FINANCIAL SHENANIGANS

Detecting Accounting Gimmicks g g that Torpedo Investments

Howard M. Schilit Financial Shenanigans Detection Group, LLC Howard.Schilit@theFSDgroup.com CFA Institute May 2010

Seven Earnings Manipulation (EM) Shenanigans

EM # 1 R 1: Recording Revenue T di R Too Soon S EM # 2: Recording Bogus Revenue EM # 3: Boosting Income Using One-Time or Unsustainable Activities EM # 4: Shifting Current Expenses to a Later Period EM # 5: Employing Other Techniques to Hide Expenses or Losses EM # 6: Shifting Current Income to a Later Period EM # 7: Shifting F t 7 Shifti Future Expenses to an Earlier Period E t E li P i d
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EM # 1:

Recording Revenue Too Soon

Recording Revenue before Completing Any Obligations Computer Associates 35 day months 35-day Recording Revenue Far in Excess of Work Completed on Contract Transaction Systems Architect push greater amount to front-end Xerox select inappropriately low discount rate to accelerate revenue Enron use of mark-to-market to accelerate revenue to early years Recording Revenue before Buyers Final Acceptance of Product Sunbeam use of bill-and-hold to accelerate revenue Krispy Kreme shipped to someone other than customer McData switched revenue time from sell-through to sell-in Recording Revenue When Buyers Payment Remains Uncertain or R di R Wh B P tR i U t i Unnecessary Kendall Square recorded revenue although customer unable to p y pay System Software customers offered 14-month extended payment term 3

EM # 2:

Recording Bogus Revenue

Recording Revenue from Transactions Lacking Economic Substance Brightpoint reported revenue from bogus finite insurance contract AIG reported bogus insurance reserves on receipts from Gen Re Recording Revenue from Transactions Lacking a Reasonable Arms-Length Process Syntax-Brillian reported bogus sales to related parties Global Crossing reported bogus revenue on round-trip sales Recording Revenue on Receipts from Non-Revenue-Producing Transactions Lehman tried to dress-up bank borrowing as a sales transaction Molten Metal recorded funds received from partner as revenue Recording Revenue from Appropriate Transactions, but at Inflated Amounts g yp p p Enron recorded agent-type activities as if a principal Overstock.com changed from the net method to gross method
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EM # 3: Boosting Income Using One-Time or U susta ab e ct t es Unsustainable Activities

Boosting Income Using One-Time Events IBM inflated operating income by including big gain from asset sale FPA Medical inflated income by including asset sale rebate Boosting Income through Misleading Classifications Enron inflated income by pushing losses from ventures to balance sheet Lucent - pushed normal operating expenses i t one-time charge L t h d l ti into ti h Toys R Us treated normal inventory write-down as non-recurring Boston Chicken treated interest income from franchisees as revenue Oracle boosted income by changing structure of affiliated company

EM # 4: Shifting Current Expenses to a Later Period

Improperly Capitalizing Normal Operating Expenses WorldCom started treating billi W ldC d i billions i li costs as an asset in line AOL inflated income by capitalizing marketing costs Amortizing Costs Too Slowly AOL changed its 12 month amortization period to 24 months 12-month Time Warner Telecom changed depreciable life from 15 to 20 years g g Fannie Mae failed to amortize loan origination costs changes properly Failing to Write Down Costs with Impaired Value Orion Pictures failed to write off costs of money-losing films Vitesse Semiconductor f il d t record i Vit S i d t failed to d inventory obsolescence t b l charge Failing to Record Expenses for Uncollectible Receivables and Devalued Investments New Century Financial reduced loan loss reserves to boost income

EM # 5: Employing Other Techniques to Hide Expenses or L E Losses

Failing to Record an Expense from a Current Transaction Rent-Way Rent Way toward end of period stopped recording vendor period, invoices United Healthcare failed to record expense on backdated options g p y Failing to Record an Expense for a Necessary Accrual or Reversing a Past Expense Dell inflated income by failing to accrue sufficient warranty reserves Failing to Record or Reduce Expenses by Using Aggressive Accounting Assumptions Delphi inflated profits using improper expected return on pension assets Xerox inflated income by changing residual value on leases Reducing Expenses by Releasing Bogus Reserves from Previous Charges Sunbeam released bogus restructuring reserves into income WorldCom regularly used acquisition-related reserves to inflate 7 income

EM # 6: Shifting Current Income to a Later Period

Creating Reserves and Releasing Them into Income in a Later Period Microsoft big buildup of unearned income benefited future period profits p W.R. Grace Medicare reimbursement receipt shifted to future period Enron released huge trading gains deferred into future periods Improperly Accounting for Derivatives in Order to Smooth Income Freddie Mac improperly d f F ddi M i l deferred d i ti gains t smooth d derivative i to th income Fannie Mae shifted billions in derivative gains to later periods GE used derivative contracts to improperly smooth income Creating Reserves in Conjunction with an Acquisition and Releasing Them into Income in a Later Period U.S. Robotics held back income to be released after deal closed Computer Associates inflates profits with target company income Recording Current Period Sales in a Later Period 8

EM # 7: Shifting Future Expenses to an Earlier Period

Improperly Writing Off Assets in the Current Period to Avoid Expenses in a Future Period AOL inflated operating income by writing off deferred marketing costs g g g period inventory y Cisco gross margins benefited from big earlier p write-off Toys R Us included repositioned inventory as part of restructuring Sunbeam took big restructuring charge when CEO Al Dunlop arrived Improperly Recording Charges to Establish Reserves Used to Reduce Future Expenses Freddie Mac reduced previous reserves to inflate income Symbol created reserves in conjunction with acquisition WorldCom regularly created reserves in conjunction with acquisition Xerox created reserves for unknown risks
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Four Cash Flow (CF) Shenanigans Sh i

CF #1: Shifting Financing Cash Inflows to the Operating Section CF #2: Shifting Normal Operating Cash Outflows to the Investing Section CF #3: Inflating Operating Cash Flow Using Acquisitions or Disposals CF #4: Boosting Operating Cash Flow Using Unsustainable Activities

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CF #1: Shifting Financing Cash Inflows to the Operating Section

Recording Bogus CFFO from a Normal Bank Borrowing Delphi D l hi accounted for collateral on bank l df ll l b k loan as sale of asset l f Enron included borrowing for related party in CFFO Boosting CFFO by Selling Receivables Before Collection Date Cardinal Health boosted CFFO by selling receivables Sanmina-SCI boosted CFFO with stealth sale of receivables Global Crossing tried to hide cash crunch selling receivables Xerox was cited by the U.S. SEC for failing to disclose sale of receivables Inflating CFFO by Faking the Sale of Receivables Peregrine used fake sale of receivables to bank to cover up fraud Vitesse never offloaded risk of default on receivables sold to bank
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CF #2: Shifting Normal Operating Cash Outflows to the Investing Section

Inflating CFFO with Boomerang Transactions Global Crossing on Gl b l C i round-trip sales, recorded outflows as d i l d d fl investing Improperly Capitalizing Normal Operating Costs WorldCom treated outflows for line costs as investing Recording the Purchase of Inventory as an Investing Outflow g y g Netflix treated outflows to purchase inventory as investing Cephalon treated cash outflows for acquiring R&D technologies as investing Biovail t t d non-cash purchases of product rights as i Bi il treated h h f d t i ht investing ti

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CF #3: Inflating Operating Cash Flow Using Acquisitions or Disposals

Inheriting Operating Inflows in a Normal Business Acquisition Tyco CFFO inflated f T i fl d from numerous acquisitions i ii WorldCom CFFO inflated from numerous acquisitions Acquiring Contracts or Customers Rather than Developing Them Internally Tyco inflated CFFO by outsourcing sales force and treated as investing Boosting CFFO by Creatively Structuring the Sale of a Business Softbank inflated CFFO with a service agreement with buyer of business Tenet Healthcare inflated CFFO to retain receivables when business sold

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CF #4: Boosting Operating Cash Flow Using Unsustainable Activities

Boosting CFFO by Paying Vendors More Slowly Home D H Depot i fl t d CFFO by squeezing vendors t inflated b i d AutoZone treated bank loans to pay vendors as operating increase Boosting CFFO by Collecting from Customers More Quickly g y g y EDS renegotiated contract with customer to accelerate cash receipt Silicon Graphics provided deep discounts to accelerate cash receipt Boosting CFFO by Purchasing Less Inventory Home Depot inflated CFFO by purchasing less inventory Silicon Graphics purchased inventory only at beginning of period Boosting CFFO with One-Time Benefits Sun Microsystems included big litigation-related windfall in CFFO

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Two Key Metrics (KM) Shenanigans Sh i

KM #1: Showcasing Misleading Metrics that Overstate Performance g g KM #2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration

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KM #1: Showcasing Misleading Metrics that Overstate Performance

Highlighting a Misleading Metric as a Surrogate for Revenue Gateway stopped disclosing number of computers sold i tough G d di l i b f ld in h period AOL inflated subscriber count on bulk sales to companies Adelphia inflated subscriber count by including unconsolidated affiliates Pegasus inflated subscriber count by including former customers on list Highlighting a Mi l di Metric as a Surrogate for Earnings Hi hli hti Misleading M t i S t f E i Spansion excluded normal expenses to inflate EBITDA metric Openwave created and twice changed definition of earnings metric Highlighting a Misleading Metric as a Surrogate for Cash Flow Rent-A-Center abnormal accounting for inventory and sales distorted EBITDA p p g p g Delphi presented a confusing metric labeled operating cash flow American Financial Realty used unusual definition of funds from operation 16

KM #2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration

Distorting Accounts Receivable Metrics to Hide Revenue Problems Peregrine tried to hide fraud by faking sale of receivables to bank Symbol tried to hide fraud by turning receivables into a note Tellabs tried to hide problem by changing calculation of days sales outstanding Distorting Inventory Metrics to Hide Profitability Problems Merck hid inventory build by reclassifying some to non-current Distorting Financial Asset Metrics to Hide Impairment Problems New Century Financial misled investors with loan loss reserves shown East West Bancorp stopped providing investors info on problem loans Distorting Debt Metrics to Hide Liquidity Problems y p Parmalat debt metrics distorted by absence of unreported loans Lehman debt metrics distorted by absence of unreported loans
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Breeding Ground for Shenanigans

Management Issues Culture of f C l f fear and i i id i to k numbers at any cost d intimidation make b Absence of checks and balances among executive ranks Unusual or inappropriate compensation structure Board of Director Issues Lack of independence in fact or in behavior Absence of investor-centric members Auditor Issues Changes in auditor or signs of lack of independence Operating in Environment of Flux and Rapid Change Key change in business or regulatory environment y g g y Frequent changes in key personnel Company changes accounting principles, estimates, or presentation Very acquisitive company Company requires frequent equity or debt infusions
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Tell-Tale Sign of Financial Shenanigans Pressure from CEO

"The most important thing we do is meet our The numbers. Its more important than any individual product, its more important than any individual philosophy, its more important than any individual cultural change were making. We stop everything else when ki W t thi l h we dont make the numbers.
Joe Nacchio, CEO, Qwest Nacchio CEO

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