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CFA Level 1 - Why Do Shenanigans Exist? Why Do Shenanigans Exist?
Shenanigans exist because under GAAP a company’s management has many options from which to choose to record certain economic events. These options are called "accounting rules" and, when used, are referred to as "accounting events". Because the various choices will have differing effects on reported earnings, management has the opportunity to manipulate its financial results, although it may not exercise that option.
So why would management want to use financial shenanigans to cook the books? Because it pays to do so; it’s easy, and the discovery of shenanigans is difficult and unlikely.
1. It pays
Displaying a good financial performance can be very beneficial monetarily for the current management, especially if its short-term compensation is based on the company’s current performance. Managers who have a significant position in a public company stock (stock-option program) will most likely want to defer reporting losses or cook the book until they sell their current holdings. There are also non-monetary incentives for management, such as keeping their job.
2. It’s easy
Financial accounting standards are broad. It is easy for management to use the accounting rules that best fit its needs rather than those of the stockholders or lenders.
3. Discovery is difficult and unlikely
Though there have been several advancements in the area of discovering accounting frauds - due in part to the Enron scandal - they remain difficult to identify, and it’s unlikely that the managers will get caught. In the past, the potential penalties for companies that engage in financial shenanigans were small. Fortunately, this has changed, and the penalties can be severe for both managers and board members.
Other Motives Behind Financial Shenanigans
Another aim of financial shenanigans is to improve liquidity. By inflating revenues or hiding debt, companies can obtain funding with lower borrowing costs and fewer restrictive financial covenants.
Likely Candidates for Shenanigans
There are certain types of companies that have a higher probability for performing shenanigans.
1.Fast-growth companies whose real growth is beginning to slow
Growth companies command a premium over slower-growth companies. If a company is no longer classified as a growth company, its valuation can be severely affected.
2. Basket-case companies trying to survive
These are companies that have a weak management. Management may resort to financial shenanigans in an effort to make investors believe that the company’s problems are not significant.
3.Newly public companies (IPO)
These have been known to have weak internal controls, making them susceptible to earnings manipulation.
4.Private companies.
Private companies that are closely held do not need to produce audited financial statements, and are likely to use financial shenanigans.
Next: CFA Level 1 - Finding Shenanigans
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