses to a Later Period:
1. Improperly Capitalizing Normal Operating Expenses
2. Amortizing Costs Too Slowly
3. Failing to Write Down Assets with Impaired Value
4. Failing to Record Expenses for Un-collectible Receivables and Devalued Investments.
Regardless of the legitimacy of an accounting change, investors must strive to understand the impact that this change had on earnings growth. Simply put: any growth related to the change will not recur. In order to be maintained, the growth must be replaced with improved operational performance.

Employing Other Techniques to Hide Expenses or Losses:
1. Failing to Record an Expense from a Current Transaction
2. Failing to Record an Expense for a Necessary Accrual or Reversing
a Past Expense
3. Failing to Record or Reducing Expenses by Using Aggressive
Accounting Assumptions
4. Reducing Expenses by Releasing Bogus Reserves from Previous
Charges.

Warning Signs: Employing Other Techniques to Hide Expenses or Losses

• Unusually large vendor credits or rebates
• Unusual transactions in which vendors send out cash
• Failing to record an expense for a necessary accrual or reversing a past expense
• Unusual declines in reserve for warranty or warranty expense
• Declining accruals, reserves, or “soft liability” accounts
• Unexpected and unwarranted margin expansion
• Unusually “lucky” timing on the issuance of stock options
• Failing to accrue loss reserves
• Failing to highlight off-balance-sheet obligations
• Changing pension, lease, or self-insurance assumptions to reduce expenses
• Outsized pension income.

SHIFTING CURRENT INCOME TO A LATER PERIOD
When we learned Shenanigan No. 1, Recording Revenue Too Soon, management used the techniques in that chapter because it believed that current-period results were more important than future-period ones, and thus decided to accelerate revenue from a later period into the current one.

Warning Signs: Shifting Current Income to a Later Period

1. Creating reserves and releasing them into income in a later period. 
2. Stretching out windfall gains over several years. 
3. Improperly accounting for derivatives in order to smooth income. 
4. Holding back revenue just before an acquisition closes. 
5. Creating acquisition-related reserves and releasing them into income in a later period. 
6. Recording current-period sales in a later period. 
7. Sudden and unexplained declines in deferred revenue. 
8. Changes in revenue recognition policy. 
9. Unexpectedly consistent earnings during a volatile time. 
10. Signs of revenue being held back by the target just before an acquisition closes. 

SHIFTING FUTURE EXPENSES TO AN EARLIER PERIOD

First, here are the two basic rules: 

(1) rather than keeping costs
on the Balance Sheet too long , rush them to the trash bin of expenses immediately, and 

(2) instead of trying to hide expenses by failing to record invoices, record them all now (the earlier the better) and then some—even if you literally make up expenses just for the heck of it.
Sounds crazy, no? Stay tuned, and soon you will fully understand how management benefits from playing this game—and companies play it more frequently than you would imagine.

Warning Signs: Shifting Future Expenses to an Earlier Period 

1. Improperly writing off assets in the current period to avoid expenses in a future period. 
2. Improperly recording charges to establish reserves used to reduce future expenses. 
3. Large write-offs accompanying the arrival of a new CEO.
4. Restructuring charges just before an acquisition closes
5. Gross margin expansion shortly after an inventory write-off. 
6. Repeated restructuring charges that serve to convert ordinary expenses to a one-time expense.
7. Unusually smooth earnings during volatile times.

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