Financial Reporting Quality: Red Flags and Accounting Warning Signs

Financial Reporting Quality: Red Flags and Accounting Warning Signs 2014 Level I Financial Reporting and Analysis IFT Notes for the CFA exam

Contents 1. Introduction... 3 2. Financial Reporting Quality... 3 3. Red Flags and Accounting Warning Signs... 5 4. Accounting Scandals: Enron... 9 5. Accounting Scandals: Sunbeam... 10 Summary... 12 Next Steps... 14 This document should be read in conjunction with the corresponding reading in the 2014 Level I CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute. Copyright Irfanullah Financial Training. All rights reserved. Page 2

1. Introduction In the earlier readings, we have seen what constitutes the various financial statements, how they are linked, and how various items such as long term liabilities, leases and inventories are accounted for under IFRS and U.S. GAAP. However, an analysis of these statements alone does not suffice in making a sound investment decision. How can investors be assured that the numbers and information reported in the financial statements are accurate, and in line with the accounting standards? Accounting scandals have surfaced from time to time, most notably, Enron, WorldCom and Tyco in the recent past, eroding investors wealth and confidence. This reading focuses on how companies manipulate financial statements, misappropriate cash, inventory, why they adopt improper accounting practices with some real examples from the past decade, and how to detect potential warnings signs as an investor. 2. Financial Reporting Quality The importance of high quality financial reporting from an investor s perspective is significant. High quality financial reports fairly represent the economic reality of a company. One of the primary concerns for users of financial reports (analysts and investors alike) is whether the earnings are misstated i.e. understated or overstated. For example, if earnings are increasing year on year but operating cash flow is decreasing, then the growing earnings number probably does not reflect economic reality. If earnings numbers do not adequately reflect the economic reality of a company, we say that the earnings quality is low. A company might have several incentives to overstate or understate earnings. Some incentives to overstate earnings are: Meet analyst expectations; publicly listed companies must report their earnings every quarter. Analysts forecast earnings. If the company has had a weak quarter, it may be Copyright Irfanullah Financial Training. All rights reserved. Page 3

motivated to overstate earnings to meet analyst s expectations, and prevent adversely affecting the company s share price. Meet debt covenants: when a company issues debt, it is obligated to meet the covenants. For example, the company needs to maintain an interest coverage ratio of greater than 6. If it goes less than 6, then the company has made a technical default which will increase the cost of debt. So, there s an incentive to report higher earnings. Improve incentive compensation. Often, the overall compensation of a senior management is linked to the performance of the company. If the company performs well, the payout is higher. This is an incentive for the management to overstate earnings. Some incentives to understate earnings are: Obtain trade relief: by reporting lower earnings, the company may enjoy tax relief, quotas or tariffs. Negotiate lower payments to counterparties. Negotiate concessions from unions if reported earnings are low, the company may negotiate to pay less. Activities Leading to Low Earnings Quality Some of the activities that lead to low earnings quality are listed below: Following U.S. GAAP but selecting alternatives which bias or distort reported results. For example, using an inappropriate depreciation method. Let s assume a company uses an asset continuously for six years. In this case, straight-line depreciation may be more appropriate. Instead, if the company uses accelerated depreciation method, then the depreciation expense in the early years would be high making net income low, thereby understating earnings. Using loopholes in accounting principles. For example, operating lease with payment equal to 89% of fair value. We ve seen in the previous reading that a lessee prefers operating leases. One of the criteria to be classified as a finance lease is present value of lease payments should be greater than 90% or more of fair value of leased asset. So the company may structure the lease payments equal to 89% of fair value so that it need not classify it as a finance lease. Copyright Irfanullah Financial Training. All rights reserved. Page 4

Setting unrealistic estimates or assumptions. For example, using longer depreciable lives for assets, higher residual lives or unrealistic assumptions about collectability of receivables. Stretching accounting principles to achieve a desired outcome. Fraudulent financial reporting has no financial reporting quality. 3. Red Flags and Accounting Warning Signs Three conditions that are generally present when a fraud occurs are shown in the fraud triangle below: Incentives/pressures lead to fraudulent financial reporting, such as pressure to meet debt covenants or analysts earning expectations. Opportunities to commit fraud such as poor internal controls. Fraud Triangle: Three conditions generally present when fraud occurs Individuals might rationalize their activities, such as desire to get company through a difficult time, after which they plan to undo their accounting games. Analysts should look out for risk factors for each of the conditions of the fraud triangle. These risk factors serve as red flags. The risk factors for each of the fraud conditions (incentives, opportunities and rationalization) are tabulated below: Conditions Fraud Risk Factors Incentives/pressures Financial instability due to economic, industry or company s operating conditions such as high degree of competition, market saturation, decline in customer demand, rapid changes in technology, or new regulatory requirements. For example, to decrease the risk of a bank, a central bank s new monetary policy Copyright Irfanullah Financial Training. All rights reserved. Page 5

Conditions Fraud Risk Factors may require them to maintain a high cash reserve ratio. Excessive pressure from directors or management to meet financial targets, analyst expectations, and debt covenants Personal financial situation of directors and senior managers threatened by entity s financial performance because their compensation may be tied to the company s profitability. For example, only 60% of the CEO may be in fixed salary and the remaining paid out relative to performance of the company. Opportunities Nature of entity s operations provides opportunities to engage in Attitudes or Rationalization fraudulent activities. For example, holding significant bank accounts or branch operations in tax haven jurisdictions without any business justification. Or a strong financial presence in an industry sector to influence unfair transactions. Ineffective monitoring of management such as domination of management by a single person. Complex or unstable organizational structure such as high management turnover. Inadequate internal controls. For example, high employee turnover of accounting/it staff, and ineffective accounting systems. Ineffective communication, implementation or enforcement of ethical values and standards Non-financial management s excessive participation in selection of accounting principles Known history of violations of laws and regulations Management s keen interest in increasing the company s stock price Management committing to analysts unrealistic forecasts Report lower earnings for tax-motivated reasons. A strained relationship between the management and the auditor Copyright Irfanullah Financial Training. All rights reserved. Page 6

3.1 Improper Accounting Practices Several studies have been conducted to identify improper accounting practices often found in fraudulent cases. These have been classified into the following four categories: 1. Improper Revenue Recognition: This is the most commonly occurring practice. Companies report revenue in advance through techniques, such as billing without shipping (bill and hold), fictitious revenue, inaccurate timing of revenue recognition, or improper valuation of revenue. 2. Improper Expense Recognition: A company may try to boost earnings by understating expenses through improper capitalization (capitalizing instead of expensing), overstating inventory, understating or deferring expenses (high NI), understating bad debts (high NI) and improper use of reserves. 3. Improper Accounting in Connection with Business Combination: Business combinations are when a company acquires a part of or 100% of another company. This is dealt in detail at Level II. 4. Other Accounting and Reporting Issues: These include inadequate disclosures, improper off-balance-sheet arrangements. 3.2 Warning Signs Based on the various accounting scandals, following are several potential warning signs of improper accounting practices: Aggressive revenue recognition a) Bill-and-hold sales arrangement bills the customer, recognizes the sale without shipping the product. b) Sales type lease discrepancy in the way a lease is treated by the lessor and lessee. Lessor treats it as a sales-type lease while the lessee reports it as an operating lease. In short, both the parties report the type of lease that is most beneficial to them. Copyright Irfanullah Financial Training. All rights reserved. Page 7

c) Recording revenue before fulfilling all contract terms for example, a computer services company may sell hardware and services with a 50% allocation in revenues to each. Assume the company has only delivered the hardware. If the company recognizes the entire revenue before delivering services, then this is incorrect as it is recording revenues without fulfilling its service obligation. Operating cash flow out of line with reported earnings. Let s assume a company s earnings are growing at a steady rate of 20% while the cash flow from operations is declining by 5%. This is an indicator of manipulating income statement as expenses may be understatement. Growth in revenue out of sync with economy and/or peer companies. If a company is reporting high revenue growth than its peer or industry group, it could be an indicator of superior management. But, a rational explanation of the quality of revenues is needed to justify the revenue growth. Growth in revenue out of sync with growth in receivables: Are receivables are growing at a faster pace than revenues and increasing over time? If so perhaps the credit policy is lax and the company should have a higher allowance for doubtful debt. Growth of inventory out of line with sales growth: If inventory is growing at a faster pace than revenues, it could mean obsolete inventory or overstatement of inventory to boost profits. Classification of non-recurring or non-operating income as revenue: It is important for analysts to pay attention to non-recurring income. For example, a company may have sold a large piece of land at a prime location. This is a non-recurring income. Deferral of expenses: Is a company capitalizing current expenditures and deferring it to future years through amortization? WorldCom fraudulently hid billions of dollars of operating expenses in 2001 and spread it over years by capitalizing. As a result, the company reported a profit of $1.4 billion when it should have actually reported a loss. Excessive use of operating leases by lessees: We ve seen before that operating leases are preferred by lessees and finance leases by lessor. Though it is not completely prohibited to use operating leases, it is prudent to do a ratio analysis if a company is use more of these leases than its peers. What would be the impact had the company purchased the assets instead of leasing them? Copyright Irfanullah Financial Training. All rights reserved. Page 8

Classification of losses as extraordinary or non-recurring: Just how a non-recurring income is reported as revenue to increase profits, the reverse occurs for expenses. Expenses that should be accounted as part of operating expenses are reported as nonrecurring year after year. LIFO liquidations: LIFO liquidation occurs when a company sells its old inventory i.e. revenues are higher than purchases. If you recall, with LIFO, net income is lower as and taxes paid lower. Companies following LIFO method for accounting inventory may resort to LIFO liquidation to keep the inventory balance low at year end. This results in higher taxable income. An analyst can detect this warning sign by reading the footnotes for a decline in the LIFO reserve. Gross margins or operating margins out of line with peer companies: In some cases, it may be an indicator of good practices to reduce costs and efficient management. However, from an analysis perspective, it is useful to compare the accounting perspectives of a company with its peers to see if it is more or less conservative. Use of long useful lives for depreciation and amortization: Assumptions of a long useful live than is reasonable will result in a lower depreciation expense and higher net income. Again these assumptions should be compared with those of peers. Common use of fourth-quarter surprises: Companies often report positive earnings surprises in the fourth quarter. If the revenues for the fourth quarter are not in line with that of the previous quarter, then the unusually high revenues or low expenses that cannot be attributed to seasonality must be carefully examined. Senior management and sales executives resort to reporting high numbers at the end of the year as their payout is dependent on the earnings. High revenues may be because of early revenue recognition. 4. Accounting Scandals: Enron We ll now discuss real life examples of accounting scandals. Can the collapse of a company as huge as Enron be sudden and unexpected? Surely, there must have been warning signs. The curriculum chooses Enron and Sunbeam to demonstrate the red flags which were evident but went unnoticed for long. The accounting manipulations used were sophisticated for a common Copyright Irfanullah Financial Training. All rights reserved. Page 9

investor to unearth, but as you ll see there were enough warning signs for investors, creditors and analysts. The curriculum discusses the Enron case in detail but the learning outcome does not specifically mention Enron. Some of the key highlights of the case are presented here along with what drove the management to misappropriate funds, and how they did what they did. Incentives/pressures: Enron was traditionally a pipeline company which supplied natural gas to consumers. The late 1980 s witnessed a high volatility in the prices of natural gas. Enron saw this as an opportunity and transitioned into an energy trading (between suppliers and producers of natural gas) to better manage the uncertainty in prices. Analysts pay undue attention to some companies than is warranted, boosting its stock price that does not accurately reflect its fundamentals. Enron was one such case lapped up by analysts. Consequently, Enron s management was under pressure to maintain its stock price and debt rating. The top management s pay was largely from bonus and stock awards. What they did: Showed financing inflows as operating inflows on the cash flow statement. A close look at the disclosures for 1998-99 shows that it was obtaining financing to support investing cash flows when the operating cash flows was on a decline. Claimed that inventory consisted of commodities and hence reported at fair value; this was extended to other assets resulting in overstating of assets. Mark-to-market for commodities is acceptable but extending it to other assets was inappropriate. Inflated revenue through securitization of assets. Inappropriately used related party transactions. 5. Accounting Scandals: Sunbeam Sunbeam created cookie jar reserves in 1996 to draw on in future years to improve earnings. The keyword here is cookie jar an accounting practice in which reserves from the good years are Copyright Irfanullah Financial Training. All rights reserved. Page 10

used to offset losses in the bad years. Let s take a look at the table below to understand what happened at Sunbeam. 1996 1997 Sales -3.21% 18.69% Inventory -22.41% 57.89% Receivables -1.28% 38.47% Notice the marginal decline in sales and receivables in 1996; nothing unusual here. Analysts were expecting the company to report losses that year. In 1996, when a new senior management came in, they decided to write down inventory which explains the 22.41% decline in inventory. This resulted in more-than-expected losses for 1996 but set the stage for profits in the coming years. The inventory which was written down in 1996 was actually sold in 1997. So, COGS for 1997 was lower than what it should have been resulting in a higher gross profit. In addition to the use of cookie jar reserves, there were other issues and potential warning signs: There was a 38.47% increase in receivables against 18.69% increase in sales. Similarly, an increase in inventory of 58% was also out of line. Sunbeam reduced bad-debt reserve relative to increase in receivables. When a company is not sure of collecting receivables, it accounts for it as a bad debt. Bad debt reserves are recorded as an expense on the income statement. In this case, even though there was an increase in receivables, the company reduced bad debt reserves instead of increasing it to boost profits. Sunbeam accelerated sales from later periods into the present quarter (accelerated revenue recognition). Sunbeam used improper bill-and-hold transactions. Copyright Irfanullah Financial Training. All rights reserved. Page 11

Summary Low earnings quality refers to a situation where a company s earnings numbers do not adequately reflect economic reality. Overstating or understating earnings numbers is referred to as managing earnings Companies might overstate earnings for the following reasons: o To meet analyst expectations o To meet debt covenants o To allow senior management to receive higher compensation Companies might understate earnings for the following reasons: o To obtain trade relief o To negotiate lower payments to counterparties Activities leading to low financial reporting quality include: o Selecting alternatives which bias or distort reported results. o Using loopholes in accounting principles o Setting unrealistic estimates and/or assumptions o Stretching accounting principles to achieve a desired outcome Fraud triangle: three conditions are generally present when fraud occurs: 1. Incentives/pressures lead to fraudulent financial reporting, such as pressure to meet debt covenants or analysts earnings expectations. 2. Opportunities to commit fraud such as poor internal controls. 3. Individuals might rationalize their activities, such as desire to get company through a difficult time, after which they plan to undo their accounting games. Risk factors related to incentives/pressures: o Financial instability o Excessive pressure from directors or management to meet financial targets o Personal financial situation of directors and senior managers threatened by entity s financial performance Risk factors related to opportunities: o Nature of entity s operations o Ineffective monitoring of management Copyright Irfanullah Financial Training. All rights reserved. Page 12

o Complex or unstable organizational structure o Weak internal controls Risk factors related to rationalization: o Ineffective communication, implementation or enforcement of ethical values and standards o Nonfinancial management s excessive participation in selection of accounting principles o Known history of violation of laws and regulations o Management using inappropriate means to reduce taxes Examples of improper accounting practices: o Improper revenue recognition Reporting revenue in advance Fictitious revenue Improper valuation of revenue o Improper expense recognition Improper capitalization Overstating inventory Understating bad debts o Inadequate disclosures Common warning signs: o Operating cash flow out of line with reported earnings o Growth in revenue out of sync with economy and/or peer companies o Growth in revenue out of sync with growth in receivables o Growth of inventory out of line with sales growth o Deferral of expenses o Excessive use of operating leases by lessees o Classification of losses as extraordinary or nonrecurring o LIFO liquidations o Gross margins or operating margins out of line with peer companies o Use of long useful lives for depreciation and amortization o Common use of fourth-quarter surprises Copyright Irfanullah Financial Training. All rights reserved. Page 13

Next Steps Solve the practice problems in the curriculum. Solve the IFT Practice Questions associated with this reading. Review the learning outcomes presented in the curriculum. Make sure that you can perform the implied actions Copyright Irfanullah Financial Training. All rights reserved. Page 14