Financial Shenanigans Fourth Edition How to Detect Accounting

Financial Shenanigans, Fourth Edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports- Howard M. Schilit Book Summary by Anandh Sundar Value Investors Mumbai Meetup 10 May 2018

Takeaways • Dishonest company executives may find ways to improperly capitalize any normal operating cost; however, the most common ones are generally those related to long-term arrangements, such as • • research and development, labor and overhead related to a long-term project, (Construction? ) software development, and (Intellect Design? ) costs to win contracts or customers (Marketing? • Sometimes a company will acquire a competitor in order to wind down a competing product and move the target’s customers onto the acquirer’s platform. This may be a good business strategy, but it could wreak havoc with organic growth metrics

New examples-Income Statement • In 2010, Diamond Foods agreed to compensate walnut growers for price increases over earlier agreed rates viz to make them whole for the 2009 crop, but they called the payment an “advance” on the next year’s crop • In 2013 Salesforce. com, for example, began the unusual practice of accounting for a large multiyear software license as a “capital lease • In June 2014, Hertz announced an initial prelimnary earnings restatement of $28 M which increased to $349 M(Pre tax) when finally concluded in July 2015, mainly due to revenue preponement/wrong recognition • In 2015, Toshiba announced restatements in profits $1. 9 billion which covered all years from 2008 to 2014, which spanned the reign of three separate CEOs. . . the most substantial amounts related to (1) inflating revenue by improperly applying percentage-of-completion accounting, (2) stuffing inventory channels on transactions in the PC business, and (3) failing to take charges for impairment and depreciation. • In the last decade, Autonomy reportedly boosted its revenue by booking sales on software deals still under negotiation with end users (but had not yet closed) and transfer the associated product to resellers

New examples-Cash Flow • In 2015 alone, T-Mobile repaid $564 million in short-term debt that was used for purchases of handset inventory and network equipment. Conveniently, this cash outflow was buried on T-Mobile’s Statement of Cash Flows as a financing activity • In 2016, Tesla’s operating cash outflows appeared to have improved, amounting to net outflows of $124 million, down from outflows of $524 million in 2015. . . orders and refundable customer deposits for its Model 3 sedan, which had been introduced only in concept. . these deposits accounted for $350 million of additional inflows, or 88 percent of the reported improvement in 2016. • In 2016, Treehouse Foods purchased a business for $2. 7 b excluding related account payables(unspecified), which improved CFO and lowered CFI. Most acquisitions have positive net working capital • In 2016 Linn Energy declared bankruptcy as it had paid out excessive dividends in the past basis ‘Adjusted EBITDA’ and excluding growth capex(60% of total capex) while estimating distributable cash flow. This inflated its dividend yield.

New examples-Balance sheet • In 2015, Olympus revealed investment/M&A fraud. As the oversized investment account on Olympus’s Balance Sheet would likely raise questions by investors, management essentially made these losses disappear by shifting them into goodwill, under cover of an acquisition, then later shifting these losses to bogus nonconsolidated entities created by management.

New Examples-KPIs • In its March 2014 earnings presentation, First Solar presented a “quarterly” bookings figure that included much more than a quarter’s worth of bookings. A close read of the fine print revealed that the bookings metric included all new bookings from the beginning of the quarter all the way through the date of the Earnings Release—a full 36 days after the quarter ended.

Business structuring accounting impact • cash paid to employees and vendors for internal research and development would be reported as an operating outflow. However, some companies report cash paid to acquire already researched and developed products as an Investing outflow. • In 2017, jewellery retailer Signet reduced its inhouse credit program, and same store sales actually dipped (61 percent of sales in the company’s sterling segment were made using Signet’s in-house customer financing)

Old Examples yet notable • 2007 -Netflix considered the purchase of DVDs to be the purchase of a capital asset, and therefore the cash outflows were presented in the Investing section. Yet, income statement included as COGS. • Tyco raised the $800 customer acquisition cost to $1000/customer viz but levied a $200 operational inflow as related fees. Net impact same

Forensic Mindset • 1. Skepticism is a competitive advantage. • 2. Pay close attention to changes—always ask “why? ” and “why now? ” • 3. Look past “accounting problems” to see if business problems are being covered up. • 4. Pay attention to corporate culture and watch for breeding grounds of bad behavior. • 5. Never blindly adopt the company’s profitability framework. • 6. Incentives matter: pay close attention to how executives are compensated. • 7. Even in financial disclosures: location, location. • 8. Like in golf, every shot counts. • 9. Patterns of behavior provide a reliable signal. • 10. Be humble and curious, and never stop learning