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The Financial Numbers Game

Detecting Creative Accounting Practices

4.0 (157 ratings)
24 minutes read | Text | 9 key ideas
In the high-stakes arena of corporate finance, where numbers dance a complex ballet of deception and allure, "The Financial Numbers Game" strips away the facade to reveal the stark truth lurking behind glossy annual reports. Mulford and Comiskey, armed with the keen insights of seasoned analysts and the pedagogical prowess of master educators, lay bare the seductive art of creative accounting. For the vigilant investor or the shrewd analyst, this book is not just a guide but a lifeline—a meticulously crafted arsenal for discerning the genuine performance of companies amidst the financial smoke and mirrors. With clarity and acumen, this essential tome empowers you to pierce the veil of manipulated earnings and embrace a reality that the quarterly figures might obscure.

Categories

Business, Nonfiction, Finance, Economics, Money, Textbooks, Accounting

Content Type

Book

Binding

Paperback

Year

2005

Publisher

Wiley

Language

English

ASIN

0471770736

ISBN

0471770736

ISBN13

9780471770732

File Download

PDF | EPUB

The Financial Numbers Game Plot Summary

Introduction

Financial reporting serves as the foundation for countless investment decisions, yet the integrity of these reports is increasingly threatened by creative accounting practices. These practices range from aggressive interpretations of accounting standards to outright fraud, creating a distorted picture of corporate performance that misleads investors and creditors alike. The gap between reported numbers and economic reality has widened as companies face intense pressure to meet earnings expectations, secure favorable financing terms, and maximize executive compensation. Understanding how to detect creative accounting requires more than technical knowledge of accounting rules; it demands analytical frameworks that can identify inconsistencies across financial statements and between reported results and business fundamentals. By examining revenue recognition practices, asset valuation techniques, liability reporting, and cash flow manipulation, stakeholders can develop the skills needed to distinguish sustainable performance from accounting illusions. This systematic approach to financial statement analysis provides a powerful defense against the potentially devastating consequences of making decisions based on manipulated financial information.

Chapter 1: The Motivations Behind Creative Accounting Practices

Financial reporting flexibility exists for legitimate reasons, allowing companies to adapt accounting methods to their unique business circumstances. However, this same flexibility creates opportunities for manipulation when powerful incentives push management toward presenting an overly favorable financial picture. The rewards for successful earnings management can be substantial, including higher stock prices, lower borrowing costs, and enhanced executive compensation tied to financial targets. Stock price effects represent perhaps the most powerful motivation for creative accounting. Companies that consistently meet or exceed analyst expectations typically enjoy premium valuations compared to those that miss targets, even by small amounts. This market dynamic creates tremendous pressure to deliver predictable earnings growth, even when underlying business performance is volatile. The pressure intensifies when executives hold significant equity positions or stock options that directly link their personal wealth to the company's stock price performance. Debt covenants and credit ratings provide additional incentives for financial manipulation. Loan agreements typically include financial covenants requiring companies to maintain specific ratios of debt to equity, interest coverage, or minimum working capital. Violating these covenants can trigger default provisions, allowing lenders to demand immediate repayment or impose higher interest rates. Similarly, credit rating downgrades can significantly increase borrowing costs. These potential consequences create strong incentives to maintain financial ratios within required parameters, even when business performance deteriorates. Executive compensation structures often inadvertently encourage creative accounting. Performance-based bonuses tied to specific financial targets create direct financial incentives for executives to achieve those targets through accounting choices if necessary. When compensation plans include thresholds that trigger substantially higher payouts once certain levels are achieved, the temptation to manage earnings to reach these thresholds becomes particularly strong. The relatively short measurement periods for most bonus plans (typically one year) further encourage short-term accounting manipulations over sustainable business improvements. Political and regulatory considerations sometimes motivate companies to understate rather than overstate financial performance. Companies in highly regulated industries or those facing potential antitrust scrutiny may prefer to appear less profitable to avoid rate reductions, price controls, or increased regulatory oversight. Similarly, companies seeking government assistance or protection from foreign competition may benefit from appearing financially weaker than they actually are. These situations create incentives for income-decreasing accounting choices that contrast with the more common income-increasing manipulations. The cumulative effect of these motivations has transformed financial reporting from a neutral communication mechanism into a strategic tool for achieving management objectives. While not all creative accounting crosses into illegal territory, the line between aggressive interpretation and misleading representation has become increasingly blurred. Understanding these motivations helps financial statement users identify situations where the risk of manipulation is particularly high and apply appropriate skepticism to reported results.

Chapter 2: Revenue Recognition: The Primary Battlefield of Manipulation

Revenue recognition represents the most critical area for detecting creative accounting practices. As the top line of the income statement, revenue directly impacts virtually all performance metrics and serves as the foundation for earnings calculations. When companies manipulate revenue recognition, they distort not only current performance but also growth trends that influence investment and lending decisions. Premature revenue recognition occurs when companies record sales before meeting all recognition criteria. Under generally accepted accounting principles, revenue should only be recognized when it has been earned (the seller has substantially completed what it must do to be entitled to payment) and is realizable (collection is reasonably assured). Companies exploit the judgment inherent in these criteria by recording revenue when significant uncertainties remain about customer acceptance, when right of return provisions make ultimate collection questionable, or when significant services remain undelivered. While these transactions may eventually result in legitimate revenue, recording them prematurely overstates current performance and creates future earnings challenges. Channel stuffing represents a particularly problematic revenue recognition practice where companies pressure distributors to purchase more inventory than needed, often through deep discounts, extended payment terms, or undisclosed rights of return. While these shipments technically qualify as sales, they artificially accelerate revenue recognition and typically lead to reduced future orders as distributors work through excess inventory. The practice creates an unsustainable revenue pattern that eventually requires correction, often through significant sales declines or large return reserves. Multiple-element arrangements create significant revenue recognition challenges, particularly in technology and service industries. When companies deliver products and services over time through complex contracts, they must allocate the total contract value across different elements and recognize revenue as each element is delivered. This allocation process involves considerable judgment, creating opportunities to accelerate revenue by assigning higher values to elements delivered immediately while minimizing deferred revenue associated with future obligations. Fictitious revenue represents the most egregious form of manipulation, involving the recording of completely fabricated sales. Companies may create documentation for non-existent customers, record shipments that never occurred, or recognize revenue for products that don't exist. In some cases, companies ship goods to warehouses or affiliated entities while recording them as third-party sales. These practices not only overstate revenue but often require complementary manipulation of other accounts, including accounts receivable, inventory, and cash flow. Detecting revenue manipulation requires careful analysis of financial statements and disclosures. Warning signs include revenue growth inconsistent with industry trends or economic conditions, increasing days sales outstanding, growing unbilled receivables, significant fourth-quarter revenue surges, or declining cash flow relative to reported income. Changes in revenue recognition policies, vague disclosure language, or unusual transaction terms may also signal potential manipulation. By examining these indicators across multiple reporting periods and comparing them with industry peers, financial statement users can identify potential revenue recognition issues before they lead to significant investment losses.

Chapter 3: Asset Valuation and Liability Reporting Distortions

Asset valuation and liability recognition involve significant judgment and estimation, creating fertile ground for creative accounting practices. Companies seeking to enhance reported results may overvalue assets, undervalue liabilities, or both, resulting in inflated shareholders' equity and earnings. These distortions can persist for extended periods before economic reality forces eventual correction, typically through large write-downs that devastate investor returns. Aggressive capitalization policies represent a common form of asset valuation manipulation. When companies capitalize costs that should be expensed, they create assets on the balance sheet while reducing current-period expenses on the income statement. This approach improves short-term profitability at the expense of future periods, which must bear the eventual amortization or depreciation charges. Software development costs, website development expenses, and internal-use software projects provide particular opportunities for aggressive capitalization, as the distinction between research (which must be expensed) and development (which may be capitalized) involves significant judgment. Inventory valuation offers additional manipulation opportunities through various techniques. Companies may overstate physical inventory counts, improperly value obsolete inventory, or manipulate overhead allocation to inflate inventory values. Since inventory directly affects cost of goods sold, these manipulations directly impact gross margins and operating profits. The LIFO liquidation technique, where companies sell older, lower-cost inventory while reducing inventory levels, can temporarily boost profits during inflationary periods without any improvement in underlying business performance. Long-lived asset impairment represents another area vulnerable to manipulation. When market values decline or business conditions deteriorate, companies should test long-lived assets for impairment and write them down to fair value if necessary. However, this testing process involves significant assumptions about future cash flows, discount rates, and asset grouping that create opportunities for delay or minimization of necessary write-downs. By manipulating these assumptions, companies can avoid or reduce impairment charges that would otherwise reflect economic reality. On the liability side, companies understate obligations by failing to accrue expenses, understating warranty liabilities, or improperly accounting for contingent liabilities. Restructuring charges provide particular opportunities for manipulation, as companies might overaccrue for future costs, creating "cookie jar reserves" that can be released to boost future earnings when needed. These reserves essentially shift expenses from future periods to the current period, allowing management to smooth earnings and create the appearance of steady performance even when underlying business results are volatile. Pension and healthcare obligations represent complex liability areas particularly susceptible to manipulation. By adjusting actuarial assumptions about investment returns, salary increases, or discount rates, companies can significantly impact reported pension liabilities and related expenses without any change in underlying economic reality. Small changes in these assumptions can produce material effects on financial statements, yet they involve such technical complexity that most financial statement users struggle to evaluate their reasonableness. Detecting asset and liability distortions requires careful analysis of financial statement disclosures and trends. Warning signs include unexplained changes in key ratios such as gross margins or asset turnover rates, significant differences between industry peers in reserve levels or asset valuations, or disconnects between reported financial performance and economic reality. Footnote disclosures often provide critical information about valuation methodologies, assumptions, and contingencies that may reveal aggressive accounting practices when carefully analyzed in context.

Chapter 4: Cash Flow Manipulation: Beyond Accrual Accounting

Cash flow reporting has traditionally been viewed as less susceptible to manipulation than accrual-based earnings, leading many investors to rely heavily on cash flow metrics when evaluating financial performance. However, companies engaged in creative accounting have developed sophisticated techniques to manipulate cash flow statements, particularly operating cash flow, which receives the most analytical attention. Understanding these techniques is essential for developing a comprehensive approach to detecting financial deception. Classification manipulation represents the most common approach to distorting cash flow reporting. The statement of cash flows divides activities into operating, investing, and financing categories, with operating cash flow considered most important for assessing sustainable business performance. Companies exploit classification flexibility by shifting unfavorable items out of the operating section while moving favorable items in. For example, companies may classify normal operating expenditures as investing activities, record investing or financing inflows as operating items, or structure transactions specifically to achieve favorable cash flow classification. Working capital manipulations directly impact operating cash flow through timing decisions. Companies may delay payments to suppliers at period-end, artificially boosting operating cash flow by increasing accounts payable. Similarly, aggressive collection efforts just before period-end can temporarily accelerate cash receipts. While these actions genuinely increase current-period cash flow, they merely shift cash between periods rather than creating sustainable improvement. Future periods typically show corresponding deterioration as these timing differences reverse, creating a pattern of volatility that masks underlying performance trends. Securitization of receivables provides another powerful tool for boosting operating cash flow. When a company sells its accounts receivable to a third party, it receives immediate cash that appears in operating cash flow. While technically compliant with accounting standards, this practice effectively borrows operating cash flow from future periods. Companies facing temporary cash flow difficulties often turn to receivables securitization as a quick fix, but this improvement in operating cash flow is not sustainable and may actually indicate underlying business problems that management is attempting to conceal. Tax allocation issues create significant distortions in operating cash flow reporting. According to current accounting standards, all income taxes paid are included in operating cash flow, regardless of whether they relate to operating, investing, or financing activities. When a company sells a business segment or investment at a significant gain, the taxes paid on that gain reduce operating cash flow, even though the proceeds from the sale appear in the investing section. This inconsistent treatment distorts the relationship between operating activities and the cash flows they generate, complicating period-to-period comparisons. The treatment of non-recurring items in cash flow statements often lacks transparency. While income statements typically highlight extraordinary items, restructuring charges, and other non-recurring expenses, cash flow statements frequently bury the cash impact of these items within operating cash flow. Without careful examination of financial statement footnotes, analysts may miss the extent to which operating cash flow includes non-recurring elements. This lack of transparency makes it challenging to assess a company's sustainable cash-generating ability based on reported figures alone. Detecting cash flow manipulation requires examining the relationship between operating cash flow and net income over time, identifying unusual fluctuations in working capital accounts, and scrutinizing footnote disclosures about non-cash transactions. Companies with persistent and growing gaps between reported earnings and operating cash flow warrant particular attention, as do those showing unusual patterns in receivables, payables, or inventory relative to sales and cost trends. By adjusting reported cash flow figures to remove non-recurring items and classification distortions, analysts can develop a more accurate picture of sustainable cash-generating ability.

Chapter 5: Analytical Techniques for Detecting Financial Deception

Detecting creative accounting requires a systematic analytical framework that integrates information from all financial statements and disclosures. This comprehensive approach recognizes that manipulation in one area inevitably creates inconsistencies across the financial reporting ecosystem, providing multiple detection opportunities for the careful analyst. By combining quantitative analysis with qualitative assessment of management incentives and business fundamentals, financial statement users can significantly improve their ability to identify potential accounting problems. Ratio analysis forms the quantitative foundation of effective detection techniques. Profitability ratios track performance trends, while efficiency ratios measure asset utilization. Liquidity and solvency ratios assess financial stability, and cash conversion metrics evaluate how effectively earnings translate into cash. Analyzing these ratios over time and against industry benchmarks highlights anomalies that warrant further investigation. Particular attention should focus on gross margin trends, asset turnover rates, days sales outstanding, and the relationship between operating cash flow and net income. Unexpected changes in these metrics often provide the first indication of potential accounting manipulation. Accounting policy analysis represents another critical component of the detection framework. The notes to financial statements reveal management's accounting choices and estimates. Investors should scrutinize revenue recognition policies, depreciation methods, inventory valuation approaches, and reserve methodologies. Changes in accounting policies, particularly those that boost current earnings, deserve special attention. The quality of disclosure itself provides insight - vague, complex, or changing disclosures often signal potential accounting issues. Companies that provide clear, consistent, and comprehensive disclosures generally present lower accounting risk than those offering minimal or obscure information. The accrual analysis technique specifically targets the relationship between reported earnings and cash flow. This approach calculates total accruals by subtracting operating cash flow from net income, then evaluates whether these accruals appear reasonable given the company's business model and growth rate. Persistent large accruals, particularly when they consistently boost earnings above cash flow, may indicate aggressive accounting practices. The quality of accruals deteriorates when they involve subjective estimates or complex calculations rather than straightforward timing differences between accounting recognition and cash movement. Earnings quality assessment extends beyond accrual analysis to evaluate the sustainability and predictability of reported results. High-quality earnings derive primarily from core operations rather than one-time gains, accounting changes, or reserve manipulations. They show reasonable correlation with operating cash flow over time and demonstrate consistency with observable business conditions and industry trends. Earnings quality deteriorates when companies rely increasingly on non-recurring items, accounting policy changes, or working capital manipulations to meet financial targets. Non-financial indicators provide valuable supplementary evidence when evaluating financial reporting quality. These include market share trends, customer satisfaction metrics, employee turnover rates, and product development pipelines. When financial results diverge significantly from these operational indicators - for example, when a company reports strong revenue growth despite losing market share - this inconsistency may signal potential accounting manipulation. Similarly, excessive executive turnover, frequent auditor changes, or unusual related-party transactions often accompany aggressive accounting practices. The most effective analytical approach combines these techniques within a comprehensive framework that considers management incentives, governance structures, and industry dynamics. Companies facing intense pressure to meet earnings targets, maintain debt covenants, or support stock prices warrant heightened scrutiny. Similarly, weak governance structures, including boards lacking financial expertise or independence, create environments where aggressive accounting practices can flourish. By integrating quantitative analysis with these contextual factors, financial statement users can develop a nuanced assessment of accounting quality that significantly improves their ability to detect potential manipulation.

Chapter 6: Red Flags and Warning Signs in Financial Statements

Specific warning signs often precede the discovery of significant accounting problems. These red flags typically fall into several categories: accounting anomalies, governance weaknesses, operational inconsistencies, and market signals. Recognizing these indicators early can help investors avoid significant losses when creative accounting practices eventually collapse under their own weight. Revenue-related red flags deserve particular attention given the prevalence of revenue manipulation. These include revenue growing significantly faster than industry peers without corresponding market share gains, increasing days sales outstanding that suggest collection problems or premature recognition, significant fourth-quarter revenue surges that may indicate period-end manipulation, and growing gaps between billed and unbilled receivables. Changes in revenue recognition policies, particularly those that accelerate recognition, warrant careful scrutiny, as do vague or changing disclosures about revenue recognition criteria. Companies that consistently meet or narrowly exceed revenue targets, especially during challenging industry conditions, may be employing aggressive recognition practices to maintain the appearance of steady growth. Balance sheet red flags provide complementary evidence of potential manipulation. These include deteriorating asset quality metrics, such as increasing days sales outstanding, inventory days, or fixed asset intensity relative to revenue. Unexplained fluctuations in working capital accounts, particularly near period-ends, may signal manipulation. Growing differences between net income and operating cash flow, especially when accompanied by increasing accruals, represent classic warning signs of earnings management. Reserves that consistently prove inadequate, requiring subsequent increases, may indicate systematic understatement of liabilities. Cash flow warning signs complement income statement and balance sheet indicators. These include operating cash flow consistently lagging reported income, significant increases in receivables or inventory relative to sales growth, decreasing or negative free cash flow despite growing earnings, and unusual fluctuations in working capital accounts. The quality of earnings deteriorates when a company reports positive income but negative operating cash flow for extended periods. Companies that repeatedly engage in receivables securitization, factoring, or other financial engineering techniques to boost operating cash flow warrant particular scrutiny. Governance and disclosure red flags provide important contextual information about manipulation risk. These include frequent auditor changes, qualified audit opinions, material weakness disclosures in internal controls, related-party transactions, and concentrated decision-making power. Board composition matters - directors lacking financial expertise or independence may provide insufficient oversight. Executive compensation structures that heavily reward short-term earnings targets create incentives for manipulation. Disclosure quality itself provides important signals - companies that provide minimal, vague, or changing disclosures about critical accounting policies and estimates typically present higher accounting risk. Operational inconsistencies between reported financial results and observable business conditions provide additional warning signs. These include financial metrics that contradict industry trends, customer or supplier reports that conflict with the company's narrative, or physical asset conditions that don't align with balance sheet valuations. Companies reporting strong financial results despite losing market share or facing significant competitive challenges deserve heightened scrutiny. Similarly, companies maintaining steady margins despite significant input cost increases or competitive pricing pressure may be employing reserve manipulation or other techniques to smooth reported results. Market signals complement these internal indicators. Significant short-seller interest, especially when accompanied by detailed analytical reports, often identifies accounting concerns before they become widely recognized. Insider selling patterns, particularly following periods of strong reported performance, may signal that management has less confidence in the sustainability of results than their public statements suggest. Credit rating agency concerns, even when not resulting in immediate downgrades, may reflect early recognition of deteriorating financial quality that hasn't yet fully manifested in reported results.

Chapter 7: Regulatory Responses and Professional Perspectives

Regulatory bodies have implemented increasingly stringent measures to combat creative accounting practices, recognizing their threat to market integrity and investor protection. The Securities and Exchange Commission (SEC) has taken a leading role in this effort, using both enforcement actions against violators and guidance initiatives to clarify accounting standards and disclosure requirements. Former SEC Chairman Arthur Levitt's 1998 speech, "The Numbers Game," marked a watershed moment in regulatory attention to earnings management, identifying specific problematic practices and announcing a comprehensive action plan to address them. The SEC's response has included issuing Staff Accounting Bulletins providing interpretive guidance on critical areas vulnerable to manipulation. SAB 99 addressed materiality considerations, clarifying that even quantitatively small misstatements could be material if they affected earnings trends or helped meet analyst expectations. SAB 101 (later superseded by SAB 104) provided detailed guidance on revenue recognition, particularly for complex arrangements involving multiple deliverables or significant post-delivery obligations. These bulletins narrowed the flexibility available for aggressive interpretations of accounting standards without requiring formal rule changes. The Sarbanes-Oxley Act of 2002 represented a landmark legislative response to accounting scandals at companies like Enron and WorldCom. The Act strengthened corporate governance by requiring independent audit committees with financial expertise, enhanced financial disclosures, established the Public Company Accounting Oversight Board to regulate auditors, and created new penalties for financial fraud. It also required CEO and CFO certification of financial statements and mandated assessment of internal controls over financial reporting. These provisions significantly increased personal accountability for financial reporting accuracy and completeness. The Financial Accounting Standards Board (FASB) has also responded by issuing more detailed and prescriptive accounting standards in areas particularly vulnerable to manipulation. Revenue recognition standards have evolved from broad principles to detailed implementation guidance addressing specific industry practices and transaction types. Similarly, standards governing financial instruments, leases, and fair value measurements have become increasingly prescriptive to reduce interpretation flexibility. While these detailed standards reduce manipulation opportunities, they also increase compliance complexity and sometimes substitute technical compliance for economic substance. Professional perspectives on earnings management reveal important tensions within the financial reporting ecosystem. A survey of chief financial officers, financial analysts, auditors, and accounting academics shows broad agreement that earnings management is common and has become more prevalent over time. These professionals identify several primary motivations: reducing earnings volatility, supporting stock prices, enhancing earnings-based compensation, and meeting consensus earnings forecasts. They generally support regulatory efforts to combat abusive earnings management while recognizing the challenge of establishing clear boundaries between legitimate accounting judgment and misleading financial reporting. The audit profession has responded to creative accounting challenges by enhancing fraud detection procedures and increasing scrutiny of management estimates and judgments. Audit standards now require specific procedures to identify fraud risks, evaluate internal control effectiveness, and challenge management assertions about complex transactions and accounting estimates. Auditors have also increased their use of data analytics to identify unusual patterns or relationships that might indicate manipulation. Despite these improvements, the inherent limitations of the audit process - including sampling approaches, management's information advantage, and the challenge of detecting collusive fraud - mean that audits cannot provide absolute assurance against creative accounting. The investment community has developed increasingly sophisticated approaches to evaluating accounting quality and detecting potential manipulation. Specialized research firms focus exclusively on forensic accounting analysis, using proprietary models to identify companies with high accounting risk. Institutional investors incorporate accounting quality metrics into their investment processes, often avoiding companies showing multiple warning signs regardless of apparent growth or profitability. Credit rating agencies have enhanced their methodologies to better assess accounting quality and its impact on creditworthiness. These market-based responses complement regulatory efforts by imposing financial consequences on companies employing aggressive accounting practices.

Summary

The financial numbers game represents a significant challenge for all participants in capital markets. Creative accounting practices, ranging from aggressive but technically compliant interpretations of accounting principles to outright fraudulent misrepresentations, distort the financial information upon which countless investment and credit decisions depend. While flexibility in accounting is necessary to accommodate legitimate business differences, this flexibility becomes problematic when exploited to create misleading impressions of business performance. Detecting creative accounting requires integrating quantitative analysis with qualitative assessment of management incentives, governance structures, and business fundamentals. The most powerful insights emerge from inconsistencies between different elements of financial reporting or between reported results and observable business conditions. By examining financial statements for internal contradictions, comparing reported performance with economic reality, and scrutinizing areas involving significant judgment or estimation, stakeholders can develop a more nuanced understanding of accounting quality that significantly improves their ability to identify potential manipulation before it leads to investment losses. This systematic approach transforms financial analysis from a mechanical exercise into a powerful tool for distinguishing sustainable performance from accounting illusions.

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Review Summary

Strengths: The book is described as the most comprehensive on accounting gimmicks, surpassing others in depth and breadth. It provides detailed techniques for both implementing and detecting financial manipulation, and includes sections on SEC policy matters. The reviewer appreciates the practical knowledge gained, which is useful for serious investors.\nWeaknesses: The book is noted for its "professionally boring language" and is not recommended for the faint-hearted due to its dense and detailed content. The reviewer stopped reading at page 170, suggesting that the book may be overly detailed for some readers.\nOverall Sentiment: Enthusiastic\nKey Takeaway: "The Financial Number Game" is a highly detailed and comprehensive resource on accounting manipulation, valuable for professionals and serious investors, though its dense language may not appeal to all readers.

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Charles W. Mulford

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The Financial Numbers Game

By Charles W. Mulford

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