Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition by Howard Schilit, Jeremy Perler
Authors: Howard Schilit, Jeremy Perler
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from Transactions That Lack Economic Substance
Our first technique involves simply dreaming up a scheme that has the “look and feel” of a legitimate sale, yet in reality lacks economic substance. In these transactions, the so-called customer is under no obligation to keep or pay for the product, or nothing of substance really was transferred in the first place.
In his brilliant 1971 hit song, John Lennon challenged us to “imagine” a perfect world. Imagination has undoubtedly helped the world become a better place, as people’s creativity has broken boundaries and led to countless innovations. Imagination has inspired talented scientists, for example, to diagnose the unknown and find cures for diseases. Similarly, technological entrepreneurs like Bill Gates and Steve Jobs have imagined exciting ways to create new products, such as Microsoft’s Windows and Apple’s iPod, that enhance our enjoyment of life.
Occasionally, though, the imagination can run amok. Many corporate executives have given imagination a bad name when they’ve used theirs to get too creative with company revenue. One such example comes from financial innovators in the insurance industry. Several years ago, industry leader AIG began imagining a perfect world for its clients (and itself) in which they would always achieve Wall Street’s earnings expectations. Imagine, AIG must have thought, how happy clients would be if they never had to experience the indignity (and stock price decline) that accompanies an earnings shortfall.
And one day that dream became a reality. AIG and several other insurers began to market a new product called finite insurance . This magic solution would guarantee clients the ability to always produce earnings that were acceptable to Wall Street by “insuring against” earnings shortfalls. In a sense, this product was an addictive drug that allowed companies to cover up quarterly blemishes by inappropriately smoothing their earnings. And not surprisingly, customers were hooked. Everybody was happy. AIG found a new revenue stream, and customers found a way to prevent earnings shortfalls. However, there was a big problem: some of these “insurance” contracts were not really legitimate insurance arrangements at all; rather, they were actually financing transactions.
How Was Finite Insurance Abused? Let’s turn to Indiana-based wireless company Brightpoint Inc. to see how some finite insurance transactions were economically more akin to financing arrangements. It was late 1998 and the bull market was racing, but Brightpoint had a problem: earnings for the December quarter were tracking about $15 million below the guidance given to Wall Street at the beginning of the quarter. As the quarter closed, management feared that investors would be unprepared for this news, and that, as a result, the firm’s stock price would be hammered.
Enter AIG and its “perfect world” products. AIG created a special $15 million “retroactive” insurance policy that would “cover” Brightpoint’s unreported losses. Here’s how the policy worked: Brightpoint agreed to pay “insurance premiums” to AIG over the next three years, and AIG agreed to pay out an “insurance recovery” of $15 million to cover any losses under the policy. This sounds like your normal insurance policy, except for one big problem: there was no transfer of risk, since the policy covered losses that had already happened. You can’t insure your house after it burns down!
Brightpoint proceeded to record the $15 million “insurance recovery” as income in the December quarter (which blotted out its unreported losses). AIG recorded what amounted to bogus revenue on the insurance premiums over the next three years. Economic sense dictates that this transaction was not an insurance contract because no real risk had been transferred. Indeed, the transaction was nothing more than a financing arrangement: Brightpoint deposited cash
Our first technique involves simply dreaming up a scheme that has the “look and feel” of a legitimate sale, yet in reality lacks economic substance. In these transactions, the so-called customer is under no obligation to keep or pay for the product, or nothing of substance really was transferred in the first place.
In his brilliant 1971 hit song, John Lennon challenged us to “imagine” a perfect world. Imagination has undoubtedly helped the world become a better place, as people’s creativity has broken boundaries and led to countless innovations. Imagination has inspired talented scientists, for example, to diagnose the unknown and find cures for diseases. Similarly, technological entrepreneurs like Bill Gates and Steve Jobs have imagined exciting ways to create new products, such as Microsoft’s Windows and Apple’s iPod, that enhance our enjoyment of life.
Occasionally, though, the imagination can run amok. Many corporate executives have given imagination a bad name when they’ve used theirs to get too creative with company revenue. One such example comes from financial innovators in the insurance industry. Several years ago, industry leader AIG began imagining a perfect world for its clients (and itself) in which they would always achieve Wall Street’s earnings expectations. Imagine, AIG must have thought, how happy clients would be if they never had to experience the indignity (and stock price decline) that accompanies an earnings shortfall.
And one day that dream became a reality. AIG and several other insurers began to market a new product called finite insurance . This magic solution would guarantee clients the ability to always produce earnings that were acceptable to Wall Street by “insuring against” earnings shortfalls. In a sense, this product was an addictive drug that allowed companies to cover up quarterly blemishes by inappropriately smoothing their earnings. And not surprisingly, customers were hooked. Everybody was happy. AIG found a new revenue stream, and customers found a way to prevent earnings shortfalls. However, there was a big problem: some of these “insurance” contracts were not really legitimate insurance arrangements at all; rather, they were actually financing transactions.
How Was Finite Insurance Abused? Let’s turn to Indiana-based wireless company Brightpoint Inc. to see how some finite insurance transactions were economically more akin to financing arrangements. It was late 1998 and the bull market was racing, but Brightpoint had a problem: earnings for the December quarter were tracking about $15 million below the guidance given to Wall Street at the beginning of the quarter. As the quarter closed, management feared that investors would be unprepared for this news, and that, as a result, the firm’s stock price would be hammered.
Enter AIG and its “perfect world” products. AIG created a special $15 million “retroactive” insurance policy that would “cover” Brightpoint’s unreported losses. Here’s how the policy worked: Brightpoint agreed to pay “insurance premiums” to AIG over the next three years, and AIG agreed to pay out an “insurance recovery” of $15 million to cover any losses under the policy. This sounds like your normal insurance policy, except for one big problem: there was no transfer of risk, since the policy covered losses that had already happened. You can’t insure your house after it burns down!
Brightpoint proceeded to record the $15 million “insurance recovery” as income in the December quarter (which blotted out its unreported losses). AIG recorded what amounted to bogus revenue on the insurance premiums over the next three years. Economic sense dictates that this transaction was not an insurance contract because no real risk had been transferred. Indeed, the transaction was nothing more than a financing arrangement: Brightpoint deposited cash
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