Financial Shenanigans

Citation

Yuan Hu, Y. (2012), "Financial Shenanigans", Pacific Accounting Review, Vol. 24 No. 2, pp. 233-235. https://doi.org/10.1108/01140581211258489

The original edition of Financial Shenanigans was published in 1983 to introduce readers to the world of corporate scandals in the form of seven earnings manipulation shenanigans (p. vii). The 2010 edition built on the 2002 revision by providing new techniques of deceptive financial reporting including cash flow and key metrics shenanigans whilst expanding the discussion of the original framework by examining financial industries, such as banks and insurance companies.

The book aims to provide the knowledge and tools that investors need to spot deceptive behaviour in company financial statements. Using illustrations from the US Securities and Exchange Commission enforcement actions, securities class‐action litigation and forensic accounting research by the Centre for Financial Research and Analysis, the authors present the latest and the most sophisticated “techniques” companies use to exaggerate revenue and earnings.

The book consists of five parts. Part I provides an introduction to the book. The authors first give a brief overview of four outrageous accounting scandals (Enron, WorldCom, Tyco, and Symbol Technologies) to elicit three categories of deceptive financial reporting techniques that are covered in the book, namely, earnings manipulation, cash flow and key metrics shenanigans. The book then provides the definition of financial shenanigans following a discussion of what environment breeds shenanigans and a holistic approach to detecting financial shenanigans.

Part II fleshes out the seven most common earnings manipulation techniques that companies use to exaggerate revenue or hide expenses under accrual based accounting, such as, applying “aggressive accounting” to increase income by recognising revenue too soon or decrease expenses by delaying recognition of expenses. However, the limitations of accrual based performance metrics, for example, net income, suggest that investors should expand their analysis to evaluate cash flow performance metrics (p. 253). Part III updates some new techniques for deceptive financial reporting by identifying four specific types of cash flow shenanigans.

Although some financial scandals can be detected by reading the financial statements, other financial malfeasance may be hidden inside the supplementary documents, such as company press releases, footnotes, etc. As a result, the authors share some deep dark secrets in Part IV by discussing key metrics shenanigans to reveal how management bypass the accounting rules to employ key non‐GAAP metrics to mislead investors. For example, changing the definition of adjusted earnings, using “operating cash flow” as a substitute for GAAP cash flow from operations, and so on. The authors then provide a recap in Part V as well as a comprehensive checklist to remind investors of what to look for in company financial statements that may indicate problem areas.

The strength of this book lies in both its comprehensive coverage of financial shenanigans and use of plain English to suit individual investors with little or no background in financial analysis. The book provides accounting detail and explains what the various financial statements are and how to read them to catch tricks management try to play. Useful tutorials (accounting capsule) are also supplied to explain very basic accounting concepts. The book offers readers more than theory; it provides real‐world examples and cases including Enron, Fannie Mae, Cisco, Microsoft, IBM and many others.

The book is particularly good in its presentation of the financial shenanigans. The authors first arrange them into two themes, earnings and cash flow manipulation shenanigans and then group financial scandals into different categories for each theme, thereby making it easy for readers to follow and comprehend.

The most interesting part of the book is how easily management can manipulate cash flow from operations. Traditionally, more faith has been put in the cash flow from operations as this number is believed to be harder to manipulate, which is not necessarily true. To boost cash flow from operating activities, management can exert a great deal of discretion regarding where, what and when to present cash flows. For example, should a cash outflow be disclosed in the operating or the investing section? Or should a cash inflow be shown in the financing or the operating section? Management may shift the “bad stuff” out of the operating section of the cash flow statement (i.e. recording the purchase of inventory as an investing outflow). Alternatively, management may push the “good stuff” into the operating section of the statement of cash flows (i.e. recoding the sale of receivables as an operating inflow). These can be further utilised to yield one time boosts using unsustainable activities, like paying vendors more slowly.

Public companies are normally required to present three financial statements. However, the book focuses on shenanigans in only two of them, the income statement and the statement of cash flows. Balance sheet shenanigans are rarely discussed in the book. In order to give a full picture of how a company “fudges” its books to create an illusion of a profitable company, it may be advantageous to include a more comprehensive discussion of balance sheet shenanigans and explain the impact on the other two statements.

In Part I the authors briefly discussed what environment breeds shenanigans. It could be strengthened even further by providing more examples and relating them to the three categories of shenanigans – earnings manipulation, cash flow and key metrics shenanigans. This may give readers more understanding of the relationship between financial shenanigans and corporate governance for illustration and guidance rather than just being prescriptive.

The book includes many examples and cases of specific companies caught engaging in financial shenanigans, but they are inadequately explored. It would be better if more details could be given on those companies' stories, such as the role of the board of directors, failure of internal controls and of auditing, impact on business and society, penalty on management after scandals, regulatory responses and corporate governance reforms following the financial shenanigans. Interestingly, none of the examples/cases mentioned in the book focus on the role of accountants in engineering fraudulent activity, even though this is reported in the press.

Further, the book could be made more appealing to academics by including academic research findings into the discussions. For example, the authors could have discussed the findings on the motivations for financial shenanigans in Part I, as this is where the temptations for accounting fraud are and where the problems start.

Overall the book continues to contribute to an understanding of the corporate scandals, fraud and creative accounting. However, it is likely to appeal to a limited audience, for example, market participants, and, with the exception perhaps of MBA courses, is unlikely to be used in the classroom as the book is mainly written from an investor's perspective.