Investment—Accounting Gimmicks Used by Execs to Cook their Books

In 2016 volatile stock market, Bert Dohmen has warned the casual investors that:^[1]

At the start of a bear market a casual investor, who is easily swayed by the opinions of others, should not listen to the opinion of any analyst with a conflict of interest. They are either with Wall Street or have investment management jobs. Both have big conflicts. None of those people can ever be candid about their opinions of the markets 

If you want analysis and forecasts without conflicts of interest, find someone with lots of experience who doesn’t work for Wall Street, who doesn’t manage money or sell investments. You never want to guess if what you hear or read is tainted.

Accounting Gimmicks

Stocks move on earnings, so execs will manipulate earnings. How can you spot their accounting gimmicks ahead of time? 

In her twitter thread, @FabiusMercurius has shared her thoughts. Here’s a rundown of top shenanigans execs used to cook their books:

1. Using SPVs to hide bad debts case: 

Enron created multiple Special Purpose Vehicles (SPVs), then gave them $ENRN stock while the SPVs gave back case. The SPVs then used Enron stock to hedge assets on Enron's balance sheet.  Enron got to reduce write-offs & report “improved” debt-to-equity. 

2. Reporting bogus revenue case: 

In 2008 Lehman Bros “sold” $50B of 💩 garbage loans to Cayman Island banks under the promise to buy them back after the fiscal/quarter ends.  This created the impression to wall street that Lehman had $50B more cash than it actually did. 

3. Round-tripping (when 2 companies buy/sell repeatedly to inflate sales) 

Case i: Valeant sold Philidor (which it had the option to buy) inflated shipments of a toenail fungus drug

Case ii: Dynegy's energy trading biz pre-arranging many buy-sells w/ an ally at designated price 

4. Recording revenues too soon 

GAAP says revenue is recognized when a goods/service is delivered, not on cash payment/upfront. 

Case: Xerox "accelerated" $3B in service fees, boosting EBIT by $1.5B.  Top execs rewarded themselves $35M in RSUs for hitting earnings targets. 

5. “Mucking” 

With depreciation to understate expenses case: literal muck-handler 💩💩Waste Management Inc. avoided depreciation expenses by inflating salvage value & extending the useful lives of its garbage trucks. 

6. Recording expenses too late 

GAAP says expenses are recognized when incurred, not when paid in cash. case: Nut-seller Diamond wanted to acquire Pringles from P&G with stock. DMND had to boost its share price. Screws walnut growers by delaying payments to offset other FY'11 costs. 

7. Booking opex as capex case: 

WorldCom used its cash flows statement to hide expenses by marking operating costs, which should have been opex, as capex. WorldCom inflated cash flow by $3.8 billion and posted quarters of positive performance when it really lost money. 

8. Channel stuffing 

When a company ships customers excess goods that were not ordered to temporarily inflate accounts receivable.  Case: Krispy Kreme allegedly sent franchises 2x usual shipments at the end of financial quarters so the company could meet Wall Street forecasts 

9. Boosting income with 1-time gains 

This one not illegal. case: At quarter ends, Lehman Bros sometimes used “repo 105” an accounting trick that defines a short term loan as a sale. Cash from sales gave the appearance of lowered reported liabilities. 

10. "Big baths" 

Also not illegal. When a new exec steps in, s/he may write off all losses possible to blame previous management. This makes the company look worse than it is, giving the new exec a low starting bar on which to build future cred 

11. Hiding losses in acquisitions: 

I-bankers charge stupidly high fees… how can CEOs use that to their advantage? 

🤔"those 👠👜 for my wife last quarter… advisory expense!" 

 ex: Tech giant Olympus hid losses on securities investments for years under the cover of acquisitions. 

12. Cookie jar reserves 

When execs hide income in order to report them in a future quarter when performance needs a boost case: 

Pre-2002 Dell hid undisclosed payments from Intel... between 2002-2006 it dipped into the jar every quarter to cover shortfalls in operating results.

References

1. Why The Next Two Years Could Be Worse Than 2008
• Before the end of March, hedge funds will probably be hit with big redemptions because of poor performance. Junk bonds will take the worst hit. Debt defaults on banks loans or ‘rescheduling,’ will cause concerns about the banking system.
2. What is EBITDA?