A very important book written by “Howard M. Schilit”. This book is all about how to detect financial frauds early. A classical book with lot of real life examples and it will help you turn into a very good analyst. You can obviously read the book or refer to the chapter by chapter main points as follows:

 

• PART 1 – ESTABLISIHING THE FOUNDATION
• Chapter 1 – As Bad as it Gets

1. When something (Results/Profits) happens to come at such numbers that it has never even touched that mark before, or it is very unrealistic, or it is not in conjunction with its peers, then it is warning sign that there might be some fraud in the financials of the company.
2. Too many acquisition/mergers/business combinations, JV’s etc. gives room for the company to adjust its financial statements. Hence, be careful if such activity is too frequent and observe over period before and after such event how the numbers are reacting. Like looking at the reserve and how it changes, checking restructure reserve to identify if amount is too unreasonable, seeing the capitalization /provision /expenses part that has changed significantly.
3. Cash Flow from Operation in relation with Net Income and Free CFO in relation with Net Income will help to determine/identify various frauds/shortcomings/positives for a company.
4. Observe something which is unusual, like sudden jump in revenue, no jump in revenue even after winning big orders, good numbers even at worst economic conditions, company providing products along with service which allows them to adjust its loan, payables and receivables etc. Observation is important. And unusual changes/things are important to note and in such case go for in depth analysis.

• Chapter 2 – Just Touch Up the X Rays

1. Absence of checks and balances among senior management: System of Checks and Balances means frauds are less. I.e. If Company’s internal control are so effective that there is hardly any way for rescue then the frauds might be less. Also, regular ROC Filings, Regular and timely returns, regular quarterly timely results announcement states that everything is going good. Some irregularity and that too after a long streak of regularity can be a warning sign that this time something bad has happened within the company.
2. An extended streak of meeting or beating Wall Street expectations: Is a warning sign especially when company performs even at the worst economic health overall. No company can continuously post robust profits and has to sometimes incur loss. I.e. Senior Executives Who Push for winning at All Costs might be involved in unfair practices to achieve better all times.
3. A single family dominating management, ownership, or the Board of Directors: I.e. Board, management, etc. all are family members or friends of family members or puppets of the family members.
4. Presence of related-party transactions: Huger the related party transaction more the changes of some advantageous adjustments. Also, make sure that the acquisition company, Merger Company also not belongs to the Related Party and if so look more in deep for some adjustments indicating fraudulent activities.
5. An inappropriate compensation structure that encourages aggressive financial reporting: I.e. if results are good there is high remuneration payable. Hence an overly high compensation structure might lure the management to post robust adjusted financial performance.
6. Inappropriate members placed on the board of directors or Boards lacking competence or Independence: example appointing a cricketer as MD in fashion company, where as he has no knowledge of running a company.
7. Inappropriate business relationships between the company and board of members: I.e. Management and Board of directors are on same page and hence frauds of the company are performed collectively.
8. An unqualified auditing firm: I.e. too small the audit firm to audit too huge the company.
9. An auditor lacking objectivity and the appearance of independence: I.e. Auditor is some old friend of Management or Too excessively high the audit fees and consultancy fees to the same auditor. Also, by rotation also, new auditors appointed are some friends of the old auditors. (example DNL and KNM)
10. Attempts by management to avoid regulatory or legal Scrutiny: i.e. trying to reduce revenue to not fall under IND AS Requirement or any such acts which escapes them from some regulatory attention is a warning sign that company might adjust something to stay away from limelight for the reason that frauds remains undetected.
11. Assessing the Competence and Ethics of Management: Just overall how ethical the person is to see whether that person is suspicious to make some frauds or he is clean chit.

 

• PART 2 – EARNINGS MANIPULATION (EM) SHENANIGANS
• Chapter 3 – EM No. 1: Recording Revenue Too Soon

1. Recording revenue before completing any obligations under Contract. I.e. recording sale even if the sale of service has service period is yet to be expired. Also, accelerating the future sale in current period by billing too soon.
2. Be Wary of Companies That Extend Their Quarter End Date. It is sign of some issue or adjustment done by company which is taking time to solve and adjust the financials.
3. Recording revenue far in excess of work completed on a contract. I.e. for example only 50% of service is served but revenue is recorded 80% of the sale contract.
4. Up-front revenue recognition on long-term contracts: I.e. Instead of spreading revenue over the period, whole of the amount is recognised in current year. Using low discount rates to find PV of the sale contract will bring revenue higher etc.
5. Changing the Revenue Recognition Policy to Record Revenue Sooner. Hence thereby inflating the revenue by a lot of margin.
6. Watch for Cash Flow from Operations That Begins to Lag Behind Net Income. Sign that Net Income is not organic and not getting converted into actual cash.
7. Be Alert for a Jump in Unbilled Receivables. And Watch for Long-Term Receivables That Grow Faster Than Revenue. Happens when revenue is accelerated but payment is still receivable a long time to go.
8. Use of aggressive assumptions on long-term leases or percentage-of-completion accounting: I.e. uses assumption in such a way that the revenue is recognized far earlier. Like a low estimation of cost will help in more percentage of completion and that percentage amount will go from sale contract in revenue.
9. Be Aware When Companies Alter the Terms of Existing Lease Arrangements in such a way that it affects financials of the company.
10. Recording Revenue on Long-Term Arrangements with Multiple Deliverables. I.e. selling of phones along with 3-4 year of service. To accelerate revenue the sale price in contract will be allotted more to the phones so as to recognize immediate revenue rather than deferred revenue for 3-4 years being allotted to service.
11. Recording revenue before the buyer’s final acceptance of the Product. I.e. buyer has still not accepted the product or has an option to return them, but still revenue is recorded. As per Accounting Standards we can’t.
12. Seller Records Revenue before Shipment. Not allowed as per Accounting Standards.
13. Watch for Bill-and-Hold Transactions Initiated by the Seller. I.e. Products sold but still the same lying in our inventory where management stating that the risk is transferred to Buyer but the delivery is pending.
14. Seller Records Revenue upon Shipment to Someone Other Than the Customer and hence chances of products being not sold actually.
15. Be Wary of Consignment Arrangements whereas goods send on consignment might be included in revenue stream.
16. Be Wary of Sellers Deliberately Shipping Incorrect or Incomplete Products and hence initially recorded as revenue but then returned. Usually done at the end of the months to boost the sale.
17. Be Alert to Sellers Shipping Product Before the Agreed-Upon Shipping Date. Accelerating the revenue.
18. Recording Revenue When the Buyer’s Payment Remains Uncertain or Unnecessary. Hence even if revenue is recorded there is no surety that we will received the sale consideration. Such receivables can be fabricated/artificial etc.
19. Seller Induces Sale by Allowing an Exceptionally Long Time to pay might have chances of revenue manipulation by recording factitious revenue.
20. Watch for Seller-Provided Financing. Seller providing financing to buyer might adjust the amount any how converting the receivables to loan and or loan to other current asset and might even adjust the same within the books. Also, the seller might offer extended and favourable terms to the buyer and also force the buyer to purchase in return might give highly attractive payment terms.

• Chapter 4 – EM No. 2: Recording Bogus Revenue

1. Recording revenue from transactions that lack economic substance. Like for example revenue is generated from some item that has no substance at all I.e. for example Scrap sale will be included in revenue and account for 30-40% of the revenue. So, scrap sale amount can be adjusted to increase the revenue of the company.
2. Beware: Bogus Reserves Will Often Lead to Bogus Revenue or Income. Because these bogus reserves formed will be utilized for accounting JV’s to transfer to revenue or book expenses.
3. Recording revenue from transactions that lack a reasonable arm’s-length process. I.e. involvement of related party will lead to questions regarding whether the transactions incurred were at reasonable rate or not. Too many related party transaction might be a warning sign that something is happening at those areas.
4. Lack of risk transfer from seller to buyer. I.e. the goods are still yet to be owned by the buyer and hence the risk lies with seller. Still the seller records the revenue, which is against the Accounting Standards.
5. Transactions involving sales to a related party, affiliated party, or joint venture partner. I.e. if someone is affiliated with one other then there are chances that some accounts might be legally written but the true transaction are unknown to the investors.
6. Boomerang (two-way) transactions to non-traditional buyers. Same party is also buying and at the same time supplying. The changes that there might be some adjustments are very high.
7. Recording revenue on receipts from non-revenue-producing transactions. Revenue is recorded even if receipt is non-revenue item. I.e. Bad Debt recovery might be routed through revenue. Similarly, repayment of loan given and other such miscellaneous receipts can be treated as revenue whereas in actuality the same is non-revenue items.
8. Recording cash received from a lender, business partner, or vendor as revenue. Making the revenue look higher but actually should not be the case.
9. Use of an inappropriate or unusual revenue recognition approach by changing Revenue recording policy which might be controversial with the accounting standards. Or even might be the case where such policy does not at all align with the practices followed by other peers in exactly same business.
10. Inappropriately using the gross rather than the net method of revenue recognition. I.e. an agent, instead of recording commission, records purchase and sale differently and hence have effects on revenue (although net is still commission amount earned)
11. Consider How Retailers Account for Returned Goods. I.e. Returned goods should be less from revenue but might be added to purchase. Also, purchase return can be added in revenue which is altogether incorrect practice.
12. Receivables (especially long-term and unbilled) growing much faster than sales. That shows that bogus revenue is recorded and hence the receivables actually does not exist. Also, studying more than 6 months outstanding, and less than 6 months outstanding debtors are useful in understanding the company pattern. Also, can be vice versa I.e. Revenue growing much faster than accounts receivable, where actual receivable does not exist at all but still revenue is getting generated.
13. Unusual increases or decreases in liability reserve accounts. When liability reserve accounts increases there is scope that these amount in liability reserve can be transferred to Revenue but just a JV. Hence, kindly note that pattern of increase in liability reserve and very unusual fluctuations so that we can try to detect whether any JV is passed to Revenue.
14. Recording Revenue from Appropriate Transactions, but at inflated amounts. I.e. contract includes service and expenses collectively. Hence revenue should be recorded in excess of contract price less the expenses amount. (I.e. how much you save is your profit.) But Company recorded the whole amount of contract as revenue and showed expense in non-operating expenses. Similarly many such adjustments can be done to write up the revenue, although true in nature but incorrect.

• Chapter 5 – EM No. 3: Boosting Income using One-Time or Unsustainable Activities

1. Boosting income using one-time events. I.e. by selling a division of the company, the company has included the gain in the expenses column. Hence, the expenses got reduced leading to higher operating Income. Actually, the one-time gain should rather be disclosed in extraordinary gain section as non-recurring.
2. Turning proceeds from the sale of a business into a recurring revenue stream. Company purposely might sell small divisions regularly and treat the gain on selling those division as revenue income. Hence, boosting the revenue as well as the Bottom line. Also, by selling a division, company may also do a joint agreement with the buyer of the division to purchase goods at very cheap rate instead of receiving money for sale of such division. Such transaction is done to get lesser COGS and hence increase the bottom line.
3. Commingling future product sales with buying a business. I.e. Buyer buys a division and makes an agreement with the seller at the same time to sell the seller of division, the whole production of division at inflated price. Buyer benefits from higher revenue and larger margin, but the adjustment has actually no effect on outflow.
4. Shifting normal operating expenses below the line. I.e. Operating Expenses are shifted to Non-Operating by giving some reason which are not clear. Also, by changing some accounting policy and disclosing them in Notes at some corner.
5. Routinely recording restructuring charges. Restructuring charges are usually one time charges and hence disclosed separately and does not have effect on operating income. Hence, company shifts normal operating expense to restructuring expenses saying the acquired business has some expense incurred. Hence it inflates the operating income.
6. Shifting losses to discontinued operations. I.e. company has 3 division and 2 has profit but 1 has immense loss. That 1 division company intends to keep up for sale. Hence, due to this assumption, the company gets to record the loss of such 1 division in discontinued operation and show only 2 profitable division. The impact of which is high operating income whereas the loss of 1 division is below the bottom line as expenses of discontinued operation.
7. Shifting non-operating income under operating income section or revenue section. Example interest income which should be ideally non-operating income is now treated as revenue income. Also, investing income is treated as revenue income.
8. Pay Attention to Where Companies Classify Joint Venture Income. As the Joint Venture is of company itself, many of the amount received from JV can be regrouped on discretion of company itself.
9. Including proceeds received from selling a subsidiary as revenue which should instead be shown as one time gain on selling of subsidy.
10. Suspicious or frequent use of joint ventures when un-warranted. I.e. JV and other partnership help to hide losses and show extra income. Loss from JV does not get added to loss in main company just by stating that JV is not significant enough that it needs to be disclosed or consolidated. Whereas profit making JV’s income is included under consolidation. Also, due to many JV’s, business arrangement and partnerships the amount can be adjusted or shown in such a way that more of the income is included in Main Company.

• Chapter 6 – EM No. 4: Shifting Current Expenses to a Later Period

1. Improperly capitalizing normal operating expenses. Normal and usual operating expenses are capitalised by stating some change in assumptions by the management. Those capitalised expense are then w/off equally for number of years hence distributing current expense to a number of years.
2. Changes in capitalization policy or accelerated capitalization of costs. This will help in understanding whether amount now to be capitalised are in true sense makes good or just to distribute up the expenses such adjustment is made.
3. Watch for Earnings Boosts After Adopting New Accounting Rules. Helps to see whether such accounting rules was just to boost revenue or the change in accounting rules makes sense. Adjust the previous numbers or current number in line with same accounting rules to see whether in actuality any growth is achieved.
4. New or unusual asset accounts. These unusual asset may indicate that the accounts of these assets are made from nowhere. Cautious when these assets have no justification by the management.
5. Capitalizing Permissible Items, but in Too Great an Amount. Too great amount to believe.
6. Watch for Different Capitalization Policies within the Same Industry. Some industry might capitalise 40% of the cost where as some may fully capitalize all the amount at once. Huge difference of treatment should be a warning sign of aggressive financial recording.
7. Jump in soft assets relative to sales
8. Unexpected increase in capital expenditures is also a warning sign that some of the expenses which are operating is shifted to capital expenses.
9. Amortizing or depreciating costs too slowly. So that the cost show in Income Statement becomes too low year on year basis. This is done by stretching out life of depreciable asset and also amortizing for longer years.
10. Improper amortization of costs associated with loans. I.e. Some loans brought on premium. Premium amount should be added to FV of Loan and slowly amortized over life of asset. However when loans are sold then whole of premium should vanish. But instead, even if loan does not exists the premium amount is still capitalized for the loans which do not exist in books at all.
11. Failing to record expenses for impaired assets. I.e. even if assets are impaired means value is written down to its fair value by rechecking every year. Company might not impair the asset at all so as to reduce the recording of expenses.
12. Watch for Slow Amortization of Inventory Costs. I.e. when sale occurs, inventory is removed through COGS and expensed out. Hence note that inventory value does not goes down by a lot of margin indicating that inventory is not expensed out properly. Signs to note when inventory level jumps in relative to the COGS recorded.
13. Failure to Write off Obsolete Inventory, failure to impair asset. Etc. are also the common practices to not report expenses.
14. Jump in inventory relative to cost of goods sold. Find using Days sales of Inventory formula to understand the relation. States whether increase in inventory is in line with the quantum of business done or inventory is stuffed up and not w/off or not expensed in COGS and expenses are underreported.
15. Failing to Record Expenses for Uncollectible Receivables and Devalued Investments. I.e. not recording expenses for bad debts and keeping in books as it is. Also, not w/off the permanent loss in value of investments.
16. Failure to Adequately Reserve for Uncollectible Receivables and also watch for a Decline in Bad Debts Expense. I.e. not providing adequate Reserve for doubtful debt (Compare from previous reserve to see drop or increase) and also under reporting Bad Debts to show less expenses.
17. Failure by lenders to adequately reserve for credit losses. I.e. NPA’s provision should be made. Under reporting the provision will lead to less expenses.
18. Decrease in loan loss reserve relative to bad loans is also a sign that company is making less loan loss reserve as compared to the debt it gives. And hence there stands a chance of manipulation of earning through change in estimates and judgement by the management.

• Chapter 7 – EM No. 5: Employing Other Techniques to Hide Expenses or Losses

1. Failing to record an expense from a current transaction. I.e. electricity bill of March not recorded as the same was received in April. Sometimes, Purchase invoice or expense invoice received late from the party and hence the bill is not recorded also becomes the case to not record the expenses. Not doing provision for Salary, Tax, etc. are also ways in which current period expense can be ignored and shifted to later period.
2. Unusually large vendor credits or rebates. I.e. party from whom we purchase, we should pay the money. But there are cases where we also receive from them. In such case we have to be extra careful as to why we received the money back. Also, rebates and debit balance of creditors is warning sign and possibility of some adjustment done in purchase and creditors area. Example, you order for 10 lakh material supplied in 3 years, but pay out 11crores. Now, supplier gives you discount of 1 lakh and returns back your money. Hence this rebate/discount is reduced from your current expense immediately irrespective of whether any purchase is made in current year or not.
3. Failing to record an expense for a necessary accrual or reversing a past expense. I.e. ESOP when granted, compensation expenses should be expensed out till the vesting period. Here the company fails to record the expense altogether. And also necessary provision are also not made.
4. Unusual declines in reserve for warranty or warranty expense. Usually company selling phones gives 1 year warranty. Hence company should make contingent liability for the same at rate of some 2-5%. Unusual declines in such reserves may state that the company is reducing the expenses by under recording the provision expenses of warranty.
5. Remember to Review Off-Balance-Sheet Purchase Commitments and contingencies. I.e. provision recorded in Balance sheet when the amount if certain and probability of losing is high. However, even if all requisite requirement to treat such contingencies as liability are available, management might not report the same thereby overstating the profit.
6. Declining accruals, reserves, or “soft liability” accounts. I.e. reserves which are recorded in liability side can be easily used up to convert the same in revenue or to reduce expense. Hence, declining reserves without any justification might indicate that reserves are utilized by the company to record revenue or reduce the expenses.
7. Unusually “lucky” timing on the issuance of stock options. I.e. during extremely bad times when stock prices are extremely low, possibility of issuing ESOP. Hence options are exercised at such low price of the stock and utilized at much higher price. Hence, unusually lucky timings indicate issuance of ESOP during the stocks lowest price.
8. Changing pension, lease, or self-insurance assumptions to reduce expense. I.e. Company needs to record pension liability on basis of certain calculations which requires assumptions. These assumptions can be in such a way the company will record higher revenue and lower expenses.

• Chapter 8 – EM No. 6: Shifting Current Income to Later Period

1. Creating reserves and releasing them into income in a later Period. I.e. at time of exceptional performance, company might not show revenue and instead record in reserves to be used in future at the times when results are bad.
2. Stretching out windfall gains over several years and stretching out unexpected gain over several years. I.e. huge one time gain may not be immediately recorded but instead deferred to later periods when the revenue is weaker.
3. Improperly accounting for derivatives in order to smooth Income. I.e. Issuing derivative in such a way that income portion is shifted to future years. Like taking position in derivative at the year end and then squaring off right after the year end will lead to shifting of certain risks to other periods. It involves many types of derivative like interest rate swaps, commodities trading. Etc.
4. Holding back revenue just before an acquisition closes. I.e. before an acquisition, the acquired is instructed to not record any of the revenue. Hence, till the merger deal is done and closed, the revenue is held and then shifted to future period all at once in the new merged company.
5. Creating acquisition-related reserves and releasing them into income in a later period. I.e. at the time of acquisition a lot of reserve is created stating in the name of restricting expenses or other acquisition related expenses. These reserve are overly created and later on released by reducing normal expenses. Thus delaying the profit amount.
6. Recording current-period sales in a later period by telling the customer to pay for the sale later on and also billing them later and not immediately.
7. Sudden and unexplained declines in deferred revenue states that now, the revenue is recorded. The piles up deferred revenue was held up of the past period and now being utilized.
8. Unexpectedly consistent earnings during a volatile time. I.e. during bad market and economy it is difficult for the company to post consistent growth. Hence, even at bad economic position if a company continues its growth then there is warning sign that some earning of past were reserved up and now there are being utilized to create income.

• Chapter 9 – EM No. 7: Shifting Future Expenses to an Earlier Period

1. Improperly writing off assets in the current period to avoid expenses in a future period. Hence, those assets whose life is about to end and hence whole amount will be written off. These amount are expensed right now, so that the need to do in future is relaxed.
2. Improperly recording charges to establish reserves used to reduce future expenses. Like recording provision for expense and then w/off reserves and reducing the actual expense.
3. Large write-offs accompanying the arrival of a new CEO. Usually when new management arrives replacing the old inefficient one. They resort to writing down huge assets and inventory upfront. And also making huge provision for expenses. Usually done to impress people that the new CEO is more strict and cleaning up the bad financials. Instead of people realizing how bad the financials were on basis of which they have invested, they tend to believe that new CEO will bring in more growth to the company. And hence, this does not punish the company’s shares even if the financials seems to be bad. The written down assets and provision are then later on used to impress good profits, making the company price even boom. However, people don’t understand that all of these things are planned to deceive them.
4. Restructuring charges just before an acquisition closes. I.e. the company which is acquiring will w/off its major assets/goodwill and show as restructuring charges. Obviously, after the merger, company will now report letter impaired goodwill value and lesser depreciation. Hence, improving the profits after merger takes place.
5. Improperly Recording Charges to Establish Reserves Used to reduce future expenses. I.e. Using Restructuring Charges Today to Inflate Operating Income Tomorrow and one should watch for Dramatic Improvement in the Numbers Right After the restructuring period.
6. Creating a Larger-Than-Needed Restructuring Reserve and Inflating Future Earnings by Releasing the Reserve. This is done by using a Restructuring Reserve to turn in to incomes and hence smoothen the Earnings. Watch for Companies That Create high Reserves at the Time of an acquisition.
7. Gross margin expansion shortly after an inventory write-off. I.e. once inventory is w/off then in future there is underreported COGS, which increases the GP Margin.
8. Repeated restructuring charges that serve to convert ordinary expenses to a one-time expense. A company might have restricting charges every quarter. Although restructuring expenses are one time, but occurrence in results of ever quarter might indicate that ordinary expenses are shifter to onetime restructuring expenses.
9. Unusually smooth earnings during volatile times. During volatile times, it is very difficult to achieve the sales forecast and target. Hence, a very smooth earning during volatile times might indicate that aggressive accounting done by the company to smoothen the earnings.

 

• PART 3 – CASH FLOW SHENANIGANS
• Chapter 10 – CF No. 1: Shifting Financing Cash Inflows to the Operating Section.

1. Recording bogus CFFO from a normal bank borrowing. Bank borrowing indicates we will receive cash for the purpose we borrowed. Borrowing is financing activity, hence should come under CFF section. However, company try to adjust the amount in such a way that those receipts of cash is treated in operating activity. Take for Example, bank gives loan on taking inventory from company as its collateral. The company may record this receipt of loan as against sale of goods, thereby reducing inventory and showing this receipt under revenue. And hence, the amount received is shown under the CFO part. Hence, bogus revenue as crated above would also indicate bogus CFFO.
2. Complicated Off-Balance-Sheet Structures Raise the Risk of Inflated CFFO. I.e. a company having many off balance sheet Subsidiaries, partnership, JV’s can record transaction in such a way that main company might have CFFO and others being recorded at CFF or CFI.
3. Boosting CFFO by selling receivables before the collection date. Early selling of receivables to the banks for discount is also a warning sign for aggressive recognition of CFFO. The receivables can be long term and might mature in 2-3 years. But to show healthy CFFO, company might sell those receivables and record the inflow of cash under CFFO.
4. Watch for Sudden Swings on the Statement of Cash Flows. I.e. observing change in receivable account and change in payables account. Intentionally not paid to payables and gave excess discount to receivables to collect cash early is a sign the CFFO is manipulated.
5. Disclosures about selling receivables with recourse. Check for disclosure regarding receivables in Notes to Accounts. Improper, incomplete information might indicate some wrong doings. Also vague statements and other such things in the filings of the company can indicate something fishy.
6. Changes in the wording of key disclosure items in the financial reports. When you compare two different annual reports, basically you should see the same wordings in NTA. However, a small wording change in annual reports NTA might change its meaning. Management play with words to disclose important information without getting it in limelight. Paying attention to these small key disclosure can reveal a lot about the company’s performance.
7. Inflating CFFO by faking the sale of receivables Changes in the wording of key disclosure items in the financial reports
8. Watch Carefully for Disclosure Changes in the Risk Factors. Addition in risk factors or changes in old risk factors wordings can say a lot about the company’s changes in policy, additional discovery, etc.
9. Providing less disclosure than in the prior period, states that company is trying to hide something.

• Chapter 11 – CF No. 2: Shifting Normal Operating Cash Outflows to the Investing.

1. Inflating operating cash flow with boomerang transactions. I.e. two way transaction from a single party is always suspect to some adjustments in financials. Transacting like selling future capacity to the company and receiving payment upfront would indicate that CFFO is recorded immediately but not the revenue. The future capacity being sold can be cancelled and amount might be returned through CFF. Always note the key disclosure part carefully to understand the trust sense of the transaction made and to see whether boomerang transactions were entered to inflate CFO or Revenue.
2. Improperly capitalizing normal operating costs. This would lead to recording the expenses in Investing activity rather than Operating activity.
3. New or unusual asset accounts. States that amount received from persons are not properly categorized in the Balance Sheets and hence they are named vague. These assets are usually some adjustments made by the company wherein possibility of receipt of cash might be treated under CFO.
4. Recording purchase of inventory as an investing outflow. This is case for companies which sells DVD’s. Example Netflix main way which it runs is business is by renting out DVD’s. Now, DVD might be considered as asset as well as inventory. Ideally it should be inventory for the company as DVD does not work for more than 1 year. Hence, capitalizing these DVD’s cost as Asset would have outflow from its Investing activity, and hence COGS (DVD not coming in inventory) will be very less. All these types of expenses have a huge impact on Revenue, Operating Income as well as CFO section of Financials. Such confusing accounting policy, will have different estimation by management in different companies. Comparing peers is important to understand true sense of the accounting adjustments.
5. Investing outflows that sound like a normal cost of business. Hence, indicates normal business expenses should be part of CFO but treated in CFI outflow.
6. Purchasing patents, contracts, and development-stage technologies. Developing internal technology will make the costs of research be routed through Operating activity whereas acquiring the patent from somewhere else will result in investing outflow.

• Chapter 12 – CF No. 3: Inflating Operating Cash Flow Using Acquisitions or Disposals.

1. Inheriting Operating cash inflows in a normal business acquisition. I.e. before an acquisition, the target company is told to pay all its payable in advance and do not collect or deposit the receivables cheque as far as possible. Hence, by this adjustment, after the acquisition happens, suddenly all the receivables are deposited. These deposits form part of merged entity and hence due to higher receivable collection and lower payable payments, the CFO looks very healthy. All kind of such stuffs are made so as to make the CFO look strong during an acquisitions. Also, the inflows from all these will be recorded in CFO, but the outflow i.e. amount paid for acquisition will be recorded in CFI activity. Hence, there is shift in these adjustments from CFI to CFO activity.
2. Companies that make numerous acquisitions are usually prone to frauds. They acquire to hide their certain accounting frauds. Hence, they keep on acquiring and at each acquisition their Financials are reinstated and hence the frauds are hided or erased by some acquisition and accounting adjustments.
3. Declining free cash flow while CFFO appears to be strong states that CFFO is result of acquisition of company. Whereas if we use free cash flow matrix, we would be better able to judge the health of the company assuming that the acquisition has never happened. Also we might as well Review the Balance Sheets of Acquired Companies to understand whether any adjustment is made before such acquisition.
4. Acquiring contracts or customers rather than developing them internally. I.e. customers and contracts of acquired company is used and merged with the main company. Hence, main company as a whole looks strong in itself. But, the truth is that the main company has no business in itself but is the acquired companies clients and orders and businesses.
5. Boosting CFFO by creatively structuring the sale of a business I.e. new categories appearing on the Statement of Cash Flows. Say that a company sold its one brand but also agreed to enter into an agreement to buy the same brands goods in future. Now, sale proceeds is 100 for example. 100 is split into two categories of 60 and 40. 60 towards receipt of sale of business and 40 as advance towards sale of goods. (Although whole amount being for sale of business). Hence, this way 40 is of CFI being converted into CFO.
6. Selling a business, but keeping the related receivables. Selling a business required taking over all the assets and liability of the company and by net purchase method the value is arrived at. Hence, here the business is sold but company retains its receivables. So, receivables are with the company and their receipts are recorded in CFO even if business is sold. On the other hand payables and other liability are sold to the company and their takeover amount is recorded in CFI.

• Chapter 13 – CF No. 4: Boosting Operating Cash Flow Using Unsustainable Activities.

1. Boosting CFFO by paying vendors more slowly. Delaying the payment to the parties will give less outflow from operating and hence increasing the CFFO.
2. Accounts payable increasing faster than cost of goods sold. States that company is not buying much products and hence COGS are not increasing that much. But still even if company is not buying, still the payables are increasing. States that payables are paid slower than normal payments.
3. Increases in other payables accounts. Might be the possibility that Payables are shifted to other payables account. Now that payables are routed through CFFO the other payables account might be routed through Financing of Investing. Hence, by changing the accounts head the Cash Flow head is also changed.
4. Large positive swings on the Statement of Cash Flows states that amounts might be adjusted, dig in deeper to know the impact of each positive swing which is large enough.
5. Evidence of accounts payable financing. Using bank loan to pay the accounts payables is a warning sign of CFO being adjusted. The amount received from bank is treated as operating inflow and payment to vendors as operating outflow on the basis that financing is done for the operation of the business. When later on these loans are repaid, the amount is adjusted through financing activity. These type of transactions are done to adjust the Cash Flows of the companies.
6. New disclosure about prepayments. I.e. stating that now the payments to leaseholder will be revised and paid quarterly instead of monthly. This type of adjustments are mostly done to adjust the Cash Flow Statements.
7. Offering customers incentives to pay invoices early. Hence, an early discount offered leads to boost of receivable collection thereby inflating the CFFO. Also, by purchasing less inventory, the outflow is deferred to the next period and CFFO is boosted.
8. Disclosure about the timing of inventory purchases. I.e. company usually purchases inventory at the start of the quarter. States that by the end of the quarter company keeps very less inventory and restates it immediately at the start of the quarter. This type of adjustment is done to show less asset value in the balance sheet. Also, not purchasing at the end of the quarter indicates that the outflow is delayed to the next quarter.
9. CFFO benefit from one-time items. I.e. say for example company has earned a onetime settlement income of 1 billion. Although this 1 billion is shown as extraordinary income in profit and loss. In cash flow, starting from net income, this 1 billion is included in CFO. Hence, people who adjusted this 1 billion would know that it is unsustainable. Other would only thing that CFO this year has boosted 1 billion more.

 

• PART 4 – KEY METRIC SHENANIGANS
• Chapter 14 – KM No. 1: Showcasing Misleading Metrics that Overstate the Performance.

1. Changing the definition of a key metric. Company often apart from releasing revenue numbers, release the ARPU/Revenue per sq. meter, Order Book pending etc. which are key metric and driver to the future growth of the company. This key metric is usually disclosed by the management of the company in its annual report. Changing the calculation of such key metric, or definition of key metric or any changes can have impact on which customer sees its business. Example, Telecom Company calculates calls and internet revenue divided by number of its Card users to know the ARPU. Now, it telecom company choses to exclude customers that have only incoming activated and no outgoing or internet. The divisor will reduce and the company will show a higher ARPU. Hence, customers will often get mislead due to small change in important key metric. Similarly many company will have different metrics and will impact differently on each factors.
2. Highlighting a misleading metric as a surrogate for revenue. I.e. there are terms like sales, net sales, net sales (excluding returns) etc. Company can come up with new name and adjust all of the bad sales and come up with some magical number. Company will then state that revenue when calculated using Net Sale (Excluding return) has increased 50% from the previous revenues. However, the metric Net Sale (Excluding return) are calculated so as to hide any bad revenue. Etc.
3. Unusual definition of organic growth. Organic growth is the sustainable growth of the company. Usually the investors are more interested in organic growth as this type of growth will only be sustainable and will continue in future. However, company usually try to show higher organic growth. In quest of doing so, the company changes the definition of many of its metrics so as to make the organic or sustainable growth appear higher.
4. Inconsistencies between the earnings release and the 10-Q will also state that management is not honest. Stating something else and showing something else.
5. Highlighting a misleading metric as a surrogate for earnings. Same as revenue metric, company comes up with new terms like Cash Earning or Cash EBIDTA to show the growth in cash flow in those terms. However, these are the terms used only to show a better growth than actual.
6. Pretending that recurring charges are nonrecurring in nature, and hence improving the operating income and showing recurring expenses as one time.
7. Pretending that one-time gains are recurring in nature. Hence increasing the operating income.

• Chapter 15 – KM No. 2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration.

1. Distorting accounts receivable metrics to hide revenue problems. Company know that investors will look for receivables being exceptionally high then the revenue. Hence, to keep those doubts at bay, company try to adjust the receivables to match in line with sales. These receivables are converted into notes, shown as some other assets or they are discounted form the bank. Hence, accounts receivables are put in line with revenue so that investors or analyst would not be able to make out.
2. A huge decline in DSO following several quarters of growing receivables states that company had earlier stuffed up the revenue unethically. Now that they are unable to collects those receivables (As non-existent) DSO has been affecting a lot.
3. Inappropriate or changing methods of calculating DSO. I.e. change from end of balance receivables to average receivables. Even Monthly Average, Yearly Average, Weekly Average has impact on the company’s DSO. Analyst should using ending receivable balance to calculate DSO.
4. Distorting inventory metrics to hide profitability problems. Increasing inventory is a sign the products are not being sold and may be written down. To address this concern of the analyst, company might resort to unnecessary stuffing the revenue and showing the inventory has been sold actually. Company sends products customers not ordered for, and also send wrong products purposely. All this done at the end of the quarter so that the inventory will be low and not impactful to have a raising question. Also, inventory can be turned as asset by the management by stating some soothing reason.
5. Distorting financial asset metrics to hide impairment problems. I.e. Company will not show that a particular asset is NPA and hence not make enough loan loss reserve. This will help the company to hide its true profits by actually understating the reserve or provision.
6. Stopping the reporting of certain key metrics. Loan loss reserve of one company was getting lesser and lesser (Actual should be way too higher) and the economy was extremely bad. Investors were questioning the quality of its assets. Hence, company had to reassess its asset count and show whole amount of loan loss reserve on actual basis. However, instead of showing regular standalone loan loss reserve, it showed consolidated and hence was successful in hiding the loan loss reserve by not disclosing the usual key metrics of showing on standalone basis.
7. Distorting debt metrics to hide liquidity problems. Company sometimes take too much debt. The borrowers insist on maintaining certain health of its balance sheet so as to continue loans. Hence, in order to keep continuing the loans and also getting new loans, company resort to window dressing of its balance sheet and show a way to better result than actual. This result in not only company getting a better loan, but also issue loan to repay the old ones. In realty the balance sheet of the company is way too bad and not in position to stand in the market.

Hence, the book helps in discovering many frauds by reading the annual report of the company, analysing the statement passed by the management through its annual reports and do some number crunching by analysing the PNL statement, BS and Cash Flow and other various metrics. This well help an investor to discover the organic and sustainable growth of the company in which it is choosing to invest and help to understand the value of the company.

 

Thank you!!

Disclaimer: I have tried my best to evaluate the content from book into short pointers and summary, and where necessary added my own point of view. By no means, this summary is an infringement to any involved party. It is just a short representation form the orignal content.