Summary of “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports” by Howard M. Schilit, Jeremy Perler (2018)

Summary of

Finance and AccountingCorporate FinanceFinancial ReportingFinancial Analysis

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Introduction
“Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports” is a comprehensive guide aimed at educating investors, analysts, and corporate executives on the various ways companies manipulate financial data to deceive stakeholders. Written by Howard M. Schilit and Jeremy Perler, the book falls under the categories of Corporate Finance, Financial Reporting, and Financial Analysis. The authors present a range of tactics employed in financial misreporting, accompanied by real-world examples and actionable advice on how to detect and counter these malpractices.

Methods of Misreporting
The book is divided into several chapters, each detailing specific methods of financial misreporting. The authors offer a systematic approach to understanding and identifying these tactics.

  1. Earnings Manipulation
  2. Example: Enron’s aggressive revenue recognition and off-balance-sheet financing.

  3. Action: Scrutinize the revenue recognition policies in financial statements and assess for unusual patterns in quarterly earnings.

  4. Manipulating Cash Flow

  5. Example: WorldCom’s recording of operational expenses as capital expenditures to inflate cash flow from operations.

  6. Action: Compare net income and operating cash flow. Significant disparities can indicate potential manipulation of cash flows.

  7. Boosting Revenue

  8. Example: A case in which a software company recognizes revenue upfront for multi-year contracts.

  9. Action: Review the company’s revenue recognition policies and ensure revenue corresponds with actual delivered services or products.

  10. Expense Manipulation

  11. Example: Understating depreciation expense by extending the useful lives of assets, as was the case with Waste Management.

  12. Action: Check the changes in depreciation policies and aggressive assumptions that can lead to lower expenses.

  13. Misleading with Metrics

  14. Example: Non-GAAP measures designed to show a more favorable financial picture, often seen in tech companies.

  15. Action: Reconcile non-GAAP measures with GAAP data and understand the adjustments made between them.

  16. Manipulating Inventory and Cost of Goods Sold (COGS)

  17. Example: Delphi overstated inventory to reduce COGS and inflate profit margins.
  18. Action: Evaluate inventory turnover ratios over time and compare with industry peers.

Concrete Examples and Analysis Techniques
Throughout the book, the authors present meticulous examples and outline specific analytical techniques:

  • Nokia’s Deferred Revenue: By analyzing how Nokia deferred revenue recognition to smooth earnings, the reader can infer the importance of checking deferred revenue accounts for signs of income smoothing.

  • Action: Assess the quality of earnings by examining deferred revenue and other accrual accounts.

  • Sunbeam’s Channel Stuffing: The company accelerated future sales into current periods to inflate revenues.

  • Action: Be alert to sudden revenue increases and corroborate them with operational metrics like order backlog and shipping volumes.

Detection Framework
Schilit and Perler provide a robust framework for detecting financial shenanigans, which encompasses:

  1. Red Flags in Financial Statements
  2. Rapid growth in revenue and accounts receivable.
  3. Discrepancies between earnings and cash flow from operations.

  4. Regular adjustments or restatements of financial statements.

  5. Action: Regularly monitor these red flags as part of your financial analysis routine.

  6. Governance and Auditor Signals

  7. Example: Companies with frequent changes in auditors or key accounting personnel may indicate potential issues.

  8. Action: Investigate the reasons behind auditor changes and the background of new accounting executives.

  9. Industry-Specific Analyses

  10. Real estate companies’ use of non-GAAP measures like Funds From Operations (FFOs).
  11. Example: Hiding expenses in joint ventures or special vehicles.
  12. Action: Adjust non-GAAP metrics to GAAP standards for a clearer picture of financial health.

Preventive Measures and Recommendations
The book not only arms readers with detection tools but also offers preventive strategies:

  • Promote Corporate Ethics: Cultivating a culture that emphasizes ethical financial reporting.

  • Action: Implement and rigorously enforce an ethical code of conduct within your organization.

  • Enhance Audit Committee Functionality: Strengthening the role and expertise of audit committees in supervising financial reporting.

  • Action: Ensure audit committees have members with strong financial expertise and independence from management.

  • Investor Vigilance: Shareholders should not solely rely on financial statements but also consider additional information such as management discussions and industry conditions.

  • Action: Attend company earnings calls and review management discussions for comprehensive insights.

Conclusion
“Financial Shenanigans” equips readers with a thorough understanding of financial reporting abuses and practical insights for detection and prevention. By emphasizing real-world examples and offering concrete steps for each type of financial manipulation, Schilit and Perler make the complex world of forensic accounting accessible to a broad audience.

This five-page summary covers the essence of the book by detailing various manipulative tactics, exemplifying real-world cases, and providing actionable steps for those aiming to understand and mitigate the risk of financial shenanigans. Whether you are an investor seeking to protect your portfolio, a corporate executive striving for transparency, or an analyst driven to uncover the true financial health of a company, this book is an invaluable resource.

Finance and AccountingCorporate FinanceFinancial ReportingFinancial Analysis