1. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-1 Today’s Topics n Shenanigan Update #1

2. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-2 Shenanigan #1 n Technique #1: n Recording revenue when obligations remain n Technique #2: n Recording revenue in excess of contract value n Technique #3: n Recording revenue before buyer’s acceptance n Technique #4: n Recording revenue when payment is not assured

3. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-3 Revenue Red Flags n Aggressive Rev. Rec. Policies n Rise in unbilled receivables n Rising receivables n Rising allowance for doubtful accounts n Increased returns

4. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-4 Earnings Manipulation Shenanigan #2- Recording Bogus Revenue n Technique #1: n Lack of economic substance n Technique #2: n Lack of arm’s length n Related parties n “Round-trip” transactions n Supplier rebates n Technique #3: n Non-operating revenue transactions n Investment income as operating revenue n Loans recorded as revenue n Technique #4: n Recording revenue at inflated amounts n Priceline.com n Technique #5: n Post merger deferred revenue

5. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-5 Shenanigan #3- Boosting (Operating) Income n Technique #1: n Boosting income using one-time events n Selling of undervalued assets n Technique #2: n Boosting income through misleading classifications n Including investment gains in ops. income n Reducing opex by investment gains n Reclassifying balance sheet accounts

6. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-6 Shenanigan #3 Warning Signs n Turning sales proceeds into recurring income n Shifting operating expenses n Recurring “restructuring” costs n Influence misinterpretation impact on income statement

7. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-7 Shenanigan #4- Expense Shifting with Assets… Think WorldCom n Technique #1: n Capitalizing normal operating costs-AOL n Technique #2: n Slow amortization/depreciation (somewhat subjective)- Time Warner Telecom n Technique #3: n Failing to write-down impaired assets-Coldwater Creek n Technique #4: n Reducing asset reserves-Vitesse

8. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-8 Shenanigan #4 Red Flags n Changes in capitalization policy pre- IPO n Late accounting change announcements

9. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-9 Shenanigan #5- Liability Games… Failure to record or understatement n Technique #1: n Failure to record current expenses n Technique #2: n Failure to accrue expenses n Technique #3: n Use of aggressive accounting assumptions n Technique #4: n Questionable cookie jar reserves-Chainsaw Al Dunlap and Sunbeam Corporation

10. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-10 Shenanigan #6 n Shifting revenue to a future period n Why would we want to do this? n What is the benefit? n Fraud vulnerability charting of this fraud

11. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-11 Why Do It? n Reserves for a “rainy day” n Investor benefit post merger

12. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-12 Techniques n Technique #1: n Creation of “cookie jar” reserves n Technique #2: n Improperly accounting for derivatives n Technique #3: n Revenue hold back before an acquisition n Technique #4: n Recording current period sales in a later period

13. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-13 “Cookie Jar” Reserves n MSFT example n Warning signs n Excessive use of reserves n Post-dating of shipping documents n Smoothing income…flat-line even (Stryker)

14. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-14 Revenue Holdback n Tyco and 3Com n Hold back revenue today n Reverse it into income after the acquisition

15. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-15 Revenue Shift n Reverse of the previous technique n Simply do not record the revenue n Use this technique even without an acquisition

16. FORENSIC ACCOUNTING - BA124 - Fall 2011Slide 6-16 Transparency is Key n Are the #s telling the story or making the story? n Is the company managing the business or managing the #s? n What is, is? versus What is. Is! n Recall SFAC #1 n Improved decision making n Insight into future cash flows n Resource information