For years, companies reported their figures under GAAP or IFRS standards. But what happens when a company commingles the GAAP/IFRS-based financial information with other performance metrics in its reports and press releases? These extra measures have no standards, and no one audits them — perfect conditions for fraud.
Let's create a company. Sprocketblend Inc. normally prepares its financial statements in accordance with generally accepted accounting principles (GAAP). These comprise a common set of accounting principles, standards and procedures that companies use to prepare their financial statements. In its first-quarter press release, Sprocketblend uses many of the GAAP terms found in its financial statements to describe its operating results. However, it also included a non-GAAP measure called "Recurring Net Income (RNI)." RNI is calculated by adding certain types of expenses and other reconciling items back to GAAP-reported net income. RNI appears to indicate that Sprocketblend is performing remarkably well, unlike its mediocre GAAP net income figures. The company's audit doesn't cover RNI, so readers of the press release were left scratching their heads because they couldn't know if Sprocketblend was upfront about its numbers or might be playing a little hocus-pocus. Not good.
Let's go a little deeper with two actual recent cases that illustrate this rapidly emerging fraudulent financial-reporting threat.
In a May enforcement action, the U.S. Securities and Exchange Commission (SEC) concluded that Swisher Hygiene Inc. fraudulently prepared its 2011 financial statements by violating GAAP. The SEC said Swisher had entered into a deferred prosecution agreement and paid a $2 million penalty. Swisher's departures from GAAP included failures to properly account for a debt prepayment penalty, certain employment contracts, earnouts and a variety of other improper earnings management issues.
In an April enforcement action, the SEC imposed a $1 million penalty on Cabela's Incorporated for violations of the Securities Exchange Act requirements to maintain accurate accounting records and a sufficient system of internal controls. In Cabela's case, these violations led to the company's failure to eliminate certain intercompany promotions fees in preparing its consolidated financial statements — a violation of GAAP.
What's fascinating about the Swisher and Cabela cases isn't the specific accounting rules they violated but, rather, the underlying motives that drove the violations. While most financial reporting fraudsters are motivated by a desire to misstate a specific figure reported under GAAP or IFRS (the International Financial Reporting Standards) — such as revenue, net income or total assets — non-GAAP performance measures drove these cases.
In Swisher's case, the focus was on "Adjusted EBITDA," a metric that the company focused on in its press releases in discussing the company's performance. EBITDA, a non-GAAP term that many companies commonly report, is an acronym for "earnings before interest, taxes, depreciation and amortization" (i.e. each of these expenses is added back to net income or loss).
Adjusted EBITDA — as disclosed by Swisher — excluded certain additional items from net income, including foreign currency gains, net gains/losses on debt-related, fair-value measurements; stock-based compensation; and third-party costs related to mergers and acquisitions. Swisher's GAAP violations enabled it to meet its targets for this critical non-GAAP performance measure.
Cabela's had its own non-GAAP metric that drove its violations. Its failure to eliminate an intercompany fee in preparing its consolidated financial statements had no effect on net income — a GAAP metric — because merchandise revenues of the parent company and operating costs of a subsidiary were overstated by equal amounts. It did, however, inflate Cabela's "merchandise gross profit margin," described by the SEC as "a key company-specific financial metric that signaled the profitability of the company and was referenced by the company in earnings releases and analysts calls."
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