Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition Read Online Free
Author: Howard Schilit, Jeremy Perler
Tags: nonfiction, Reference, Business & Economics, Mathematics, Management, Accounting & Finance
$3.8 billion decline in free cash flow—a staggering deterioration of over $6.1 billion. Noting this dramatic and troubling turnabout, WorldCom investors should have concluded that the business was in deep trouble, fraud or no fraud.
Key Lesson: When free cash flow suddenly plummets, expect big problems.
WORLDCOM: FINANCIAL SHENANIGANS IDENTIFIED
Earnings Manipulation Shenanigans
• Recording Bogus Revenue
• Shifting Current Expenses to a Later Period
• Employing Other Techniques to Hide Expenses or Losses
• Shifting Future Expenses to an Earlier Period
Cash Flow Shenanigans
• 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
Tyco: Most Shameless Heist by Senior Management
Similar to WorldCom, Tyco International Ltd. loved doing acquisitions, making hundreds of them over a few short years. From 1999 to 2002, Tyco bought more than 700 companies for a combined total of approximately $29 billion. While some of the acquired companies were large businesses, many were so small that Tyco did not even bother disclosing them to investors in its financial statements.
Tyco probably liked the businesses that it was buying, but more than that, the company loved to be able to show investors that it was growing rapidly. However, what Tyco seemed to like best about these acquisitions was the accounting loopholes that they presented. The acquisitions allowed the company to reload its dwindling reserves, providing a consistent source of artificial earnings boosts. Moreover, the frequent acquisitions allowed Tyco to show strong operating cash flow, even though it merely resulted from an accounting loophole. (We will come back to this in Cash Flow Shenanigan No. 3: Inflating Operating Cash Flow Using Acquisitions or Disposals.) Indeed, Tyco loved the acquisition accounting benefits so much that it even used them when no acquisitions at all occurred.
Tyco’s Clever Accounting Games
Consider how Tyco accounted for payments that it made in soliciting new security-alarm business in its ADT subsidiary. Rather than hire additional employees, Tyco decided to use an independent network of dealers to solicit new customers. Tyco was so enamored with acquisition accounting that it decided to use this technique to record the purchase of these contracts from agents. In so doing, Tyco inflated its profits by failing to record the proper expense. Moreover, Tyco inflated its operating cash flow by recording these payments in the Investing section of the Statement of Cash Flows.
But Tyco had many more tricks up its sleeve. It increased the price paid to dealers for each contract, and in return, required the dealers to pay that increased amount back to it as a “connection fee” for doing business. While this arrangement clearly had no impact on the underlying economics of the transaction, Tyco inappropriately decided to record this connection fee as income, providing an artificial boost to both earnings and operating cash flow. The boosts really added up when you consider that Tyco played this game with hundreds of thousands of contracts that it purchased.
The SEC Charges Tyco with Fraud
The SEC reviewed Tyco’s arrangements with dealers and gave the company a “thumbs down” for its creative accounting. As part of an overall billion-dollar fraud, the SEC alleged that Tyco used inappropriate accounting for ADT contract purchases to fraudulently generate $567 million in operating income and $719 million in cash flow from operations. Moreover, the SEC charged that Tyco engaged in improper acquisition accounting practices that inflated operating income by at least $500 million.
Key Lesson: When free cash flow suddenly plummets, expect big problems.
WORLDCOM: FINANCIAL SHENANIGANS IDENTIFIED
Earnings Manipulation Shenanigans
• Recording Bogus Revenue
• Shifting Current Expenses to a Later Period
• Employing Other Techniques to Hide Expenses or Losses
• Shifting Future Expenses to an Earlier Period
Cash Flow Shenanigans
• 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
Tyco: Most Shameless Heist by Senior Management
Similar to WorldCom, Tyco International Ltd. loved doing acquisitions, making hundreds of them over a few short years. From 1999 to 2002, Tyco bought more than 700 companies for a combined total of approximately $29 billion. While some of the acquired companies were large businesses, many were so small that Tyco did not even bother disclosing them to investors in its financial statements.
Tyco probably liked the businesses that it was buying, but more than that, the company loved to be able to show investors that it was growing rapidly. However, what Tyco seemed to like best about these acquisitions was the accounting loopholes that they presented. The acquisitions allowed the company to reload its dwindling reserves, providing a consistent source of artificial earnings boosts. Moreover, the frequent acquisitions allowed Tyco to show strong operating cash flow, even though it merely resulted from an accounting loophole. (We will come back to this in Cash Flow Shenanigan No. 3: Inflating Operating Cash Flow Using Acquisitions or Disposals.) Indeed, Tyco loved the acquisition accounting benefits so much that it even used them when no acquisitions at all occurred.
Tyco’s Clever Accounting Games
Consider how Tyco accounted for payments that it made in soliciting new security-alarm business in its ADT subsidiary. Rather than hire additional employees, Tyco decided to use an independent network of dealers to solicit new customers. Tyco was so enamored with acquisition accounting that it decided to use this technique to record the purchase of these contracts from agents. In so doing, Tyco inflated its profits by failing to record the proper expense. Moreover, Tyco inflated its operating cash flow by recording these payments in the Investing section of the Statement of Cash Flows.
But Tyco had many more tricks up its sleeve. It increased the price paid to dealers for each contract, and in return, required the dealers to pay that increased amount back to it as a “connection fee” for doing business. While this arrangement clearly had no impact on the underlying economics of the transaction, Tyco inappropriately decided to record this connection fee as income, providing an artificial boost to both earnings and operating cash flow. The boosts really added up when you consider that Tyco played this game with hundreds of thousands of contracts that it purchased.
The SEC Charges Tyco with Fraud
The SEC reviewed Tyco’s arrangements with dealers and gave the company a “thumbs down” for its creative accounting. As part of an overall billion-dollar fraud, the SEC alleged that Tyco used inappropriate accounting for ADT contract purchases to fraudulently generate $567 million in operating income and $719 million in cash flow from operations. Moreover, the SEC charged that Tyco engaged in improper acquisition accounting practices that inflated operating income by at least $500 million.
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