Financial Shenanigans by Howard Schilit
Explained in 3 minutes
About the Author: Howard Schilit is an internationally recognized expert in forensic accounting and financial statement fraud. He is the founder of the Center for Financial Research and Analysis (CFRA), and his work primarily revolves around identifying misleading practices in corporate financial reports.
In "Financial Shenanigans," Howard Schilit unravels the intricate webs that companies might use to deliberately distort their reported financial performance and condition.
These manipulations, commonly referred to as 'shenanigans', are done with various intentions, from making a company look more profitable than it is to strategically positioning it for future benefits.
Why Do Companies Engage in Shenanigans?
To Inflate Current Earnings: By appearing more profitable than they truly are, companies can attract investors, enhance stock prices, or secure loans more easily.
To Deflate Current Earnings: Some companies might intentionally lower their earnings. For instance, if a company is about to be acquired, presenting a less-than-stellar financial picture – taking a 'sick bath' – can make future improvements look impressive, benefiting the new management.
Which Companies are Most Likely to Engage in Shenanigans?
Companies that frequently acquire other businesses.
Companies with poorly-constructed incentive structures.
Recently public companies which may face pressures to demonstrate profitability.
Private companies, due to less public scrutiny.
Those that have changed their business model recently.
Companies facing operational challenges.
Seven Main Financial Shenanigans:
Recording Revenues Too Soon or of Questionable Quality: This involves recognizing revenues before they are truly earned or when the quality of that revenue is uncertain.
Recording Bogus Revenue: Here, companies might record sales that never occurred or aren't likely to materialize.
Boosting Income with One-Time Gains: This could involve selling assets or other one-off events to give the illusion of operational profitability.
Shifting Current Expenses to Later Periods: By deferring expenses, companies can artificially inflate current profit figures.
Failing to Record or Improperly Reducing Liabilities: Understating liabilities can make a company appear financially stronger than it is.
Shifting Current Revenue to a Later Period: By postponing the recording of revenue, a company can present a more consistent growth pattern.
Shifting Future Expenses to the Current Period as a Special Charge: This creates a 'kitchen sink' scenario where all bad news is reported at once, allowing for a clean slate in subsequent periods.
Before Diving into Financial Statements:
Examine the Auditor’s Report, and consider the reputation of the auditing firm.
Scrutinize Footnotes to unearth details that might not be prominent in the main report.
Peruse the President’s Letter for insights from the top management.
Dive into the Management Discussion & Analysis (MD&A) sections in 10K & 10Q reports for a deeper understanding of company operations and performance.
Keep an eye on Form 8K, especially for critical events like changes in auditors.
Tools for Analysis:
Common Size Analysis: This involves both vertical and horizontal examination of an income statement and balance sheet. It's a method to compare items in a relative manner, which can be particularly useful in identifying financial patterns or anomalies.