Japanese camera maker Olympus Corp. was aggressively diversifying its business in the 1980s and early 1990s.

Since they confidently believed these new investments would add much value to the company, the investments were properly listed as assets on the balance sheet. Unfortunately, that optimism was misplaced and most of these investments proved to be worthless.

What to do? Accounting rules require the immediate write-off of assets as soon as their value becomes impaired. Olympus either chose to ignore this rule or had tremendous optimism that the value of its investment would soon recover. Regardless of the reason for failing to write off the investments and instead keeping them on the balance sheet, Olympus was improperly inflating profits by using an earnings manipulation (EM) shenanigan, shifting current expenses to a later period.

The EM Shenanigans box lists the seven categories of earnings manipulation shenanigans. The first five EM shenanigans inflate current-period profits: numbers 1, 2 and 3 do so by inflating revenues or gains; numbers 4 and 5 inflate current-period profits by deflating costs, expenses or losses.

In contrast, the last two EM shenanigans (numbers 6 and 7) have the opposite goal—they deflate current-period profits, but the purpose is to inflate future-period profits.

Covering Up the Trick With Acquisition Accounting Shenanigans

Olympus tricked investors into believing their investments were still sound, using EM number 4, which inflates profits by shifting any possible write-off to tomorrow. As the bad investments grew to an uncomfortably large amount (and it became easier for investors to notice the problem), Olympus knew it had to find another trick to make the balance in its investment account disappear.

What to do? Management must have known that they would soon get caught, so they found a clever way to hide the problem (and cover up the first accounting trick, EM number 4). They used an acquisition accounting (AA) shenanigan. Olympus made a series of strange acquisitions, recording a new asset called goodwill and reducing the bloated investment account balance, all under the hard-to-spot cover of acquisition accounting.

Olympus’ Massive Fraud Cover-Up

In October 2011, when Olympus fired its newly appointed CEO, Michael Woodford, it was revealed that the company had been operating a tobashi scheme (a scheme that makes problems “fly away,” in Japanese) in which $2 billion was said to have been siphoned off to cover bad investments made up to 20 years earlier.

Around 2008, Olympus bought three companies and paid far more than they were worth, according to Woodford. The inflated price (totaling a whopping 30% of the deal value) was labeled “fees to a middleman.” Woodford pointed out that the cut for investment bankers typically would be 1% to 2%, so the $674 million paid on the $2 billion deals likely was a payment to cover losses and move the investments from the balance sheet to an unconsolidated, related-party entity.

In summary, Olympus fraudulently was inflating profits by hiding losses at the time of closing acquisitions. (See EM number 3.)

The AA Techniques box lists four techniques that companies sometimes use (under the cover of an acquisition) to artificially boost revenue and earnings.

While the combination of earnings manipulation shenanigans followed by acquisition accounting shenanigans covered up a massive fraud that doomed Olympus, the following examples provide techniques showing how easy it is to use these tricks, even when no major fraud exists. They describe acquisition accounting tricks to inflate revenue and profits.

Inflating Profits at the Target Company Before the Deal Closes

Investors at Valeant Pharmaceuticals (VRX) would have found a very puzzling pattern had they paid close attention to the revenues of the company’s acquisition targets just prior to consolidation. In several cases, reported revenue at the target company slowed down dramatically compared to prior periods, just before the deal closed. No example, however, was more extreme than at Salix, a company Valeant acquired April 1, 2015. Table 1 shows Salix’s quarterly sales from 2013, 2014 and 2015. Notice a few interesting patterns in the numbers: (1) during the last three quarters of 2013, sales were virtually unchanged; (2) during the first quarters of 2014 (when Salix management began actively shopping the company), sales grew rapidly compared to the same prior-year periods; (3) during the last quarter of 2014 and first one of 2015 (when Valeant was in the process of closing the Salix acquisition), sales completely dried up; and (4) in the last three quarters of 2015 (after Valeant acquired Salix), sales grew dramatically.

Table 1. Quarterly Revenues for Salix

Let’s dig a bit deeper to make sense of these strange numbers and trends. Starting in 2014, Salix made a strong push to report terrific sales growth to maximize the share price an acquirer would pay for the company. Trying to spruce up the financial statements before a deal might be fairly common, but stuffing inventory to distributors that have no customers to buy those products (an example of EM shenanigan number 1) goes a bit too far. Indeed, this aggressive channel stuffing caught the attention of regulators at the U.S. Securities and Exchange Commission (SEC) and eventually cost the company’s CEO and CFO their jobs.

The accounting games were far from over. In the fourth quarter of 2014, for example, Salix reported almost no sales at all—a mere $13 million. So, compared to the same quarter in 2013, sales declined an unbelievable 95%. How is that even possible? We can think of only two possible explanations: (1) the numbers reported are correct and Salix’s business must have completely imploded—a very unlikely scenario as Valeant chose not to abort the deal, or (2) the numbers reported by Salix must have been rigged and they had intentionally refrained from booking any business during the fourth quarter of 2014 to allow Valeant to include that revenue in the periods after the deal closed on April 1. This trick is called “spring-loading” revenue to a later period.

After the deal closed, Valeant booked a whopping $1.3 billion (averaging $424 million per quarter) in Salix product sales over the remaining three quarters of 2015. While we claim no “smoking-gun” evidence to prove inflated revenue at Valeant from spring-loading sales, the numbers in Table 1 look quite convincing.

Creating Dubious New Revenue Streams After an Acquisition

Both buyers and sellers of businesses have great flexibility in structuring a deal to create dubious future revenue streams. One trick we have seen is to cleverly create a bogus recurring revenue stream by bundling a seemingly unrelated agreement into the acquisition accounting. Indeed, FPA Medical Management appears to have done just that.

In 1996, FPAM paid $197 million to nursing home operator Foundation Health to purchase a group of medical facilities. As part of the acquisition, however, FPAM guaranteed that Foundation Health’s patients would receive continued and uninterrupted access for the next 30 years. In exchange, Foundation Health (the seller) agreed to pay FPAM $55 million in rebates over the next two years. As FPAM received the $27.5 million payment each year, it recorded these amounts as sales revenue. As we thought through the essence of this transaction, we considered it quite aggressive by FPAM to record any sales revenue for the transaction. In real economic terms, FPAM paid $197 million for the medical facilities and received a $55 million rebate over two years, resulting in a net acquisition cost of $142 million and zero revenue on this deal. Investors should be wary if revenue (or a gain) is recorded when assets are purchased. It is far more logical to expect revenue (or gains) to be recorded when assets are sold.

The key lesson for investors is to first spot such an unorthodox new revenue stream and conclude that if the “seller” of a property pays anything to the “buyer,” the amount received should be viewed as an adjustment to the purchase price, not as a new revenue stream.

A different trick to watch for after a deal closes is when the acquirer changes accounting practices of the target company, resulting in inflated profits of the acquirer.

Indeed, one of Valeant’s many tricks involved using acquisition accounting as a “cover” to make a variety of accounting policy changes at the target company—just after the deal closes. Indeed, the aggressive increases in the pricing to the new drugs acquired (in some cases over 500%) led to an outcry from Congress and others to curtail this horrible practice. But in the less noticed financial statements, Valeant found ways to immediately boost sales (as the Salix story also revealed).

Just after closing an acquisition of Medicis Pharmaceutical at the end of 2012, Valeant changed the revenue recognition policies, resulting in sales being recorded at an earlier point—making Valeant’s sales appear to be growing faster. Specifically, Medicis sold through its distributor, McKesson Corp., which then sold to its customer, the physicians. Medicis historically used the more conservative “sell-through” approach, that is, booking no sales until the distributor sold to the physicians. To goose sales at the Medicis unit after the deal closed, Valeant had Medicis immediately switch to the more aggressive “sell-in” approach and started recognizing sales much earlier—when product was sent to the distributor. Not surprisingly, this brazen change caught the attention of the SEC, which notified the company in a formal letter and asked it to explain any reason for this change.

Inflating Profits by Releasing Suspicious Reserves

During the closing process of a deal, a variety of new opportunities are created for management to provide an artificial boost to net income at a later point. For example, management can take a charge for layoffs or projected legal payments and later release part of these reserves back into income, as management deems such payments will be much less than first anticipated. This trick was widely used at two of the biggest frauds over the last quarter century (WorldCom and Cendant). The creation of bogus reserves at the time of acquisition and subsequent release of such reserves whenever needed created billions in fictitious profits.

While far less troubling than these colossal frauds, games with deal-related contingency reserves can also create myths of stupendous jumps in operating profits. Here’s how it works.

Let’s assume you buy a business paying $60 million cash and later might have to pay an “earn-out” for as much as another $40 million if the acquired business achieves certain agreed-upon targets. That $40 million would be recorded as a “contingent consideration liability” on the balance sheet.

Say, one year later, the business performs below expectations and the expected payout drops from $40 million to $30 million. You must make an accounting entry reducing (debiting) the contingent consideration reserve and reducing (crediting) operating expenses, which results in a $10 million increase to earnings. On the face of it, the outcome seems illogical. You increase your profits when the business you bought underperforms. From an accounting perspective, however, the reduction of the future earn-out is considered a gain.

If a company wants to play games with contingent consideration reserves, it is quite easy to do so. Both inflating the initial fair market value of the total estimated payment to be made and later asserting that the acquired business is performing poorly (and little or no future payments will be made), management, like a master magician, can take out its wand and create profits out of thin air.

And, speaking of magic, no better tool exists than acquisition accounting to give the reported operating cash flows a nice shot in the arm.

Concluding Thoughts

Corporate financial scandals have been around for as long as corporations and investors themselves have been. Dishonest management has preyed on unsuspecting investors, and it is time for investors to redouble their efforts to be alert for such shenanigans, so they can protect themselves.

Since shenanigans, at their most basic level, represent management’s attempt to put a positive spin on a company’s financial performance and economic health, our universal message is that investors should assume that the urge to exaggerate the positive and hide the negative will never disappear. And where temptation exists, shenanigans often follow.