I began using many of those interesting vignettes in teaching my Intermediate Accounting and Auditing classes. As I saw that the students found those stories fascinating, I started publishing articles on this subject to share with a larger group.
And, of course, the next logical step to reach an even greater audience was to write a book. Shortly after my forty-first birthday, in early McGraw-Hill published the first edition of Financial Shenanigans. The book introduced readers to seven broad categories of earnings misrepresentations, identified 20 discrete techniques that management might employ, and sprinkled in many examples of actual companies that had been sanctioned for tricking investors.
A few pleasant surprises emerged after the book was released. First, lots of readers reached out to thank me for shedding light on the steps that investors could take to safeguard their wealth.
Second, the book had made its way into the ranks of big institutional investors, who sought to hire me to train their analysts on how to spot companies playing accounting games. Eventually they began asking me to examine the companies in their portfolios. While was an eventful year with the publication of Financial Shenanigans and my introduction to some influential investors, it would have been impossible to predict the dramatic changes that followed in as I launched the Center for Financial Research and Analysis CFRA.
Out of the spare room in my house, I began publishing a monthly newsletter highlighting companies I believed to be struggling but that were using accounting tricks to hide the problems. On the fifteenth of each month, I sent reports via overnight mail to our subscribers. Thankfully, the service was well received, and over 60 investment firms became subscribers during our first year. In I resigned my tenured teaching position at American University in order to devote myself fully to the growing business.
I leased office space and began hiring a team of analysts; CFRA was off to the races. By , we began posting our warnings for clients online and sending out e-mails. Yay, no more printing and collating reports and sending them via overnight mail.
Our client count grew substantially as we became a major player on Wall Street and around the world, with clients on five continents and offices in Washington, D. During the early s, accounting scandals proliferated, with frauds revealed at Enron, WorldCom, and Tyco. The Governmental Affairs Committee of the U. Senate investigating the Enron fraud asked me to testify in February I was regularly interviewed on TV and in print about the growing usage of accounting tricks.
In April , the second edition of Financial Shenanigans was released, and sales spiked as the stock market was spooked by a seemingly endless parade of companies using accounting tricks.
As you might imagine, those were golden times for CFRA. Over new subscribers signed up for our research product in alone, and by the end of the year we were serving over clients. Jeremy eventually became the global head of research, and Yoni led our quantitative research team and headed business strategy for the company.
In early , several potential acquirers came knocking, and I decided to sell a majority stake to the Boston-based private equity firm TA Associates. Yoni left for Harvard Business School in , and upon graduation, he worked for an investment management firm in Boston.
Jeremy remained at CFRA until and then became a forensic accounting specialist at a prominent hedge fund. My retirement years involved a lot of traveling, still giving seminars to investment groups and MBA students. By , I was eager to share some of my new ideas and I approached Jeremy about partnering with me to coauthor a third edition of Financial Shenanigans. We worked very closely on the book during the summer and early fall of , and the book was released the following April.
Knowing that my noncompete would end later that year, I became much more active on the speaking circuit, giving seminars and interviews and doing in-depth research on companies. I was very excited about coming out of retirement and building a new business from scratch. Log in with Facebook Log in with Google. Remember me on this computer. Enter the email address you signed up with and we'll email you a reset link. Need an account? Click here to sign up. Download Free PDF. Lelo Habibi.
A short summary of this paper. Download Download PDF. Translate PDF. Most companies leave telltale signs of their fraudulent behavior, but auditors and analysts must be independent, imaginative, and skeptical in their examination of company accounts if they expect to find these signs.
Such behavior occurs in both ings can be organized into seven categories: reputable and disreputable companies. In fact, 1. Recording revenue too soon, many of the companies that I cite in my examples 2. Recording bogus revenue, are highly regarded companies, so I am not pointing fingers at any particular type of company. But all of 3. Boosting income by using one-time or unsus- the companies I cite have at least one thing in com- tainable activities, mon: Their management sets a tone that encourages 4.
Shifting current expenses to a later period, the use of tricked-up accounting. For example, con- 5. Employing other techniques to hide expenses sider the words spoken at an employee meeting at or losses, Qwest Communications International by Joseph 6. Shifting current income to a later period, and Nacchio, the CEO at the time: 7. Shifting future expenses to an earlier period. The most important thing we do is meet our numbers. Sometimes, the numbers. Lower income and The intention of this presentation, therefore, is higher expenses lead to lower taxes.
In this EM identify some of the telltale signs and behaviors that technique, a company does not fabricate revenue can indicate such shenanigans are happening. For example, if a company is having ence held in Boston on 16—19 May SEC complaint March Computer Associates was particularly per- revenue on the sale. The customer must not only sistent at recording revenue before any obligations order the product but also take possession of it, test were complete.
Its specific technique was to keep it, and approve it as acceptable for its needs. Cus- open the last month of any given quarter until it was tomer acceptance is an important step in the process, able to produce enough revenue to satisfy Wall yet some suppliers try to maneuver around this final Street. Computer Associates was infamous for its step. Sunbeam Products was notorious for acceler- day months. Generally, a receivable is recorded at the cleaning products.
The retailers would not pay for same time as the revenue, and one would expect the the products, and Sunbeam would not ship the customer to pay within 30—60 days, not days products.
In fact, Sunbeam did not even bill for the later. When a company shows long-term receiv- products, so the name of the strategy is a misnomer. For example, if a software com- The warning sign that Sunbeam was playing pany signs a five-year licensing deal, the company fast and loose with its revenue recognition was will receive payment over that month period and detectable in its gross margins, which were initially should not be picking up all of the revenue in the low and fairly stable.
The margins hardly fluctu- first month. But that is exactly what Computer ated, yet Sunbeam was not the manufacturer. It Associates was doing. Companies can use this tech- Mart Stores. Soft- math was wrong. Because Sunbeam was using the ware companies often use this kind of contract. For bill-and-hold strategy, however, it continued to example, when Apple sells an iPhone, part of its hold the product.
Inventory was not being con- revenue is from selling hardware and part is from verted to cost of goods sold, which resulted in a the two-year contract for iPhone service. Certainly, misleadingly high gross margin. Therefore, beware this is a legitimate way of doing business, but it can of gross margins that skyrocket or fluctuate wildly also lead to accounting shenanigans.
Kendall Square Research was aggressive at picking up ever larger portions of its notorious for recording revenue even when its cus- revenue at the front end and smaller portions at the tomers were unable to pay. Such sales are simply back end.
One sign that helped me discover this bogus. Therefore, when analysts are trying to deter- behavior was that new accounts began appearing on mine whether a company is overly aggressive in the balance sheet.
When I see a new account, only recording its sales, they should examine not only the two explanations seem logical: The company is cre- ating a new business, or it has decided to account for practices of the company that is making the sale but things in a different way.
Such accounts as unbilled receiv- Another way of carrying out this same trick is ables and receivables in excess of billing began to to make sales based on extended payment terms. A business typically takes cer- One indicator of such behavior is a big increase tain steps—such as developing a product, shipping in receivables.
Companies typ- skeletons are buried. From transactions lacking economic substance, attention. On receipts from nonrevenue producing trans- 75 days. From appropriate transactions but at inflated calls with management, and the stock price came amounts. Then the DSO suddenly Some examples of this type of shenanigan dropped from 70 days to 37 days. I took this message as a cue to immediately reporting bogus revenue on round-trip sales, and look for accounting shenanigans. I examined the Overstock.
It simply reclassified some of those receiv- bank borrowing as if it were a sales, not a borrow- ables as prepaid expenses. Finally, consider the behav- end of a quarter to cover normal operating ior of software company MicroStrategy. During the expenses—to meet payroll, perhaps, or to pay height of the Internet bubble in early , I began down some of its debt. Such repos, or repurchase following MicroStrategy, and on 5 October , just agreements, are normal business transactions in five days after the end of the quarter, I noticed that which the lender expects collateral.
But Lehman it had issued a press release containing two oddities. Brothers did not treat these transactions as loans First, the timing was too early to include earnings but rather as sales of assets.
It took the assets that numbers; they usually appear about three weeks were used as the collateral in the repos off its books after a quarter ends. Second, the press release and never reported the debt side of the transaction. An important It had no effect on the income statement. It struck lesson I have learned is to be very critical of any press me, and should strike any analyst, as unusual that release a company issues. In fact, whenever I receive MicroStrategy was engaging in investment-related a press release, I first ask myself, What message is activity with the same party that was becoming a this company trying to sell?
The intent of the release customer. This sort of activity muddies the waters is not necessarily devious, but most press releases and almost always indicates that something bad is are crafted to sell a message. It is up to the reader to about to happen. I was told that the transaction was its net leverage had come down.
Nevertheless, I continued to have questions saw that the cost of goods sold surprisingly increased about the company. Then during the first week of by 9 percent.
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