Financial Analysis–Ho

Analysis Ho
ow to Spot Red Flags

Tom Robinson,
Robinson PhD
PhD, C
CPA CFP
CPA, CFP, CAIA,
CAIA CFA
Managing Direcctor, Education
CFA In
nstitute
tom.robinson@
@cfainstitute.org

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 Financial Stattement Fraud
• Some Basic Concep pts
• Some Historic Scandals
• Red Flags (Warningg Signs) for Financial
Statement
State e t Irregulari
egu a ties
t es

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 The Fraud
d Triangle
g

Pressure or Incentive

Opportunity Rationalization

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 Checks and
d Balances

Spending
S di $10
$10,000 off C
Cash
h ffor an expense
impacts net inccome and hence the balance
sheet through
g owner’s
o equity
q y

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 Checks and Balances
B ( )
(2)

Spending
S di $10
$10,000
000 off Cash
C h for
f an assett does
d nott impact
i t
net income, but doess impact the balance sheet

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 George Santayana

“Those who ign

nore history are
doomed too repeat it”

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 Scandals Overr Time - 1920s

Charless Ponzi

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 Scandals Over Time
T - 1920s (2)
( )

• Kreuger & Toll 1920s s/1930s

– Swedish match con nglomerate
– Fictitious assets – largely intangibles

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 Scandals Overr Time - 1930s

• McKesson & Robins – LateL 1930s

– Musica Brothers/Fore eign Crude Drug Business
– Fictitious sales, receiv
vables, and inventory
– Déjà vu – McKesson HBOC late 1990s

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 Scandals Overr Time - 1960s

• National Student Marke

eting 1960s
– Campus marketing program
p with a P/E of 100
– Overstated sales and
d receivables

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 Scandals Overr Time - 1970s

• E
Equity
i F Funding
di 1970
1970s
– Mutual Funds/Insura ance
– Fictitious life insuran
nce of $2 billion out of
$3 billion sold
– Department 99

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 Scandals Overr Time - 1980s

• C
Crazy Eddi
Eddie, IInc. 19800s
– Electronics retailer
– Overstated sales, re eceivables, and inventory
– What is wrong with tthis picture:
• Year Days Inventory
• 1984 7
79.68
• 1985 9
93.68
• 1986 1112.42
• 1987 1446 23
46.23
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 Scandals Over Time
T - 1980s (2)
( )

• Miniscribe 1985 to19986

• “Q.T.
Q Wiles”es
– Sales + 62.23%
– Receivables
R i bl + 147 7 94%
7.94%
– Inventory + 100.49
9%
– Gross Margin
• 1985: 6 6.46%
46%
• 1986: 28.87%

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 Scandals Overr Time - 1990s

• Sunbeam
S b
“Chainsaw Al Dunlap”
p
1996 1997
Sales -3.21
3 21% +18 69%
+18.69%
Inventory -22.4
41% +57.89%
Receivables -1.28
8% +38.47%

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 Scandals Over Time
T - 1990s (2)
( )
• Sunbeam
– The Company recognize es revenues from product
sales p p y at the time of shipment
principally p to
customers. In limited circcumstances, at the
customer’s request, the Company may sell seasonal
product on a bill and ho old basis…
basis
– …During 1997, the Com mpany initiated early buy
programs for highly sea asonal products such as grills
and warming blankets in n order to level production
and distribution activitiess.

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 Sunb
beam

150,000
100,000
50,000
0 Net Income
(50,000) (thousands)
((100,000)
, ) Operating Cash
Flow (thousands)
(150,000)
((200,000)
, )
(250,000)
1996 1997

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 World
dCom

• June 2002
• Audit committee reports improper booking of
$3 85 billion of expense
$3.85 es
• “Line costs” were capitaalized as Property, Plant
and Equipment rather tthan expensed.
expensed Also
classified as an investin
ng cash outflow rather
than operating
operating.
• “The principal compone ents of line costs are
access charges and tra ansport charges
charges.“

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 WorldC
Com (2)
( )

9,000
9 000
8,000
7,000
,
6,000
5,000
4 000
4,000
Operating
3,000
Income (millions)
2 000
2,000
1,000
0
(1,000)
(2,000)
1995 1997 1999 2001

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 WorldC
Com (3)
( )

60 00%
60.00%

50.00%

40.00%

30.00% Line Costs as a

Percent of Sales
20 00%
20.00%

10.00%

0.00%
1995 1997 1999
9 2001

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 WorldC
Com (4)
( )

50.00%
45.00%
40.00%
35.00%
30 00%
30.00%
25.00% PP&E as a Percent
20.00% of Assets
15.00%
10.00%
5.00%
0.00%
1995 1997 199
99 2001

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 WorldC
Com (5)
( )

10 000
10,000

8,000

6,000
4,000 Operating
p g
Income (millions)
2,000 Free Cash Flow
0 (Milli
(Millions)
)

((2,000)
, )

(4,000)
1995 1997 1999
9 2001

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 WorldCom 10K
K Restatements

• Cumulative reduction in equity

e of $70.8 billion
• 2001 NI reduced $17.1 billion
• 2000 NI reduced $53.1 billion
• j
Line costs adjustment about $2 billion in 2000 and
$3 billion in 2001

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 Scandals Overr Time - 2000s
• Allou Health and Beauty
• Enron
– Special purpose entities
– Related
R l t d party
t ttransactions
ti
• Adelphia
– Related party transactions/“lo
transactions/ lo
ooting
ooting”
• Parmalat
– Off-balance sheet debt/oversstated cash
• Tyco
– Improper loans/forgiveness/sspending
• Satyam
– Related Parties/overstated re evenue and cash
• Madoff and Others
– “When the tide goes out, you can see who is swimming naked.”
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 Allou Health and Beauty
y

10,000,000
5 000 000
5,000,000
0
((5,000,000)
, , )
Net Income
(10,000,000)
(15,000,000)
Ope at g Cash
Operating Cas
(20 000 000)
(20,000,000)
Flow
(25,000,000)
((30,000,000)
, , )
(35,000,000)
2000 2001 2002

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 Enron’s 2000 Footnotes

• In 2000 and 1999

1999, Enron eentered into transactions
with limited partnerships (tthe Related Party) whose
general partner's
partner s managinng member is a senior
officer of Enron.
• In 2000
2000, Enron entered intto transactions with the
Related Party to hedge ce ertain merchant
investments and other asssets. …Enron contributed
to newly-formed entities (the Entities) assets valued
at approximately $1.2 billio
on…

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 Enron’s 2000 Footnotes (2)
( )

• In 2000
2000, Enron entered d into derivative
transactions with the Entities
E with a
combined notional amo ount of approximately
$2.1 billion to hedge ce
ertain merchant
investments and other assets…

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 Enrron
• ENRON VICE CHAIRMAN CLIFF BAXTER RESIGNS
• FOR IMMEDIATE RELEASE E: Wednesday, May 2, 2001
HOUSTON -- Enron Corp. announced
a today that Vice
Chairman J. Clifford Baxter is resigning
g g from the company
p y
• ENRON ANNOUNCES SKILLIN NG RESIGNATION; LAY
ASSUMES PRESIDENT AND CEO C DUTIES
• FOR IMMEDIATE RELEASE E: Tuesday
Tuesday, August 14,
14 2001
HOUSTON -- Enron announ nced today that its Board of
Directors has accepted the resignation of Jeffrey K. Skilling
as Enron’s
E ’ P
President
id t andd CEO
EO.

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 U.S. SEC
C Study
y
• Improper
p ope Revenue
e e ue Recognition
ecog t o ((126
6 cases)
– Revenue in advance, bill and hold, fictitious revenue, improper valuation of
revenue.
• Improper Expense Recognition (101 cases)
– Improper capitalization, overstating inventory, understating bad debts/loan
losses, failure to record impairmennts.
• Improper Accounting in Connecction with Business Combinations
(23 cases)
• Other Accounting and Reporting
g Issues (130 cases)
– Inadequate disclosures
– Failure to disclose related party tra
ansactions
– Inappropriate
pp p accountingg for non-mmonetaryy and roundtripp transactions
– Improper accounting for foreign pa ayments in violation of the Foreign
Corrupt Practices Act
– Improper
p p use of off-balance sheet arrangements
g
– Improper use of non-GAAP financ cial measures

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 Warning
g Sign
gns - Revenue

• Aggressive revenue recogn nition These include:

nition.
– Bill and hold sales – invo
oicing a sale without
shipping merchandise.
– Sales type leases – Lesssor reporting leases as a
sale, particularly when th
he lessee is treating the
transaction as an operatting lease
lease. [IBM]
– Recording revenue at the time a contract is signed,
but before delivery of go
oods or services.
– Recording revenue priorr to fulfilling all of the terms
of contracts (such as insstallation or verification that
computer equipment/sofftware is functioning
according to contract terrms).
– The use of swaps or barrter arrangements to
generatet sales.
l
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 Warning
g Signs
g - Revenue (2)
( )

• Growth in revenues out of sync with economy

economy,
industry or peers companies and with growth in
receivables.
• Particular attention should
d be paid when receivables
are growing faster than revvenues or days
receivables
i bl are iincreasing
i g over time.
ti Thi
This could
ld
indicate non-existent saless.
• Revenue/assets side wherre estimates of reserves
are a major determinate off value [Bre-X, Shell]

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 Warning
g Signs
g s - Revenue+
• Operating cash flow out of line with reported earnings
earnings.
• If a company is reporting positive
p and perhaps growing
earnings,
g but cash flow is negative
n g or declining
g this
could indicate accounting irregularities.
• A cash flow earnings indexx (operating cash flow
di id d b
divided by nett iincome)) iis useful
u f l in
i id
identifying
tif i potential
t ti l
problems (a ratio consisten ntly below 1.0). Similarly
FCF Index OCF/CapEx < 1.

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 Warning
g Signs
g - Revenue (3)
( )

• Classification of non
non-opera
opera
ating or non
non-recurring
recurring income
as revenue. Some compan nies may attempt to move
income up the income statement to mask deteriorating
revenues or show higher re evenue growth. [Cineplex
Odeon]]

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 Warning
g Sign
g s - Expenses
p

• Growth in inventory out of line with sales growth or

days inventory increasing over time. This could
indicate p
problems with inventoryy management,
g ,
potentially obsolete inventtory or, in some cases
inappropriate overstateme ent of inventory to increase
gross and net profits.

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 Warning
g Signs
g - Expenses
p ((2))

• Deferral of expenses
expenses.
• The accounting policies of a company may indicate that
current expenditures are be eing capitalized and deferred
to future years (through am mortization or some other
means). ) It is important
p to id
dentifyy if this is a common
industry practice or whether the company is boosting
current period profits. This often results in a increase in
assets with terms like “defe erred customer acquisition
costs,” so any assets which appear unusual can also
b scrutinized
be ti i d tto id
identify
tif thiis
i activity.
ti it [AOL]

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 Warning
g Signs
g - Expenses
p ((3))
• Excessive
cess e use o of ope
operating
at g leases
eases by lessees.
essees While e
there are legitimate reasons for leasing and this does
not violate accounting stand dards, some companies
structure equipment acquissitions in the form of operating
leases to achieve desirable e financial ratios (low debt
ratios, higher return on assets). If a company is using
these to a greater extent than peers this is a potential
warning sign. It is usually best to adjust the financial
statements to see what the ratios would look like if the
equipment
i t had
h dbbeen purch hased.
d

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 Warning
g Signs
g - Expenses
p ((4))
• Classification
C ass cat o o of e
expenses
pe ses oor losses
osses as e extraordinary
t ao d a y o
or
non-recurring. While some e companies try to move
income up the income state ement to revenues, the
opposite occurs for expenses.es If a company has these
“special” type charges yearr after year, it is usually best
to classify them as ordinaryy operating expenses for
classification purposes
purposes.

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 Warning
g Signs
g s - Expenses+
p

• Gross margins or operating g margins out of line with

peer companies. While ind dicative of good management
and cost control, it can alsoo indicate accounting
methods are being selected to improve financials
relative to peers. It is usefu
ul to compare the accounting
methods in the footnotes to o see if they are more or less
conservative
ti th
than peer com mpanies.
i Thi
This could
ld also
l
indicate use of other techniques described above such
as overstatement of inventtoryy or capitalization
p of costs.

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 Warning
g Signs
g - Expenses
p ((5))
• Use of long g useful lives for deprecation
p and
amortization. These should d be compared with other
peer companies to see if th hey are reasonable.
[Cineplex Odeon]
• Use of aggressive pension plan assumptions. This
can result in a misstatemen nt of both earnings and
financial leverage. Particularly watch for:
– High
g discount rates ((lowers p pension expense
p and
liability)
– High expected return on plan assets (lowers
pension expense)
• Fourth quarter surprises

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 Warning Signs - Balance Sheet
+
• Equity method of accounting
• Special purpose entities
• Off balance sheet financin
ng/guarantees
• Related party transactionss [Adelphia and lots of others!]

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 Where to Look in Financial
Statem
ments
• Read the cash flow stateme ent and balance sheet in
conjunction
j ti with
ith th
the iincomee statement
t t t
• Read the footnotes and anyy management
discussion/analysis
– Particularly read the footnote on accounting policies
– Particularly examine discclosures on off-balance sheet
items
– Watch
a c for
o related
e a ed paparty
y trransactions,
a sac o s, uunconsolidated
co so da ed
entities
• See “Related-Party Transsactions: Cautionary Tales for
I
Investors
t in
i Asia”
A i ”b
by L
Lee Kha
Kh Loon,
L CFA IInstitute
tit t Centre
C t for
f
Financial Market Integrity. Available on our website.
• Ask questions. If no satisfacctory answers – walk away if
you are a prospective invesstor or creditor.
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