Financial Shenanigans

How to detect accounting gimmicks and fraud in financial reports

Book by Howard Schilit

Article and Review by GlobalMacroForex

There are many ways companies can artificially inflate their financial statements to make it look like revenue is higher or earnings are smoother than it actually is.  In his text, Howard Schilit goes over a variety of examples and techniques that companies use, educating investors to make better decisions to short or long a stock.

We’ll cover topics including:

·      Aggressive revenue recognition

·      Revenue loops

·      Investment income as revenue

·      Smoothing earnings

Let’s dig right in…

Aggressive Revenue Recognition

Howard Schilit teaches the reader some of the typical ways that companies artificially boost their revenue.  He points out that revenue is not truly earned until the customer has unconditionally accepted the product, and the product has to be shipped.  He suggests that a frequent source of poor revenue recognition is when “unbilled receivables” grow substantially faster than “billed receivables.”  This means the company is owed larger and larger amounts of money from customers whose revenue it is recognizing in its financial statements, but the company is extending out the bill cycle so much that the customer hasn’t even been billed yet.  Howard Schilit gives the example of Sunbeam (SOC) in November 1996, which was recognizing revenue on a bill-and-hold basis in its 1997 10-K report.

Another questionable practice is when companies record revenue even though the customer isn’t obligated to pay.  In addition, there are substantial risks with seller-provided financing, which is especially common in telecommunications and software companies.  Schilit gives the example of Chicago- based System Software Inc. in 1995, which extended payment terms up to 14 months for its customers, leading to non-performing loans that were not acknowledged.

Revenue Loops

Howard Schilit argues that many companies are engaged in circular transactions that should not be counted as legitimate revenue.  He gives the example of a company selling to an affiliated party, and then that affiliate purchases products back.

He gives a few examples of companies where the revenue stream is going in a loop but a high profile case would be Microsoft and Healtheon (WebMD).  Healtheon paid Microsoft $162 million in license fees over a 5 year term.  In return, Microsoft agreed to pay Healtheon the first $100 million of revenues from advertising on Microsoft’s 3 health care channels.  These transactions should have been netted out.

Investment Income as Revenue

Schilit is disgusted by firms that sell one-time investment capital gains as revenue because it paints a false picture that the core business is improving its margins and growth when in fact this situation will not repeat.  He gives the example of Cineplex Odeon which was experiencing declining revenue in 1989 and whose core business was doing poorly.  Cineplex Odeon sold its production company subsidiary and recorded this one-time only investment gain income as revenue, which masked the actual poor performance.

Howard Schilit points out how this is a huge problem even if the company isn’t selling an entire subsidiary but just assets of the subsidiary.  He writes that the reason most mergers end badly is because it allows companies to boost their profits only in the short-term by selling assets that were undervalued on the purchased company’s balance sheet.  The true cost of these assets was the full merger cost, but by selling these assets and marking any profit above what the firm originally stated was the book value, it may significantly inflate these gains.  

Counting this artificial fire-sale of subsidiaries’ unwanted assets as revenue is egregious, and the tip-off is when companies account for the merger as a “pooling-of-interest transaction.” This means that the combined firm’s books are valued at the original book cost (not the price the buyer paid in the market for the subsidiary).  If those assets were acquired many years ago, it’s very likely the book value was undervalued to begin with.

Howard Schilit gives the example of GE, which used the pooling-of-interest method for Utah International in 1976.  The book value of Utah was $547.8 million and and GE sold those assets for a gain.  However, this surpressed $1.4 billion in value that GE had paid for Utah, thus overstating gains from these sales considerably.

Smoothing Earnings

Howard Schilit points out how the stock market hates volatility in earnings, so corporate management sometimes tries to smooth out earnings by shifting current expenses to a later or earlier period.  He gives the example of Snapple’s accounting change just weeks before their quarter ended, and it took some analysts by surprise.  On June 7, 1994 (3 weeks before the quarter ended) rather than expense advertising as it occurred, Snapple’s management estimated what advertising costs would be for future periods and then shifted those costs to the previously completed first quarter based on these projections.   This change would make these costs avoid being recognized on Snapple’s income statement and instead only modified retained earnings directly.   Two months after the accounting change became known, Snapple’s share price was cut in half, then cut in half again over the period of a few months.

Howard Schilit points out how it’s usually a warning sign when a firm is capitalizing normal operating costs.  This hides the true costs of doing business in the given time period.  An even bigger tip-off is when a firm changes its capitalization policy just before its IPO.  This usually is an attempt to hide costs for a higher IPO market capitalization.

Conclusion

Howard Schilit goes over a variety of common techniques that corporations use to artificially manipulate their financial statements.  These could range from techniques to smooth earnings, get a boost from one-time investment income, or circular revenue flows that aren’t meaningful transactions.  This brief summary article has only gone over a fraction of the many techniques covered in this wonderful book, and even if you are not planning on short-selling stocks, it can help you avoid a bad long.