Financial Shenanigans (Howard Schilit) 0 comments

The first edition of this book was written in the early 1990s in the aftermath of the junk bond and LBO boom of the 1980s, and the second edition, written in 2001-02, was even more relevant as it was right after the dot-com boom when all the skeletons in the closet sprang out.

The author is a former academic and the founder-President of the Center for Financial Research and Analysis (CFRA), an independent financial research organisation in the US. It is regrettable that Singapore does not have many of such independent equities research firms that can claim to have little conflicts of interest in their work. In line with the main specialty of CFRA, this book is all about the various manners in which financial statements can be manipulated by companies to portray things the way that they not really are.

A warning about the book: it requires basic accounting knowledge at least (and in fact, probably a higher level than that), given that it straightaway delves into specifics on the balance sheet and income statement. But more seasoned fundamental-inclined investors will appreciate the level of detail entered into and clarity of explanation shown by the author.

The author starts by describing several examples of financial chicanery, where companies have stretched accounting principles and often distorted the spirit of them entirely. He explains the three major reasons for such manipulation by the company executives: (1)it pays to do it (their remuneration is tied to performance), (2)it is easy to do it (given interpretation of GAAP, Generally Accepted Accounting Principles, are flexible; made even easier if internal controls are lax), and (3)they seldom get caught (eg. quarterly statements are not audited).

Financial shenanigans are actions that intentionally distort a company's reported financial performance (income statement cash flow) and financial condition (balance sheet). Half of the book is spent on describing the seven main shenanigans as follows:
(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 reducing liabilities
(6)Shifting current revenue to a later period
(7)Shifting future expenses to the current period as a special charge

Basically, the idea behind these financial shenanigans is to overstate revenue and manipulate income through discrete timing of expenses, for example through creation of inventory reserves and acquisition reserves that can be written back to the income statement progressively over the next few years and hence padding operational income. It defies the basic spirit of accounting --- to match billable revenue earned during a period with the exact corresponding expenses incurred --- but yet is subject to such borderline interpretation or managerial cover-up that auditors often miss them. In particular, the author advises particular caution on merger & acquisition accounting and has one chapter entirely on it, due to its abuse by managers over the years through understatement of assets and overstatement of goodwill, taking big acquisition writeoffs that can subsequently be written back, etc (also see "Mergers and Acquisitions").

The rest of the book covers how to spot such financial shenanigans, and there is plenty useful stuff to be learnt here. The author lists down what to look out for in each part of the financial report; based on his experience, he advises that the oft-neglected parts are the most important (because management knows they are neglected and thus choose to put the devilish details there)-- things like the auditor's statement, proxy statement (litigation, related-party transactions), footnotes, insider transactions.

The author classifies two main methods of checking for financial shenanigans: quantitative and qualitative. Quantitative refers to stock-screening based on certain valuation parameters that appear abnormal: high and disproportionate inventory rises, sharply rising or declining gross margins, sequential decline in sales etc. There is a most useful set of methods introduced that I think every serious investor should implement when doing their stock research: common-size analysis where income statement and balance sheet items are expressed in percentage composition or percentage change within a time period to clearly reveal structural changes in asset structure (vertical analysis) or alarming year-on-year changes in an asset/expense (horizontal analysis). Qualitative screening is rather interesting: it refers to screening financial reports for certain words that spell trouble: examples include "changes in accounting policies", "changes in account classification", "insider stock sales", "unbilled receivables", "related-party transactions" etc.

Basically, it is quite impossible for one to analyse a financial report based on the entire checklist that the good author has drawn up, of course. However, he should at least be aware of all the possible ways that management can manipulate the accounting statements, and hence learn to take them with a fair amount of skepticism. That, in essence, is what the author hopes to put across to the reader --that a system (accounting) devised by humans could be circumvented in spirit by other unscrupulous humans.