Is It Possible to Forecast Financial Schenanigans

Introduction

I found Peregrine's story on the Internet while doing a Google search. As I was reading "Financial Shenanigans" from Horward Schilit to prepare for the level 2 of the CFA examination, I decided to have a closer look at the financial statements of Peregrine Systems Inc. that were published before the shenanigans became publicly known (in May 2002) in order to detect those shenanigans solely based on those financial statements - more specifically on the forms 10K filed by Peregrine between 1998 an 2001.

Here is a summary of the story, quoted from the court that had to rule on those irregularities:

1.Peregrine Systems, Inc. ("Peregrine") was a computer software company headquartered in San Diego, California. Peregrine was incorporated in California in 1981 and reincorporated in Delaware in 1994. From its initial public offering ("IPO") in April 1997 until it was delisted on August 30, 2002, Peregrine was a publicly held corporation whose shares were registered securities traded under the symbol "PRGN" on the National Association of Securities Dealers Automated Quotation system ("NASDAQ"), a national securities exchange that used the means and instrumentalities of interstate commerce and the mails.

2. Peregrine developed and sold business software and related services. Software license fees accounted for the bulk of Peregrine's publicly reported revenues. Peregrine sold its software directly through its own sales organization and indirectly through resellers such as value added resellers and systems integrators.

3. From its IPO in April 1997 through the quarter ended June 2001, Peregrine reported 17 consecutive quarters of revenue growth, always meeting or beating securities analysts' expectations. Peregrine's stock price soared from its April 1997 IPO price of approximately $2.25 per share (split adjusted) to approximately $80 per share in March 2000. By March 2002, Peregrine had issued over 192 million shares.

4. In May 2002, Peregrine disclosed that its prior public reports had been materially false and that it had employed a variety of devices, schemes and fraudulent accounting practices over an extended period of time in order to portray itself as far more healthy and successful that it actually was. After Peregrine disclosed its true financial results and condition, its stock price dropped precipitously and now trades at below $1 per share.

Bibliography: Review of "Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud In Financial Reports" by Howard M. Schilith

Financial shenanigans are used to hide or distort the real financial performance or financial condition of an entity. Such techniques are often referred to as "window dressing" or "cooking the books". Those shenanigans range from minor deceptions (such as failing to clearly segregate operating from non-operating gains and losses) to more serious misapplications of accounting principles (such as failing to write off worthless assets; they also include fraudulent behavior, such as the recording of fictitious revenue to overstate the real financial performance). Since management is clever about hiding its tricks, investors and others must be alert for signs of shenanigans.

Schilit goes on to discuss a wide range of financial shenanigans that devalue the investment worth of a company. The shenanigans are classified in the following categories:

1. Recording revenue too soon or of questionable quality

2. Recording bogus revenue

3. Boosting income with one-time gains

4. Shifting current expenses to a later or earlier period

5. Failing to record or improperly record liabilities

6. Shifting current revenue to a later period

7. Shifting future expenses to the current period as a special charge

Each financial shenanigan is discussed in detail, and a real-world example of a public company affected by the shenanigan is given. Stock price charts are also given to show the stock-price behavior of the company's stock following the disclosure of the shenanigan (usually the stock price drops like a rock after accounting trickery is discovered).

For instance, in chapter 2, Schilit discusses the shenanigans used at AOL and at Medaphis (MEDA - a medical information company).

Medaphis went out of business after their shenanigans became public. That is because its fraud was more serious as it involved recording bogus revenue (by including in revenue the proceeds from an investment).

In contrast, despite the fact that AOL had an aggressive accounting practice of pushing expenses to a later period (they capitalized the marketing cost of sending out CDs), its revenue was solid and was reported accurately.

In summary, a company can survive from shenanigans if their business operation was strong besides the fact that financial statements may have been inaccurate. On the other hand, if the goal of the gimmicks was to camouflage the fact that the company doesn't have any clients/business, then a bankruptcy is quite probable.

Another example would Tie Communications' stock, which fell from a high of $40.38 per share in 1983 (five years after going IPO) to a low of $0.31 per share by 1990. The 1983 annual report stated profits of the company were "given a shot in the arm by the sale of some investments at a substantial gain...." Schilit goes on to explain that some companies use the sale of appreciated assets to hide losses from normal business operations and make the company appear more profitable than it really is.

Schilit explains that capitalizing costs that have no future benefit is one way to enhance current earnings at the expense of future earnings. Shilit discusses De Laurentiis Entertainment, a producer and distributor of motion pictures, as an example. In 1987, the SEC charged Laurentiis Entertainment with improperly capitalizing expenses that should have been charged against current earnings. Schilit's stock chart shows that shares of DEG fell from a high of $19.25 in 1986 to a low of $0.06 in 1989.

Serious, long-term investors don't want to hold stock in companies such as De Laurentiis Entertainment in 1987 and Tie Communications in 1983. Schilit gives a list of fifty-two techniques to help the investor spot financial shenanigans in advance