Financial Analysis—How to Spot Red Flags CFA Institute Robinson_1up

Financial Analysis–HoFinancial Analysis Ho

Tom Robinson PhD CTom Robinson, PhD, CManaging Direc

CFA Intom.robinson@

Hosted by CFA Institute—www.cfawebcasts.org

ow to Spot Red Flagsow to Spot Red Flags

CPA CFP CAIA CFACPA, CFP, CAIA, CFA ctor, Educationnstitute

@cfainstitute.org

1

Financial Stat

• Some Basic ConcepSome Basic Concep• Some Historic Scan• Red Flags (Warning

Statement IrregulariState e t egu a


tement Fraud

ptsptsdals

g Signs) for Financial tiest es

2

The Fraud

Pressure or

Opportunity


Opportunity

d Triangleg

Incentive

Rationalization

3

Rationalization

Checks and

S di $10Spending $10,impacts net incsheet through og


d Balances

000 f C h f000 of Cash for an expensecome and hence the balance owner’s equityq y

4

Checks and B

S di $10 000 fSpending $10,000 ofnet income, but does


Balances (2)( )

f C h f t d t i tf Cash for an asset does not impact s impact the balance sheet

5

George SGeorge S

“Those who igndoomed to


antayanaantayana

nore history are o repeat it”

6

Scandals Over

Charles


r Time - 1920s

s Ponzi

7

Scandals Over T

• Kreuger & Toll 1920s– Swedish match conSwedish match con– Fictitious assets –


Time - 1920s (2)( )

s/1930snglomeratenglomeratelargely intangibles

8

Scandals Over

McKesson & Robins L• McKesson & Robins – L– Musica Brothers/Fore– Fictitious sales, receiv– Déjà vu – McKessonDéjà vu McKesson


r Time - 1930s

Late 1930sLate 1930seign Crude Drug Businessvables, and inventoryHBOC late 1990sHBOC late 1990s

9

Scandals Over

National Student Marke• National Student Marke– Campus marketing p– Overstated sales and


r Time - 1960s

eting 1960seting 1960sprogram with a P/E of 100d receivables

10

Scandals Over

E i F di 1970• Equity Funding 1970s– Mutual Funds/Insura– Fictitious life insuran

$3 billion sold$3 billion sold– Department 99


r Time - 1970s

ancence of $2 billion out of

11

Scandals Over

C Eddi I 1980• Crazy Eddie, Inc. 1980– Electronics retailer– Overstated sales, re

What is wrong with t– What is wrong with t• Year Days In• 1984 7• 1985 91985 9• 1986 11

1987 14Hosted by CFA Institute—www.cfawebcasts.org

• 1987 14

r Time - 1980s

00s

eceivables, and inventorythis picture:this picture:ventory

79.6893.6893.6812.4246 23

12

46.23

Scandals Over T

• Miniscribe 1985 to19• “Q.T. Wiles”Q es

– Sales + 62.23%R i bl + 147– Receivables + 147

– Inventory + 100.49– Gross Margin

• 1985: 6 46%1985: 6.46%• 1986: 28.87%


Time - 1980s (2)( )

986

7 94%7.94%9%

13

Scandals Over

S b• Sunbeam“Chainsaw Al Dunlap”p

1996Sales 3 21Sales -3.21Inventory -22.4Receivables -1.28


r Time - 1990s

1997% +18 69%% +18.69%

41% +57.89%8% +38.47%

14

Scandals Over T

• SunbeamSunbeam– The Company recognize

sales principally at the tip p ycustomers. In limited circcustomer’s request, the product on a bill and hoproduct on a bill and ho

– …During 1997, the Comprograms for highly seaprograms for highly seaand warming blankets inand distribution activities


Time - 1990s (2)( )

es revenues from product me of shipment to pcumstances, at the Company may sell seasonal

old basisold basis…mpany initiated early buy asonal products such as grillsasonal products such as grills n order to level production s.

15

Sunb

100,000150,000

050,000

(100,000)(50,000)

(200,000)(150,000)( , )

(250,000)( , )

1996 19


beam

Net IncomeNet Income(thousands)Operating CashFlow (thousands)

97

16

World

• June 2002June 2002• Audit committee report

$3 85 billion of expense$3.85 billion of expense• “Line costs” were capita

and Equipment rather tand Equipment rather tclassified as an investinthan operatingthan operating.

• “The principal componeaccess charges and traaccess charges and tra


dCom

s improper booking of esesalized as Property, Plant than expensed Alsothan expensed. Also ng cash outflow rather

ents of line costs are ansport charges “ansport charges.

17

WorldC

9 000

7,0008,0009,000

4 0005,0006,000,

2 0003,0004,000

01,0002,000

(2,000)(1,000)

1995 1997 1999


1995 1997 1999

Com (2)( )

OperatingIncome (millions)

2001

18

2001

WorldC

60 00%

50.00%

60.00%

40.00%

20 00%

30.00%

10.00%

20.00%

0.00%1995 1997 1999


1995 1997 1999

Com (3)( )

Line Costs as aPercent of Sales

9 2001

19

9 2001

WorldC

45.00%50.00%

30 00%35.00%40.00%

20.00%25.00%30.00%

10.00%15.00%20.00%

0.00%5.00%

1995 1997 199


1995 1997 199

Com (4)( )

PP&E as a Percentof Assets

99 2001

20

99 2001

WorldC

10 000

8,000

10,000

4,000

6,000

2,000

4,000

(2,000)

0

(4,000)

( , )

1995 1997 1999


Com (5)( )

Operatingp gIncome (millions)Free Cash Flow(Milli )(Millions)

9 2001

21

WorldCom 10K

• Cumulative reduction in e• 2001 NI reduced $17.1 b• 2000 NI reduced $53.1 b• Line costs adjustment abj

$3 billion in 2001


K Restatements

equity of $70.8 billionillionillionout $2 billion in 2000 and

22

Scandals Over

• Allou Health and Beauty• Enron

– Special purpose entitiesR l t d t t ti– Related party transactions

• Adelphia– Related party transactions/“loRelated party transactions/ lo

• Parmalat– Off-balance sheet debt/overs

• Tyco– Improper loans/forgiveness/s

Satyam• Satyam– Related Parties/overstated re

• Madoff and Others


Madoff and Others– “When the tide goes out, you

r Time - 2000s

ooting”ooting

stated cash

spending

evenue and cash

23

can see who is swimming naked.”

Allou Health

5 000 00010,000,000

(5,000,000)0

5,000,000

(20 000 000)(15,000,000)(10,000,000)( , , )

(30,000,000)(25,000,000)(20,000,000)

(35,000,000)( , , )

2000 2001


and Beautyy

Net Income

Operating CashOpe at g CasFlow

2002

24

Enron’s 200

• In 2000 and 1999 Enron e• In 2000 and 1999, Enron ewith limited partnerships (tgeneral partner's managingeneral partner s managinofficer of Enron.

• In 2000 Enron entered intIn 2000, Enron entered intRelated Party to hedge ceinvestments and other assto newly-formed entities (tat approximately $1.2 billio


0 Footnotes

entered into transactionsentered into transactions the Related Party) whose

ng member is a seniorng member is a senior

to transactions with theto transactions with the ertain merchant sets. …Enron contributed he Entities) assets valued on…

25

Enron’s 2000

• In 2000 Enron enteredIn 2000, Enron enteredtransactions with the Ecombined notional amocombined notional amo$2.1 billion to hedge ceinvestments and other


Footnotes (2)( )

d into derivatived into derivative Entities with a ount of approximatelyount of approximately ertain merchant assets…

26

Enr• ENRON VICE CHAIRMAN CLI

• FOR IMMEDIATE RELEASEHOUSTON -- Enron Corp. aChairman J. Clifford Baxter

• ENRON ANNOUNCES SKILLINASSUMES PRESIDENT AND C• FOR IMMEDIATE RELEASE• FOR IMMEDIATE RELEASE

HOUSTON -- Enron announDirectors has accepted the

E ’ P id t d Cas Enron’s President and C


ronFF BAXTER RESIGNS

E: Wednesday, May 2, 2001 announced today that Vice is resigning from the companyg g p y

NG RESIGNATION; LAY CEO DUTIES E: Tuesday August 14 2001E: Tuesday, August 14, 2001 nced today that its Board of resignation of Jeffrey K. Skilling EOEO.

27

U.S. SEC

• Improper Revenue Recognition p ope e e ue ecog t o– Revenue in advance, bill and hold

revenue.• Improper Expense RecognitionImproper Expense Recognition

– Improper capitalization, overstatinlosses, failure to record impairmen

• Improper Accounting in Connec• Improper Accounting in Connec(23 cases)

• Other Accounting and Reporting– Inadequate disclosures– Failure to disclose related party tra– Inappropriate accounting for non-mpp p g– Improper accounting for foreign pa

Corrupt Practices Act– Improper use of off-balance sheet


p p– Improper use of non-GAAP financ

C Studyy

(126 cases)( 6 cases), fictitious revenue, improper valuation of

(101 cases)(101 cases)g inventory, understating bad debts/loan nts.ction with Business Combinationsction with Business Combinations

g Issues (130 cases)

ansactionsmonetary and roundtrip transactionsy payments in violation of the Foreign

arrangements

28

gcial measures

Warning Signg g

• Aggressive revenue recognAggressive revenue recogn– Bill and hold sales – invo

shipping merchandise.– Sales type leases – Less

sale, particularly when thtransaction as an operattransaction as an operat

– Recording revenue at thbut before delivery of go

– Recording revenue priorof contracts (such as inscomputer equipment/sofcomputer equipment/sofaccording to contract ter

– The use of swaps or bart l


generate sales.

ns - Revenue

nition These include:nition. These include:oicing a sale without

sor reporting leases as a he lessee is treating the ting lease [IBM]ting lease. [IBM]e time a contract is signed,

oods or services.r to fulfilling all of the terms stallation or verification that ftware is functioningftware is functioning rms).rter arrangements to

29

Warning Signsg g

• Growth in revenues out of• Growth in revenues out of industry or peers companireceivables.

• Particular attention shouldare growing faster than rev

i bl i ireceivables are increasingindicate non-existent sales

• Revenue/assets side wher• Revenue/assets side wherare a major determinate of


- Revenue (2)( )

sync with economysync with economy, es and with growth in

d be paid when receivables venues or days

ti Thi ldg over time. This could s.re estimates of reservesre estimates of reserves f value [Bre-X, Shell]

30

Warning Signsg g

• Operating cash flow out ofOperating cash flow out of • If a company is reporting p

earnings, but cash flow is ngcould indicate accounting i

• A cash flow earnings indexdi id d b t i ) idivided by net income) is uproblems (a ratio consistenFCF Index OCF/CapEx < 1FCF Index OCF/CapEx < 1


s - Revenue+

line with reported earningsline with reported earnings. positive and perhaps growing negative or declining this g grregularities.

x (operating cash flow f l i id tif i t ti luseful in identifying potential

ntly below 1.0). Similarly 11.

31

Warning Signsg g

• Classification of non opera• Classification of non-operaas revenue. Some companincome up the income statincome up the income statrevenues or show higher reOdeon]]


- Revenue (3)( )

ating or non recurring incomeating or non-recurring income nies may attempt to move ement to mask deterioratingement to mask deteriorating evenue growth. [Cineplex

32

Warning Signg g

• Growth in inventory out of• Growth in inventory out of days inventory increasing indicate problems with invppotentially obsolete inventinappropriate overstatemegross and net profits.


s - Expensesp

line with sales growth orline with sales growth or over time. This could entory management, y g ,tory or, in some cases ent of inventory to increase

33

Warning Signs g g

• Deferral of expenses• Deferral of expenses. • The accounting policies of a

current expenditures are becurrent expenditures are beto future years (through ammeans). It is important to id) pindustry practice or whethecurrent period profits. This assets with terms like “defecosts,” so any assets whicb ti i d t id tif thibe scrutinized to identify thi


- Expenses (2)p ( )

a company may indicate that eing capitalized and deferredeing capitalized and deferred

mortization or some other dentify if this is a common yr the company is boosting often results in a increase in

erred customer acquisition h appear unusual can also i ti it [AOL]is activity. [AOL]

34

Warning Signs g g

• Excessive use of operatingcess e use o ope at gthere are legitimate reasonnot violate accounting standstructure equipment acquisstructure equipment acquisleases to achieve desirableratios, higher return on assthese to a greater extent ththese to a greater extent thwarning sign. It is usually bstatements to see what the

i t h d b hequipment had been purch


- Expenses (3)p ( )

leases by lessees. While eases by essees es for leasing and this does dards, some companies

sitions in the form of operatingsitions in the form of operating e financial ratios (low debt ets). If a company is using an peers this is a potentialan peers this is a potential est to adjust the financial ratios would look like if the

dased.

35

Warning Signs g g

• Classification of expenses oC ass cat o o e pe ses onon-recurring. While someincome up the income stateopposite occurs for expensopposite occurs for expens“special” type charges yearto classify them as ordinaryclassification purposesclassification purposes.


- Expenses (4)p ( )

or losses as extraordinary or o osses as e t ao d a y oe companies try to move ement to revenues, the es If a company has thesees. If a company has these r after year, it is usually best y operating expenses for

36

Warning Signsg g

• Gross margins or operatingGross margins or operatingpeer companies. While indand cost control, it can alsomethods are being selectemethods are being selecterelative to peers. It is usefumethods in the footnotes to

ti thconservative than peer comindicate use of other technas overstatement of invent


s - Expenses+p

g margins out of line withg margins out of line with dicative of good management o indicate accounting d to improve financialsd to improve financials

ul to compare the accounting o see if they are more or less

i Thi ld lmpanies. This could also iques described above such

tory or capitalization of costs.y p

37

Warning Signs g g

• Use of long useful lives for gamortization. These shouldpeer companies to see if th[Cineplex Odeon][Cineplex Odeon]

• Use of aggressive pension can result in a misstatemencan result in a misstatemenfinancial leverage. Particul– High discount rates (lowg (

liability)– High expected return on

pension expense)• Fourth quarter surprises


- Expenses (5)p ( )

deprecation and pd be compared with other

hey are reasonable.

plan assumptions. This nt of both earnings andnt of both earnings and arly watch for:ers pension expense and p p

plan assets (lowers

38

Warning Signs -++

• Equity method of accountiEquity method of accounti• Special purpose entities• Off balance sheet financinOff balance sheet financin• Related party transactions


- Balance Sheet ++

ngng

ng/guaranteesng/guarantees s [Adelphia and lots of others!]

39

Where to LooStatemStatem

• Read the cash flow statemej ti ith th iconjunction with the income

• Read the footnotes and anydiscussion/analysisdiscussion/analysis– Particularly read the foot– Particularly examine disc– Particularly examine disc

items– Watch for related party tra c o e a ed pa y

entities• See “Related-Party Trans

I t i A i ” b LInvestors in Asia” by Lee Financial Market Integrity

• Ask questions. If no satisfac


Ask questions. If no satisfacyou are a prospective inves

k in Financial mentsmentsent and balance sheet in

t t te statementy management

note on accounting policiesclosures on off-balance sheetclosures on off-balance sheet

ransactions, unconsolidated a sac o s, u co so da ed

sactions: Cautionary Tales for Kh L CFA I tit t C t fKha Loon, CFA Institute Centre for . Available on our website.ctory answers – walk away if

40

ctory answers walk away if stor or creditor.

Financial Analysis—How to Spot Red Flags CFA Institute Robinson_1up

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