Financial Shenanigans: How to Detect Accounting Gimmicks

by: Patient Capital
While the stock prices of a company move up thanks to aggressive accounting policies, you will never hear a board member make a statement regarding the stock price being too high. Furthermore, these aggressive accounting policies may be hard to detect and recognize to begin with. After all, it may be only 1 of 20 positions for an investor. For the company and its managers though, it’s the only thing that they focus on and so we should have the tools necessary to detect these problems as early as possible.

These problems are not only found in hard-to-understand businesses, but also in the easier-to-understand businesses. This includes Waste Management, a trash hauler. Financial Shenanigans starts with examples of accounting problems and their subsequent impact on the stock price. Waste Management peaked at $57 in 1999; however fell to $14 in 2000 less than 1 year later.

Takeaway for investors: If a trash hauler can fool the public, get by the SEC, and keep auditors quiet, you simply have to watch out for yourself with your own analysis
Financial Shenanigans is a 17-chapter book that was written by Howard Schilit. Each chapter is about 15 pages long and so it’s a book that you can easily read even when you don’t have a lot of time.
The book discusses 7 important topics, which are the meat of the book:
  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
The next 2 chapters discuss methods of finding these companies. There are quantitative methods (largest drop in cash flow versus net income, sequential sales decline, receivables growth, etc.) as well as qualitative methods (changes in estimates, customer financing, bill and hold, nonmonetary transactions, etc.) to help detect this. The book also walks readers through a common-size analysis, where balance sheet items are represented next to the income statement as a percentage of net sales or revenues. This can give you clues as to where the problems may exist.
If you aren’t familiar with accounting tricks, here’s a great example from the book:

“Sale of Assets Acquired in a Pooling Transaction

As an example of a business combination accounted for under the pooling method, assume that a company acquires another company by exchanging stock with a market value of $1 million (but a book value of $200,000). The company holds the new business for one year, then sells it for $1.1 million. Clearly, the company’s economic gain is $100,000. Because of a quirk in GAAP, however, the company would report a gain of $900,000…”

The pooling method’s loophole was closed up in 2002 and so it isn’t an issue now, but don’t be fooled and think that there won’t be accounting tricks in the future.

The book goes on to discuss acquisition accounting tricks in lots of detail, revenue recognition problems, and wraps it all up with more history of accounting problems, including Enron.
Financial Shenanigans is a book that will arm you with the tools necessary to help detect these problems early. Howard Schilit has simply done an amazing job at presenting this information in a compelling book that is enjoyable to read. Investors concerned with the possibility of fraud should be reading this book and learning just how the professionals detect fraud.
Disclosure: No position