Finance 101 — Problems & Terms
Many tricks played in business involve financial engineering, i.e., creating financial tools n strategies to maximize profits.
Here are 10 most common manipulations you should know, with real life examples. As you’ll see, there is a considerable overlap between them, i.e., one strategy such as ‘mark-to-market’ inevitably results in earnings management and often a company is involved in multiple of them.
1. Earnings Management:
To make profits look bigger than real. e.g., delay reporting current expenses until the next quarter so profit looks good in the current quarter.
Example: in 2001, Enron’s declared bankruptcy. Enron had inflated profits by recording expected profits as if they were already realized (mark-to-market accounting). They also hid debt n losses by creating complex off-balance sheet entities, known as Special Purpose Entities, n transferring assets and liabilities to these SPEs. So, these SPEs look in debt not Enron.
2. Off-Balance Sheet Financing:
Keeping certain liabilities or assets off the balance sheet to obscure the true financial position. e.g., to lease expensive equipment instead of buying it outright, so the debt (and depreciation of that equip) doesn’t show up on their balance sheet.
Example: in 2008, Lehman Brothers used off-balance sheet entities, known as “Repo 105 transactions,” (lit. repurchasing at 105% of the initial sale price) to hide its mess.
So imagine u r LB and desperate for cash. If you take out loan, it will alarm investors and damage your reputation (in finance lingo, increase your leverage i.e. debt to equity ratio). So, you want to sell your stuff/assets, but if you sell stuff, its value will be deducted from balance sheet and will make you look poor. So, you’re stuck. Here is a way out. You sell your assets and repurchase it at a higher price on credit. Like needing money and selling your 10k car to someone for 10k on cash but then repurchasing the same car for 10.5 k on credit, 0.5k being the interest that you will pay your creditor/person you sold your car to. Now, you have 10k cash AND you got your car bcs u need it BUT you are 10.5k in debt. (similar to tawarruq arrangement mentioned here).
Why all this circus? Cuz now Lehman can keep this repo transaction off the balance sheet — not permanently as different steps of this entire repo arrangement will be recorded as different things and at different times. But for the time being, Lehman got cash thru neither straightforward sale nor straightforward debt, but sth in between. And still look good on balance sheet.
3. Tax Avoidance Strategies:
using legal loopholes to minimize tax.
Example: Apple establishes subsidiaries in low-tax countries like Ireland, to minimize its tax obligations in higher-tax jurisdictions such as the US.
4. Financial Derivatives Abuse:
Sometimes derivatives are used for hedging legitimate risks, sometimes abused for speculative purposes or to manipulate financial statements. An example of derivatives for hedging legitimate risk — tho still impermissble in islam — is when you’re a wheat farmer n worry that 6 months down the road, the prices will plummet n u won’t make any profit for this harvest, so you sell futures contract. Basically you sell the promise to deliver a specified quantity of wheat of a certain grade and quality at a predetermined future date (the delivery or expiration date) to the buyer i.e. a distributer for example. Remember the price is not paid at the time of futures contract but locked in.
Now let’s see an example where derivatives are abused.
Example: around 2008, Goldman Sachs sold complex mortgage-backed securities (MBSs) before the 2008 financial crisis, allegedly misleading investors about the risks involved. Now MBS themselves are not derivatives; they are financial instruments backed by a pool of mortgages. However, derivatives can be created based on MBS, and the trading of MBS in the financial markets often involves derivative products. and thats what Goldman did.
5. Creative Revenue Recognition:
Recognize revenue prematurely.
Example: in 2002, WorldCom engaged in creative accounting practices, including recognizing revenue from bogus accounting entries, to inflate its reported earnings.
6. Channel Stuffing:
Artificially inflating sales by pushing excess inventory onto distributors or customers. like a car manufacturer selling extra inventory to car dealers even when he knows these cars will not be sold any time soon.
Example: in 2015, Volkswagen shipped excess inventory to dealerships, artificially inflating its sales figures, before the emissions scandal in 2015.
7. Round-Trip Transactions:
like borrowing money from your friend, then immediately lending it back to them just to make it seem like you’re doing a lot of transactions, even though nothing of economic substance really exchanged.
Example: in 2000s, Tyco International was accused of engaging in round-trip transactions to artificially boost its reported revenues, a practice that contributed to the company’s downfall in the early 2000s.
8. Mark-to-Market Accounting Manipulation:
explained above.
Example: in 2008, Bear Stearns faced allegations of manipulating the valuation of its mortgage-backed securities to hide losses during the subprime mortgage crisis, leading to its collapse and acquisition by JPMorgan Chase in 2008.
9. Misclassification of Expenses:
Example: WorldCom also misclassified ordinary expenses as capital expenditures to spread out costs over time, artificially inflating its profits.
10: Income Smoothing:
Think of it as if you get a big allowance some weeks and barely any on others, but you save some of the big weeks’ money to use during the small weeks so it seems like you have a steady income.
Example: General Electric (GE) engaged in income smoothing to meet Wall Street expectations consistently.
