7 Ways Companies Fuddle Numbers ('Financial Shenanigans' Book Review)

A few readers asked me if I would review some books dealing with accounting issues. I’m happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.

Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:

1. Recording revenue too soon.
2. Recording bogus revenues.
3. Boosting income with one-time gains.
4. Shifting current expenses to a later period.
5. Failing to record or disclose all liabilities.
6. Shifting current income to a later period.
7. Shifting future expenses to the current period.

There are several common factors at play here.

• Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
• Watch revenue recognition policies closely. It is the largest area of financial misstatement. (1-2)
• Look for assets and liabilities that aren’t on the balance sheet, and avoid companies with hidden liabilities. (5)
• When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow. (6,7)

The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of the accounting troubles that occurred. Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings. I wouldn’t say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet. Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two. To do three, it takes fraud.

Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings. That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not. For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.

The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it. For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies. Financial companies are more complex (they are all accruals — the cash flow statement is not very useful), and can’t easily be analyzed for earnings quality from looking at the financial statements alone.

Full disclosure: I get a pittance from each book sold through the links here.

Comments

[Prudent Man...:]

Those of us that have been in the investment business (50 years & CFA) have complained for decades the inadequacies and, virtual, fraud in financial statements. In my view, there are absolutely no rational reason for any "off balance sheet items". Furthermore, for the SEC, Exchanges, FASB the CPA regulator bodies can let this continue is criminal.

Most investors as well as professionals are unaward that there is very little independence in and independent audit. I had hoped that the Enron fraud would have awaken all of the regulatory bodies, and especially Congress, to this wide ranging problem. I am as much for Free Enterprise and a Libertarian as regards regulation as anyone, but when companies, their lawyers, accountants and managements pervert the free market system they do so at their own risk.

Being from the Old School where investment professionals invested trust, retirement, fiduciary funds, etc. I take a more serious view than those who "bet" on the market. I know independent analysis is hard work but when one holds himself out as an analyst and looks no further than technicals for guidance the investor has a problem.

I just hope that before I retire that the industry I loved reverts to one of trust and the regulatory authorities do their jobs regardless of the heat from politicians and Wall Street.

Basically, the market is rigged against the investor as long as the financial statements are dishones.

2008 Feb 04 01:06 PM

[Prudent Man...:]

The typing areas are results of my fat, arthritic fingers.

2008 Feb 04 01:09 PM

[Prudent Man...:]

That's typing errors!

2008 Feb 04 01:09 PM

[pochovilla:]

What ever happened to EF Hutton "we make money the old fashioned way, we earn it" ?
Today, BIG MONEY through lobbyists can buy legislation with enough loopholes and deceptive language to produce obscene profits based on financial alchemy and "idealogical mathemathics" with the transparency of a black box. Too much politics for the benefit of a few and too much pain for most of the "herd"

2008 Feb 04 03:40 PM