The financial numbers game: detecting creative accounting practices.

Résumé de The financial numbers game

1. 1

   When Numbers Lie: The High-Stakes Game of Financial Manipulation

   

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   In 2002, WorldCom shocked markets with a $3.8 billion accounting fraud that eventually ballooned to $11 billion. Their stock plummeted 94% within months. A year earlier, Enron's collapse had already wiped out $74 billion in shareholder value. These weren't isolated incidents but dramatic examples of what former SEC Chairman Arthur Levitt called "the numbers game" - the widespread practice of manipulating financial reporting to create altered impressions of business performance. This dangerous game has devastating consequences. When Centennial Technologies' fraudulent asset overstatements were discovered, its stock collapsed from $55.50 to $3 in just three weeks. Similarly, Twinlab's share price plunged from $20 to under $3 when its aggressive revenue recognition practices came to light. Why does this happen? Imagine driving on a highway where everyone speeds. If you maintain the legal limit, you'll be passed by competitors and possibly punished by impatient investors. This pressure creates a race to the accounting bottom, where companies feel compelled to stretch the rules just to keep pace. As Warren Buffett remarked, "Only when the tide goes out do you discover who's been swimming naked." The financial numbers game works until it doesn't - and when it fails, the consequences are swift and severe.

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   Exploiting Accounting Flexibility: How Companies Bend the Rules

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   Accounting principles contain inherent flexibility to accommodate varying economic conditions. While this allows for fair presentation, it also creates manipulation opportunities. Medical companies illustrate this flexibility: Matria Healthcare amortizes goodwill over 5-15 years, Allergan over 7-30 years, and C.R. Bard over 15-40 years. For inventory, companies choose either LIFO or FIFO methods based on reporting needs. Companies often stretch this flexibility beyond intended limits. Waste Management boosted earnings by extending equipment lifespans. Bausch & Lomb overshipped products while underproviding for returns. Aurora Foods misreported promotional expenses, requiring restatements that eliminated $81.5 million in pretax earnings. Earnings management involves guiding reported results toward predetermined targets. General Electric exemplifies this with remarkably smooth earnings despite diverse, cyclical businesses. In bad years, companies may take a "big bath" by writing down assets, making disappointing years worse but cleaning the balance sheet for future growth. Accounting principles are like guardrails on a mountain road - designed for safety, but determined drivers can still steer around them, sometimes with disastrous results.

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   Meeting Expectations at Any Cost: The Earnings Management Trap

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   Missing earnings forecasts by even a penny can trigger severe stock price declines, driving widespread earnings manipulation. When Cisco Systems beat analyst forecasts by exactly one penny for 13 consecutive quarters, it wasn't coincidence but calculated financial maneuvering. Evidence of this practice appears in SEC enforcement actions and academic studies showing clear patterns: small profits vastly outnumber small losses, small earnings increases exceed small decreases, and companies just meeting forecasts outnumber those just missing them. To hit targets, companies employ various techniques: boosting end-period sales through special incentives, reducing discretionary spending, minimizing expense accruals, or expanding nonrecurring classifications. More deceptive practices include discarding invoices, creating false documents, recording fake inventory, making false entries, backdating agreements, and altering legitimate documents. Views on earnings management differ between "bad" management (hiding real performance through artificial entries) and "good" management (representing reasonable business practices). Think of earnings management as financial cosmetics - a light touch might enhance natural features, but excessive application creates a false impression that eventually washes away, often at the worst possible moment.

4. Chapitre 4

   Revenue Recognition: The Top Accounting Deception

   Revenue recognition is the prime target for creative accounting because it directly impacts earnings. For many companies, especially startups valued on revenue multiples, this area is particularly vulnerable to manipulation. The two main deceptions are premature recognition (recording legitimate sales too early) and fictitious recognition (creating nonexistent sales). Properly recognized revenue must be both earned (company has fulfilled obligations) and realized or realizable (exchanged for cash or claims to cash). Companies employ various tactics: Twinlab booked sales before completing shipment; Peritus Software recorded revenue upon receiving orders rather than shipping; and Pinnacle Micro backdated shipping records. "Channel stuffing" occurs when companies like Bausch & Lomb offer deep discounts to induce distributors to overbuy, essentially borrowing from future sales. Secret side letters that modify official sales terms represent another deceptive practice. To detect improper recognition, watch for unusual increases in accounts receivable. Sunbeam's aggressive bill-and-hold scheme in 1997 showed 18.7% sales growth but 38.5% accounts receivable growth, increasing A/R days from 79.2 to 92.3-a clear warning sign. When revenue recognition is compromised, the entire financial structure becomes unstable and eventually collapses.

   Chapitre 5

   Tomorrow's Expenses Today: The Capitalization Game

   Aggressive capitalization policies allow companies to report current expenses as assets, delaying expense recognition and artificially inflating earnings. These "assets" are then amortized over time, shifting today's costs to future periods. America Online's 1996 case exemplifies this manipulation. AOL took a $385 million charge to write down capitalized subscriber acquisition costs. Without this capitalization, AOL would have reported a loss instead of $62.3 million in pretax earnings. Software development costs can be capitalized after establishing technological feasibility, though this determination involves significant management judgment. American Software increased its capitalization rate from 42.2% in 1998 to 51.9% in 2000, boosting pretax earnings by $6.8 million in 2000 alone. Companies also manipulate amortization periods. Semiconductor firms show wide variation - Cypress Semiconductor depreciates buildings over 7-10 years, while Diodes uses 20-55 years. For Vitesse Semiconductor, extending equipment depreciation from 4 to 6 years would reduce expenses by $11.3 million, increasing pretax income by 14%. To identify aggressive capitalization, examine what the capitalized costs represent, whether they have independent market value, and if the company has a history of such practices. Companies like Sciquest.Com capitalize customer acquisition costs that create significant earnings drag - they recorded $9.1 million in such expenses against just $3.9 million in annual revenue. Think of a company as a marathon runner who sprints early by pushing current expenses into the future. Eventually, that future arrives, and the accumulated burden becomes too heavy to bear.

   Chapitre 6

   The Cash Flow Reality Check: When Earnings Quality Fails

   Operating cash flow can be manipulated by shifting cash between operating, investing, and financing categories without changing total cash flow. GAAP requirements create distortions in operating cash flow reporting. Income taxes appear in operating cash flow regardless of source, discontinued operations remain included, and tax deductions from nonqualified stock options can create nonrecurring benefits that artificially boost operating cash flow. Cost capitalization affects operating cash flow more severely than earnings. Capitalized costs temporarily boost earnings until amortized but never reduce operating cash flow since they're classified as investing activities-creating significant comparability issues. The adjusted cash flow-to-income ratio (CFI) compares adjusted cash flow from continuing operations to adjusted income. Declining ratios indicate earnings growing faster than cash flow-a potential warning sign. Xerox exemplifies this problem. Their reported $2.4 billion improvement in operating cash flow (1998-1999) came primarily from a one-time $1.5 billion securitization of finance receivables. After adjustments, Xerox's cash flow remained negative while reported income appeared strong. Their adjusted CFI ratio fell from 0.92 in 1994 to negative values in 1998-1999-a clear red flag. Remember: you can't spend accruals at the bank. Cash flow eventually reveals the truth about financial health.

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