By Howard M. Schilit and Jeremy Perler
Today I am continuing my in-depth review of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below).
You can read the other parts of this review here. Stay tuned each Saturday and Sunday for the next parts of this review.
Chapter 9: Earnings Shenanigan No. 7: Shifting Future Expenses to an Earlier Period
Similar to the last chapter, where we talked about shifting current income into a later period, this chapter covers a counter-intuitive earnings shenanigan: shifting future expenses into the current period. Both shenanigans are used to smooth earnings, which I pointed out in the previous review, is a fool’s errand.
The authors point to two ways companies can shift future expenses to the current period. I’ll show the methods, and then ways investors can detect these frauds.
1. Improperly writing off assets in the current period to avoid expenses in a future period
Companies have discretion over when they write down assets as there are many assumptions involved in determining whether the asset will produce undiscounted cash flows that equal the current carrying value. This discretion allows companies to take charges in the present period that rightfully belong in future periods. The authors use the example of Cisco Systems (NASDAQ: CSCO), which wrote off billions in inventory in 2001 ($2.25B) which represented more than 100% of the quarter’s inventory sales. Just a few quarters later, the company’s margins exploded as it sold inventory that had been written off.
2. Improperly recording charges to establish reserves used to reduce future expenses
Rather than impairing specific assets, companies often take general “restructuring” charges which serve to reduce current period net income (but leaves operating earnings stable, since restructuring occurs below the line). Later, operating earnings are inflated as the company can sweep some of the operating expenses under the rug.
As part of my thesis for investing in Asta Funding Inc (NASDAQ: ASFI), I think the company has taken significant write-offs of its loan portfolios despite the recurring revenue from these “zero-basis” (or wholly written off) assets, leading to significant off-balance sheet value. You can read my original thesis for ASFI here, and my subsequent posts here.
How to Detect these Frauds:
Key methods (These should be part of your process for analyzing companies!):
- Beware of regular restructurings/write-offs, or excessively large one-time impairments. These may include future period recurring expenses that have been pulled forward to the present period.
- Watch for a dramatic improvement in margins or specific expense line items after a restructuring, and be sure not to project these into the future!
This is the end of the earnings shenanigans. In the next review, I’ll look at Part 3 of the book which covers cash flow shenanigans.
Author Disclosure: This book was provided by the publisher