Management And Accounting Web

Schilit, H. 2002. Financial Shenanigans: How to Detect Accounting Gimmicks &Fraud in Financial Reports. 2nd edition. McGraw Hill.

Brief summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Creative Accounting and Earnings Management Main | Internal Auditing and Internal Control Main

This is a just a sketch of Howard Schilit's very interesting and informative book. Schilit's work should be useful to a very wide audience including accounting, finance, and economics students and faculty, auditors, financial analysts, investors, corporate executives, and anyone else interested in accounting, economics, and finance.

Part One: Establishing the Foundation

Chapter 1: You can fool some of the people all of the time

The Whopper, Part I: Cendant/CUC - Auditors found more than $500 million of bogus operating income.

The Whopper, Part II. Informix - Used a variety of ways to accelerate revenue and to record fictitious revenue, e.g., backdating license sale agreements, entering into side agreements that granted customers refunds and other concessions, recognizing revenue on transactions with resellers that were not credit worthy.

The Whopper, Part III. Waste Management - Moved operating cost like maintenance and repair and interest expense to the balance sheet and then depreciating them over 40 years.

The Whopper, Part IV: Lucent - Used aggressive accounting to boost earnings, e.g., failed to write down impaired assets, capitalized software costs, and changed some pension assumptions.

Chapter 2: Seek and ye shall find

Financial shenanigans defined: Actions that intentionally distort a company's reported financial performance and financial condition.

Seven financial shenanigans:

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.

Chapter 3: Searching for Shenanigans

Sources of information analysts use to find problems:

Press releases - using pro forma earnings excluding some expenses.

SEC filings- Annual Form 10-K, Quarterly Form 10-Q, Form 8-K for special events, Form 144 to register insider purchases and sale of stock.

Documents to search:

Auditor's report - Look for absence of opinion or qualified report.

Proxy statement - Look for litigation, executive compensation, related party transactions.

Footnotes - Look for accounting policies, changes in policies, related party transactions, contingencies or commitments.

Presidents letter - Look for forthrightness, consistency with footnotes.

Form 8-K - Look for disagreements over accounting policies, past performance, quality of management and directors.

Company interviews.

Commercial databases - Compustat and Lexis/Nexis.

Part Two: The seven shenanigans

Chapter 4: Shenanigan No 1: Recording revenue too soon or of questionable quality - "front-end load". Note that revenue should be recorded after the earnings process has been completed and an exchange has occurred.

Six techniques:

Recording revenue when future services remain to be provided.

Recording revenue before shipment or before the customer's unconditional acceptance.

Recording revenue even though the customer is not obligated to pay.

Selling to an affiliated party.

Giving the customer something of value as a quid pro quo.

Grossing up revenue.

Chapter 5: Shenanigan No 2: Recording bogus revenue

Five techniques for creating fictitious revenue:

Recording sales that lack economic substance.

Recording cash received in lending transactions as revenue.

Recording investment income as revenue.

Recording supplier rebates tied to future required purchases as revenue.

Releasing revenue that was improperly held back before a merger.

Chapter 6: Shenanigan No 3: Boosting Income with one-time gains.

Four easy-to-use techniques:

Boosting profits by selling undervalued assets.

Including investment income or gains as part of revenue

Reporting investment income or gains as a reduction in operating expenses

Creating income by reclassification of balance sheet accounts.

Chapter 7: Shenanigan No 4: Shifting current expenses to a later or earlier period

Five techniques to boost profit by excluding expenses:

Capitalizing normal operating costs.

Changing accounting policies and shifting current expenses to an earlier period.

Amortizing costs too slowly.

Failing to write down or write off impaired assets.

Reducing asset reserves.

Chapter 8: Shenanigan No 5. Failing to record or improperly reducing liabilities

Five techniques:

Failing to record expenses and related liabilities when future obligations remain.

Reducing liabilities by changing accounting assumptions.

Releasing questionable reserves into income.

Creating sham rebates.

Recording revenue when cash is received, even though future obligations remain.

Chapter 9: Shenanigan No 6: Shifting current revenue to a later period when the need for them is greater

Two techniques:

Creating reserves and releasing them into income in a later period - income smoothing.

Improperly holding back revenue just before an acquisition closes to benefit the acquirer.

Chapter 10: Shenanigan No 7: Shifting future expenses to the current period as a special charge

Three techniques:

Improperly inflating the amount included in a special charge.

Improperly writing off in-process R&D costs from an acquisition.

Accelerating discretionary expenses into the current period.

Part Three: Techniques for detecting shenanigans

Chapter 11: Database searching

Quantitative screening

Qualitative screening

Chapter 12: Analyzing financial reports

Three major steps:

Create and analyze the common-size balance sheet and statement of operations.

Carefully read the footnotes and other qualitative information.

Compare cash flow from operations and net income.

Appendix: Comprehensive checklist of warning signs

Balance sheet and Statement of Operations (Includes 26 warning signs and problems indicated or suggested)

Cash and equivalents decline relative to total assets - Liquidity issues.

Receivables grow substantially faster than sales - Aggressive revenue recognition.

Receivables grow substantially slower than sales - Reclassified receivables.

Bad debt reserves decline relative to gross receivables - Under reserving and inflating operating income.

Unbilled receivables grow faster than sales or billed receivables - More revenue coming from the percentage of completion method.

Inventory grows substantially faster than sales, cost of sales, or accounts payable - Inventory may be obsolete.

Inventory reserves decline relative to inventory - Under reserving and inflating operating income.

Prepaid expenses shoot up relative to total assets - Improperly capitalizing certain operating expenses.

Other assets rise relative to total assets - Improperly capitalizing certain operating expenses.

Gross plant and equipment increases sharply relative to total assets - Capitalizing maintenance and repair expense.

Gross plant and equipment declines sharply relative to total assets - Failing to invest in new plant and equipment.

Plus 15 more...

Statement of Cash Flows

CFFO materially lags behind net income - Quality of earnings suspect.

Company fails to disclose details of cash flow from operations - Trying to hide the source of the cash problem.

Cash inflows come primarily from asset sales, borrowing, or equity offerings - Weakness

Footnotes, management discussion, proxy, auditor's letter (Includes 26 warning signs and problems indicated or suggested)

Change in accounting principle - Attempt to hide an operating problem.

Change in accounting estimate - Attempt to hide an operating problem.

Change in accounting classification - Attempt to hide an operating problem.

Change in auditor - Sign of risky client

Change in CFO or outside counsel - Sign of risky client.

Investigation by the SEC - Could lead to accounting restatements.

Long terms commitments/contingencies - Potentially large drain on cash reserves.

Current or potential litigation - Potential large drain on cash reserves.

Liberal accounting policies - Financial reports may inflate profits.

Misguided management incentives - May lead to some financial shenanigans to boost profit, share price or bonuses.

Plus 16 more...

Part Four: Problem areas

Chapter 13:  Acquisition accounting tricks

Eight tricks:

Rolling up unprofitable companies.

Shifting losses to a stub period.

Taking big write-offs before and after acquisitions.

Releasing reserves created through big write-offs

Changing the allocation of the purchase price after an acquisition

Recording revenue related to the acquiring company.

Labeling pooling as immaterial.

Giving stock or warrants as an inducement for future purchase commitments.

Chapter 14: Revenue recognition

Four transactions that create tempting opportunities for inflating revenue:

Revenue from long-term construction contracts.

Consignment sales.

Installment sales.

Revenue from leasing assets.

Part Five: Looking back...Looking forward

Chapter 15: History of financial shenanigans

Pre-World War II scams

More recent shenanigans

Shenanigans during the 1990s

Chapter 16: Leading the battle to combat shenanigans

Ten groups leading the battle:

Rule makers - FASB, IASB

Corporate executives and internal auditors

Outside directors

Independent auditors

Regulators

Educators

Watchdog organizations

Financial analysts

Financial media

Lawyers representing investors

How can shenanigans be prevented?

Four methods:

Improving auditor's ability to audit.

Improving training for users of financial reports.

Improving the control environment within organizations.

Restructuring managers incentives.

Chapter 17: As bad as it gets

Discussion of Enron

Appendix tutorial: Understanding the basics of financial statements

Basic accounting principles and journal entries.

The structure and purpose of each major financial statement.

Key aspects in understanding financial statements.

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Note: The third edition of this book was published in 2010. See Schilit, H. and J. Perler. 2010. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd edition. McGraw-Hill Education.

Part three includes four chapters on cash flow shenanigans:

Chapter 10: Shifting financing cash flows to the operating section.

Chapter 11: Shifting normal operating cash flows to the investing section.

Chapter 12: Inflating operating cash flows using acquisitions or disposals.

Chapter 13: Boosting operating cash flows using unsustainable activities.

Part four includes two chapters on key metrics shenanigans:

Chapter 14: Showcasing misleading metrics that overstate performance.

Chapter 15: Distorting balance sheet metrics to avoid showing deterioration.

Related summaries:

Collingwood, H. 2001. The earnings game: Everyone plays, nobody wins. Harvard Business Review (June): 65-74. (Summary).

Dechow, P. M. and D. J. Skinner. 2000. Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons (June): 235-250. (Summary).

Healy, P. M. and J. M. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons (December): 365-383. (Summary).

Healy, P. M. and K. G. Palepu. 2003. How the quest for efficiency corroded the market. Harvard Business Review (July): 76-85. (Summary).

Lev, B. 2004. Sharpening the intangibles edge. Harvard Business Review (June): 109-116. (Summary).

Martin, J. R. Not dated. What is a business valuation? Management And Accounting Web. http://maaw.info/BusinessValuation.htm

Romney, M. B., W. S. Albrecht and D. J. Cherrington. 1980. Red-flagging the white collar criminal. Management Accounting (March): 51-54, 57. (Note and list of Red Flags).

Waddock, S. 2005. Hollow men and women at the helm ... Hollow accounting ethics? Issues in Accounting Education (May): 145-150. (Summary).