Ruly Bookshelf: Financial Shenanigans
Financial Shenanigans by Howard M. Schilit, Ph.D., C.P.A. has been on my reading list for some time. I assumed that the book was about how to learn to recognize fraud or misleading statements in financial statements. It is about this but not in exactly the way you might expect. This book is an important read for anyone who invests in stocks or runs a business but there are many insights for individuals too.
Dr. Schilit refers to the techniques he reveals in this book as “shenanigans” which he defines as “actions or omissions intended to hide or distort the real financial performance or financial condition of an entity.” It is not exactly the same as “fraud” because some of the techniques he outlines are perfectly legal and perfectly acceptable under Generally Accepted Accounting Principles or GAAP.
Dr. Schilit indicates there are 7 common accounting shenanigans:
- Recording Revenue Too Soon.
- Recording Bogus Revenues
- Boosting Income with One-Time Gains
- Shifting Current Expenses to a Later Period
- Failing to Record or Disclose All Liabilities
- Shifting Current Income to a Later Period
- Shifting Future Expenses to the Current Period
Even though I have had a brief course in accounting, I erroneously assumed that accounting is a sort of black-and-white exercise where there is one “correct” way to record your revenue and expenses. After reading this book, you too will understand that there is a lot of discretion and even creativity in accounting.
While we in the general public might want stocks to be regulated so that every company reports revenue and expenses in exactly the same way (making it easier to compare which companies are doing well and which are doing poorly), professional stock analysts don’t seem to have the same expectations. These professional stock analysts instead are trained to evaluate all of the “shenanigans” presented in corporate accounting statements and use the information as a competitive advantage to make their buy and sell recommendations. For example, if an analyst spots a company using a trick to boost income, they might anticipate a drop in revenues later on and sell the stock. If they see a company “taking a bath” by suffering large expenses now, they might buy knowing that profits in later periods are likely to improve.
It is unrealistic to assume that we all can become as knowledgeable as professional stock analysts but if we can just learn a little about this type of analysis we might be able to get out of bad investments before we lose a lot of money.
One of the best tips I learned in this book was where to look for the most telling information about a given company. If you have ever invested in a stock (either individually or through a retirement account), you have probably been sent voluminous reports, such as quarterly and annual reports or proxy statements asking you to vote on certain issues. Many people likely just toss these reports in the trash and think, “Who has time to read all of this?” Most of us probably make our investing decisions based on quick recommendations from financial experts and news sources.
The next time you receive a report on a publicly traded company’s financial performance, Dr. Schilit advises you to look the most carefully at the following information sources. Note that none of these sources are the actual financial statements provided by the company! While those are clearly important as well, Dr. Schilit advises that you can only evaluate the actual numbers with the background provided in the following supplementary sources of information.
- Auditor’s Reports. Usually, these are found in the 10-K. If you see any qualifying statements from the auditor about the accuracy of the reporting of the company’s financial situation, you should be quite alarmed. Note that the quarterly 10-Q reports are not audited, only the annual report.
- Litigation Statements. Make sure you look closely at any statements about pending or potential lawsuits against the company and do your best to evaluate what the cost impact of these lawsuits might be.
- Executive Compensation. Does the way executive compensation is structured give management an incentive to (legally) shift money into certain quarters/years rather than record it exactly when it occurs?
- Related Party Transactions. Is the company engaging in transactions with subsidiaries that disguises how a transaction is presented? Are conflicts of interest occurring?
- Footnotes to the Financial Statements. Dr. Schilit indicates that many accounting irregularities are cleverly hidden in the footnotes where most people aren’t going to read them.
- The President’s Letter in the Annual Report. If the President mentions the word “challenging” frequently, you might want to think about selling.
- Management Discussion and Analysis in the 10-K.
Dr. Schilit spends a chapter on each of the shenanigans going over in detail what each one means and how it might appear in the accounting. He illustrates each example with actual company misconduct. Dr. Schilit also provides examples of frauds throughout the past century and a brief chapter on accounting concepts at the end (that a novice might want to read first).
Some of the eye-opening examples were Dr. Schilit’s discussion of how executive compensation influences significantly how revenue and expenses are reported and the (legal) use of a corporate sugar bowl technique for the “smoothing of income.”
“Most executives prefer to report earnings that follow a smooth, regular upward path. They hate to report declines; but they also want to avoid increases that vary widely from year to year. It’s better to have two years of 15 percent earnings than increases of 30 percent one year and none the next. As a result, some companies ‘bank’ earnings by understating them in a particularly good year and then use the reserves in bad years to boost profits.”
Due to the age of the book (the version I read was published in 1993, although a third edition, is due to be released in May 2010), most of the companies profiled are unrecognizable but it was helpful for me to realize that recognizing accounting fraud is by no means a modern problem and is something that has always plagued investors. It was also comforting to know that some of the problems with corporate accounting Dr. Schilit identifies have since been corrected by regulation to a small extent. Now companies are required to expense stock options, have independent audit committees, establish codes of business conduct and adopt other fraud prevention procedures. These steps may not prevent fraud entirely but they are at least a step in the right direction. I assume the revised edition of Financial Shenanigans will address these changes as well as comment on recent shenanigans, like the Madoff scandal.
There are also some shenanigans that we can address in our own personal finances to improve our budgeting practices. For example, if you need to buy a new computer every 5 years at a cost of about $2,000, then you really are incurring a regular expense of about $33.33 per month for computer equipment. If you set aside this amount each month, then every 5 years you will have enough to replace your computer equipment with no shock to your budget. Some people, however, employ a “shifting future expenses” shenanigan and just make a big one-time purchase out of their cash reserves in year 1 and for years 2-5 have no allocation for computer expense. When year 6 rolls around and it is time to replace the computer, there is a budget crisis.
By reading this book, you will not become an expert on detecting financial shenanigans and avoiding fraud. You will learn that in order to completely avoid fraud, you would need to know information that never appears in any required public financial statement reporting. The information you might really want to know about a company’s finances likely occurs in private internal meetings, emails, and conversations with auditors and lawyers. Dr. Schilit’s book, however, is the next best thing, and gives you the tools to learn the substance behind the numbers and become a more savvy investor.
How would you rate your own skills at interpreting corporate financial statements? What information would you like to know about the companies you invest in? Have you ever been burned by a financial shenanigan? Please share in the comments.