Financial Shenanigans - Howard Schilit

Detecting financial shenanigans

Bad management will find ways to enrich themselves at the expense of investors. We cannot always depend on auditors and regulators to protect us from incorrect or fraudulent financial reporting. Howard Schilit, Jeremy Perler and Yoni Engelhart (SP&E) provide a great introduction to this topic in Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. Their observations and case studies give insight into the tricks that corporate fraudsters use to masquerade their operations.

History in particular is replete with examples of manipulation in earnings, key metrics, acquisitions, cash flows, and so on. From misrepresentations of economic reality to accounting ‘cookie jars’, the authors show the vastness in scope for financial shenanigans and fraudulent reporting. This post will review some of the lessons that I took from their work, focusing on common accounting red flags and how we might spot them.

Accounting for reality

There are many ways for companies to manipulate reported earnings. They might record revenue early, delay or hide expenses, rely on ‘one-time’ additions and/or falsify accounting items entirely. Given the room for discretion, some managers will boost reported incomes during good times, and hide losses in their balance sheets during bad times.

SP&E remind readers to compare the economic and accounting reality of a business. Some companies may report the gross value of transactions as revenue when the commission is what they actually earn (case in point: Groupon); Or record supplier rebates as revenue as opposed to an adjusted cost in inventories purchased. Others might recognise borrowings and divestments as recurring revenue, and recurring expenses as restructuring charges or discontinued operations.

To boost reported incomes, some companies might also over-capitalise operating expenses, depreciate assets slowly, rely on off-balance sheet purchases, avoid impairment write downs, and ignore uncollectible receivables. Some companies will also tweak accounting assumptions to their benefit. Common items include assumptions for pensions, insurance, derivatives, loss contingencies and warranties.

Barter or arms-length transactions with affiliates, joint-ventures and/or parent companies are another common source of trouble (case in point: Iconix). This is where sales are recorded on transactions, but little-to-no cash is exchanged. The ways to misrepresent economic reality are endless.

Calendar gaming

Accounting standards require us to recognise revenues when we have delivered the good or service to our end-user. SP&E highlight how bad managers can record revenue before they meet their obligations or complete their contracts. Likewise, bad sellers may record sales before they ship their goods, or before their customers have accepted it (case in point: Sunbeam).

SP&E recommends investors watch for these calendar games. They include immediate revenue recognition of long-term contracts and timing-related changes in the company’s accounting policies. Similarly, we should be cautious of a company’s revenue recognition policy when they engage in excessive supplier-financing, extended payment conditions and flexible payment terms. Some sellers might offer very long repayment terms to customers, while recording their sales immediately.

‘Cookie jar’ reserves are another fraught practice. Here, companies will inflate their charges and liabilities today to smooth or improve future reported earnings. Some companies might write-off and later reverse impairments to inventory, intangible assets and deferred costs.

When companies cannot meet their targets, there is incentive to upfront expenses and defer revenue. They may try to smooth revenues and losses over many years to meet future earnings targets and bonus thresholds (case in point: Bristol-Myers). How managers engage in calendar games will depend on their desire to inflate current and/or future period earnings.

Cookie jars are also difficult to spot given the opportunity for discretion in restructures and acquisitions. For instance, in an acquisition, the acquiree may delay their record of revenues to give their acquirer a one-time boost instead. Similarly, some companies might use economic downturns to set up restructure charges and their cookier jars.

Robin Hood

It’s important to remember that companies report revenue and expenses on an accrual basis. This is when the company earns it revenue and derives the benefit of its expenses, which can differ from the timing of actual cash flows. That said, we should expect net income to correlate with cash flows from operations (CFFO) over time. SP&E believes it’s a red flag when companies report consistently high net incomes but low or deteriorating CFFO.

The authors also describes the accounting trick they call Robin Hood that companies use to boost reported CFFO. This involves reclassifying operating, investing and financing cash flow items in misleading ways (case in point: Delphi). For example, they may reclassify financing inflows, such as bank borrowings, as an operating inflow.

They may also exclude operating outflows from reported CFFO. Common tricks here include ‘boomerang’ transactions, inappropriate capitalisation of expenses, or classifying working capital and/or internal R&D as an investment outflow. They may also engage in calendar games and creative ways to report CFFO on a ‘pro forma’ basis.

Companies might also distort classifications for receivables, inventory, payables and debt to mask problems with liquidity and working capital. Regular changes in the reporting presentations, uncertificable transactions in the auditor’s report, and unusual reliance on special-purpose entities are common red flags (case in point: Enron).

Day sales and payables

SP&E suggest that the company’s day sales outstanding (DSO) can provide an indication of the company’s cash management and recognition policies. DSO measures the average time taken for a company to receive payment after sales are made. A spike in DSO may indicate aggressive recognition and/or worsening financial position.

The authors also recommend investors monitor the company’s days payable outstanding (DPO). Extraordinary increases in payables, payable financing and reported cash flows may be another red flag. However, it’s important to remember that DSO and DPO are simple and fallible indicators. Where context matters, good judgement is needed.

DSO = (accounts receivable / total sales) x no. days in the period

DPO = (accounts payable / cost of goods sold) x no. days in the period

Liquidity and capital disclosures

SP&E recommends investors compare company disclosures between filing periods, review the economics and legitimacy of cash flow classifications, and monitor company free cash flow levels (CFFO minus CAPEX). Investors should also scrutinise management’s discussion and analysis of liquidity and capital resources in the company’s 10Q and 10K. They may contain important disclosures about the company’s cash flow reporting practices.

Surrogates belie

Failing companies will make attempts to disguise deteriorating performance through distortions in and surrogates for reported financial metrics. For example, the company might have a unique method to calculate non-GAAP earnings.

Surrogate metrics are neither good nor bad by themselves. Its utility depends on the intention of management. While some companies use surrogate metrics to educate their investors (case in point: Constellation Software or Berkshire Hathaway), others use it to mislead and disguise.

Where possible, SP&E recommend readers verify the reasonableness of reported measures. For example, if retailers use same-store sales as a non-GAAP measure of success, investors might want to sanity check it against revenue per store. Significant discrepancies in your sanity checks could be a red flag. Likewise, the authors recommend investors keep a peeled eye for changes in surrogate definitions over time.

Dubious acquisitions

There’s plenty of evidence on the follies and value trap of mergers and acquisitions (M&A). In his research paper Capital Allocation, Michael Mauboussin described the acquirer’s tendency to overestimate the benefits of M&A.

SP&E is also wary of managers that pursue M&A for its ‘synergies’ and accounting benefits. Bad companies will use M&A to engage in financial shenanigans. M&A is a common mechanism for companies to engage in cookie jar reserves, calendar gaming, earnings and balance sheet manipulation, and so on (case in point: Tyco).

Red flags include extraordinary shifts in revenue, earnings, cash flows and reserves for the acquiree and acquirer, both prior and following the acquisition. Investors should look at free cash flows to account for serial acquirers that have the majority of their expenses reported as an investment outflow.

If businesses are sold to or purchased from another public company, we can check their disclosures to triangulate the legitimacy and economics of such transactions. The authors also recommend readers to scrutinise how companies report the attributable and unattributable results of their subsidiaries in their income statements. Accounting quirks can mislead in the absence of watchful eyes.

Integrity, intelligence and energy

“In looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don’t have the first, the other two will kill you.”
Warren Buffett

There are two things that strikes me most from reading Financial Shenanigans: (1) the many ways in which bad companies can mislead and defraud investors; and (2) how difficult it is for investors to recognise sophisticated fraud from a simple reading of the financial statements alone.

I think it’s partly for these two reasons that legendary value investors such as Warren Buffett, Charlie Munger and Phil Fisher prefer to invest in companies and managers with unquestionable honesty and integrity. They’re happy to pass on companies that are too complex to understand from an operating and/or financial standpoint.

Incentives and alignment

The risks of bad behaviour are higher in companies with management that have a short-term horizon. The authors offer us several red flags here: managers that hold an insignificant equity stake in the company; pay themselves excessive salaries and special dividends; engage in reckless M&A and leverage; and slash long-term expenses like R&D. Poor accountability, promotional cultures, bad remuneration schemes, and figurehead boards may add to this risk.

Sugar coats and blind-eyes

Investors should be careful not to overlook accounting investigations and a history of unethical business practices. Executive communications have a tendency to “sugar-coat the problem”. If companies are restating their financial reports in a substantial way, the situation is probably worse than they have let on (case in point: Kraft Heinz). Even worse is when they’re feuding publicly with their auditors. We shouldn’t ignore these events. If we cannot rely on management or Wall Street to understand the company, we’ll have to use our own judgement to determine its prospects. Common sense can prevail.

Investing between the lines

Some awareness of business history can offer us an additional safeguard against future shenanigans. In her book Reading Financial Reports, Lita Epstein recommends several financial scandals that are worth studying: Enron, Madoff, Citigroup, Adelphia, WorldCom, Waste Management, Halliburton, Arthur Andersen, Sunbeam, Tyco and Bristol-Meyers Squibb. Through these cases, one can see the gamut of financial shenanigans on full display.

Finally, in Investing Between the Lines, LJ Rittenhouse recommends investors scrutinise executive communications for accountability, candour, integrity, capital stewardship and long-term orientation. While we can never be truly certain about a company’s integrity, an understanding of their numbers, leaders, policies, and culture may tilt the odds in our favour. We should raise our red flags when the numbers and narratives tell us different stories.

References

Accounting is the language of business and investing. To use it well, we have to understand its limitations and how others might exploit it. This made Financial Shenanigans a welcome addition to my reading list and toolkit, one that I’ll revisit from time to time. And for those of you who haven’t, I’d encourage you to read their book as well.

Schilit, H., Perler, J., & Engelhart, Y. (2018). Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports. 4^th Edition. More articles at < https://www.schilit.com/in-the-media >
Schilit, H. (2010). Financial Shenanigans: CFA Institute Presentation to CFA Institute. Available at < https://www.cfainstitute.org/en/research/multimedia/2010/financial-shenanigans-how-to-detect-accounting-gimmicks-and-fraud-in-financial-reports >

Financial Shenanigans — Howard Schilit on Financial Reporting Fraud