Review: Financial Shenanigans by Howard M. Schilit

Financial shenanigans are actions taken by management that mislead investors about a company’s financial performance or economic health. As a result, investors are often tricked into believing that a company’s earnings are stronger, cash flow more robust, and balance sheet position more secure than really the case. Some shenanigans can be detected in the numbers present in the balance sheet, statement of income, statement of cash flows, but some requires scrutinizing the narratives contained in footnotes, quarterly earnings releases, and other publicly available representations by management.

When one of the financial statements contains shenanigans, warning signs generally appear on the other ones. Thus, earnings manipulation tricks can often be detected indirectly through unusual patterns on the balance sheet and statement of cash flows. Similarly, deciphering certain changes on the statement of income and balance sheet often can help investors sniff out cash flow shenanigans.

Management’s use of any accounting shenanigans should be viewed in a negative light and investors should avoid owning companies with suspect financial reporting practices.

1. Breeding ground for shenanigans – warning signs to look out for
   1. Absence of checks and balances among senior management. E.g. a single dictatorial leader has control over the rest who cannot freely criticize and disagree with him, even if he wishes to create misleading financial reports.
   2. Watch for senior executives who push for winning at all costs (renowned for pushing hard to meet or beat Wall Street estimates). Such culture can lead to aggressive accounting practices and fraudulent reporting.
   3. Be wary of an extended streak of meeting or beating Wall Street expectations. Be skeptical of boastful or promotional management. When a management publicly boasts about its long consecutive streak of meeting or exceed Wall Street’s expectations, when tough times or speed bumps emerge as they invariably will, such management may feel pressured to use accounting gimmicks and fraud to keep the streak alive, rather than announcing that its run of success has ended.
   4. A single family dominating management, ownership (hold a large percentage of voting shares), or the board of directors. The lack of checks and balances may embolden management to engage in financial reporting tricks.
   5. Presence of related-party transactions e.g. acquisition of CEO’s relative or friend’s company.
   6. An inappropriate compensation structure that encourages aggressive financial reporting.
   7. Inappropriate members placed on the board of directors
      1. Do board members belong on the board and are they qualified for the committees on which they sit? E.g. audit or compensation. They should have the essential skills and serve only on appropriate committees that suit their technical skills.
      2. Are they appropriately performing their duties to protect investors? E.g. do they challenge management on related-party transactions or inappropriate compensation plans? A sign of a healthy and effective board is when a dissenting view overturns a management-driven consensus.
   8. Inappropriate business relationships between the company and board members, e.g. receiving loans or being permitted to purchase products from the firm for less than the market price, or receiving remuneration for providing professional services to the company – these would cloud an outside director’s objectivity and appearance of independence.
   9. An unqualified auditing firm e.g.one that is small and unknown
   10. An auditor lacking objectivity and appearance of independence, e.g. astronomical fees received for firm leading to a conflicted independent auditor, or too long and close a relation that prevents a fresh look at the picture.
   11. Attempts by management to avoid regulatory or legal scrutiny, e.g. sidestepping the normal registration process for an IPO by merging into an already-public company, using a backdoor approach to becoming a public company and avoiding the typical detailed review that is part of the normal IPO process. Investors should be wary of companies that avoid SEC review by merging into a “shell company” using either a reverse merger or a “special-purpose acquisition company” partner and immediately becoming a public company.

2. Earnings manipulation shenanigans

1. Recording revenue too soon – inflate current period income by increasing revenue. The impact of management when it restates results caused by premature revenue recognition is that it reports to investors a higher total revenue over a number of years than otherwise. The corrected entry would remove the inflated profits from retained earnings and establish a deferred revenue account. Reversal of past years’ revenue is often ignored by Wall Street, particularly if it can be recognized again.
   1. Recording revenue before completing any obligations under contract (push future period sales into current period i.e. recognizing revenue before the sale even happens)
      1. Some companies record sales on the last day of the quarter and sometimes get creative in how they mark the quarter’s end and push a future period’s sale into the current period.
      2. The reason for management to push sales higher for a period to drive stock prices up is when top executives have compensation plans that are dependent on share prices reaching certain levels and remaining there for at least a certain period of time. Be wary of such compensation schemes.
      3. Be wary of companies that extend their quarter end date.
      4. In order for revenue to be recognized according to accounting guidelines, 4 conditions must be met: a) evidence of an arrangement exists, b) delivery of the product or service has occurred, c) the price is fixed or determinable, d) the collectability of the proceeds is reasonably assured. Failure to meet any one of these conditions requires deferral of revenue until all requirements have been satisfied.
   2. Recording revenue far in excess of work completed on a contract (although seller has started to deliver on the contract, management records a far greater amount than is warranted) – this is not sustainable as legitimate future period revenue has been shifted to the present period and would no longer be available for reporting as revenue in future period; achieving comparable revenue growth in the future on top of the inflated sales figure would also be an enormous challenge.
      1. Up-front recognition of a long-term contract; company recognize the present value of all revenue for the entire contract immediately, but cash will not be collected for many years to come. Economic reality dictates that revenue should be deferred until the billing period for each instalment sale.
      2. Bulging long-term receivables should also alert investors to aggressive revenue recognition policy.
      3. Days’ sales outstanding is calculated as [(Ending Receivables/Revenue)*Number of Days in the Period] (for quarterly periods approx. 91.25 days) i.e. [Ending Receivables/Revenue per Day] – DSO is a metric outside of GAAP principles so companies may present their DSO calculated in a different way but it is advised to use this method. The ending receivable is the average amount of money still owed by customers on a particular day, and when divided by the average sales per day, shows the average number of days that a company takes to collect revenue after a sale has been made.
      4. To evaluate whether customers are paying their bills on time, use DSO. Higher DSO indicates aggressive revenue recognition in addition to poor cash management. Check against industry average DSO.
      5. Be wary of companies changing the revenue recognition policy to record revenue sooner.g. recording entire value of 5 year customer contracts upfront compared to previous approach of spreading revenue over 5 year contract period.
      6. Watch for cash flow from operations that begins to lag behind net income. Look at the difference between CFFO and net income and see if it is increasing.
      7. Watch for a jump in unbilled receivables (especially when compared to the increase in sales in % terms). If sales increased by a particular quantity and it all go into unbilled receivables (which increased by an equal amount), it is suspicious. Generally the % increase in unbilled receivables should be the same % increase in sales if the proportion of unbilled receivables to sales should remain constant. Unbilled receivables are typically not receivables at all. These accounts are generally created during the production period, when customers are not yet responsible for payment.
      8. Watch for long-term receivables that grow faster than revenue in % terms. Normally receivables are collected within a month or two of a sale. Long term receivables represent sales that the company will not collect for more than a year after the balance sheet date.
      9. Certain types of long term contracts actually allow the seller to recognize some revenue even though future services remain to be provided. While these arrangements are guided by accounting methodologies permissible by GAAP, the timing of revenue recognition is very sensitive to discretionary management estimates. Some of these arrangements include a) long term construction contracts that use percentage-of-completion accounting, b) lease agreement, c) arrangements with several distinct deliverables, d) utility contracts recorded using mark-to-market accounting.
      10. The amount of revenue recognized under percentage-of-completion accounting to subject to various estimates, creating opportunities for financial shenanigans. Management calculates revenue based on the percentage of the project that was completed during that period. This type of accounting is typically used for long term construction or production contracts. The amount of revenue recognized in a given period is determined by the percentage of the total contract that was completed during the period. To calculate revenue, companies first determine the amount of costs they incurred under the contract, as a percentage of the estimated total costs to be incurred over the entire lifetime of the contract. Then, this percentage is applied to the total revenue expected to be recognized under the contract.
      11. Look out for companies inappropriately using percentage-of-completion accounting to accelerate revenue. Service companies are typically ineligible to use such an accounting method since their projects have a shorter term. Companies that sell products with very short production cycles should refrain from using percentage-of-completion as well.
      12. Be alert for companies using aggressive assumptions in applying percentage-of-completion accounting. A warning sign that a company using percentage-of-completion accounting is using it improperly would be a large increase in unbilled receivables when sales and billed receivables grow more moderately.g. on a $1,000,000 contract, management estimates total costs will be $500,000 and that $100,000 of costs were incurred during the 1^st quarter. Percentage-of-completion accounting would dictate that 20% of the revenue be recorded in the first quarter, even if a different amount would be billed to the customer (what has not been billed but has been recorded as revenue will go to unbilled receivables in the balance sheet). If management simply assumed that total estimated cost would be $200,000 instead of $500,000, then revenue in the 1^st quarter would be 50% of the total contract value instead of 20%.
      13. Lease accounting also relies heavily on management estimates and investors must monitor these inputs since management might begin using unreasonably optimistic projections. Capital leases – at the inception of the lease, the seller recognizes as revenue a large portion of the present value of future lease payments. Estimates such as the discount rate, residual value, length of the contract, and other lease terms dictate the timing of revenue recognition over the course of the lease. E.g. the discount rate is used to calculate the current value of future lease payments, adjusted for the time value of money. This present value is recognized as revenue immediately and the remainder of payments is recorded as interest income over the lease term. A higher discount rate yields a lower present value for revenue recorded, while a lower discount rate yields a higher present value. By choosing an inappropriately low discount rate, management could aggressively accelerate the recognition of revenue.
      14. Watch for companies that select inappropriately low discount rates. Look at the discount rate on capital leases and compare to the average local borrowing rates.
      15. Be wary when companies alter the terms of existing capital lease arrangements. E.g. incorrectly accounting for price increases and lease extensions imposed on existing lease customers.
      16. For long term arrangements with multiple deliverables, by changing assumptions in estimating how to split revenue between multiple deliverables, companies can influence the distribution of revenue in a way that may allocate more revenue upfront to the front end of a contract and less to the back end. Monitor receivables balance and days’ sales outstanding as higher figures indicates aggressive revenue recognition.
      17. For utility companies entering into long term commodity delivery contracts with customers e.g. selling future delivery of natural gas, economic sense dictates that the utility company must record revenue on these long-term service contracts only when the service, such as delivery of gas, had been provided. Beware when a utility company fail to treat these arrangements as service contracts but defining them as sale of commodity futures contract. Enron adopted an accounting methodology that was specifically intended for use by financial institutions that trade securities such as futures contracts, mark-to-market accounting. Under this method, all expected profits under this contract should be recorded immediately and as estimates of contract profitability change over time, the value of the “security” will be adjusted as well. Beware when companies adopt an acceptable accounting methodology e.g. mark-t0-market or percentage-of-completion, that was intended for other industries.
   3. Recording revenue before the buyer’s final acceptance of the product
      1. Recording revenue before the shipment of product to the buyer, involving bill-and-hold arrangements. The seller bills the customer and recognizes revenue, but continues to hold the product. For most sales, revenue recognition requires shipment of product to the customer. Accounting guidelines allow revenue to be recognized in bill-and-hold transactions provided that the customer requests this arrangement and is the main beneficiary, e.g. buyer doesn’t have adequate storage space and ask seller to hold on the purchased goods as a courtesy. Under no circumstances can early recognition of revenue occur under a bill-and-hold arrangement if the arrangement is initiated by the seller, for the benefit of the seller, to record revenue at an earlier date. Read revenue recognition footnote in a company’s 10K to see if company recognized revenue from bill-and-hold transactions (even if company says they are requested by customers, be cautious) and calculate the revenue recognized under this, and minus away this total sum from net profit earned during the period (since costs from these revenues are not recognized).
      2. $60 million of Sunbeam’s supposed record $189 million earnings for 1997 were the result of fraudulent accounting. Even just 3% of revenue being recognized prematurely under the bill-and-hold transaction amounts to $35 million (i.e. income not earned and overstated during the period), due to total revenue being $1.16 billion. $35 million out of a total $189 million in annual earnings is a huge sum, despite 3% seeming to be a small figure.
      3. Recording revenue after shipment, but to someone other than the buyer. Auditors often look at shipping records as evidence that the seller delivered the product to the customer, allowing revenue to be recorded. Management might attempt to trick its auditors into believing that a sale occurred by shipping products to someone else other than the customer.
      4. Be wary of consignment arrangements. With consignment sales, products are shipped to an intermediary, called a consignee. The consignee is an outside sales agent who is given the task of finding a buyer. The manufacturer (the consignor) should recognize no revenue until the sales agent consummates a transaction with an end customer. If the consignor records revenue upon sending products to the consignee, but before the goods are sold to the end user, no revenue should be recognized.
      5. In certain industries, a complication arises in recording revenue concerning who should be considered the “customer”. A manufacturer may sell products to a distributor, who then resells them to end users. The manufacturer can choose to record revenue when the products are sold to the distributor (called sell-in), or when they are ultimately purchased by the end user (called sell-through). Both approaches are widely used and permissible under GAAP. Be wary however, when a company switches from the more conservative sell-through method to the more aggressive sell-in model. By doing so, the company accelerate revenue recognition and artificially boosts profits. You can read about changes in revenue recognition policy in a company’s 10Q or 10K. Warning signs also include large increase in accounts receivables while sales remained unchanged (compare quarter this year to quarter last year and this quarter to last quarter, percentage change in sales vs percentage change in accounts receivables), causing DSO to increase.
      6. Beyond evaluating whether an accounting change complied with GAAP, investors should always ask the question, why make this change, and why now? In many cases, an accounting change, even a permissible one, is an attempt to hide an operational deterioration.
      7. Recording revenue after shipment, but while the buyer still has the ability to void/reject the sale. This may occur if a) the customer received the wrong product, b) the customer received the correct product, but too early, or c) the customer received the correct product at the right time but still reserves the right to reject the sale. When a buyer has received a product but can still reject the sale, the seller must either wait until a final acceptance to record revenue or the expiration of the return period or recognize the revenue but record a reserve estimating the amount of anticipated returns.
      8. Be wary of sellers deliberately shipping incorrect or incomplete products. Sometimes companies scheme to inflate revenues by intentionally shipping out the wrong product and recording the related revenue, although they know fully well that the product will be returned.
      9. Be alert to sellers shipping product before the agreed-upon shipping date. Merchandise is rushed out of the warehouse to customers toward the end of the year even before the sales have taken place, and sales revenue is recorded. An increase in DSO can often be an indicator that a product was shipped late in a quarter.
      10. Be mindful of sellers recording revenue before the lapse of the right of return. Companies are required to delay revenue recognition until the right of return lapses or estimate an amount of expected returns and reduce revenue by that amount. If the amount of product being returned is in excess of the company’s plans or estimates, the company may be guilty of recognizing too much revenue up front.
   4. Recording revenue when the buyer’s payment remains uncertain or unnecessary
      1. The seller may be accelerating revenue recognition if it records sales when the buyer lacks the ability to pay (payment remains uncertain) or when the seller aggressively induces sale by not requiring the customer to pay until long after the sale (payment remains unnecessary).
      2. A company might recognize revenue before its customers had secured the necessary financing, when no revenue should be recognized until such funding had been secured.
      3. Watch for companies that change their assessment of customers’ ability to pay – hint of revenue slowdown. Management’s assessment of a customer’s ability to pay is what determines the estimates used to account for uncollectible receivables. Changes in these assessments may provide companies with a non-recurring boost to income, e.g. initially being conservative but now recognize revenue immediately by concluding that customers were no longer a deadbeat. You can find such changes in a company’s 10Q or 10K revenue recognition footnote (might not see it in quarterly earnings release and conference calls as they are less revealing about changes in accounting). Companies will almost always put that “this change in policy did not have a material impact for the quarter/year ended …” – lies.
      4. Seller induces sale by allowing an exceptionally long time to pay. Investors should be cautious about seller-provided financing arrangements including very generous extended payment terms, as they may indicate the acceleration of revenue into the current period, tepid customer interest in the product, or the buyers’ lack of ability to pay.
      5. Watch out for companies that offer extended or flexible payment terms. Watch out for companies that offer extended payment terms on new products. Sometimes companies offer sweet payment terms in order to entice customers to purchase additional products earlier than normal. While offering favourable payment terms to customers may be a completely appropriate business practice, it may also add a level of uncertainty to the eventual collectability of receivables. Even when extending terms to credit-worthy customers, overly generous terms may effectively shift sales that originally were slated for future periods into the current one. This shift would allow for unsustainably high near-term revenue growth and produce pressure to fill the void create in that later period.
      6. Sound the alarm when new extended payment terms are disclosed and DSO jumps. Might indicate coming slowdown in sales growth.

2. Recording bogus revenue – inflate current period income by increasing revenue. Look out for receivables (especially long-term and unbilled) growing much faster than sales % wise, revenue growing much faster than accounts receivable, unusual increases or decreases in liability reserve accounts, and profits not growing proportionately with sales.
   1. Recording revenue from transactions that lack economic substance
      1. In these transactions, the so-called customers is under no obligation to keep or pay for the product, or nothing of substance was transferred in the first place.
      2. In order to be considered an insurance policy for accounting purposes, an arrangement must involve a transfer of risk from the insured to the insurer. Without this transfer of risk, GAAP treats the arrangement as a financing transaction, with premium payments being treated like bank deposits and recoveries being treated like the return of principal.
      3. Some companies bribe their reseller to purchase more of their product from the distributor to create artificial demand. And purchased its own products back at a much higher price than that at which it had initially sold. Although the company loses money, it had created fake revenue growth.
      4. With bogus revenue comes increasing receivables. A rapid increase in accounts receivable is often an indication of deteriorating financial health. However, some companies will prevent questions regarding their stubbornly high receivables balance that they inappropriately lowered receivables balances and improperly inflated CFFO.
   2. Recording revenue from transactions that lack a reasonable arm’s length process
      1. Although some transactions that lack a reasonable arm’s-length process are sometimes appropriate, but prudent investors should bet against it as most related-party transactions that lack an arm’s-length exchange produce inflated, and often phony, revenue.
      2. If a seller and a customer are also affiliated in some other way, the seller’s quality of revenue on sales may be suspect. g. a sale to a supplier, relative, corporate director, a majority owner, or business partner, raises doubt as to whether the terms of the transaction were negotiated at arm’s length. Was a discount given? Was the seller expected to make future purchases from the vendor? Were there any side agreements requiring the seller to provide a quid pro quo? A sale to an affiliated party or strategic partner may be an appropriate transaction but investors should spend time scrutinizing these arrangement as it is important to understand whether the revenue recognized is truly in line with the economic reality of the transaction.
      3. Beware when a large percentage of increase in sales comes from 1 party (a related party e.g. JV partner).
      4. Beware when a related party accounts for a large percentage of total sales.
      5. Beware when a large percentage of accounts receivable balance is from 1 party (a related party).
      6. Watch for unusual sources of revenue at the time of an acquisition. Revenue between 2 parties that are about to merge clearly lacks an arm’s-length process. g. a company can sell more products to another company it is about to acquire, and increase the amount that it would pay to acquire the company by the same amount to cover the price of the products, with no real net economic impact.
      7. Be alert to 2-way transactions with a non-traditional buyer, e.g. simultaneously buying and selling products to a customer-vendor company.
      8. Be alert to transaction involving sales to a related party, affiliated party, or joint venture partner.
   3. Recording revenue on receipts from non-revenue-producing transactions
      1. Bogus revenue can arise from misclassification of cash received from non-revenue-producing activities. Not all cash received represents revenue or even directly pertains to a company’s core operations. Some inflows are related to financing activities like borrowing and stock issuance, and other to the sale of businesses or sundry assets.
      2. Question revenue recorded when cash is received in lending Never confuse money received from banks with E.g. a company taking out a loan with a bank, posting inventory as collateral, but rather than recording the cash as liability, it recorded it improperly as sale of goods, recording bogus revenue and provided bogus cash flow from operations. Money received from customers. A bank loan must be repaid and is considered a liability, while money received from customers in return for a service rendered is yours to keep and considered revenue.
      3. Challenge advances received from a (JV) partnership that are classified as revenue.
      4. Be wary of revenue recorded on receipts from vendors. Generally, cash flows with vendors involve cash outflows to purchase products or services. Occasionally, a company will agree to overpay a vendor for inventory upon purchase, provided the vendor rebates that excess charge with a cash payment in a later period. Recording that cash rebate as revenue is clearly inappropriate and should be recorded as an adjustment to the cost of the inventory purchased. Some companies also commit to future purchases from a particular vendor in exchange for an immediate “rebate” from that vendor, inappropriately recorded as revenue.
      5. Consider how retailers account for returned goods and be wary when companies record refunds/credits from suppliers or other vendors as revenue, instead of reducing the value of the inventory purchased. g. recording as revenue one-time vendor credits for returns or sourcing troubles.
   4. Recording revenue from appropriate transactions, but at inflated amounts
      1. Recording excessive revenue might result from a) using an inappropriate methodology to recognize revenue, or b) grossing up revenue to make a company appear larger than it really is.
      2. Using inappropriate revenue recognition methodologyg. a consulting company tasked with a budget by a client to carry out a project should book revenue by calculating an hourly or daily rate for service rendered, but instead recognize the entire budget under its disposal as revenue. If you spot signs of a questionable accounting approach, test it by comparing the results and practices to those of a similar company that is much larger.
      3. Inappropriately using the gross rather than the net method of revenue recognition. Grossing up revenue to appear to be a larger company can be used by companies that are matchmakers (“agents” of a sale) who facilitate the sale between a buyer and a seller, unlike companies that produce or purchase inventory and then sell it to customers (“principals” of the sale). Principals recognize sales revenue at the gross amount of the transaction, i.e. cost of the product plus the mark-up. Agents simply recognize revenue at the net amount, i.e. the agent’s fee, which is the difference between the cost of the product and the sales price paid by a customer. Principals recognize much more revenue than agents for a transaction that looks the same to an end customer, and rightfully so, because they actually own the inventory and bear the risk of loss. Misleading accounting arise when a company that effectively bears no inventory risk (agent) accounts for sales as a principal and records revenue at the much higher gross amount.

3. Boosting income using one-time or unsustainable activities – inflate current period income by increasing revenue.
   1. Boosting income using one-time events
      1. Watch out for large discrepancies between growth in revenue and growth in operating income % wise. E.g. revenue growing at a much slower pace than operating income and pre-tax profits. Check the cost components to see if there are any large declines, and investigate if these are one-off occurrences by checking the footnote in the 10K or 10Q, e.g. by including proceeds from selling a subsidiary as revenue.
      2. Watch out for companies turning the sale of a business into a recurring revenue stream – beware of commingling the sale of a business with future sale of product. Watch out for 10Q or 10K company’s discussion of its transaction with other businesses and see if they are buying/selling a business at a higher or lower than market price, or entering into a contract to buy/sell goods at a higher or lower than market price. Always review both parties’ disclosures on the sale of businesses to best grasp the true economics of the transactions. Watch out for companies negotiating asset sale and supply agreement concurrently. Some companies will sell a manufacturing plant or a business unit to another company, and at the same time enter into an agreement to buy back product from that sold business unit. These transactions are common in the technology industry and are often used as a quick way to “outsource” an in-house process. Such transaction that commingle a one-time event (the sale of a business) and a normal recurring operating activities (the sale of product to customers) creates an opportunity for the seller of the company to take less money for the sale of its business if the buyer also agrees to give the company a good deal on future purchases (lowering its costs in the future). A company may also sell a business at a deflated price if the buyer also agrees to purchase other goods from the seller at an inflated price (increasing its revenue in the future). For the seller of the company, recurring revenue stream in the form of inflated prices impresses investors far more than cash received from the sale of a business so they prefer to receive less cash upfront from the sale of a business in exchange for more cash later in the form of revenue from the sale of product. Understate one-time gain and overstate the more desirable stream of revenue, which fails to capture the underlying economics of the transaction.
   2. Boosting income through misleading classifications
      1. When assessing a company’s business performance, it is important to analyse the earnings generated by the actual operations of the business (operating income) – gains and losses from interest, asset sales, investments, and other sources unrelated to actually operating the business (non-operating income) are important to analyse as well, but not in a review of a company’s operating performance. Investors typically pay more attention to the operating income (above-the-line) in assessing a company’s health, so companies prefer to showcase strong recurring operating income. Below-the-line income consists of non-operating or non-recurring income.
      2. Ways a company could inflate operating income are a) shifting the “bad stuff” like normal operating expenses out to the non-operating section, b) shifting the “good stuff” like non-operating or non-recurring income into the operating section, and c) using questionable management decisions regarding balance sheet classifications to help offload the bad stuff or upload the good stuff.
      3. Companies can shift normal operating expenses below the line by writing off costs that would normally appear in the operating section e.g. taking a one-time charge to write off inventory or plant and equipment would effectively shift the related expenses (cost of goods sold or depreciation) out of the operating section into the non-operating section, pushing up operating income.
      4. Watch for companies that constantly record “restructuring charges” and “one-time charges” – view them with scepticism as company may be bundling normal operating expenses into these charges and trying to pass them off as one-time in nature. Investigate what these charges are more closely to understand what the company is trying to keep out of its operating income. To understand the economic reality at a company that records restructuring charges every quarter is to reduce operating income by the amount of those charges. Companies can abuse charges related to a restructuring plan (normally a non-recurring cost) e.g. closing down an office and paying a severance to employees and fee to break the office lease, by recording “restructuring charges” in virtually every period.
      5. Watch for companies that shift losses to discontinued operations. A company can announce plans to sell off a money losing division and put it up for sale and account for it as a “discontinued operation”. In doing so the entire loss from the division would be moved below the line and most likely ignored by investors.
      6. Watch for companies that include investment income or non-operating gains as revenue.g. a restaurant including interest income on loans from franchisees as a source of revenue, instead of purely restaurant sales revenue as revenue.
      7. Be suspicious of inflated operating income related to subsidiaries due to the quirks of consolidation accounting. If a company decides to form several majority-owned JVs, owning 60% of each, accounting rules require that the units be consolidated and the “parent” report as its own all of the revenue and operating expenses as operating income; the 40% owned by other would be subtracted later on the income statement, below the line. Investors will see an operating profit that is 100% of the subsidiary’s operating profit, not the economic reality of 60% of the subsidiary’s operating profit.
      8. Pay attention to where companies classify investment JV income. Under the equity method of accounting for investments, if an investor possesses the “ability to exercise significant influence” (generally held to be at least 20% stake), its proportionate share of the profits should be included as non-operating investment income, not as revenue. Misclassifying investment JC income as revenue instead of non-operating investment income would overstate sales and operating profits.
      9. Beware of companies using discretion regarding balance sheet classification to boost operating income. Non-consolidated JVs require management to assess whether it possess the ability to exercise significant influence, often using a 20% stake as a general guideline. If management believes that such influence exists, the company’s proportionate/pro rata share of the JV’s income or loss should flow to the statement of income (equity method of accounting). If the company lacks such influence, the balance sheet account related to the JV is simply adjusted to fair value. Management can carry out shenanigans by pushing income into income statement by asserting that they possess that influence in periods when the income from the JV is strong, or to push losses off to the balance sheet by stating that no significant influence exists when the JV’s operations are weaker. Watch out when a company changes the structure of its ownership of a subsidiary (when its economic stake in the business remains unchanged, e.g. by placing its ownership interest in a trust and it doesn’t vote anymore but the trustees vote instead) where it either asserts it has influence when the subsidiary is profitable, or that it has no influence when the subsidiary is losing money. Misclassification of income from JVs.
      10. Accounting for investments in other companies: for a small investment in a company, typically under 20%, the owner presents the investment at fair value on its balance sheet. If the investment is designated as a trading security, changes in fair value are reflected on income statement. If it is designated as available for sale, changes in fair value are presented as an offset to equity, with no impact on earnings unless permanent impairment exists. For a medium-sized investment, typically from 20% to 50%, the owner reports its proportional share of the investment’s earnings as a single line on the income statement, called the equity method. For a large investment in a company, typically over 50%, the owner fully merges the investment’s financial statements into its own, called consolidation method.
      11. Beware when companies shift losses on JVs to the balance sheet, but consolidates gains into their own income statement. g. Enron invested in a series of new ventures that require massive infusion of capital that would probably produce large losses during the early years, which potentially would cause damaging impact of debt on the balance sheet and big losses on the income statement. It created thousands of partnerships that are not consolidated, and as a result, would keep all this new debt off its balance sheet. Moreover, this complicated structure would help it hide the expected economic losses, or whenever possible, pull in gains.
      12. Beware of suspicious or frequent use of joint ventures when unwarranted

4. Shifting current expenses to a later period – inflate current period income by reducing expenses. Companies account for their costs and expenditures in a 2-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 recorded on the balance sheet as an asset. Step 2 happens when the benefit is received and at this point the cost should be shifted from the balance sheet to the income statement and recorded as an expense. Costs with a long-term benefits sometimes require a slower dance in which the cost remains on the balance sheet and is recorded as an expense gradually (e.g. equipment with a useful life of 20 years). Costs that provide a short-term benefit require a fast-pace dance in which the 2 steps happen virtually simultaneously. Such costs spend no time on the balance sheet, but instead are recorded as expenses e.g. typical operating expenses like salaries and electricity costs. Management can exert influence over the speed at which they dance the 2 steps and management can improperly keep costs frozen at step 1 on the balance sheet, instead of moving them to step 2 as expenses on the income statement.
   1. Improperly capitalizing normal operating expenses, i.e. records costs on balance sheet as an asset (capitalizes the costs) instead of expensing them immediately
      1. Assets fall into 2 categories: a) those that are expected to produce a future benefit e.g. inventory, equipment, prepaid expense, b) those that are ultimately expected to be exchanged for another asset such as cash e.g. investments and receivables. Assets that are expected to provide a future benefit are close cousins of expenses; they both represent costs incurred to grow a business. The key different between assets and expenses is timing.
      2. Watch out for unexpected decline in free cash flow (since it minuses capital expenditure from operating cash flow, so capitalizing expenses still count as capital expenditure and won’t be hidden from FCF) along with an equally big drop in cash flow from operations (but sometimes company might capitalize all additional expenses to keep cash flow from operations same as before).  
      3. Question large increase in capital expenditure that are unexpected and belies the company’s original guidance and market conditions. Look at industry trends and whether competitors are increasing their capital spending as well. Look at the company’s operating cash flow and operating income – if it is deteriorating, is it appropriate that the company is increasing its capital spending.
      4. Look out for unwarranted improvements in profit margins and a large jump in certain assets (that used to be of smaller value – could be capitalized expenses that are not being amortized).
      5. Watch for improperly capitalization of marketing and solicitation costs. Marketing and solicitation costs are examples of normal operating expenses that produce short-term benefits. Accounting guidelines normally require that companies expense these payments immediately as normal recurring short-term operating costs. However some companies aggressively capitalize these costs and spread them out over several periods.
      6. Watch out for new categories of unusual and relatively large assets (as a % of sales or costs or assets or inventory) and find out what they are. Be even more suspicious if they are related-party in nature, or if they are increasing at a rapid rate. A surge in any unusual asset accounts, particularly ones that involved a related party, should send investors running for the exits.
      7. Watch for a change in policy from expensing to capitalizing certain costs, even if company justifies it, especially if it has a big impact on earnings. Can be found in footnotes.
      8. Watch for earnings boosts after adopting new accounting rules. Occasionally the decision to begin capitalizing costs comes not from management but from compliance with a new accounting rule promulgated by the standard setters. While criticizing management for such a change would be unjustified, but investors should recognize that any improvement in profit resulting from the change would be ephemeral and unrelated to operational success.
      9. Regardless of the legitimacy of an accounting change, investors must strive to understand the impact that this change had on earnings growth. Any growth related to the change will not recur. In order to be maintained, the growth must be replaced with improved operational performance.
      10. Companies might be capitalizing permissible items, but in too great an amount. Accounting guideline permits companies to capitalize some operating costs, but only to a certain extent or if certain specific conditions can be met. These costs are hybrids – costs that are recorded partially as an expense and partially as an asset. A common operating cost that finds its way to the balance sheet particularly at technology companies is the cost incurred to develop software-based products. Early-stage research and development costs for software would typically be expensed. Later-stage costs (those incurred once a project reaches “technological feasibility”) would typically be capitalized. Investors should be alert for companies that capitalize a disproportionately large amount of their software costs or that change accounting policies and begin to capitalize costs, particularly if those costs are out of line with industry practices. Companies within the same industry may apply the rules of capitalization in different ways, as some may define “technological feasibility” differently, causing different companies to have varying levels of capitalized costs and different profitability trends. The sooner a company decides that technological feasibility has been achieved, the sooner it can begin capitalizing costs and no longer charging them as expenses on the income statement.
      11. Watch for different capitalization policies within the same industry.
      12. Watch for an accelerating rate of software capitalization. g. from capitalizing software costs representing 10% of total capital expenditure to 20%. An accelerating rate is often a red flag that earnings benefited from keeping more costs on the balance sheet.
      13. Improper capitalization of costs also inflates operating cash flow. While normal operating costs are reflected as operating cash outflow, capitalized costs would be presented as capital expenditures in the investing section of cash flow statement.
   2. Amortizing costs too slowly
      1. The nature of a cost and the timing of its related benefit dictate the length of time that this cost remains on the balance sheet. Expenditure to purchase of manufacture inventory remain on the balance sheet until the inventory is sold and revenue recorded. Expenditures to purchase equipment or a manufacturing facility provides a much longer-term benefit. These assets remain on the balance sheet for the duration of their useful lives, over which they gradually become expenses through depreciation or amortization.
      2. Investors should raise concerns if costs remain as assets for too long, as evidenced by an unusually long amortization/depreciation horizon. This can be done by comparing depreciation policies with industry norms. Investors can determine whether a company is writing off assets over an appropriate time span and should be concerned when a company depreciates its fixed assets too slowly, thereby creating a boost to income, especially in industries that are experiencing rapid technological advances.
      3. Investors should be warned if management decides to lengthen the amortization/depreciation period, providing a boost to income as expenses per period is reduced and the “asset” stays on the balance sheet for a longer period. This often suggest a company’s business may be in trouble and it feels compelled to change accounting assumptions to camouflage the deterioration. Regardless of how management tries to justify such changes, investors should always be wary. Calculate the impact on operating income by taking away from operating income the “savings” by reducing depreciation expenses.
      4. Compare a company’s net income to its operating cash flow.
      5. Be wary of improper amortization of costs associated with loans. If a company buys mortgage loans, it needs to pay a premium or discount depending on whether the loan interest rates are higher or lower than current market rates. Such premium, discount, and certain loan origination costs, must be amortized over the life of the loan as an offset to interest income. When the company buys a loan at a premium, it amortizes that extra cost over the estimated life of the loan. However, the estimated loan life sometimes needs to be adjusted as borrowers pay off their loans more quickly or more slowly than was originally estimated (called the prepayment rate) and if that happens, rules require that a “catch-up” adjustment be made in order to get the amortization back on schedule (if pay off earlier, amortization of premium needs to be amortized more quickly). If interest rates keep falling and loan takers refinanced their loans at lower rates, the company needs to make catch-up adjustments.
      6. Watch for slow amortization of inventory costs. In most industries, the process of turning inventory into expense is straightforward. When a sale takes place, inventory is transferred to the expense called cost of goods sold. In certain businesses thought, determining when and how inventory turns into expense can be more difficult. E.g. the cost of making movies of TV shows are capitalized before their release. These costs are then matched and charged as expense against revenue based on the receipt of revenue. Since revenue may be realized over several years, a film company must project the number of years of anticipated revenue flow. If it chooses too long a period, the inventory and profits will be overstated during the early years. The company would then be left with a useless inventory balance that would no longer generate revenue (if the movie stops generating revenue) which has to be written off and immediately expensed.
   3. Failing to write down assets with impaired value i.e. failing to record an expense for costs that had been properly capitalized but that diminished in value before the expected benefit was received.
      1. Failure to write off impaired plant assets. It is not enough for companies to simply depreciate fixed assets on a rigid schedule and assume that nothing can ever happen to change that plan. Management must continuously review these assets for possible impairment and record an expense whenever the assumed future benefits fall below book value. Companies that announce big restructuring charges are often trying to “clean house” after failing to write off impair assets in the appropriate earlier periods.
      2. Failure to write off obsolete inventory. Sometimes demand for a product fails to meet the company’s expectations and as a result the company has to lower its prices in order to move the less desirable inventory, or it may have to scrap and write off the inventory completely. Management must routinely estimate its “excess and obsolete” inventory and reduce its inventory balance accordingly by recording an expense often called an inventory obsolescence expense. However, unlike the depreciation of fixed assets like equipment, no predetermined rate would have been established for which inventory would be reduced, and thus these adjustments are subject to a higher level of management discretion and potential manipulation. Management can inflate earnings by failing to record a necessary expense for excess and obsolete inventory, but earnings will be pressured at the time when the inventory is sold at a deep discount or thrown away. Investors should monitor a company’s obsolescence expense and the related inventory reserve in order to ensure that the company does not inflate its profits by changing estimates. Regardless of the justification given by management for recording a lower expense, the impact is an artificial boost to earnings.
      3. Watch for an unexpected inventory build-up. Investors should monitor a company’s inventory level by calculating its days’ sales of inventory (DSI). I.e. jump in inventory relative to cost of goods sold.
      4. Sometimes a company will stock up on inventory heading into a period of expected increased demand and rapid sales growth. While this may be a perfectly legitimate business strategy, companies use it as a common excuse to justify unwarranted inventory growth. Investors should determine whether the strategy has been planned before the inventory build-up or whether the strategy was hatched as a defensive response to the inventory build-up. Investors should be skeptical if no mention of this growth strategy had previously been made. An alternative strategy to test whether an inventory build-up might be justified is to compare the growth in the absolute level of inventory to the company’s expected revenue growth. If inventory growth far exceeds the expected sales growth, the inventory bulge is probably unwarranted and a concern for investors, and a sign of diminished profits in the future.
      5. DSI is calculated as [(Ending inventory/Cost of Goods Sold)*Number of Days in the Period] (for quarterly periods use 91.25 days as an approx.) – for financial shenanigan purposes it is recommended to calculate DSI using ending balance of inventory rather than average balance as the ending balance provides more relevant data about future margin pressure, potential obsolescence, product demand, etc. DSI standardizes inventory balance for the amount of inventory sold in a period. This helps investors determine whether an increase in the absolute level of inventory is in line with the overall growth of the business or whether it might be a harbinger of margin pressure.
   4. Failing to record expenses for uncollectible receivables and devalued investments.
      1. Most companies will have a certain number of deadbeat clients and the occasional clunker in their investment portfolio. Accounting rules require that certain assets be regularly written down to their net realizable value (the amount you expected to get paid). Accounts receivable should be written down each period by recording an estimated expense for likely bad debt. Lenders should record an expense or loan loss each quarter to account for the anticipated deadbeat borrowers. Investments that experience a permanent decline in value must be written down by recording an impairment expense. Failing to take any of these charges will result in overstated profits.
      2. Failure to adequately reserve for uncollectible customer receivables. Companies must routinely adjust their accounts receivable balance to reflect expected customer defaults. This entails recording a bad debt expense on the income statement and a reduction of accounts receivable (allowance for doubtful accounts) on the balance sheet. Failing to record sufficient bad debts expense or inappropriately reversing past bad debts expense creates artificial profits. Watch for a decline in bad debt expenses. Check the inventory obsolescence expense, bad debts expense and expense for estimated sales returns etc. as a % of revenue and see how it compares to the previous quarter or year. If the % has fallen dramatically, it is a cause for concern, and investors should adjust operating income to see what the figure is if these estimates have not been reduced.
      3. Watch for a drop in allowance for doubtful accounts. Under normal business conditions, a company’s allowance for doubtful accounts will grow at a rate similar to that for gross accounts receivables. A sharp decline in the allowance for doubtful accounts (compare % of change in doubtful accounts to % of change of receivables, and doubtful accounts as a % of receivables last period vs this period), coupled with a rise in receivables, often signals that a company has failed to record enough bad debt expense, and thus has overstated earnings. Calculate the operating income had the allowance for bad debt account been maintained as the same % of receivables as the previous period.
      4. Failure by lenders to adequately reserve for credit losses. Lenders must continually estimate the portion of the loans they make that they expect to never collect, called credit losses or loan losses. The lender records an expense on the income statement called provision for credit losses or loan loss expense, and a reduction in total loans receivable on the balance sheet called allowance for loan losses or loan loss reserve. Ideally the total amount in the loan loss reserve should be enough to cover all loans that the bank believes are now or are likely to be in default based on conditions that exist at the date of the financial statements. The additions to reserves charged against income each year should be enough to maintain the reserves at the appropriate level. When management fails to reserve a sufficient amount for losses, profits will be overstated. This overstatement will eventually catch up to the company when the loans go bad, as the company will be forced to write off bad loans with insufficient reserves accrued.
      5. Be wary of a drop in the loan loss reserves (as a % bad (non-accrual or nonperforming loans)) – for debt, loans and inventory. It will inflate profits and leave the company under-reserved and exposed to deterioration in credit quality.
      6. Failure to write down impaired investments. If an investment in a stock, bond, or other security experiences a sharp and permanent decline in value, the company must record an impairment expense. This especially pertains to industries like insurance and banks, for which investments represent a large portion of their assets. When asset become permanently impaired, management cannot just keep reporting them at inflated values on the balance sheet and pretend that there has been no adverse impact on earnings. Impairment charges must be recorded to reduce these assets to their appropriate fair value. Investors should watch for companies that fail to take impairment losses during market downturns.

5. Employing other techniques to hide expenses or losses – inflate current period income by reducing expenses. While monitoring trends in assets, expenses and capitalization policies is a helpful way to catch companies that are inflating their earnings by improperly keeping costs on the balance sheet, costs that provide only short-term benefits never appear on the balance sheet because they are expensed immediately. Look out for unexpected and unwarranted margin expansions.
   1. Failing to record an expense from a current transaction
      1. A way to hide expense is to pretend you never saw an invoice from a vendor until after the quarter has ended, and record the expense only in a later period, overstating net income in the current quarter.
      2. Investigate unusual transactions in which vendors send out cash. Always question any cash receipt from a vendor. Cash normally flows out to vendors, not in. To artificially reduce expenses and inflate profits, companies can carry out ploys involving receiving sham rebates from suppliers. The company might agree to purchase products from a vendor at a higher price the next year, if the vendor pays the difference upfront in the current period upon signing the agreement, reducing expenses and increasing earnings by the difference (which should have been recorded as a reduction of the inflated price of future products purchase).
      3. Watch for unusually large vendor credits or rebates (as a % of profit). This can be found in the footnotes disclosures of unusually large vendor credits. All the more suspicious if it is a related-party transaction.
   2. Failure to proper account for stock option backdating expense, where management secretly give themselves stock options that had already increased in value. By not reporting the compensation expense resulting from these “in-the-money” stock options grants, companies are overstating their earnings. Look out for unusually “lucky” timing on the issuance of stock options.
   3. Failing to record an expense for a necessary accrual or reversing a past expense
      1. Expense accruals are generally company estimates of routine liabilities incurred in normal business operations, such as a manufacturer’s warranty. Often these costs are estimated and recorded at the very end of the quarter. Failing to appropriately record an expense for these costs, or reversing past expenses, will inflate earnings. Since these costs depends on management assumptions and discretionary estimates, to generate more earnings and meet Wall Street expectations is to tweak these assumptions.
      2. Watch for declines in reserves for warranties or warranty expense relative to revenue as it may signal that earnings are being inflated through under-accruing for warranty obligations – monitor these trends quarterly.g. Dell cannot wait and see how much it will wind up spending on warranty costs for computers covered under warranty, and must record an expense for expected future warranty costs at the time the product is sold. If management chooses too little expected warranty expense, profits will increase, if it choose too much, profits will be constrained or simply held back for a rainy day.
      3. Watch for declines in the employee bonus accrual. Employees earn bonuses over the course of the year and accounting rules require that the expense be spread throughout the year even if the employees receive a single lump-sum payment. If management fails to record this accrual in any particular quarter, earnings for that period will be overstated. Inappropriate reversal of past bonus accruals will inflate earnings as well.
      4. Be alert for companies that fail to accrue expenses for loss contingencies. Sometimes management may be required to establish a contingency reserve and record an expense or loss for outstanding yet unsettled disputes. Accounting rules require that losses be accrued for such contingencies e.g. expected payments related to litigation or tax disputes, when the following 2 conditions exist: a) there is a probable loss, and b) the amount of the loss can be reasonably estimated.
      5. Remember to review off-balance-sheet purchase commitments, which can be found in footnotes – investors should pay attention to any commitments and contingencies discussed in the footnotes or the management discussion and analysis section of the financial report. Despite not being reflected on the financial statements, these obligations can doom a company. Sometimes unrecorded liabilities for commitments and contingencies are more significant than liabilities reported on the balance sheet, e.g. a company owning futures to purchase a lot of products at far above market prices. Future obligations and contingencies that companies have include a company agreeing to purchase inventory over the following 2 years or having committed to funding a project or renting real estate. While these purchase obligations often cannot be rescinded, they are typically excluded from the liability section of the balance sheet and are thus considered “off-balance-sheet” liabilities.
   4. Failing to record or reducing expenses by using aggressive accounting assumptions
      1. Companies that provide pensions and other postretirement benefits to employees can change their accounting assumptions in ways that reduce the recorded expense. Similarly, companies that lease equipment make a variety of estimates that will have a bearing on the reported liabilities and expenses.
      2. Boosting income by changing pension assumptions. Companies that provide pension for employees must record an expense each quarter to account for the incremental costs incurred under the plan. Pension expense generally is not shown explicitly on the income statement but grouped together with other employee salary costs (usually a component of COGS or SG&A). Investors should scrutinize the pension accounting assumptions in the footnotes, as they allow for considerable management discretion that might be used to reduce or eliminate that expense. Regardless of the legitimacy of increasing the expected return, this change reduces pension expense and provides a one-time boost to earnings. Watch for aggressive assumptions for the expected return on plan assets, and for increases in the rate of return (and whether it makes sense given market conditions and when compared to their peers). If management chooses a more aggressive expected return, the recorded pension expense will be smaller, inflating profits. Companies that consistently overestimate investment returns on plan assets are hiding the true economic costs associated with their obligations to both current and former employees. Aggressive assumptions might persist for years, with actual returns falling far short of expectations, leading to supressed pension expense and inflated earnings for many years.
      3. Pension expense is calculated by taking the incremental annual costs of running a pension plan, and subtracting the expected investment return on pension plan assets. Management can exercise great influence on the underlying assumptions of both measures. The investment return on pension plan assets is not simply the actual return earned that year. Accounting rules state that the investment returns is a smoothed return consisting of a) the estimated expected return on the asset base (the estimate we are discussing), and b) the amortization of the cumulative difference between the estimated return and the actual return (a slow “catch-up”).
      4. Watch for changes in other estimates and assumptions. Many actuarial assumptions must be used to calculate pension expense, including discount rates, mortality rates, and compensation growth rates etc. companies usually disclose changes to these assumptions in their pension footnotes. g. by increasing life expectancy of plan participants, a company can spread “unrecognized losses” over a longer period and reduce its pension expense to inflate income.
      5. Watch for changes in measurement date as a change in the month designated as the measuring date for the pension plan can inflate profits. Look at how this change (compared it usual date) impacts on earnings.
      6. Watch for outsized pension income, especially when considered as a % of total operating income. There could be pension income instead of pension expense when expected gains from investing the plan assets become larger than the incremental annual costs of running the pension plan. Usually these situations arise at companies with large legacy pension plans and few or no new employees entering the plan. The pension footnote is required reading for any company with a large pension plan and investors should monitor key assumptions and assess the impact of pension expense on earnings.
      7. Watch out for companies boosting income by changing lease assumptions like increasing the residual value on certain lease equipment. Residual value is a company’s estimate of what the leased equipment will be worth when it is returned by the customer at the end of the contract. When leasing equipment to customers, a company records revenue for the lease payments as well as a cost for the equipment provided, which is depreciation during that period for an equipment. Since equipment would be depreciated down only to its residual value, companies can boost profits by having a high residual value, as this would lower the amount that would be subject to depreciation.
      8. Some companies don’t buy business insurance but “self-insure” certain risks. They create a fund that they believe will be sufficient to pay out insurance claims, and record expenses each period for the amount needed. How large the self-insurance liability should be and how much self-insurance expense should be accrued each quarter depends on estimates. Be alert for changes in self-insurance assumptions, e.g. instead of using general industry loss assumption, change to internally developed assumptions based on own loss experience. Regardless of the legitimacy of this change, it provides a nonrecurring boost to earnings (look at how big a decline in expense as a % it represents of earnings and of earnings growth)
   5. Reduce expenses by releasing reserves from previous charges
      1. One benefit of taking a special charge is to inflate future-period operating income because future costs have already been written off through that charge. A second benefit is that the liability created with the charge becomes a reserve that can easily be released into earnings in a later period. One type of reserves is a generic liability reserves that management might have established by taking a charge at some point. By creating bogus liability, whenever needed, management can make an accounting entry that moves the credit from the liability to an expense account, reducing expense and boosting profit.
      2. Watch for the release of restructuring reserves into income. During restructuring, a company records restructuring charges, thereby creating reserves to be used for future expenditures related to the restructuring plan. However, improper reserves can be released into income, inflating profit margin and creating illusion of successful restructuring.
      3. Many of these liability reserves, especially the generic ones, are often grouped in a “soft” liability account sometimes called “other current liabilities” or “accrued expenses”. Investors should monitor soft liability accounts closely and flag any sharp declines relative to revenue. Often, companies discuss these soft liabilities in a footnote. Make sure to read them and track the individual reserves as well.

6. Shifting current income to a later period – inflate future period income by holding back revenue from current period (shift earnings from one period with excess profits to another in need of profits; smooth out volatile earnings in order to portray a more steady business). Look out for unexpectedly smooth earnings during a volatile time.
   1. Creating reserves and releasing them into income in a later period
      1. When business is booming and earnings far exceed Wall Street estimates, companies might not report all their rightfully earned revenue but save some of it for a rainy day by storing it on the balance sheet. It will increase a balance sheet liability account called deferred revenue or unearned revenue in the current period, and when the deferred revenue is needed in a later period to boost earnings, another entry is made to move it to actual revenue.
      2. Watch for large increases in the unearned revenue account. Regardless of the legitimacy of policy changes to release unearned revenue account, the impact is to increase earnings. (from revenue recognition disclosure in the 10K)
      3. Companies stretch out unexpected or windfall gains to future periods. When a company experiences a significant and unexpected increase in revenue/profit, management can defer some of the unanticipated income by increasing or establishing reserves, and then releasing them in order to create steady earnings growth and hide volatile growth.
      4. Watch out for release of large excess reserves into income. These are not sustainable earnings boost.
   2. Improperly accounting for derivatives in order to smooth income
      1. Some companies are healthy companies that are attempting to portray a more predictable income stream, but misrepresent economic reality to investors.
      2. Accounting rules for derivatives provide a framework for categorizing hedges into groups based on different attributes, such as their purpose and effectiveness. The categorization is important because it determines whether or not fluctuations in the derivative will affect earnings. E.g. all quarterly gains or losses from the change in value (the mark-to-market adjustment) on a hedge that is deemed to be “ineffective” should be recognized as current-period income. For certain types of “effective” hedges, the change in value doesn’t affect earnings at all. If the derivative is used as an effective cash flow hedge on a future transaction for an asset or liability, the value of the hedge will move in the opposite direction from the value of the asset or liability. As a result, quarterly fluctuations in fair value on certain types of effective hedges do not affect earnings.
      3. Some companies commit fraud when disregarding the hedge accounting rules by valuing and categorizing its hedges inappropriately. E.g. not recording declines in the value of its derivatives appropriately, classifying some hedges as effective (no impact on earnings) when they should have been treated as ineffective (impact on earnings). This can help a company smooth its earnings by giving management the discretion to take gains and losses on derivatives in whatever period it saw fit.
      4. Beware of large gains from ineffective hedging as these ineffective “hedges” may really be unreliable speculative trading activities that could just as easily produce large losses in the future. Also be aware of ineffective hedges that produce gains well in excess of the loss in the underlying asset or liability (implies speculation being done). Also be wary of “hedges” that move in the same direction as the underlying asset or liability as this may signal that management is using derivatives to speculate, not to hedge.
   3. Creating an acquisition-related reserves and releasing them into income in a later period
      1. Acquisitive companies create some of the biggest challenges for investors as they become more difficult to analyse on an apple-to-apple basis. Acquisition accounting rules also creates distortions in the presentation of cash flow from operations.
      2. Companies making acquisitions might be tempted to have the target company hold back some revenue that was earned before the deal closes so that the acquirer can record it in the later period. Look out for lower revenue at a target company just before it is acquired (quarter vs previous quarter or vs previous year quarter). Whatever the real reasons for failing to close sales, it has provided its new owner with an artificial revenue boost.
   4. Recording current-period sales in a later period when the current period has very strong revenues and earnings.

7. Shifting future expenses to an earlier period – inflate future period income by accelerating future expenses to current period (shift earnings from one period with excess profits to another in need of profits; smooth out volatile earnings in order to portray a more steady business). Rush costs on the balance sheet to expenses immediately and record all invoices now and even more as expenses of the current period. Watch out for unusually smooth earnings during volatile times.
   1. Improperly writing off assets in the current period (by recording expenses much earlier than is warranted) to avoid expenses in a future period. This involves recording expenses today in order to prevent past expenditures which remain as assets on the balance sheet from becoming future expenses.
      1. Companies accelerate future-period expenses into the current period and by categorizing the write-off as being unrelated to normal activities and showing it below the line, it inflates future period profits with no detriment to current period operating results. Watch out for large write-offs in general.
      2. Improperly writing off deferred marketing costs as a one-time charge.
      3. Improperly writing off inventory as being obsolete long before any sale takes place. Inventory costs should be capitalized and then later expensed either when the product is sold or when it is written off as obsolete. Watch out for large write-offs in inventory, especially when followed by rapid margin expansion in subsequent periods.
      4. Improperly writing off plant and equipment considered impaired. Management can curtail the depreciation period and announce impairment charges for certain pieces of plant and equipment, even though they may be perfectly fine. Look out for large write-offs in plant and equipment. Investors should be particularly alert to this type of shenanigans when it corresponds to the hiring of a new CEO with tantalizing stock options or if management uses this ploy with uncommon regularity.
      5. Improperly writing off intangible assets. Most intangible assets (with goodwill as a notable exception) will be amortized over a set period established by management. Curtailing the time horizon for amortization lowers profits by charging off more expense per period. Look out for shortened useful life on intangible assets.
      6. Watch for restructuring charges just before an acquisition closes by the company to be acquired. By taking a merger-related charge, the company being acquired allows the acquirer to avoid recording these costs as part of normal operations after the merger. By writing off things like fixed assets, goodwill and technology purchased, future periods depreciation and amortization expenses will be reduced and income increases.
      7. Be wary when restructuring occurs with uncommon regularity. Restructuring costs for streamlining operations and cost containment programs often are warranted during tough economic times. However, restructuring events shouldn’t become a yearly affair. If a company incurs a certain type of cost every year, it should be shown as a recurring operating item.
   2. Improperly recording charges to establish reserves used to reduce future expenses. This involves recording an expense today in order to keep future expenditures from being reported as expenses. Management loads up the current period with expenses, taking some from future periods and making some up. When future period arrives, operating expenses will be underreported and bogus expenses and related bogus liabilities will be reversed, resulting in underreported operating expenses and inflated profits.
      1. Using restructuring charges today to inflate operating income tomorrow. Any company taking a restructuring charge e.g. laying off workers, might consider padding the total dollars written off in order to lower future period operating expenses. Thus, salary expenses to employees who are laid off today will decline in future periods, as any future severance payments received will be bundled into today’s one-time charge. Future periods’ above the line operating expense disappears, and the current period’s below the low restructuring charge increases by that same amount. Since investors generally ignore restructuring charges, the more a company throws into the charge-off, the better for the company.
      2. Watch for dramatic improvement in operating income right after the restructuring period.
      3. Watch for “big bath” charges during difficult times. There is no better time to record huge charges than when the market is in a downturn. Since during these times investors are more focused on how companies will emerge from the downturn, large charges are rarely frowned upon, and are often seen as positive.
      4. Creating a larger-than-needed restructuring reserve and inflating future earnings by releasing the reserve. Companies can use restructuring reserves to smooth earnings by releasing the bogus reserves in the liability account and reducing expenses.
      5. Watch for companies that create reserves at the time of an acquisition (excuse being that these charges are necessary for restructuring of operations, merger integration costs, unknown risks arising out of the transaction). It is a violation of GAAP by recording a reserve for an unknown and unquantifiable risk. A company can then release funds into income whenever its results fall short of expectations.

3. Cash flow shenanigans – investors often compare net income with CFFO and become concerned when CFFO lag behind net income. High net income along with low CFFO signals the presence of some earnings manipulation. Companies are aware that investors are concerned about the CFFO section and move the cash inflows to the most important operating section, while sending the cash outflows to the financing and investing sections.

1. Shifting financial cash inflows to the operating section
   1. Recording bogus CFFO from a normal bank borrowing
      1. A company can borrow a short term loan from a bank and put up as collateral its inventory (which could be seized if the company cannot pay back the loan). The company should record the money received as a borrowing, i.e. an increasing in cash flow from financing activities, and increase cash and liability (loan payable) on the balance sheet. But, the company can instead record the transaction as a sale of inventory, recording the transaction not in a manner consistent with the economics and intent of the parties.
      2. Bogus revenue might also signal bogus CFFO.
      3. Be wary of pro forma CFFO metrics i.e. CFFO metrics that are defined by the company and could provide a misleading picture. Be cautious whenever management places such an intense focus on a company-created cash flow metric that covertly redefines the very important CFFO. Normally investors use CFFO and operating cash flow interchangeably but some companies might define them differently.
      4. Complicated off-balance-sheet structured raise the risk of inflated CFFO. Off-balance-sheet vehicles such as special purpose entities might borrow money and use the cash received to buy goods from the parent company, and the company records the cash received as CFFO.
   2. Boosting CFFO by selling receivables before the collection date
      1. Companies can turn receivables into cash even though the customer has yet to pay by finding a willing investor, often a bank, and transfers the ownership of some receivables to it. In return the company pockets a cash payment for the total amount of receivables, less a fee. It is important to recognize when a company is selling its receivables, as these transactions are recorded as CFFO inflows. There are different ways in which companies can sell their receivables, including factoring transactions and securitizations, and one must keep an eye out for these words in financial statements. Factoring is the simple sale of receivables to a 3^rd party, often a bank or a special-purpose entity. Securitization is the sale of receivables to a 3^rd party, often a special-purpose entity, for the purposes of creating new financial instruments by repackaging the receivable inflows.
      2. Selling accounts receivable is an unsustainable driver of operating cash flow growth. A company is essentially collecting on receivables that would normally have been collected in future quarters. By collecting the cash earlier than anticipated, the company essentially shifted future-period cash inflows into the current quarter, leaving a “hole” in future periods’ cash flow. The transfer of cash flow to an earlier period is likely to result in disappointing future CFFO.
      3. Watch for sudden swings on the statement of cash flows. Look out for huge increases in cash flows coming from a particular source, e.g. receivables – look at the % change of cash inflow coming from that source this period vs last period, and how big a % of the total cash inflow it makes up). Focus not only on how much CFFO grew but also on how it grew, and find out what is the primary driver of growth.
      4. Accounts receivable sales would be disclosed in earnings release (not all the time) as well as the 10Q or 10K filing (not likely to be disclosed on the statement of cash flows itself). Know that the growth of CFFO came from a nonrecurring source.
      5. When normalizing CFFO to exclude the impact of sold receivables, use the change in sold receivables outstanding at the end of the quarter – this way you account for the receivables that were outstanding last quarter but collected during this one.
      6. Be wary of companies that don’t provide investors with details and not being transparent about their sale of receivables. It could be a warning of window dressing the cash flow statement, or an impending cash flow crunch.
   3. Inflating CFFO by faking the sale of receivables
      1. If a company transferred its receivables to a bank in exchange for cash, but the risk of collection loss still remains with the company (who needs to return the cash to the bank for receivables not collected), then the economics of the relationship would be more like a collateralized loan, and should be presented as a financing cash inflow. However a company might ignore the economic reality of the situation and record it as sale of receivables and an operating cash inflow.
      2. Watch carefully for disclosure changes in the risk factors. Many investors overlook the “risk factor” section of corporate filings. Try to identify changes in the text. If new risks have been added or previously listed ones have been changed, the change is deemed worthy of disclosure by the company or its auditor, and you need to know about it. The mere fact that a risk disclosure found its way into the risk factors tells you that it must have been significant – no matter how a company justifies why they need it)
      3. Look for disclosure changes each quarter, particularly in the most important sections of the filings. Most research platforms and word processing software have “word compare” or “Blackline” functionality, where reviewing both filings side by side is not as cumbersome as it sounds.
      4. Be wary when a company provides less disclosure than in the prior period.
      5. Whenever companies disclose that a mysterious new arrangement is a driver of CFFO (or of any important metric), investors should seek to understand the mechanics of the arrangement. Only significant changes require new disclosure so when you notice something new, consider it a big deal. New disclosures should provide more answers. Avoid companies where new disclosures provide more questions instead.

2. Shifting normal operating cash outflows to the investing section
   1. Inflating CFFO with boomerang transactions
      1. Be on the lookout for boomerang transactions (buying from and selling to the same party); look for disclosures of them in 10K and 10Q filings. Companies won’t talk about boomerang transactions explicitly but there are details about these transactions, particularly when they are substantial in size. Once you have seen one, it is imperative that you dig around and understand the true economics of the arrangement, and look for further disclosure. Assess the economics of the transaction and understand how it contributes to the company’s results. Consider whether the company has been deliberately avoiding or complicating disclosure – it may not want you to understand how its boomerang transactions work. If you cannot get comfortable with a boomerang transaction, steer clear of the company. Companies can sell something to a customer, representing an operating cash inflow, and simultaneously buy something from the same customer, but recording the cash outflow in investing outflow.
   2. Improperly capitalizing normal operating costs
      1. If you suspect a company of receiving an earnings benefit from improper capitalization, don’t forget there may be a boost to operating cash flow as well, since the cash outflow will be classified under investing outflow.
      2. Dishonest management may find ways to improperly capitalize any normal operating cost, however, the most common ones are generally those related to long-term arrangements such as R&D, labour and overhead related to a long term project, software development, and costs to win contracts or customers. Monitor these accounts for the best chance of spotting aggressive capitalization.
      3. Rapidly growing or new fixed asset accounts or “soft” asset accounts (e.g. “other assets”) may be a sign of aggressive capitalization. Create a quarterly common-size balance sheet (i.e. calculate all assets and liabilities as a percentage of total assets) to help you quickly identify assets that are growing faster than the rest of the balance sheet.
      4. Pay attention to free cash flow as if a company improperly capitalizes expenses, CFFO will be overstated but FCF may not be affected since it is a measure of cash flow after capital expenditure.
      5. Take note of unexpected increase in capital expenditure.
      6. Take note of jump in soft assets relative to sales.
   3. Recording purchase of inventory as an investing outflow
      1. The economics of purchasing goods to be sold to customers suggests that these purchasing should be classified as operating activity on the statement of cash flow. However some companies treat these purchases as investing outflow.
      2. Consider differences in accounting policies when comparing competitors, e.g. a company which places DVD purchases in investing cash outflow cannot be compared to the CFFO of a company that places DVD purchases in operating cash outflow, without making an adjustment.
      3. Question any investing outflow that sounds like a normal cost of doing operations. Make sure to scan all sections of cash flow statement, even the investing and financing sections, in order to spot categories which might seem like they don’t belong to that section.
      4. Keep an eye out for companies that purchase goods and then lease or rent those goods to customers. They might capitalize the goods they purchased to lease out, instead of putting them into the operating cash outflows.
      5. Some companies rely on their own internal R&D projects to grow their business organically, while others choose to grow inorganically by acquiring development-stage technologies, patents and licenses. While these different business strategies are both means to the same end, the expenditures are often treated differently on the cash flow statement. Cash paid to employees and vendors for internal R&D would be reported as operating outflow, while some companies report cash paid to acquire already researched and developed products as an investing outflow. In certain industries, acquiring development-stage technologies is considered commonplace, e.g. pharmaceutical industry. When analysing a pharmaceutical company’s business, you should be considering the cash paid to acquire the drug rights. Since the payment will be classified in the investing section, many investors have no idea it even exists. Keep an eye out for treatment of purchase of development-stage technologies being classified as investing outflow, especially at companies where individual patents or rights agreements have a significant impact on the business, such as pharmaceutical and technology companies.
      6. Take note when a company purchases right to a patent/contracts/development-stage technologies through noncash transactions. Instead of paying cash at the time of purchase, a company might instead compensate sellers by issuing a note, i.e. a long term IOU under which the company will pay cash in the future. Since no cash changes hands at the time of the sale, there is no impact on the cash flow statement. When the company pays down the debt over time in the future, the cash outflow will be presented as a financing outflow as repayment of debt. The economics suggests that this purchase relates to normal business operation, yet they are reflected as financing outflow. When analysing a company’s ability to generate cash, these purchases using noncash transactions should not be ignored.
      7. Look for “supplemental cash flow information”. Companies frequently provide information about noncash activities in disclosures. The disclosure is sometimes found after the cash flow statement, sometimes buried deep in the footnotes.

3. Inflating operating cash flow using acquisitions or disposals – Companies that make numerous acquisitions (such companies often lack internal engines of growth, such as product development, sales and marketing) (for acquisitive companies, suggested to compute an adjusted free cash flow that removes total cash outflows for acquisitions)
   1. Inheriting operating cash inflows in a normal business acquisition
      1. Do not rely heavily on CFFO for acquisitive companies as a sign of business strength and quality of earnings. There is an accounting loophole that enables acquisitive companies to show strong CFFO every quarter simply because they are acquiring other businesses. When a company pays for the acquisition, they do so without affecting CFFO as if they buy the company with cash, it is recorded as an investing outflow, and if they buy with stock, there is no cash outflow. As soon as they gain control of the acquired company, all of the acquired company’s revenue and operating cash inflow will become part of the company’s. The company is able to generate a new cash flow stream via the acquired business without any initial CFFO outflow. In contrast, companies that seek to grow their business organically would generally first incur CFFO outflows in order to build the new business. Now that the company has inherited the receivables and inventory of the acquired business, they can generate an unsustainable CFFO benefit by rapidly liquidating these assets by collecting the receivables and selling the inventory. Normally accounts receivable result from past cash expenditure, e.g. cash paid to purchase or manufacture the inventory sold, so a cash inflow from collecting a receivable comes only after you have had a cash outflow to generate that receivable. When you acquire a company however, and inherit its accounts receivables, the cash outflows involved in generating those receivables were recorded on the acquired company’s books prior to the acquisition. Thus when the acquirer collect those receivables, they will be receiving an operating cash inflow without ever having recorded a corresponding operating cash outflow. The same is true with inventory. The proceeds received from selling inventory inherited in an acquisition will be recorded as an operating inflow even no operating outflow ever occurred. Cash spent to purchase inventory and other costs related to the sale occurred before the acquisition, and when the company close on the deal, the company must pay the seller for inventory, receivable etc. but those outflows are reflected in the investing section. After the deals close, the company collect all the cash from customers and show it as inflows in the operating section. By liquidating and not replenishing these assets e.g. keeping the acquired business’s inventories at a lower level, the company can show an unsustainable benefit to cash flow. In an acquisition context, cash outflows never hit the operating section, yet all the inflows do. To be fair, when companies inherit working capital liabilities like accounts payable, the acquirer will be on the hook for paying off the seller’s vendors and cash paid will be an operating cash outflow. However, most acquisitions involve companies that have positive net working capital i.e. more receivables and inventories than accounts payable. This is why companies that grow through acquisitions often appear to have stronger CFFO than companies that grow organically.
      2. Beware of serial acquirers who make numerous acquisitions of mediocre companies and brag to investors about the strength of their underlying business, pointing to the exploding CFFO. But the cash flow boost had virtually nothing to do with the performance of their business.
      3. For some acquirers, getting a boost to CFFO is not enough, but they also get the soon-to-be-acquired company to purposefully abandon collection efforts of receivables and prepay bills down rapidly, and cause the target company’s CFFO to be abnormally low in the weeks leading up to the acquisition. Look out when the target acquired company has abnormally low CFFO in the weeks leading up to the acquisition. Once the acquisition is closed, there will be an unusually large number of receivables to collect and an unusually small number of bills to pay, causing CFFO for the newly acquired division to be abnormally high in the period immediately after the acquisition. The scheme can continue as long as the company keep acquiring new companies every quarter.
      4. Treat CFFO differently for acquisitive companies. Instead, use free cash flow after acquisitions (CFFO minus capital expenditures minus cash paid for acquisitions) to assess the cash generation ability at acquisitive companies. Companies might record negative free cash flow after acquisitions despite reporting positive CFFO and this is a warning that operating cash flow was not what it appeared to be.
      5. Review the balance sheets of acquired companies and gauge the potential inherent working capital benefits it will provide to the acquirer. It may be difficult to be precise in this analysis but you will be able to make an assessment within the ballpark of the potential benefit.
      6. Be wary when free cash flow suddenly plummets.
   2. Acquiring contracts or customers rather than developing them internally
      1. Companies can outsource the acquiring of customers through an external network of dealerships. The dealers will allow the company to outsource a portion of its sales force, who are not on the company’s payroll, but are received a lump sum for every new customer. Some companies can falsely account for these “contract acquisitions” as investing outflows, when they should rightfully be normal customer solicitation costs and thus go under operating outflow, overstating CFFO.
   3. Boosting CFFO by creatively structuring the sale of a business
      1. Recording CFFO for proceeds from the sale of a business. Be wary when a company sells a business and simultaneously enters a contract to sell its service/product. It might receive a lump sum, but only consider a part of the cash received to be for the sale of the business (under investing inflow), and allocate a large part to an “advance” on its future revenue stream (under operating inflow). Compare the part allocated to operating inflow as a % of total CFFO.
      2. Watch out for new categories on the cash flow statement, especially if it has a huge impact on CFFO, e.g. increase in deferred revenue.
      3. Watch out when a company sells a business, but sells everything except the receivables. This will be disclosed in a disclosure regarding the sale of a company in a 10Q or 10K. Do not be misled that this produces a sustainable CFFO. Normally all proceeds from selling a business would be recorded as an investing inflow. But by stripping out the receivables prior to the sale, the company lowers the sale price (and the investing inflow), and soon collects the receivables from former customers, and all proceeds will be reported as an operating inflow. This allows the company to shift a portion of investing inflow to operating inflow.

4. Boosting operating cash flow using unsustainable activities
   1. Boosting CFFO by paying vendors more slowly
      1. Companies can wait till the beginning of January to pay their December bills. If the company push payments out a month, the ending of year balance will be higher, and it will seem as if they generated more cash this year. But this is not recurring, as to grow cash flow again next year, the company has to push 2 months’ worth of payments into the following January. The cash inflow from pushing out payments (check for an increase in payables) should be considered a one-time activity, not a sign that the company has found a lasting way to generate more cash.
      2. Check for companies that pay their vendors slowly by watching for an increase in payables relative to COGS i.e. increase in DSP– this might be a major driver of impressive CFFO growth which is nonrecurring. Increase in days’ sales of payables (DSP) means that the company is paying its payables over a long period of time. A decrease in DSP means that the company is paying its bills more quickly. Assess the extent to which CFFO growth is derived from stretching out payments to vendors and consider that amount an unsustainable boost that is unrelated to improved business activities.
      3. Days’ Sales of Payables is calculated as [(Accounts payable/cost of goods sold)*Number of Days in the Period] (91.25 days is an approx. per quarter)
      4. Look for large positive swings in the statement of cash flow e.g. improvements in accounts payable and inventory are primary drivers of CFFO – this is not a sustainable improvement.
      5. Watch for large positive swings in other payable accounts e.g. tax payments, payroll or bonus payments, pension plan contributions, etc. that might be one-off. Could be due to delay in making payments or credits or refunds for taxes.
      6. Check for companies that has a reduction in inventory at each store – this might be a major driver of impressive CFFO growth.
      7. Accounts payable is a relatively straightforward account. If you see a discussion of accounts payable that is longer than a couple of sentences, there is probably something in there you want to know, e.g. accounts payable financing arrangements.
      8. Be alert when companies use accounts payable “financing”, e.g. using bank loans to pay their vendors. The approach that makes the most economic sense is to record the bank loans as a financing activity for both cash inflow and outflow. In order to properly compare cash flow generation for companies using different policies and classifications, investors must adjust for this difference in policy.
   2. Boosting CFFO by collecting from customers more quickly
      1. Companies can generate nonrecurring CFFO boost by convincing customers to pay them more quickly. This would not be considered a bad thing and may even speak well of a company’s significant leverage over its customers. But companies cannot continue to collect at a faster and faster rate every quarter forever, and the growth in CFFO that results from accelerated collections should be deemed unsustainable.
      2. Watch for new disclosure about prepayments in 10Q or 10K, e.g. increase in prepayments. The growth in CFFO that results from accelerated collections should be deemed unsustainable.
      3. Watch for elaborate strategies to influence the timing of cash flow from company disclosure in 10K or 10Q. E.g. companies that offer discounts to customers to induce early payments, holding vendor payments to the beginning of the following quarter, buying inventory at the start of the next quarter, in order to show cash on its balance sheet at its highest point on the last day of the quarter.
      4. Be wary of dramatic improvements in CFFO and dig at the source of these improvements to see if they are one-time benefits, e.g. increase in accounts payable and drop in accounts receivable. Increase in accounts payable could be due to forgoing early payment discounts with vendors and delaying payments so that CFFO will be higher.
      5. Be warned when management says that they are “aggressively managing working capital” as it is a warning sign that recent CFFO growth may not be sustainable.
   3. Boosting CFFO by purchasing less inventory
      1. Companies can lower their inventory levels simply by not restocking shelves after goods had been sold. Company just did not purchase as much inventory from vendors in previous years. Failing to restock inventory levels would also provide an unsustainable boost to CFFO. Read footnotes and disclosures and watch out for companies that improve their CFFO via unsustainable boosts via lowering inventory levels (if you don’t buy as much, you don’t need to pay as much, so operating outflow is lower).
      2. Buried deep in the 10Ks and 10Qs is extra insights about the drivers of cash flow. Read*** Management Discussion & Analysis, and near the back there is a section called “Liquidity and Capital Resources” and this is a must-read for all companies.
      3. Watch for disclosures about timing of inventory purchases within each quarter, providing unsustainable boosts to CFFO. E.g. purchasing inventory at the very beginning of each quarter and working it down as much as possible by the end of the period, only to purchase (and incur an operating outflow) once the quarter closed.
   4. CFFO benefit from one-time items
      1. The term operating means different things when it comes to operating cash flow and operating income. Taxes, interest, and large one-time events are considered to be part of operating cash flow, but not of operating income.
      2. Non-recurring boosts to CFFO are often not plainly disclosed on the cash flow statement. Whenever you spot any kind of one-time earnings benefit, ask yourself how will this boost affect the cash flow statement, and find out which category did management the inflow under, to make sure it doesn’t provide a one-time unsustainable boost to CFFO. g. a company might list settlement income as a nonrecurring, non-operating income in its income statement, but state it as operating inflow in its cash flow statement, not listed separately but bundled up with net income.

4. Key metrics shenanigans

Investors should read the income statement, cash flow statement, balance sheet, company press releases, earnings announcements, footnotes, management discussion and analysis and the financial reporting of competitors to compare performance and health measures, and also to assess the application of accounting standards and disclosure. Before digging in, remember to ask the 2 important questions: 1) What are the best metrics of that specific company’s performance and does management highlight, ignore, distort, or even make up its own version of these metrics? 2) What are the best metrics that would reveal a specific company’s deteriorating economic health, and does management highlight, ignore, distort, or even make up its own version of these metrics?

For a given industry or company, start out by learning the very best metrics for evaluating economic performance and health – both past and expected in the near-term. Longer-term performance predictions tend to be woefully inaccurate and provide little value for investors. E.g. for a subscription-based business, we need to look at trends in recent subscriber counts, the trends in amount of revenue from each subscriber, etc.

Create your own grading chart for metrics in each industry/company: Metric grading chart:

A – Essential and properly used by management

B – Useful addition

C – Neutral, no real value

D – Correct metric, but misused by management

F – Misleading metric created by management

Categories of performance metrics – information reflects past performance, but often provide relevant indicators about the strength of the company and can shed light on what to expect tomorrow. Gives insight into a company’s recent operational performance.

Surrogates for revenue: management often tries to clarify and expand its disclosure on customer sales and provide insight into future demand and pricing power. E.g. broadcast cable operator subscriber count, airline load factor (% of total seats filled), internet portal number of paid clicks, hotel operator revenue per available room. Industries and companies often provide their own unique metrics to help investors get a better grasp of the company’s performance. Other common metrics considered as revenue surrogates include same-store sales, backlog, bookings, subscriber count, average revenue per customer, organic revenue growth.

Surrogates for earnings: management sometimes tries to present a “cleaner” version of earnings to convey the true operating performance of the business. E.g. remove a large one-time gain from selling real estate. Common metrics include pro forma earnings, EBITDA, non-GAAP earnings, constant-currency earnings, and organic earnings growth.

Surrogates for cash flow: management may try to present a “cleaner” version of its cash flow although this may be trickier and often more controversial. E.g. a retail chain may present cash flow excluding a substantial one-time cash payment for a legal settlement. Some other common metrics include pro forma operating cash flow, non-GAAP operating cash flow, free cash flow, cash earnings, cash revenue, and funds from operations.

Whenever management makes significant accounting or classification changes or even makes an acquisition, comparisons with earlier periods become very difficult for investors to make. To provide an apple-to-apple comparison, companies include pro forma adjusted financial statements as supplementary information. E.g. if a company changes its revenue recognition policy, a pro forma presentation would include the results of both periods under the new revenue recognition policy.

Categories of economic health metrics – information reflects up-to-date cumulative performance, which can shed light on what to expect tomorrow (reflected on the balance sheet).

For a given industry, start by learning the very best metrics for evaluating economic health and stability, both past and expected in the near term. When evaluating economic health metrics, use the grading chart as above. The best supplementary economic health metrics should provide added insight into the strength of a company’s balance sheet, including how well the company 1) maintains prudent inventory levels, 2) manages customer collections, 3) maintains financial assets at their appropriate value, and 4) keeps liquidity and solvency risks in check to prevent a cash crunch.

Evaluation of accounts receivable management: use DSO metric to catch signs of collection problems. Higher DSO typically suggests customers have been paying more slowly. Also evaluate accounts receivable DSO metric provided by management to see if it fairly presents the underlying economics of the business. Distorting accounts receivable metrics could be an attempt to hide revenue problems.

Evaluation of inventory management: holding too much of an undesirable product leads to write-downs, and not having enough of a hot one will lead to missed sales opportunities. Monitor inventory levels closely using DSI. Management might create misleading inventory metrics to hide profitability problems or classify inventory incorrectly on the balance sheet to trick investors into using the wrong input when DSI.

Evaluation of asset impairment for financial companies: companies provide metrics that give investors insight into the quality or strength of their financial asset. E.g. delinquency rates on mortgage loans, fair value of investments. Investors must monitor supplement data to ensure that proper reserves and impairments are being recorded.

Evaluation of liquidity and solvent risks:

1. Showcasing misleading metrics that overstate performance
   1. Be wary when a company changes the definition of a key metric
   2. Be wary when a company highlights a misleading metric
   3. Highlighting a misleading metric as a surrogate for revenue
      1. Additional supplementary non-GAAP metrics are used to supplement revenue, providing investors with more insight into product demand and pricing power.
      2. Same-store sales. Revenue growth at retailers and restaurants is often fuelled by the opening of additional stores. Companies that are in the middle of a rapid store expansion show tremendous revenue growth since they have more stores this year than last. While total company revenue growth give some perspective on a company’s size, it gives little information on whether individual stores are performing well. To measure how the company’s stores have been performing, use the metric “same-store sales” or “comparable-store sales”. This metric establishes a comparable base of stores for which to calculate revenue growth, allowing for more relevant analysis of true operating performance. E.g. company may present its revenue growth on stores that have been open for at least 1 year. No universally accepted definition exists as it falls outside GAAP coverage, and calculations may vary from company to company, and worse yet a company may change definition of SSS from one period to the next period.
      3. Compare SSS to the change in revenue per store (total revenue/average total stores) to spot positive or negative change in a business by looking for divergence in trends between the two. When a company experiences fairly consistent growth, SSS should be trending up consistently with the average revenue at each store. g. assume that a company’s SSS growth has been consistently tracking well with its revenue per store growth. If a material divergence in this trend suddenly appeared with SSS accelerating and revenue per store shrinking, investors should be concerned. This divergence indicates 1 of 2 problems: 1) the company’s new stores are beginning to struggle, driving revenue per store down, but don’t affect SSS because they are not yet in the comp base, 2) the company has changed its definition of SSS, which affects SSS calculations but not revenue per store.
      4. Watch for changes in the definition of SSS. Companies usually disclose how they define SSS and once the definition is disclose, it is easy to track it from period to period. Companies can manipulate SSS by adjusting the comp base in 2 ways: 1) changing the length of time before a store enters the comp base, e.g. requiring the store to be open for 18 months vs 12 months before, 2) changing the type of stores included in the comp base, e.g. excluding certain stores based on geography, size, businesses, remodelling etc.
      5. Watch for bloated SSS resulting from company acquisitions. The universe of stores in the comp base keeps changing each quarter if a company continuously bought stores and put them in the comp base. SSS would be calculated using a slightly differently universe each quarter, making it hard to be comparable. If the company had purchase companies with strong sales, the acquisition activity would have had a positive impact on SSS performance.
      6. Be wary when a company stops disclosing an important metric no matter what justification they use.
      7. Look for strange unusual definitions of organic growth/internal growth. Scrutinize the organic growth calculation of acquisitive companies as it may include revenue that spilled over from the target company. Companies should exclude all revenue from acquired businesses when calculating internal growth. But some companies might use a fixed amount to remove based on acquired business’s revenue for the previous year, i.e. the acquirer can include in its own internal growth any large deals that the acquired company booked just before the acquisition.
      8. When comparing key non-GAAP metric across companies in the same industry, it is important to ensure these metrics are being calculated in the same way. g. in the broadcast industry, a common metric analysed in average revenue per user (ARPU). But different definitions of it exists, where in some companies revenue included subscription, advertising and activation fees, while others only include subscription revenue.
      9. Subscriber data are often disclosed in both the earnings release and the 10Q. Look for inconsistencies between the 2 sources, particularly discrepancies in which subscribers are shifted between categories. Subscription-based businesses like research providers, telephone companies, newspapers, fitness clubs etc. rely on new subscribers for growth and so it is helpful to monitor subscriber levels in order to get a sense of the most recent trends in the business. Logically, the number of new subscriber additions and level of cancellations (“churn”) each quarter is often a good leading indicator of upcoming revenue. A company with a healthy subscriber base with growth in new subscribers and shrinking churn can expect strong revenue growth ahead. However companies can manipulate subscriber additions and churn metrics, e.g. adding in categories of “customers” as subscribers when they shouldn’t be added, such as bulk subscription to corporations which might not all be activated, including subscribers of unconsolidated affiliates which had not previously been included in the count, including subscribers to other product lines in its count of subscribers for another line, or not removing customers who have bills that are overdue by many days (who were previously removed from the subscriber base once they hit a number of days overdue).
      10. Many companies disclose their “bookings” or “orders” which are supposed to represent the amount of new business booked during the period. Companies may also disclose their backlog, which represents their outstanding book of business, i.e. all past order that have yet to be filled and recognized as revenue. “Book-to-bill” is a common disclosure that compares current period bookings to current period revenue and is calculated as bookings divided by revenue. If presented accurately, they are important indicators as they provide investors with insight into upcoming revenue trends. However, companies can define what should and should not be included in bookings and backlog for categories such as cancellable orders, orders in which the quantity purchased is not defined, bookings for longer term service or construction contracts, contracts with contingencies or extension clauses, booking on noncore operations, etc. Investors must understand what a metric represents before putting any faith it is due to the varying definitions of bookings and backlog across companies. If the metric is a key performance indicator for a company, investors should use extra diligence to ensure that the company doesn’t change its own definition of bookings in a way that flatter the metric.
      11. Formula showing the general relationship between bookings, backlog and revenue (for all revenue streams that run through backlog). This is helpful when analysing companies as it can be used to test the veracity or consistency of non-GAAP metrics and used to calculate bookings when only backlog is given. Beginning backlog + Net bookings – Revenue = Ending backlog. (Net bookings is total bookings minus cancellation)
   4. Highlighting a misleading metric as a surrogate for earnings
      1. Be wary of pro forma earnings or adjusted earnings or non-GAAP earnings and investigate what they consist of.
      2. Be wary of companies that pretend that recurring charges are one-time in nature in presenting their own earnings metric.
      3. Be wary of companies that pretend that one-time gains are recurring in nature in presenting their own earnings metric.
      4. Be wary of companies that change the definition of their own version of adjusted earnings, e.g. excluding expenses from stock options or restricted stock gains or acquisition-related costs from non-GAAP net income.
   5. Inconsistencies between the earnings release and the 10Q
   6. Highlighting a misleading metric as a surrogate for cash flow
      1. “Cash earnings” and EBITDA are not cash flow metrics. These calculations add back noncash expenses like depreciation, and are poor representations of performance and profitability especially for capital-intensive businesses because all of the major capital costs run through the income statement as depreciation and are thus excluded from EBITDA.
      2. Ignoring working capital changes when calculating cash flow will provide you with a fictional portrait of a company’s cash generation ability – companies will adjust for working capital using the indirect method for presenting cash flow.
      3. Ignoring accruals for bad debts, impairments and warranty expenses will give you an illusionary sense of profitability.
      4. Non-GAAP cash flow metrics put there to confuse investors include “operating cash flow” and investors should look carefully to see how they are defined. Investors should calculate CFFO themselves from the cash flow statement instead of relying on company highlighted metrics as companies might trick you into thinking a pro forma metric they created is the real CFFO. Normal operating expenditure should be included in calculation of CFFO.
      5. The REIT industry uses funds from operations (FFO) metric as a standard for measuring company performance, as a gauge of a REIT’s ability to generate cash flow, and is widely viewed as being more useful than traditional GAAP earnings or cash flow measures. Any time a company reports an important non-GAAP metric or shuns an industry standard definition, you need to read and monitor the definition to ensure that you understand exactly what information the metric conveys.

2. Distorting balance sheet metrics to avoid showing deterioration
   1. Distorting accounts receivable metrics to hide revenue problems
      1. Management is aware that investors review working capital trends to spot signs of poor earnings quality or operational deterioration. A surge in receivables out of line with sales will lead investors to question the sustainability of recent revenue growth. Management thus keep reported accounts receivables by 1) selling them, 2) converting them into notes receivables, 3) moving them elsewhere on the balance sheet.
      2. Selling accounts receivables lowers the DSO reported to investors, making it appear that customers have been paying more quickly. Dishonest management can conceal DSO by selling more accounts receivable.
      3. Whenever you spot a CFFO boost from the sale of receivables, also realize that by definition, the company’s DSO will have been lowered as well. The sale of receivables represents a financing decision, and it is the sale of these receivables, not operational efficiencies, that drives DSO lower and CFFO higher.
      4. To calculate DSO on an apple-to-apple basis, simply add back sold receivables that remain outstanding at quarter-end for all periods.
      5. Companies can turn accounts receivables into notes receivable – reclassifying them to an account not closely monitored by investors in order to lower DSO and fool investors to assume that sales are good and customers had paid on time and receivables problems solved. Investors should be concerned when they see a large decline in DSO, particularly following a period of rapidly rising DSO, as they are when they see a large increase in DSO.
      6. Watch for increases in receivables other than accounts receivables and identify the reason for such a change. E.g. increase in bank notes and commercial notes as companies trade in their accounts receivables. Read footnotes to spot this improper account classification.
      7. Watch out for companies that fail to prominently disclose the sale of accounts receivables.
      8. Watch out for varying company DSO calculations. Investors should use the ending, not average, receivables balance. Using average receivables works fine when investors are trying to assess cash-management trends but works less well when they are trying to detect financial shenanigans. Ignore companies if they tell you that your DSO calculation is incorrect or not in accordance with GAAP. If you are assessing the likelihood a company has accelerated revenue by booking a significant amount of revenue on the last day of the quarter i.e. stuffing the channel, it makes sense to calculate DSO using the ending balance of receivables than the average one. If you are worried about the collectability of receivables and are evaluating a company’s exposure, it is best to use the ending balance. If you wish to calculate the average time over which a company collects its receivables, you may want to use the average balance of receivables.
      9. Watch for company changes in DSO calculations e.g. calculating based on ending receivables but change to using quarterly average receivables. When a company changes how it computes operational metrics, it is attempting to hide some deterioration from investors. Since receivables surged in the quarter in which the change was made, the average receivables balance would be much lower than the ending one, allowing for a more favourable presentation of DSO.
   2. Inappropriate or changing methods of calculating DSP
   3. Distorting inventory metrics to hide profitability problems
      1. Investors view an unexpected rise in inventory as a sign of upcoming margin pressure through markdowns or write-offs or falling product demand. Some companies avoid this by toying with their inventory metrics. Some companies might sell products aggressively by offering customers very generous return conditions, recording fictitious entries to reduce inventory, leaving product deliveries on the receiving docks without recording them as inventory, and selling inventory to a 3^rd party but agreeing to repurchase it.
      2. Watch for inventory that moves to another part of the balance sheet, i.e. reclassifying of inventory to a different account. E.g. reporting part of inventory as a long-term asset included in “other assets” line. Read footnotes to reveal oddly classified inventories and what products they relate to and their reasons for being classified as such. If they are long-term inventory that are not expected to be sold in a year, they should also be included in inventory totals when analysing inventory trends.
      3. Be cautious about new company-created metrics, especially when traditional metrics are on a downward negative trend e.g. DSI rise and inventory per square foot rise, and to address concerns about inventory, company creates a new metric called “in-store” inventory per square foot. It however completely inappropriate to ignore inventory owned and included on balance sheet but was not on store shelves. “Out-of-store” inventory qualifies as inventory and has no less markdown risk than “in-store” inventory.
      4. Be wary of companies providing an “apple-to-orange” comparison of metrics, using different definitions.
   4. Distorting financial asset metrics to hide impairment problems
      1. Financial institutions often present metrics to help investors understand the strength and performance of their assets, e.g. nonperforming loans, delinquency rates, loan loss reserve levels.
      2. Watch for changes in financial reporting presentation in earnings release and other filings, e.g. changing reserve presentation by grouping loan loss reserve with another reserve and presenting the 2 as one unit, hiding from investors that loan loss reserve has been reduced due to increase in bad loans being written off and failing to record sufficient expense to refill reserve. This is a sign of hiding problems.
      3. Be wary when companies stop disclosing important metrics.
   5. Distorting debt metrics to hide liquidity problems
      1. To minimize the probability of loan defaults, many lender lay out rules that require borrowers to maintain a certain level of economic health, called debt covenants. E.g. maintain a certain level of sales, profitability, working capital, book value. The covenants often pertain to non-GAAP measures of operating performances such as EBITDA. Investors should be alert to any shenanigans used by management that result in artificially meeting such debt covenants, e.g. by changing assumptions on revenue recognition, classification of things, lowering reserve levels etc.
      2. Cringe when you see a company having a public disagreement with its auditor, particularly on a shady transaction of significant magnitude.