Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (33 page)

Read the Quarterly Filings to Know What to Anticipate.
Certainly, a full reading of the 10-K (which, by now, you should know to do) would have revealed that sales of receivables drove CFFO. But could you have suspected that this was the case before the 10-K was even filed? Indeed, the answer would be yes. Astute investors would have read the previous quarter’s 10-Q and noticed that Sanmina discussed the sale of receivables no fewer than four times. They also would have noted that the company had mentioned the arrangement in passing on its earnings conference call two quarters earlier. These A-plus investors would have known that they should be wary in the fourth quarter when the CFFO suddenly surged as a result of a significant decline in receivables. They certainly would have been able to connect the dots.

Shun Opacity.
It is clearly inappropriate for companies to be opaque when reporting sensitive and impactful structured arrangements such as selling receivables. Be wary if companies fail to provide investors with details. Question their reasons for not being transparent about how they monetize their receivables. Perhaps management’s objective was simply to window-dress its Statement of Cash Flows. The worst-case scenario would be that the company is trying to hide a real cash crunch from investors. Such a cover-up clearly goes far beyond simple window dressing and points to a company camouflaging a material deterioration in its business. Dotcom high-flyer Global Crossing sold $183 million in receivables just six months before it filed for bankruptcy in 2002. Similarly, Xerox raised the ire of the SEC by silently selling $288 million in receivables at the end of 1999 in order to report a positive year-end cash balance of $126 million.

3. Inflating CFFO by Faking the Sale of Receivables

In the previous section, we discussed the implications of normal receivable sales for CFFO. We pointed out that in many cases, selling receivables may be not only appropriate, but also a prudent business decision. However, investors also need to understand that the cash flow that was expected in a future period has now been collected, and that this inflow should be viewed as unsustainable. In this section, we take a step into more nefarious territory. We will encounter another top-secret procedure being performed in the companies’
Twins
labs: faking the sale of receivables.

Sham Sales of Receivables—The Watergate of Shenanigans

President Nixon resigned in disgrace as a result of trying to cover up the break-in at the Watergate Hotel. The smoking-gun evidence apparently was included on an 18 ½-minute section of a White House recording that was conveniently erased to cover up the crime. Similarly, Peregrine Systems used a convenient cover-up to hide its accounting fraud. As we discussed in Chapter 4 (“EM Shenanigan No. 2: Recording Bogus Revenue”), Peregrine embellished its revenue in the years leading up to its 2002 bankruptcy, using deceptive practices such as recording bogus revenue and entering into reciprocal transactions. All of this fake revenue resulted in bloated receivables on the Balance Sheet that would never be collected. Peregrine became concerned that these bloated receivables would become the smoking gun of its bogus revenue. So, the cover-up began in earnest with
fake sales of accounts receivable.

In this cover-up, Peregrine transferred its receivables to a bank in exchange for cash; however, the risk of collection loss remained with Peregrine. That collection risk was huge, of course, because
there were no customers
— many of the related sales were bogus. Since the risk of loss had not been transferred, Peregrine remained on the hook to return the cash to the bank when the receivables inevitably were not collected.

Since the receivables had never actually been transferred, the economics of this transaction would be more akin to a collateralized loan, just as we saw with Delphi earlier in this chapter. Peregrine borrowed money from the bank and used receivables as collateral. On the Statement of Cash Flows, this should be presented as a
Financing
inflow. Peregrine, however, ignored the economic reality of the situation. Instead, it recorded the transaction as the sale of receivables, and shamelessly reported the cash received as an
Operating
inflow.

Watch Carefully for Disclosure Changes in the Risk Factors
. Many investors overlook the “Risk Factor” section of corporate filings because it seems like legal boilerplate.
Warning to investors
: ignore the risk factors at your own peril. While most of the text may be similar from quarter to quarter, investors should carefully try to identify changes in the verbiage. If new risks have been added or previously listed ones have been changed, then the change is deemed worthy of disclosure by the company or its auditors, and you need to know about it.

For instance, in 2001, the year before Peregrine imploded in fraud, the company inserted an important new risk factor disclosure that should have awakened investors from their slumber. Peregrine actually changed its risk factor disclosure twice, first in June 2001 and then again in December 2001. The new disclosure in June 2001 informed readers that Peregrine was engaging in new customer financing arrangements, including loan financing and leasing solutions. It also reported that some customers were failing to meet their obligations. The mere fact that this disclosure found its way into the risk factors tells you that it must have been significant.

PEREGRINE’S NEW RISK FACTOR DISCLOSURE IN

JUNE 2001

In addition, other factors, including indirect factors resulting from the macroeconomic climate, could have an adverse effect on our operating results in a given quarter or over several quarterly periods. For example, in the current economic environment, we have experienced increased demand from some customers for customer financing, including loan financing, and leasing solutions. We expect this demand for customer financing to continue, and we have engaged in customer financing where we believe it is a competitive factor in obtaining business. Although we have programs in place to monitor and mitigate the associated risks, there can be no assurance that such programs will be effective in reducing related credit risk. We have experienced losses due to customers failing to meet their obligations. Future losses, if incurred, could harm our business and have a material adverse effect on our operating results and financial condition.

Then, in December 2001, Peregrine added one small sentence to the end of the new disclosure from the June period. While it was only 12 words, it read like a five-alarm fire:

PEREGRINE’S NEW RISK FACTOR DISCLOSURE IN

DECEMBER 2001

The Company may at times market certain client receivable balances without recourse.

Peregrine was doing more than just finding new ways to provide its customers with financing; it was also trying to sell its accounts receivable. The cryptic nature of this new sentence, together with the hush-hush disclosure in the risk factors with no mention of it elsewhere, is extremely concerning. Peregrine was clearly hiding something big from investors and trying to comply with the minimal level of disclosure requirements.

Tip:
It is well worth your time to look for changes in disclosure each quarter, particularly in the most important sections of the filings. Most research platforms and word processing software have “word compare” or “blackline” functionality. Reviewing both filings side by side is also not as cumbersome as it sounds.

Computer Associates Makes an Accounting “Decision”

Computer Associates’s FY 2000 10-K revealed that one of its primary sources of operating cash flow that year had come from its recent fourth quarter “decision” to assign accounts receivable to a third party. No other details were provided. Investors were given no insight into the details of the arrangement, the mechanics of the “assignment,” or the magnitude of the impact.

COMPUTER ASSOCIATES ACCOUNTS RECEIVABLE DISCLOSURE

IN ITS FY 2000 10-K

The primary source of cash for the year was higher net income adjusted for non-cash charges. Other sources of cash included strong collections of outstanding accounts receivable and
the Company’s decision, in the fourth quarter, to assign selected existing installment accounts receivable to a third party.
The Company may continue to explore the use of financing companies as a means of expediting debt reduction, mitigating interest rate risk, and reducing installment accounts receivable balances. [Italics added for emphasis.]

RED FLAG!
A company overtly stating that it made an accounting “decision.”

Recall from Chapter 3, “EM Shenanigan No. 1: Recording Revenue Too Soon,” that the SEC charged Computer Associates with prematurely recognizing more than $3.3 billion in revenue from 1998 to 2000. Well, like Peregrine, Computer Associates needed a cover-up to conceal this bogus revenue. It found one by offloading receivables, and it certainly tried to keep that news under wraps. Whenever companies disclose that a mysterious new arrangement is a driver of CFFO (or of any important metric, for that matter), investors should seek to understand the mechanics of the arrangement. Only significant changes would require new disclosure, so when you notice something new, consider it a big deal. At the benign end of the spectrum, it may simply be a nonrecurring benefit that might be important to your analysis. However, on the other end of the spectrum (think Computer Associates), it may be a red flag signaling a major impropriety.

Tip:
New disclosures should provide more answers, not more questions. Avoid companies in which the reverse is true.

Vitesse Semiconductor Emulated Its Friends at Peregrine and Computer Associates

Vitesse Semiconductor also admitted to classifying cash that it received from a bank as the sale of accounts receivable rather than as borrowing. The alleged scheme involved Vitesse “selling” accounts receivable (many of which related to uncollectible or fraudulent revenue) to Silicon Valley Bank at the end of each quarter, to make it seem that Vitesse’s accounts receivable had remained relatively stable. Vitesse never really offloaded the risk of loss from these receivables, however, as the bank retained the right to demand that Vitesse repurchase these receivables.

The scheme came to light only serendipitously when a special committee of the company’s board was given the task of investigating Vitesse’s stock option backdating practices. As the cockroach theory (“where there is one, there are many”) would have it, the committee found many more problems than options backdating tricks. It found damning evidence of accounting improprieties and provided a startling list of transgressions, two of which involved manipulating cash flow, including (1) “improper accounting for certain transactions as sales of accounts receivable rather than borrowings” and (2) “failure to disclose practices to increase reported cash balances, which balances were not representative of operating cash balances throughout the reporting period.”

Looking Back

Warning Signs: Shifting Financing Cash Inflows to the Operating Section

• Recording bogus CFFO from a normal bank borrowing

• Boosting CFFO by selling receivables before the collection date

• Disclosures about selling receivables with recourse

• Inflating CFFO by faking the sale of receivables

• Changes in the wording of key disclosure items in the financial reports

• Providing less disclosure than in the prior period

• Big margin expansion shortly after an inventory write-off

Looking Ahead

A second clever way in which management may inflate operating cash flows is by pushing some of the “bad stuff” (i.e., the outflows) from the Operating section to another place on the Statement of Cash Flows. The next chapter shows just how easy it is to move these outflows to the less-scrutinized Investing section.

11 – Cash Flow Shenanigan No. 2: Shifting Normal Operating Cash Outflows to the Investing Section

Jimmy Hoffa, corrupt boss of the Teamsters Union, left a Detroit restaurant on July 30, 1975, and vanished without a trace. It is widely believed that he was “whacked” in a mob hit, yet despite having searched for the past 35 years, the FBI has been unable to locate his remains. Urban legends run rampant, providing many different accounts of his final resting place, including a New Jersey landfill, a Michigan sanitation plant, the Florida Everglades, and even (the old) Giants Stadium. Only one thing is for certain: whoever buried Jimmy Hoffa did not want him to be found.

Like Hoffa’s handlers, many companies have a secret dumping ground for pesky cash outflows that they don’t want anyone to find. It’s called the Investing section of the Statement of Cash Flows (SCF). Companies have found numerous clever ways to dump normal operating cash outflows into the Investing section, hoping that they will vanish forever. And most investors, like the FBI in its hunt for Jimmy Hoffa, seem to have very few clues as to where to look.