Introduction

• Where we focus attention
• Operating revenue enhancement
• Methods of revenue enhancement – fictitious sales
• Revenue enhancement – clues for detection
• Operating cost
• The balance sheet
• The cash flow statement

To mischief trained, e’en from his mother’s womb, Grown old in fraud, tho’ yet in manhood’s bloom.

Adopting arts, by which gay villains rise, And reach the heights, which honest men despise;

LORD LOUGHBOROUGH (1761)

Introduction

The material in this book so far has been concerned with how we can use values in the published accounts of a company to give us information about its overall performance.

But how certain are we that the numbers shown in the accounts do in fact reflect reality and give us a true picture of the state of affairs in the organization concerned? The answer is that in the vast majority of cases we can be certain because of the great scrutiny that these numbers are subject to from the investment community, the banking fraternity and the various regulatory bodies that govern business affairs, for example, the SEC (Securities and Exchange Commission), the stock exchange, the accounting institutes, etc. These bodies have derived very detailed regulations governing the presentation of annual accounts and these regulations are constantly being updated to reflect changing circumstances.

Nevertheless because of the diversity of different business situations these regulations cannot be too prescriptive. A certain leeway is still permitted to managers and where companies do not wish to show the true state of affairs, where for various reasons their intent is to present a picture that is more optimistic than justified by the true operating performance, there is still scope for some creative accounting.

Accordingly accounts may be produced where some of the numbers have been manipulated. The purpose of this chapter is to show the more likely areas where such manipulations can occur, and to indicate how some of these may be detected.

Occasionally a company will wish to present accounts that understate performance. This is a much less frequent occurrence and this chapter will concentrate on overstated accounts.

As the subject is constantly evolving, there are still areas in reported accounts where even the most diligent investigator can, at least for a short time, be deceived.

Where we focus attention

We know what the factors are which determine a company’s overall rating in the marketplace, i.e.:

• profitability
• liquidity
• growth.

It is useful to remember at this stage that if a number anywhere in the accounts is altered or exaggerated then there has to be a balancing change somewhere else in the accounts. For instance if we show an exaggerated profit in the income statement the amount of the exaggeration will appear either as an enhanced asset or reduced liability in the balance sheet. We can therefore always look for a possible manipulation in two separate sections of the accounts.

The ‘notes to accounts’ that always accompany the published statements are a very fertile source of information even if they are often written in tedious and obscure language. Nevertheless they must be read most diligently because each phrase is carefully constructed and designed to portray the information that regulations demand and often not one whit more than that information.

Of particular interest should be the note on ‘accounting policies’. This is where many of the principles governing the accounts in question are specifically identified. A change in one of the policies, for example, depreciation policy, could be a strong warning signal and pointer towards the need for further investigation.

The next most fertile area of investigation lies with the various ratios that have been detailed in the early chapters in this publication.

Operating revenue enhancement

Operating revenue is revenue that derives from the core business of a corporation. It is distinguished from non-operating revenue, for example, the once-off sale of a fixed asset that, because of its non-recurring nature, would not be considered to be an indicator of current or future business performance. We use the same distinction in relation to operating and non-operating income and operating and non-operating cost.

Revenue recognition

Therefore it is important to consider when revenue can be recognized in the books of account. The rules are very precise.

Revenue is earned when a product or service is fully delivered* by arrangement to a customer at an agreed price and the customer unconditionally accepts the corresponding financial liability and will probably be able to meet this liability.

The most powerful way to affect disclosed profitability is to alter the figure for operating revenue. There are three ways in which this can be achieved.

We can distinguish three methods by which operating revenue can be artificially inflated:

• By incorrectly moving revenue from one time period into another. This generally involves bringing revenue which should properly be shown in a future time period back to the current period – premature revenue.
• By recording sales which do not exist – fictitious revenue.
• By including one-time gains as normal operating revenue – wrongly classified revenue.

Premature revenue

We can incorrectly take revenue from a future period back into the present time period in the following ways.

Method 1 – backdating

The simplest way to move revenue into a current period from the succeeding one is simply to alter the cut-off date or backdate invoices and/or delivery notes. This may even involve changing the date in the computer. This, of course, has a very-short-term effect and if enhancement of revenue is required over a number of time periods the effect is cumulative and likely to become visible within a short time.

Method 2 – stuffed revenue

Sometimes a company will generate increased revenue for a period by offering customers special inducements, for example, major discounts or bonuses, to take product before they require it and in excess of any sales forecasts. This is called ‘stuffing the channel’. These sales appear to be genuine but they are not appropriate for the current time period. They give a false picture of company performance, they result in lower margins in the current period and much lower revenue in future periods.

Method 3 – revenue invoiced but not shipped

For revenue to be recognized the product/service should have been delivered and accepted by the customer. A company may invoice goods in one quarter when in fact these goods will not be shipped until the following quarter.

Method 4 – revenue for goods shipped but not ordered

Companies have been known to ship and invoice goods prior to a customer order. Again as no arrangement for this transaction exists with the customer this is not valid revenue. This practice is more common where an agent or dealer rather than a final customer is involved.

Method 5 – revenue for long-term contracts

Sometimes a supplier will receive cash up front for a contract that extends over a number of time periods. An example of this would be the sale of a five-year software licence or long-term lease of capital equipment. The supplier may or may not have continuing obligations relating to the contract. Either way the total initial cash receipt cannot be considered as revenue in the current period but in practice it may well be.

Method 6 – consignment and instalment sales

These terms refer to types of sales agreements where the sale is not complete until the product is sold on to the ultimate customer. Such sales should not be recognized as revenue.

Methods of revenue enhancement – fictitious sales

Method 1 – Side-letter

This is where a product is delivered, invoiced and accepted by the customer, but the customer is given a side-letter that gives him or her certain guarantees, such as full rights to return the goods.

Method 2 – Contra agreement

Sometimes a sale will be made that is offset by a contra purchase transaction such as, ‘If you buy my software I will take your hardware in return’.

Method 3 – Conditional sale

Here the customer will not be obliged to pay for goods unless some later condition is fulfilled, for example, no liability for payment unless the goods are ultimately sold or payment is conditional on funds being obtained from a third party.

Method 4 – Vendor funds sale

In this case the vendor actually provides the funds to the customer to make the purchase.

Method 5 – Purchaser unlikely to pay

This is where goods are invoiced to a customer who is not likely ever to be able to pay for them.

Method 6 – Sales to associated companies

Where the vendor company is closely related to or actually controls the purchasing company, sales between these are highly suspect.

Method 7 – Pure bogus sales

Companies may create sales from nothing at all. False production records, false delivery notes and false invoices will be used.

Revenue enhancement – clues for detection

It is not always possible to detect where revenue enhancement practices are being implemented. Even Wall Street experts can be fooled. However listed below are some areas of investigation which may disclose some of the more blatant examples.

Revenue recognition policies

At the start of this chapter we drew attention to the explanatory notes that accompany published annual accounts and drew particular emphasis to the ‘accounting policies’ section. This will contain a statement setting out the company’s revenue recognition policy. A very careful reading will often identify anomalies.

An example from BMC Software’s annual report reads: Revenue from the licensing of software is recognised upon the receipt and acceptance of a signed contract or order.

Accounts receivable days

Enhanced or fictitious revenue will not generate cash and will therefore appear in the balance as accounts receivable. A surge in the value of accounts receivable or an unusual increase in account receivable days may indicate that something is amiss. An unusual increase in long-term accounts receivable would be even more significant. This could indicate that revenue is being currently recognized for cash flows that are more than one year away.

Sales capacity

Sometimes a very blatant example of revenue enhancement can be detected simply by considering whether a commercial organization has the physical capacity in terms of plant and other assets to produce such a sales outcome. The sales to total assets or sales to fixed assets ratios compared to those of similar companies may throw light on this question.

Cash flow

A common sign of aggressive revenue recognition is when the trend in cash flow does not follow the trend in income. Over the longer period the rate of growth in cash flow should follow closely the rate of growth in earnings. When these growth rates deviate significantly for an extended period a close investigation is called for to establish the cause. This subject is discussed further on pages 329–30.

Operating cost

Following on from revenue the next most fruitful area of investigation exists in the operating cost section of the profit and loss account. Despite the multitude of rules governing the presentation of accounts there are still quite a number of items where it is accepted that nobody from outside the company can give better answers to certain questions than the existing management. For this reason management has considerable discretion in deciding on some of the values that will be used in the financial accounts, for example:

• Inventory – Will it in due course be used or sold on at full value?
• Fixed assets – What are the expected useful lives and what residual values will remain at the end of those lives?

We will look at the following areas where the accounts are particularly vulnerable:

• depreciation and amortization charges
• capitalized costs
• use of reserves.

Depreciation and amortization

No specific guidance is given by the regulatory authorities as to the appropriate period over which fixed assets should be depreciated and companies vary widely in the approach they take. Even companies with similar types of plant and equipment show a great variation in the expected asset lives they report in the accounts, and of course the longer the anticipated lives assigned to plant, the lower the annual cost and the higher the reported profit.

Management, by taking either a conservative or aggressive approach to the charge for depreciation, can considerably influence the profitability statement. In this case however the reader has quite an amount of information available to help towards a reasonable assessment.

The notes section of the accounts will have a policy statement concerning the depreciation policy being pursued. Also, in a separate section of the notes to accounts, a considerable breakdown is given of the main categories of fixed assets and the corresponding depreciation amounts. One can use this information to compare the differing approaches of different companies and to take a common sense view of the adequacy of the depreciation charges.

In particular one should pay very close attention to any indication of a change in depreciation policy or its implementation as this has been a method used historically to hide poor financial results.

Capitalized costs

Whenever a company makes a cash payment or incurs a liability a corresponding entry must be made in either the profit and loss account or the balance sheet.

For example, $100,000 paid out in operating wages will be reflected in the profit and loss account, whereas the same sum laid out to acquire a piece of equipment will be reflected in the balance sheet.

Every cost ends up either in the profit and loss account or the balance sheet. One way a company can show improved profitability is by moving cost out of the profit and loss account onto the balance sheet. We refer to this as excessive capitalization.

When can a cost be capitalized? The ‘matching principle’ applies. A cost is correctly charged into the time period in which the corresponding benefit is received. Where the benefits from expenditure will occur in a future rather than in the current time period the cost can be carried forward in the balance sheet to the relevant period, i.e., it can be capitalized.

When inventory is purchased it goes first into the balance sheet and it is transferred to the profit and loss account only when the inventory is incorporated in goods sold. Likewise the purchase of a piece of equipment is first charged to the balance sheet and this initial cost is then transferred to the profit and loss account through the depreciation charge over the life of the asset.

For example, a brewing company at the launch of a new product may decide on a major and very expensive marketing and advertising campaign. These millions of dollars spent up front, if treated as a purely operational cost, will have a devastating effect on the operating results for the current period. Management may argue that these heavy initial expenses will bring benefits over many future years and should therefore be capitalized, i.e., shown as an asset on the balance sheet.

Similar arguments can be used in relation to the heavy costs of recruiting subscribers to a service or members to a club. However, one cannot be certain of these future benefits, a considerable amount of judgement is involved as different companies take different approaches.

Conservative companies will write off many costs to the profit and loss account that an aggressive company will capitalize to the balance sheet. Therefore, one needs to pay great attention to the capitalization policy as stated in the notes to accounts.

Use of reserves

Companies create many kinds of reserves in order to cushion themselves against possible future losses. One obvious example is the reserve for doubtful debts which is offset against accounts receivable. Other common reserves are the inventory obsolescence reserve and the deferred tax reserve.

To create a new reserve or increase an existing reserve we make a charge to the profit and loss account. When a reserve is reduced we reverse that charge and credit the profit and loss account.

By their very nature, reserves are only estimates and management has a lot of flexibility in deciding what reserves are appropriate and what the periodic charge to the profit and loss account should be. This is therefore an area where opportunity exists for some manipulation of the numbers and it merits particularly close attention.

The final balances in the reserve accounts and all movements in and out of reserves must be examined carefully. Particular attention must be paid when a reduction in a reserve is reported. Such a reduction can be used to boost reported profits.

We can ask basic commonsense questions about the adequacy of reserves, for example, is the reserve for bad or doubtful debts increasing in line with accounts receivable? Why has the deferred tax reserve shown a major reduction.

One variant of the reserve manipulation technique is known as the ‘big bath’. A company going through a difficult period may decide to take a very heavy restructuring charge in the current period to provide for future losses related to the closure of plants, redundancy of workers, disposal of bad inventories, etc. This charge will be viewed as a once-off non-recurring cost to the company. It will show up as a restructuring reserve in the balance sheet.

Then in subsequent periods very heavy operating costs can be charged against this reserve and removed from the profit and loss account. The result can be an apparently much improved profit performance which may not be genuine. The time to be especially vigilant against the possibility of this occurring is when a new CEO has been appointed or after a major acquisition.

The balance sheet

Sometimes an examination of various asset and liability amounts in the balance sheet will show up an earnings enhancement ploy that would not necessarily be evident in the profit and loss account.

If earnings have been enhanced artificially then the value of an asset will be overstated or a liability undervalued.

The assets most likely to be affected are:

• accounts receivable
• inventory
• prepayments.

The liabilities most likely to be undervalued are:

• accruals
• accounts payable.

Overvalued assets – accounts receivable

Revenue that is boosted artificially through the recording of either premature or fictitious revenue will cause a corresponding increase in accounts receivable. Accordingly any unexplained surge in this account would call for investigation.

One way to identify an abnormal increase in accounts receivable is to plot the percentage change in sales over a period against the percentage change in accounts receivable. A wide variation in the latter compared to the former would be a cause for alarm. A second way is to extract the ‘accounts receivable days’ ratio. Both will show similar trends and pinpoint a possible difficulty.

Overvalued assets – inventory

Probably the most common method of increasing declared profit is simply to overvalue closing inventory. This can be achieved by overstating the physical count, by putting excess value on individual items or by failing to write off stock shrinkages or obsolescence.

To investigate whether this has occurred we can track unusual movements in inventory using methods similar to those outlined under accounts receivable above, i.e., plot percentage change in inventory over time against percentage change in sales. Also extract the ‘inventory days’ ratio.

Note that overvaluation of inventory has the further effect in that it will enhance the gross profit to sales percentage. Therefore an unexplained or abnormal increase in inventory combined with a similarly unexplained increase in the gross profit margin would be a major cause for concern.

Overvalued assets – prepayments

The prepayments account identifies expenses that have been paid out in the current period but which are properly chargeable in the subsequent period, for example, insurance premiums paid in advance.

The effect of stating that an item of expense is a prepayment is to remove the cost from the current profit and loss account into the subsequent one and thereby increase the reported profit for the current period. A company that is experiencing problems with its operating results may be tempted to conceal these problems for a short while by artificially creating prepayment amounts.

Undervalued liabilities – accruals

A liability that is understated in the balance sheet represents a future loss to the company.

If accruals are understated in a period then profits are correspondingly overstated. One would expect the trend in the value of this account to reflect the trend in sales over time. Over the short term there could be a good business case for divergence but in the longer term the total accruals in the balance sheet should track reasonably well with sales.

One effect of an understatement of this account could be an apparent reduction in administration and selling overhead in the profit and loss account. Therefore if these overhead costs showed a percentage decrease relative to sales at the same time that accruals showed an unusual decrease further investigation would be called for.

Undervalued liabilities – accounts payable

The principal debits to accounts payable relate to inventory purchases from suppliers. It has been known to happen in companies that invoices received late in the period have been ignored. This would result in an undervalued accounts payable amount. The effect of undervaluation is that the cost of goods sold will also be understated resulting in an increase in gross margin.

As with other short-term liabilities in the balance sheet, the total value in accounts payable could be expected to move roughly in line with sales. The checks that can be carried out are similar to those mentioned in respect of accounts receivable, i.e., accounts payable days and percentage change relative to percentage growth in sales.

Issues affecting only the balance sheet

The areas of investigation listed above affect both the profit and loss account and the balance sheet. However, there are certain issues that affect the balance sheet only. These relate mainly to the question of liquidity or balance sheet strength.

In chapter 10 the importance of the amount of debt relative to the amount of equity in the balance sheet was emphasized. A very high debt/equity ratio is a sign of financial instability that will lead to a lower share price and a higher interest rate for debt.

Accordingly, management in highly borrowed companies have an incentive to reduce the apparent amount of debt in the balance sheet. We could have some ‘off balance sheet’ financing.

Two ways this can be achieved are through:

• certain kinds of leases – operating leases and capital leases
• special purpose entities (SPEs).

Operating leases

When a company leases or hires a substantial piece of equipment for a limited period to carry out a particular operation (e.g. a heavy duty transporter to help with the sale and delivery of a unit of product), this is called an operating lease. Ownership of the leased item is not passed to the lessee and the lease cost is a proper charge against the profit and loss account.

Capital leases

However, the company may decide that it will have a continued need for this equipment and accordingly it decides to lease it for five years at a total cost over that period that is almost equal to the full purchase price of the equipment. Furthermore, the company may have an agreement with the supplier that at the end of the lease period it will have the right to purchase the equipment at a fixed price.

Even though in strictly legal terms ownership of the leased item is not transferred to the lessee, all the risks and the rights of ownership are transferred. Both the asset and the corresponding loan must be recognized in the balance sheet.

Declaring a transaction to be capital lease therefore has the effect of bringing onto the balance sheet additional borrowing related to the cost of the equipment.

If a company is concerned about its overall debt situation it will be in the interest of management to so arrange matters that a lease that is really of a capital nature is classified as an operating lease.

Special purpose entity (SPE)

A special purpose entity is, as the title implies, an organizational entity, usually structured as a partnership, set up for some particular purpose such as ownership of a property. Usually there are very good business and financial reasons for using this instrument.

For example, it could be advantageous for a company to have its property assets owned by an SPE. With various safeguards put in place the SPE could be construed to fall into a category of very low risk and it would be able to obtain borrowed money at a very good rate.

Furthermore, by observing the many regulations that govern the structure of SPEs the company can ensure that the accounts of the SPE are not consolidated into the company’s own published accounts. In this manner both the asset in question, i.e., the property, and the amount of borrowing against that property will appear in the balance sheet of the SPE and not in that of the parent company. Provided that the whole transaction is transparent and is disclosed fully in the notes to the published accounts it would simply be considered a good financial structure.

However the whole subject of SPEs achieved notoriety during the investigation of the financial affairs of ENRON. There were up to 400 separate SPEs related to these accounts. Their purpose, justification and control was non-transparent and indeed was extraordinarily complex. Through them they succeeded in hiding the true state of the company’s affairs from many skilled and experienced investors.*

The cash flow statement

In comparison with the profit and loss statement and the balance sheet practically no latitude exists in the production of the cash flow statement. Simply stated: when money is received by a company it is a cash in-flow, when a payment is made it is a cash out-flow. For this reason many analysts give greater weight to it than to the profit and loss account. They believe that it gives a more accurate reflection of the true state of the company affairs than either of the other two statements.

In looking at the total cash flow statement it is useful to distinguish the different categories of cash flow.

Cash flow categories – see figure 19.1

Refer to pages 346 and 348 where the term EBITDA (earnings before interest, tax, depreciation and amortization) is discussed. To arrive at the EBITDA figure we simply add to EBIT the amounts for depreciation and amortization charged in the accounts.

Figure 19.1 Categories of cash flow

We remind ourselves that this term represents the cash flow that arises solely from the trading account. Furthermore when non-recurring items are removed it is considered to be the cash flow from trading that is sustainable into the future.

However there are other flows generated by the operations of the company that are not identified at EBITDA level. First the working capital needs (accounts receivable, accounts payable and inventory) of the business must be provided for. Then we remove interest and tax payments, to arrive at CFFO.

Cash flow from operations (CFFO)

This is a very important number and it is one that features prominently in many analysts’ reports. (Also referred to as ‘operating cash flow’.)

So we segregate cash flow into its three major activities:

• cash flow from operations (CFFO)
• cash flow from investments
• cash flow from funding.

CFFO versus net income

We would expect over time to see a relationship between CFFO and net earnings. They should show similar rates of growth over time. If this relationship is solid it tends to be a sign of good health. However, if a significant divergence emerged between the trends in these two variables it could indicate that the reporting of earnings is being artificially inflated, that aggressive accounting measures are being used to cover up fundamental problems.

One way to inflate earnings is to create premature or fictitious revenue. However, neither of these kinds of revenue generate any extra cash. Therefore even though a company can report extra revenue it cannot report extra cash in-flow.

Similarly when a company indulges in aggressive cost capitalization it moves items of expense from the profit and loss account onto the balance sheet, thereby reporting extra profit. Cash however has been paid out in respect of these expenses and whereas moving the expense to the balance sheet will result in increased profit it will not result in increased cash flow. Likewise we can boost declared profit by reducing a reserve account, but this again will not boost cash flow, and so on.

In the figure for CFFO therefore we have a further tool to test the integrity of financial accounts.

* Two recomended publications that deal exclusively with this subject are: The Financial Numbers Game, Mulford and Comiskey, John Wiley; and, Financial Shenanigans, Howard Schilit, McGraw Hill.

* There are a number of situations where revenue can be recognized without delivery having taken place, e.g. long-term contracts and certain ‘bill and hold’ contracts mentioned below. However let us stay with the more general definition stated above.

* A full discussion of SPEs is beyond the scope of this book, and we would refer you again to the publications listed in a footnote on the first page of this chapter.