Financial Shenanigans – Chapter 8: Shifting Current Income to a Later Period

Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports

By Howard M. Schilit and Jeremy Perler

Today I am continuing my in-depth review of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below).

You can read the other parts of this review here. Stay tuned each Saturday and Sunday for the next parts of this review.

Chapter 8: Earnings Shenanigan No. 6: Shifting Current Income to a Later Period

This chapter is devoted to situations where companies shift income into the future. This seems counterintuitive at first; why wouldn't the company want to recognize earnings now? It turns out many executives are convinced that Wall Street favours stable earnings with uninterrupted growth, even if this is achieved via poorer quality financial statements that resemble fiction more than reality. This belief is mistaken, as noted by the McKinsey partners that wrote Value: The Four Cornerstones of Corporate Finance (you can read my review here), but I suppose this isn't the point; companies often try to smooth earnings. The authors point to four methods of smoothing earnings. I'll show the methods, and then ways investors can detect these frauds.

1. Creating reserves and releasing them into income in a later period

As we learned in the review of earnings shenanigan #1, revenue should be recognized when

1. Evidence of an arrangement exists
2. Delivery of the product or service has occurred
3. The price is fixed or determinable
4. The collectability of the proceeds is reasonably assured

Companies can create a “deferred revenue” or “unearned revenue” liability in the current period, bypassing the income statement, and then later bring it into revenue by decreasing the liability.

2. Improperly accounting for derivatives

SFAS 133 requires derivatives be marked to market each quarter. This adjustment flows through the income statement, unless the derivative is considered an effective hedge, which means it effectively hedges the change in value of an asset or liability, in which case the change in value does not go to the income statement and instead stays on the balance sheet.

Companies sometimes inappropriately treat derivatives as the wrong type of hedge (effective or otherwise). For example, a company may choose to treat a derivative as an ineffective hedge when the derivative being marked to market resulted in large gains. However, investors should be wary, as this could signify risky derivatives trading behaviour which could swing to losses in future periods.

3. Creating reserves in conjunction with an acquisition and releasing them into income in a later period

As part of complex M&A transactions, companies have a great deal of opportunity to shift value around the financial statements to create reserves that can be used at later points. Additionally, the relationship between the acquiror and the target sometimes allows for less obvious reserves. For example, the acquiror may conspire with the target company such that the target company holds back some of the pre-transaction revenue until after the transaction occurs. This creates the illusion of revenue growth.

4. Recording current-period sales in a later period

Sometimes the easiest way to smooth revenues is simply to record them next period. This is difficult to detect.

How to Detect these Frauds:

Key methods (These should be part of your process for analyzing companies!):

1. Track “deferred revenue” or “unearned revenue” liabilities. Constant growth in this type of account could signal smoothing
2. Watch for large gains from ineffective hedges.
3. Watch for below expected revenue (or earnings) at a target company in the period preceding an acquisition, followed by above average revenue or earnings at the parent company after the transaction

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Author Disclosure: This book was provided by the publisher

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Related posts:

1. Financial Shenanigans – Chapter 6: Shifting Current Expenses to a Later Period
2. Financial Shenanigans – Chapter 5: Boosting Income Using One-Time or Unsustainable Activities
3. Financial Shenanigans – Chapter 7: Employing Other Techniques to Hide Expenses or Losses