Managing Company Financials: Where to Find Manipulation

The majority of companies that exist do not want to mislead the public and their investor base. Most business owners are not inherently deceitful but when monetary incentives are misaligned the urge to play accountings games is present. In this piece, I will talk through the most common forms of financial misrepresentation, including examples and how you can avoid these tricks. While most investors know to be leery of GAAP earnings figures, we often blindly trust cash flow figures because they are "harder" to fudge. As you will see, cash flow figures have their own set of manipulation techniques that investors must be aware of.

Revenue & Cost Manipulation

Recording Revenue Too Soon

Explanation: In this case, we are talking about long-duration contract sales, for example, that, according to accrual methods, should be booked as the performance is completed. Companies that sign a 5-year contract for $50M total should recognize the revenue in $10M increments as performance under the contract is completed. What companies can do to manipulate, however, is to recognize that the full $50M upfront, therefore boosting revenue in the current period. This creates a long-term receivables line item on the balance sheet, so checking for large one time increases in receivables relative to other balance sheet items is critical. Another concrete item to look at for revenue recognition issues is growth in Net Income in excess of CFFO.

Recording Bogus Revenue

Explanation: The concept of entering bogus revenue can come in many different forms. In the case of AIG and finite insurance, Brightpoint was $15M short and agreed to pay AIG $15M for insurance recovery with AIG paying them retroactively to cover the loss. The problem here and why this is bogus is that there is no actual transfer of risk, and it is the equivalent of fire insurance on a house already engulfed in flames. In the tech spaces, companies were doing side deals with customers, essentially loaning them money to buy their product that they ultimately didn’t want or need to begin with, just to hit targets. In terms of ways to spot this one, a good rule is to examine transactions that are not reasonably arm’s length. Another accounting-specific approach is to watch the growth in earnings in relation to receivables if revenue outstrips receivables by a wide margin, that’s a red flag.

Boosting Income Using One-time or non recurring gains

Explanation: One of the easiest examples of this seems to me to be management changes where restructuring charges/one time write offs are massive, which can be used to simply slash legitimate operating expenses to boost earnings in future periods. The other way this shows up is in JV partners/ majority stakes. If a business asserts or does not assert control/influence to the degree in which it has, this can change the way the business is accounted for. If the business is majority owned/influenced, then the equity method is used, but if not, then the simple change in fair value would be calculated on the balance sheet. Watch for changes in how businesses account for their stakes in other businesses.

Shifting Current Expenses to a Later Period

Explanation: companies account for their expenses twice – once when they are incurred and the second time when the benefit has been received. Some expenses never see the balance sheet, as these are clearly operating expenses that go straight into the reduction from gross profit to get an operating income figure. The problem with this is the discretion by management of how long expenses remain or do not remain on the balance sheet. For example, line costs at WorldCom were their largest operating expense, and they figured that by simply shifting those to a capital expense and creating an associated asset would massively inflate profits, which they did. Watch out for amortization/depreciation schedules that lengthen or shorten unexpectedly.

Hiding Expenses/Losses

Explanation: There are a myriad of ways to incur high expenses and losses, but one major red flag is cash inflows from vendors – almost always is cash flowing OUT to vendors, so if they begin to go the other way, a “boomerang” transaction might be at play. Similar to our past example, businesses that are using a rebate system move around accounting entries. Stock-based comp can also be a way to hide costs and boost executive comp. In the 2000s, businesses back-dated option grants to the low point in the stock price, which essentially removed the cost of the options since it was fictional to begin with, compensation expense was never recorded, and overstated earnings to shareholders. Finally, reserve liabilities are a way companies create cushions to boost earnings. In a typical reserve liability, the expense has to be probable and reasonably estimated. The same is true of leases as it relates to residual value; by assuming a high residual value, depreciation expense is shrunk and net income is boosted.

Shifting Current Income to a Later Period

Explanation: Examples abound here, but deferred revenue and the impact of derivatives as “hedges” and how those are classified come to mind. For deferred revenue its essentially the same ideas as any other reserve, where management plays games with the recognition of the revenue and releases it when needed and holds it for a rainy day. For derivatives accounting states that there are effective and ineffective hedges which, depending on managements discretion must be adjusted with the value changes in one case (effective) and do not need to be adjusted in others (ineffective). The general rule is that if the hedge is offsetting something, then it can be treated as effective, and the value is not adjusted over time; the reverse is true for ineffective. This can occur when reasonable hedging activity is simply over and above what is actually needed to offset the risk, which came with GE commercial paper, which it hedges with interest rate swaps, which at the last second before taking a $200M charge, the business changed swaps from ineffective to effective. The other part that I found compelling is in the ways companies doing large amounts of M&A can use accounting tricks to boost results. The acquiree is told to speed up vendor payments, add receivables/inventory and then once the deal closes the new management does a “one time restructuring” where they essential get rid of the operating expenses involved in obtaining these balance sheet assets so future period sales are higher margin than before because the operating expenditure they would have otherwise paid was done before the acquiring business owned them and the second it closes vendor payments are delayed again and the expedited stocking up of inventory is normalized.

Shifting Future Expenses to an Earlier Period

Explanation: As we talked about before, businesses use the two-step process of expenditure recognition as a tool to manipulate. In this case, rather than freezing cost on the balance sheet or extending asset salvage value, just the opposite occurs. In this case, the shifting of ordinary expenditure might be deemed one-time expenses to lessen future period payments. Essentially here we are talking about management putting on a faulty provision or reserve that they know to be more than what is required just to use and release later on back into earnings – with the example here being companies who fire employees and account for $5M in severance with the marketing facing expectation to fire 200 people when in reality they only planned to fire 100 for $2.5M in this case the company simply uses the charge as a provision and in the future conveniently adds back $2.5M as a release in reserve.

 Cashflow Manipulation

Shifting Financing Cash Inflow to the Operating Section

Explanation: the trick here that is easiest to point to is a bank financing agreement that you run through operating cash flows when it should be in financing. The way investors get by with this is through the hope that most investors look only to CFFO and ignore mismatches in financing or investing cash flows. On the other hand, you can also simply move any operating cash outflow you do not like to the investing section and call it a capital expense, which will affect the FCF line but not the CFFO, which is what these manipulators are hoping will be ignored. The sale of receivables is classified as Factoring or Securitization which include either the direct sale to a third party like a bank or in the case of securitization it is a packaging of a group of receivables used to create a new instrument (often seen in the banking world like what SoFi does or other non bank entities to leverage their lending as they do not have access to deposits). Peregrine, prior to its demise, was doing bogus revenue by way of boomerang or reciprocal transactions, meaning the quality of the receivables was poor. Peregrine then sold those receivables to the bank in exchange for cash, yet the risk of recoupment remained with Peregrine, which essentially made this a loan from the bank with these crappy receivables as collateral. That banking “element” of the transaction made it so Peregrine felt comfortable with booking these “sales” into the operating cash inflow line on the SCF rather than financing, which would have been more appropriate.

Shifting Normal Operating Cash Outflows to the Investing Section

Explanation: During the 2000s tech boom, companies got creative with how they boosted CFFO. In the case of Global Crossings, they were partaking in boomerang transactions in which they simply sold capacity on their network and simultaneously bought it in a similar amount from the same company. The manipulation came from GC booking the inflows for net work capacity into the operating cash flow line, boosting CFFO while expensing the reciprocal purchase of capacity from that customer as an Investing outflow. Another piece of this is capitalizing normal operating cash outflows as investing or capital investment. Netflix had a large operating outflow by way of the purchase of the DVDs it would rent to its customers. Rather than booking these as expenses out of the operating expenditure line, they simply called these investing cash outflows and removed a massive line item from their unit cost. While the depreciation of the DVDs was accounted for in the income statement, it was not recorded as an inventory asset on the balance sheet but as a capital asset.

Inflating Operating Cashflow Using Acquisitions/Disposals

Explanation: In order to sell inventory and collect accounts receivable, you have to incur a cash expenditure. In the case of companies that do not grow organically and simply acquire new businesses to grow their companies that previous company had already paid the cash for these items and therefore you coming in and rapidly collecting receivables and selling inventory you can generate a one time massive inflow of cash. The trick here is that the price you pay for the company and its associated assets is run through the SCF as an investing outflow, but the sale of the associated assets (receivables and inventory) is booked as an operating inflow, thus boosting CFFO. This does NOT work, however, if the company being bought has a negative working capital position wherein payables exceed inventory and receivables, but I would venture to guess it is more common that the company has a positive working capital position that is being bought.

Boosting Operating Cashflow Using Unsustainable activity

Explanation: This section is important to note that what shows up as a major boost, in earnings and then associated CFFO might not be sustainable and we should be skeptical of any spikes. A tip from the book was to always read the Liquidity and Capital Resources section of the MD&A in the 10K and in addition, comparing an increase in payables to COGs is a likely indicator of stretching payment timeframes to vendors. The other key piece to this section was the explanation that what is deemed operating income and operating cash flows are distinct – taxes, interest and large one time charges are considered to be operating cashflows but not included in operating income which makes sense as you are differentiating between recurring operating income and expenses vs cash flows in and out that occur in the course of operations for the business which in any given period can be one-time in nature like a large law suit that a company wins and receives a check for.


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