Financial Shenanigans

Financial Shenanigans includes aggressive or creative accounting, window dressing and accounting frauds with an intent to create a wrong impression about the financial performance and health of the enterprise. Dishonest companies have often used these tricks to attract investors .The lure of these techniques is often strong with companies which are not able to meet stakeholders expectation or are not able to compete effectively in the market. Financial shenanigans can range from relatively insignificant breaches involving creative interpretation of accounting rules/policies to absolute scam over several years.

Although, financial shenanigans are used to present a healthy picture of financial performance of a company but it may lead to consequences like fall in stock price, bad reputation, bankruptcy, imprisonment of senior management personnel, dissolution of the company etc.

Financial shenanigans can be used both ways

a. To overstate revenues and profits with the purpose of increasing EPS and having positive impact on stock prices

b. To understate revenue and profits to smoothen the profits over a span of years or to evade taxes.

Key Drives for Financial Shennaigans :- A number of companies use window dressing of their financial statements to hide the correct picture of their financial performance .Although, there can be multiple factors which prompt companies to go for financial shenanigans, the most common motivational factors are

1 .Cover up company’s declining financial performance- If the company is facing a declining profitability and financial condition, the management may be prompted to use techniques to misrepresent the profits and /or financial condition

2. Avoid taxes- One of the common reasons that companies go for financial shenanigans is to reduce their tax liability.It may include use of an accounting policy which may help the manangement in reducing the company’s tax liability

3. Raising funds through banks-If a company plans to take a large loan from the bank and it’s financial condition is not pretty good.It may resort to falsify its financial performance to become eligible for getting funds from the bank.

4. Satisfy the earning anticipations of shareholders/general public- In case of listed companies results are shared on a quarterly basis with different stakeholders with focus on expected future earnings. This may lead to creation of market expectation for the future performance of the company and then management may manipulate the results to meet those expectation in order to maintain their reputation in the market.

5. When compensation is linked to performance-Sometimes, managerial self interest becomes a motivation for use of aggressive accounting practices. Particularly in cases where the senior manangement people hold a significant number of ESOP , they may be tempted to falsify financial statements to improve stock price which will improve their personal wealth.

Techniques for Financial Shenanigans

Although, companies have number of ways to window dress or falsify their financial statements if they so desire. But , the most common ones which are often used are discussed below:-

Improper or premature revenue recognition-It may include

i. Recording revenue in excess of the work done

ii. Recording revenue when the payments is not certain

iii. Recording revenue without delivery/acceptance of goods by buyer

iv. Recording bogus revenue by raising false invoices

Channel Stuffing-  Channel stuffing is shipment of goods to dealers/wholesalers in excess of honest demand from the end users by extending rewarding incentives. It is the name given to dishonest business practice used by a company to inflate its sales and earnings figures by deliberately sending more material in its distribution channel than they are able to sell.The channel partners are given the freedom to later on return the goods.Thus , by using this technique companies can achieve higher deceptive sales in a particular period. This technique is often used at year end by the corporates.

Shifting financing cash inflows to operating sections- It is a technique used to deceive the investor by showing Financing cash inflows in operating section of CFS.This way the company reports a good cash flow from operation to attract investors.

Sales versus Commission- An enterprise may be engaged in the business of trading in goods for other entities.In such a transaction the enterprise should record only commission as it’s revenue .But, in order to boost their top line/revenue some companies may record purchase price plus commission as their sales revenue. Although, it will not impact the net income as the company will also show purchase price in it’s cost of goods sold. However, this financial shenanigan has the effect of enhancing the top line

Boosting income using one time or unsustainable activities- It may include

a. Selling undervalued assets for a profit

b. Selling investments for a gain and recording it as revenue, or using it to reduce current operating expenses

c. Reclassifying certain balance sheet accounts to create income for eg one time customer advance of huge amount is recorded as revenue, One time loan taken is recorded as revenue

Shifting current expenses to a later period- In order to increase revenue for a particular period , company may shift it’s current expenses to future period via Prepaid expenses.

Backdating of transactions- In order to increase revenue to meet the targets, an enterprise may keep its accounts open for an extended period of time.Sales of subsequent period may then be backdated and included in previous accounting period. For eg, the accounts for the year ended 31st March 2012 may be kept open till 20th April 2012 .Any sales order received till 20th  April 2012 may be backdated and recognized as revenue for the year ended 31st March 2012.

Using aggressive accounting policies- Some of these can be

i. Lengthening asset lives so that depreciation charge is reduced and profits can be increased

ii. Using straight line depreciation method so that there is lower depreciation expenses in earlier periods

iii. Choosing FIFO against LIFO in period of rising prices so that COGS is lower and profits are on higher side

iv. Capitalisation of operating cost of expenses

Income Smoothening/Cookie Jar Accounting- It is the practice of income smoothening by creating reserves during good periods and utilizing the same during not so goods period.This is based on assumption that companies reporting smooth profits are viewed to be less risky by the investors than the companies with unstable profits.For eg, a company with quarterly profits of Rs 4000 million, Rs 1200 million, Rs 3500 million and Rs 1800 million will be considered volatile compared to another company with quarterly profits of Rs 2800 million, 2600 million, 2700 million and 2400 million.In both the cases , total absolute profits are same.But second income stream is more stable and this company will enjoy better valuations in market.

Improper Classification

An enterprise may use improper classification of incomes, expenses, assets and liabilities.For example extra ordinary incomes may be clubbed with operating incomes to create a wrong impression about revenue growth of the company.