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CFA Level 1 - What are Shenanigans? B. SHENANIGANS
Shenanigan Strategies
Financial shenanigans are actions or omissions (tricks) intended to hide or distort the real financial performance or financial condition of an entity. They range from minor deceptions to more serious misapplications of accounting principles.
There are two basic strategies underlying accounting shenanigans:
- Inflating current reported income - A company can inflate its current income by inflating current revenues and gains, or deflating current expenses.
- Deflating current reported income – A company can deflate current revenues by deflating current revenues or gains, or inflating current expenses.
Shenanigans aimed at inflating current reported income are considered more serious, because they make the company look much better than it is. Furthermore, over time, the inflation of current income will most likely be discovered in the future and will make the company stock plummet. On the other hand, deflating current reported income will only serve as an income-smoothing mechanism and will not have as serious of an impact on common shareholders. Methods of Inflating or Deflating Income
These two basic shenanigan strategies can be classified into seven categories of techniques:
1. Recording revenues prematurely and/or of questionable quality, such as:
- Recording revenues when a substantial portion of the service has not been delivered
- Recording revenues of unshipped items
- Recording revenues of items that have not yet been accepted by the client
- Recording revenues of items for which the client has no obligation to pay (consignment)
- Recording sales that were made to an affiliate
- Reporting revenues (gross) that do not include appropriate reserves for returns 2.Recording fictional revenues, such as:
- Recording sales for no reason
- Misclassifying income from investments as revenue
- Recording the cash received from a lending transaction as revenues
- Recording supplier rebates as revenues 3.Creating special transactions or one-time transactions to generate a gain, such as:
-Selling undervalued assets for a profit
-Selling investments for a gain and recording it as revenue, or using it to reduce current operating expenses
-Reclassifying certain balance sheet accounts to create income4.Not recording or reducing liabilities improperly, such as:
- Excluding expenses and the related liability
- Modifying accounting assumptions in an effort to decrease the reported liabilities
- Failure to record unearned revenues (customer prepayments) and recording these amounts as revenues5.Shifting current expenses to past or future periods, such as:
- Reclassifying previously capitalized costs as operating expenses
- Increasing the life of an asset to reduce the amortization expense
- Reducing asset reserves
- Failing to record impaired assets
- Changing accounting practices in an effort to shift current expenses to an earlier period
- Modifying accounting assumptions in an effort to decrease the reported liabilities
- Failure to record unearned revenues (customer prepayments) and recording these amounts as revenues6.Deferring current revenues to a future period, such as:
- Refraining from recording revenues before a merger or acquisition
- Increasing allowance for bad debt
- Increasing other reserves such as warranties and returns7.Recognizing future expenses in current expenses as a special one-time charge, such as:
- Inflating one-time charges
- Increasing expenses such as R&D, advertising, etc.
- Recognizing expenses that will continue to provide the company with a future economic benefit, such advertising, R&D and maintenance expenses, among others.
Aggressive Accounting Policies
- Increasing the useful file of an asset beyond its estimated useful life
- Using FIFO versus average cost or LIFO
- Accruing losses associated with contingencies
- Capitalizing all software development and R&D costs
- Capitalizing startup costs
- Amortizing costs slowly
- Recording investment income as revenue
- Capitalizing normal operating costs
- Not accounting for or allocating a small amount for returns, warranties, allowance for bad debt and allowance for doubtful accounts
- Extensive use of off-balance-sheet financing (joint ventures, operating leases and take-or-pay and throughput contracts) Conservative Accounting Policies
- Rapid write-off of fixed assets (DDM)
- Using a conservative estimate of assets useful lives
- Minimal capitalization of software and startup costs
- Adequate provision for contingent liabilities
- Impaired assets written off quickly
- The use of completed-contract method for long-term projects
- Little use of off-balance-sheet financing
- Net income closely resembles cash flow from operations
- Adequate reserves allocated to returns, warranties, allowance for bad debt and allowance for doubtful accounts
Next: CFA Level 1 - Why Do Shenanigans Exist?
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