Monday, March 29, 2010

7 ways numbers can be fudged - Howard Schilit, Financial Shenanigans

Below are some of the way financial statements are represented fraudulently as in the book.
  1. Recording revenue too soon.
  2. Recording bogus revenues.
  3. Boosting income with one-time gains.
  4. Shifting current expenses to a later period.
  5. Failing to record or disclose all liabilities.
  6. Shifting current income to a later period.
  7. Shifting future expenses to the current period.

I think some more can be added now. It seems like besides playing with the P&L which used to be the case, theres also balance sheet plays and cash flow plays, some of which i placed below.
  1. Off balance sheet items, SPVs and the manipulation of JV and associate relationships 
  2. Deferred and accrued items, goodwill
  3. Capitalized items (rate of capitalization, impact on P&L, size versus equity)
  4. Fake cash that ties to the cash flow statements (profits vs cashflows) 
  5. Inventory, receivables and payables (turnovers too high)
  6. Increased depreciation with growing PPE or rapidly depreciation assets 
  7. Mark to "own market" - (Allied Capital case)
The key is to think operationally rather than on the face of the financials and mechanically doing valuations. Further, alot of scuttlebutt needed to confirm financials and to question possible red flags. Last but not least, read the footnotes carefully, understand the trends in the financials and relate to the business. In these days, bank statements can be forged and AR can be un-billed so besides the micro analysis, take a step back and look at the big picture, think logically and simply to spot anomalies.

Feel free to add to the list.

7 point summary courtesy of David Merkel at Seeking Alpha

Others to note:

  • Financials
  1. Low R&D expenses - esp if its a high tech or low asset base firm
  2. Unusually low accounts payables
  3. High quality returns/margins when logically firm should not be capable of generating or when the rest of the industry (esp the market leader) is slumping - watch the magnitudes
  4. High land use rights, weird capex increases 
  5. Fantastic profits but cash flows are an issue
  • Corporate structure and members 
  1. High CFO / auditors turnover with reasons always being unable to pay for the big 4
  2. Dubious backgrounds of management
  3. Resignation of board members
  4. Poor representation by industry personnels and other factors ex. poor website functions
  5. No clear controls or systems in place 
  • Corporate actions

  1. Constantly raises money despite excess abilities 
  2. Capital raising at low ball parks and often foreign only
  3. Non disclosure on transactions and parties in the deals
  4. Firm rejected an IPO in China 



Look for regular numbers consistence.

Post a Comment