Introduction I found Peregrine’s story on the Internet while doing a Google search. As I was reading “Financial Shenanigans” from Howard 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 10 K 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 de listed on August 30, 2002, Peregrine was a publicly held corporation whose shares were registered securities traded under the symbol “PRG N” 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.
SchilithFinancial 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’s tock, 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. Schilit 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 when evaluating a company for investment. These techniques range from looking for management incentives that encourage false reporting, to not being fooled by profits enhanced by retiring debt, to watching for worthless investments the company is making. Examining these factors together should help the investor evaluate the overall honesty and viability of the company long-term. The investor will gain insight as to whether the company is being conservative in its accounting or being too aggressive in its accounting. In which companies are financial shenanigans most likely to occur? SS High growth companies The capitalization’s of high growth companies are very sensitive to a decrease in earnings because shareholders of such companies are buying growth rather than the current level of earnings.
As a decrease in earnings will be interpreted as a sign that the growth opportunities are actually smaller than it was predicted. Peregrine fits into the category of high growth company as its revenue grew by more than 75% every given year between 1998 and 2001 (76. 6% in 1998; 123. 1% in 1999; 83. 5% in 2000; 122. 9% in 2001) SS Very weak companies Financial shenanigans are a way for them to convince investors that their problems are actually quite small.
SS Private companies Private company’s financial statements are unaudited. Private companies typically also have weak internal control. SS Newly public companies Newly public companies may have weak internal control inherited from the time they were private. Peregrine is also a newly public company (it went public in April 1997). Allen and Gerald (1989), Welch (1989), Grin blatt and Hwang (1989) ‘s alternative IPO Deliberately Underpricing Theory states that companies well managed (which expect to announce good profit the following quarters) under price their IPOs in order to create an increasing trend in the stock price. Such companies would then recover part of the money left on the table by doing a secondary equity offering when the stock price will be high.
Badly managed companies would under price their stocks as well in order imitate the well-managed ones. Badly managed corporations may then try to keep an earning growth trend using “innovative accounting ” Balance sheet and income statement warning signs: 1. “Cash and equivalents decline relative to total assets ” Signification: “Liquidity issues; may need to borrow ” The common-sized balance sheet shows a decline in cash and cash equivalents from 1998 to 2000 and an increase in 2001. The same pattern can be found on the liquidity ratios. The liquidity ratios allow us to see that even if such a decline existed, the overall liquidity situation of the company was good. The days of sales outstanding could have been a concern – an interesting fact is that the DSO worsened in 2001 while the other liquidity indicators improved in 2001 1998 1999 2000 2001 Current ratio 1.
945074 1. 474193 1. 193917 1. 628807 Cash ratio 0. 594174 0. 403782 0.
316838 0. 881227 DSO 97. 51539 101. 5545 99. 4015 114.
99182. “Receivables grow substantially faster than sales ” Signification: “Aggressive revenue recognition – recording revenue too soon or granting extended credit terms to customers” 1999 2000 2001% increase in Acct receivable 132. 37% 79. 58% 157. 90%% increase in sales 123. 12% 83.
47% 122. 93%We do see a noticeable difference in 2001, which is consistent with the increase in DSO. 3. “Receivables grow substantially slower than sales ” Signification: “Receivables may have been reclassified as another asset category ” Doesn’t seem to be the case here 4. “Dad debt reserves decline relative to gross account receivable ” Signification: un-collectable amounts may have been underestimated = > “Underreserving [bad debt] and inflating income” 1998 1999 2000 2001% allowance for doubtful accounts relative to gross account receivable 2. 81% 3.
10% 3. 02% 6. 00%No warning sign 5. “Unfilled receivable grow faster than sales or billed receivables ” Signification: A greater portion of revenue may be coming from sales under the percentage-of-competition method Doesn’t seem to be the case here (no result for the search of the words “un billed” and “competition”) Weak warning for lack of disclosure / information 6. “Inventory grows substantially faster than sales, cost of sales or account payable ” Signification: “Inventory may be obsolete, requiring a write-off; company may have failed to charge the cost of sales on some sales” = > Inflated inventory due to EITHER the inventory valuation method OR COGS not charged on sales Not relevant: there’s no inventory 7. “Inventory reserves decline relative to inventory ” Signification: “Underreserving and inflating operating income ” Not relevant: there’s no inventory 8.
“Prepaid expenses shoot up [i. e. increase] relative to total assets ” Signification: “Perhaps improperly capitalizing certain operating expenses” 1998 1999 2000 2001 Prepaid expense expressed as a percentage of total assets 3. 18% 2. 37% 1.
62% 0. 69%No warning sign 9. “Other asset rise relative to total asset ” Signification: “Perhaps improperly capitalizing certain operating expenses” 1998 1999 2000 2001 Other current assets expressed as a percentage of total assets 3. 48% 4. 99% 4. 36% 3.
13%Intangible assets, net and other expressed as a percentage of total assets 34. 91% 54. 48% 25. 62% 9.
90%No real trend = > No warning sign 10. “Gross plant and equipment increases sharply relative to total assets ” Signification: “Perhaps capitalizing maintenance and repair expense ” As I don’t have info on the gross PPE, I used the net amount: 1998 1999 2000 2001 Gross PPE expressed as a percentage of total assets 12. 23% 11. 11% 8. 44% 5. 55%Lack of information can be a concern, but there doesn’t seem to be a warning sign here 11.
“Gross plant and equipment decreases sharply relative to total assets ” Signification: “Failing to invest in new plant and equipment ” As I don’t have info on the gross PPE, I used the net amount: 1998 1999 2000 2001 Gross PPE expressed as a percentage of total assets 12. 23% 11. 11% 8. 44% 5. 55%Warning 12. “Accumulated depreciation declines as gross plant and equipment rises ” Breakdown of ‘Property and equipment, net’ 1998 1999 2000 2001 Gross PPE 10, 219 23, 075 44, 197 111, 157 Leasehold improvement 2, 249 5, 035 8, 830 17, 259 Accumulated depreciation (7, 013) (12, 215) (23, 490) (45, 699) 5, 455 15, 895 29, 537 82, 717 No warning 13.
“Goodwill rises sharply relative to total assets ” Signification: “Perhaps tangible assets were reclassified to goodwill avoid expending them in future periods” 2000 2001 Gross Goodwill expressed as a percentage of total assets 55. 00% 76. 21%Net Goodwill expressed as a percentage of total assets 44. 61% 59. 53%There’s not much of a track record for goodwill. Nevertheless, we can notice a sharp increase in goodwill between 2000 and 2001 = > Warning 14.
“Accumulated amortization declines as goodwill rises ” Signification: Failing to take sufficient amortization charge – inflating operating income 1998 1999 2000 2001 Gross goodwill 0 0 287, 910 1, 527, 033 Accumulated depreciation 0 0 54, 406 334, 178 Net Goodwill 0 0 233, 504 1, 192, 855 No warning 15. “Growth in account payable substantially exceeds revenue growth ” Signification: “Failed to pay off current debts for inventory and supplies – will require larger cash outflow in future periods” 1999 2000 2001 Percent increase in accounts payable 190. 76% 192. 13% 81. 48%Percent increase in revenue 123. 12% 83.
47% 122. 93%Warning in 200016. “Accrued expenses decline relative to total assets ” Signification: “Perhaps company released reserves – inflating operating income” 1998 1999 2000 2001 Accrued expenses expressed as a percentage of total assets 13. 29% 12. 74% 9. 37% 10.
03%Warning in 200017. “Deferred revenue declines while revenue increases ” Signification: “Either new business is slowing or company released some reserves to inflate revenue” 1999 2000 2001 Percent increase in deferred revenue 73. 28% 83. 45% 135. 60%Percent increase in revenue 123. 12% 83.
47% 122. 93%No warning: they follow the same trend 18. “Cost of goods sold grows rapidly relative to sales ” Signification: “Pricing pressure results in lower gross margins” 1999 2000 2001% increase in cost of sales 305. 87% 162. 26% 215. 16%% increase in revenue 123.
12% 83. 47% 122. 93%Cost of sales being the addition of cost of licenses and cost of services 1997 1998 1999 2000 2001 Gross profit margin 13. 92% 17. 21% 23. 60% 20.
87% 20. 14%Net income (loss) 5, 802 (616) (23, 370) (25, 070) (852, 241) Warning: The gross profit margin worsen, even if it is still greater than in 1997-1998 When it comes to the net profit margin, that’s even worse, the company was profitable in 1997 just creates bigger and bigger losses. 19. “Cost of goods sold declines relative to sales ” Signification: “Company may have failed to transfer the entire cost of the product from inventory ” Opposite of previous criterion = > No warning 20. “Cost of goods sold relative to sales fluctuates widely from quarter to quarter ” Signification: “Unstable gross margin could indicate accounting irregularities” 1997 1998 1999 2000 2001 Cost of licenses expressed as a percentage of licenses revenues 1. 05% 0.
84% 1. 17% 0. 85% 0. 73%Cost of services expressed as a percentage of services revenues 32. 01% 44. 73% 62.
25% 60. 64% 52. 92%I would like to look more carefully at the services section to see if the trend is smooth between 1997 and 1999. I do not have the quarterly statements and without those, I cannot raise a warning. 21. “Operating expenses decline sharply relative to sales ” Signification: Some operating costs have been capitalized rather than expense 1997 1998 1999 2000 2001 Operating expense relative to sales (ratio) 0.
727 0. 765 0. 864 0. 825 2. 239 No warning 22. “Operating expenses rise significantly relative to sales ” Signification: “Company may have become less efficient, spending more for each unit sold” 1997 1998 1999 2000 2001 Operating expense relative to sales (ratio) 0.
727 0. 765 0. 864 0. 825 2.
239 Warning: This confirms that the company is being managed less efficiently, which end up translating into increasing losses. 23. “Major portion of pre-tax income comes from one-time gains ” Signification: “Core business may be weakening ” No warning 24. “Interest expense rises materially relative to long-term debt ” Signification: “Higher cash outflows expected ” Not relevant: The company didn’t have any significant long-term (i.
e. it was un leveraged) 25. “Interest expense declines materially relative to long-term debt ” Signification: “Perhaps improperly capitalizing certain operating expenses ” Not relevant: The company didn’t have any significant long-term (i. e. it was un leveraged) 26.
“Amortization of software costs grows more slowly than capitalized costs ” Signification: “Perhaps improperly capitalizing certain operating expenses ” Statement of cash flows warning signs: Warning: First of all, the presentation of the cash flow statement changed during the period that I follow. That is a warning sign as the company may be trying to hide some material information this way. The 2001 statement of cash flow was obviously less detailed than the previous ones. 1. “CFFO materially lags behind net income ” Signification: “Quality of earnings may be suspect or expenditures for working capital may have been too high ” Using the definition given by the book, no warning sign would be justified: 1998 1999 2000 2001 Net income $ (616) $ (23, 370) $ (25, 070) $ (852, 241) CFFO $3, 918 $ 13, 707 $ 47, 016 $ (10, 171) However, I considered that it would be appropriate to adjust it. CFFO doesn’t include any investment activities whereas net income includes those items thru “Depreciation and amortization” and “Acquired in-process research and development costs”, therefore, I added back those items into net income: 1998 1999 2000 2001 Adjusted net income $11, 240 $ 24, 411 $ 43, 223 $ 101, 990 CFFO $ 3, 918 $ 13, 707 $ 47, 016 $ (10, 171) In this case, a warning would be appropriate.
2. “Company fails to disclose details of cash flow from operations ” Signification: “Company may be trying to hide the source of the operating cash problem ” Warning: This is part of the warning that I raised in the introduction with regards to the cash flow statement. The cash flow from operation wasn’t as detailed in 2001: SS The categories “Depreciation and amortization” and “Acquired in-process research and development costs” were merged into “Depreciation, amortization, acquisition costs and other ” SS The Deferred tax assets were included in the “other current asset category ” Change in accounting estimate or accounting principle Change in a firm’s auditor, CFO or outside counsel Warning: That was a big warning sign that showed up just before the company had to reveal its financial shenanigans. Even then, the change of auditor from A Andersen to KPMG could have been seen as understandable (as A Andersen was virtually going out of business due to Enron’s case). The fact that PricewaterhouseCoopers quickly replaced KPMG would have definitely been a warning sign would it have occurred before the shenanigans became publicly known. In this case, it occurred after the fact and therefore it cannot be used to predict shenanigans going on.
It is likely that Peregrine changed auditors precisely because the client-auditor relationship with KPMG wasn’t as good after KPMG has brought the accounting problems to the board’s attention. April 8 th 2002: KPMG replaces A Andersen as Peregrine’s auditor May 23 rd 2002: A press releases makes the shenanigans to be publicly known July 2 nd 2002: PricewaterhouseCoopers replaces KPMG as Peregrine’s auditor Summary Management warnings Shenanigan warnings Weak Medium Strong Weak Medium Strong Balance sheet & income statement warnings BS&IS 5 X BS&IS 11 X BS&IS 13 X BS&IS 15 X BS&IS 16 X BS&IS 18 X BS&IS 22 X Cash flow statement warnings CF 1 X CF 2 X Change in the firm’s auditor From this study, it seems that there weren’t any strong shenanigan warning. The only strong sign appeared when the change in the firm’s auditor occurred. Interpretation This study couldn’t detect most of the shenanigans going on. The only strong warning sign occurred with the change in the company’s auditors – investors would then have a little bit more than a month to sell the stock. The presentation of the 10 K could also have raised some flags: The presentation of the cash flow statement becoming less detailed in 2001 is one.
Another could have been the shrinking size of the 10 K that went from 1330 pages in 1999 to 154 pages in 2001. That implies that the company disclosed significantly less information on the way it constructed its financial statements. This study also found some weaker warnings, but failed to find the heart of the gimmicks. I don’t think that those warnings could lead to any conclusion by themselves, as there may be some noise even in a healthy company. What actually happened? Peregrine: SS Inflated revenue by recording sales to resellers that weren’t finals Sold false invoices to banks Improperly accounted for cash collection Improperly wrote off receivables Improperly accounted for stock options Failed to maintained adequate books and records It seems that even if they inflated revenue, they had a strong business activity (even if it wasn’t as large as what their statements indicated) – the other gimmicks didn’t involve revenue. Their stock price, which hit a low of $2.
25 during the crisis, is now trading in the $20 range.