FR&A - Red Flags/Warning Signs (cont.)

10:15 AM

Common earnings manipulation tactics/signs of abuse (cont.)

• Delaying expense recognition = capitalizing opex.  Look for increases in strange assets (Deferred Marketing Charges, Deferred Customer Acquisition Costs, etc.)
• Op leases instead of capital leases -  compare practices to peers.
• Hiding expenses under 'extraordinary' to boost EBIT
• LIFO liquidations - when a LIFO firm dips into old inventory, this reduces COGS and juices net income - such profits are not sustainable.  Effects of LIFO reserve liquidation should be noted in footnotes.
• Abnormal margins compared to industry peers
• Extending useful lives of long term assets - compare lives to peers
• Aggressive pension assumptions - result in lower pension expense and liability
• Year end surprises - high earnings in Q4 that cannot be explained by seasonality
• Equity method investments and off balance sheet SPEs
• Equity method investments are not consolidated but pro rata share of investee's earnings are included in net income
• Watch for extensive use of nonconsolidated SPEs
• Other off balance sheet arrangements inc. debt guarantees
• Must disclose these in footnotes
• Consider increasing liabilities to account for this

Note: Remember these are warning signs of low quality earnings, and not necessarily indications that fraud has occured or will occur

Enron Scandal

• Insufficient operating cash flow
• Much of its true financing activities fell under operating as well
• Did not make enough CFO to fund investments, and relied on financing for the rest
• Pressure to support stock price/ratings
• Additional collateral requirements in form of Enron stock if debt dropped below investment grade
• Wanted to keep compliance with covenants
• Revenues reported using mark to market accounting
• In some cases there were no established markets for the underlying contracts
• Excessive revenues reported in latter half of year
• Disproportional to previous years' trends
• Inflated sales to SPEs
• Use of mark to market accounting for equity method investments
• Recorded gains on equity investments rather than just their net income
• Use of barter transactions
• Enron would sell cable capacity to a party and simultaneously purchase capacity from another party
• Related party transactions - probably most egregious use
• LPs whereby an Enron employee served as general partner
• LPs engaged in billions of dollars of derivatives transactions with Enron
• Primary assets of the LPs included receivables from Enron and Enron securities
• Senior mgmt compensation and turnover

Sunbeam Accounting Scandal

• Created 'cookie jar' reserves
• Recognize losses and charges in early year, but loss turns to profit when inventory is sold in later years
• Receivables increased faster than sales
• Negative operating cash flow
• Primarily a result of increasing inventories and receivables
• Bill and hold sales arrangements
• Revenue recognized before goods are shipped
• Inappropriate reduction of bad debt expense
• Bad debt expense decreased even though sales and receivables both increased greatly
• Increased Q4 revenues
• Sunbeam was a nonseasonal business - Sunbeam initiated an early buy program for certain products

End

10:30 AM

0.25 hrs