What Are Financial Shenanigans?
Financial shenanigans are actions designed to misrepresent the true financial performance or financial position of a company or entity. Financial shenanigans can range from relatively minor infractions involving merely a loose interpretation of accounting rules to outright fraud perpetuated over many years. Financial shenanigans may also include taking independent fraudulent actions, creating fraudulent entities, or building Ponzi Schemes.
In almost every instance, the revelation that a company’s performance has been due to financial shenanigans will have a calamitous effect on its stock price, future prospects, and potentially management. Depending on the scope of the shenanigans, the repercussions may include a steep sell-off in the stock, bankruptcy, dissolution, shareholder lawsuits, or possibly jail time for those involved.
- Financial shenanigans usually involve misrepresentation of the true financial performance or financial position of a company or entity.
- Financial shenanigans can encompass fraudulent accounting, fraudulent entities, or fraudulent acts that seek to steal financial information.
- Sarbanes-Oxley was enacted in 2002 to improve the governance structure of financial reporting and corporate audits.
Financial Shenanigans Explained
Financial shenanigans can be broadly classified into a few different types:
- Schemes that manipulate financial reporting through aggressive, creative, or fraudulent methods.
- Entities that are based on fraudulent founding or work as a front for fraudulent activities.
- Independent scammers or fraudulent groups that seek to steal financial information such as credit cards or account numbers.
There are a multitude of ways individuals and entities can be involved in financial shenanigans. Manipulating financials to gain an advantage over competitors, obtain better capital rates, or improve the performance of management are often top motivations in creative corporate reporting schemes. This has played out throughout history with many companies making headlines and receiving penalties for the manipulation of their financials. Some of the most well known cases have included Enron, WorldCom, Lehman Brothers, and the Bernie Madoff Scandal.
For interested constituents and investors, several books have been written to provide insight into these questionable activities. Popular books have included:
- Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, by Howard Schilit
- The Financial Numbers Game: Detecting Creative Accounting Practices, by Charles W. Mulford
- Creative Cash Flow Reporting, by Charles W. Mulford
Scammers can be one of the most basic things to watch out for. They make work individually or in groups. Typically, scammers seek to steal important information for their own gain. Targets will often include credit card details, social security numbers, all kinds of personal information, investment account numbers and passwords, banking account numbers, and more.
Scammers can pose as entities seeking information through phone, email, or direct communication. A piece of technology called "skimmers" can also be attached to monetary outlets such as ATMs and gas station card readers for the purpose of skimming personal information that can be used fraudulently for financial gain. Being aware of these scams and being cautious about providing personal information can often be key in mitigating these problems.
Creating a fraudulent entity for financial gain can be another form of financial shenanigans. In this realm, business professionals pose as entrepreneurs or investing gurus, founding a business that often targets high net worth investors. These businesses can be called Ponzi Schemes. In general, they most often lure money from investors by pitching fabricated investment presentations. Early investors are rewarded with money from subsequent investors to create the illusion of success. After that, returns dwindle as the scammers begin laundering the money into their own accounts.
Bernie Madoff’s Bernard L. Madoff Investment Securities LLC scheme is the largest Ponzi Scheme in history. Madoff stole approximately $65 billion from investors over a 17-year period. The 2008-09 financial crisis helped to uncover the scandal since the company’s invested financial losses became too exorbitant to maintain the overall scheme.
Financial Statement Manipulation
Financial shenanigans can also involve financial statement manipulation, which provides nearly unlimited opportunities for taking aggressive, creative, and fraudulent actions for the advantage of some form of financial gain. Two areas where financial statement manipulation can be most prominent are in the reporting of assets and liabilities.
A company’s assets include fixed assets, including property and equipment, inventory, accounts receivable, prepaid expenses, cash and cash equivalents, and marketable securities. Overstating any of these assets can inflate the balance sheet portraying a stronger financial position than is actually present.
Inflating assets can be a way to show higher levels of collateral for obtaining credit. Within this realm, revenues may also be overstated, which inflates assets and carries over to higher gross and net profit on the income statement. Recognizing revenues prematurely, recording sales made to an affiliate, recording sales of unshipped items, and reclassifying balance sheet items to create revenue are some of the creative accounting methods companies have used to boost revenues.
All types of asset inflation with other things equal will improve a company’s equity position, which can potentially have a positive effect on the return on equity performance measure. Inflating revenues with other things equal will boost the bottom line net income and net income per share reporting at quarterly earnings time. In general, better than actual performance measures can often be tied to increased stock prices and higher compensation for management as well as bonuses in cash, stock, or stock options.
In the liabilities category, companies also have a multitude of expenses that can potentially be understated. Understating expenses reduces the liabilities on the balance sheet and also reduces the expenses on the income statement. Lowering expenses can have similar effects to inflating assets. Companies with understated expenses will report higher levels of shareholders’ equity, higher net income, and higher net income per share. The combination of these effects can also potentially improve the return on equity metric.
Another more advanced scheme for understating expenses specifically can be tied to off-balance sheet reporting, primarily through the use of minority active ownership investments in subsidiaries or joint ventures. These types of investments use the equity method of accounting, which adjusts values for profits and losses of the subsidiary, making it more prone for companies to offload some expenses with subsidiaries or special purpose vehicles.
Minority active ownership accounting rules that apply to companies holding 20% to 50% ownership in a subsidiary, joint venture, or special purpose vehicle can create several opportunities for financial shenanigans and financial reporting manipulation.
In the United States, 2001 and 2002 saw the unearthing of a significant number of financial shenanigans at companies such as Enron, WorldCom, and Tyco. In the case of Enron and WorldCom, senior executives were convicted and spent time in jail for lying to investors and employees.
The spate of corporate shenanigans during this period led to the passage of the Sarbanes-Oxley Act in July 2002, which set new and enhanced standards for all U.S. public company boards, management, and public accounting firms. One goal of this act was to make creative accounting issues more easily identified by auditors who had also previously been unaware of reporting manipulations.