by Howard Schilit, Jeremy Perler and Yoni Engelhart
Preface: Reflections on My Last 25 Years
ESTABLISHING THE FOUNDATION
1 25 Years of Shenanigans
2 Just Touch Up the X-Rays
EARNINGS MANIPULATION SHENANIGANS
3 Earnings Manipulation Shenanigan No. 1: Recording Revenue Too Soon
4 Earnings Manipulation Shenanigan No. 2: Recording Bogus Revenue
5 Earnings Manipulation Shenanigan No. 3: Boosting Income Using One-Time or Unsustainable
6 Earnings Manipulation Shenanigan No. 4: Shifting Current Expenses to a Later Period
7 Earnings Manipulation Shenanigan No. 5: Employing Other Techniques to Hide Expenses or Losses
8 Earnings Manipulation Shenanigan No. 6: Shifting Current Income to a Later Period
9 Earnings Manipulation Shenanigan No. 7: Shifting Future Expenses to the Current Period
CASH FLOW SHENANIGANS
10 Cash Flow Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section
11 Cash Flow Shenanigan No. 2: Moving Operating Cash Outflows to Other Sections
12 Cash Flow Shenanigan No. 3: Boosting Operating Cash Flow Using Unsustainable Activities
KEY METRIC SHENANIGANS
13 Key Metric Shenanigan No. 1: Showcasing Misleading Metrics That Overstate Performance
14 Key Metric Shenanigan No. 2: Distorting Balance Sheet Metrics to Avoid Showing Deterioration
ACQUISITION ACCOUNTING SHENANIGANS
15 Acquisition Accounting Shenanigan No. 1: Artificially Boosting Revenue and Earnings
16 Acquisition Accounting Shenanigan No. 2: Inflating Reported Cash Flow
17 Acquisition Accounting Shenanigan No. 3: Manipulating Key Metrics
PUTTING IT ALL TOGETHER
18 The Unraveling
19 The Forensic Mindset
Reflections on My Last 25 Years
Having recently reached my sixty-fifth birthday, I began reflecting on my life and the many changes over the last quarter century since writing the first edition of Financial Shenanigans. In short, I feel very blessed. On a personal level, my wife Diane and I love spending time with our three young grandchildren, and are eagerly awaiting our fourth. Professionally, I am enjoying building my second business, a forensic accounting consultancy called Schilit Forensics, with my fantastic partners and coauthors, Jeremy Perler and Yoni Engelhart.
In addition to the research engagements we work on for our clients, we spend a fair amount of time teaching the trade of forensic accounting—to investors, regulators, journalists, and graduate students. After a recent presentation at Stanford’s Graduate School of Business, my partners and I realized that seven long years had passed since publication of the last edition of Financial Shenanigans and that almost 25 years had passed since the first edition. Over that time, more than 100,000 readers have purchased the book around the globe, including translations in Chinese, Japanese, and Korean. We’ve learned a lot in the intervening years, and as such we felt it timely to share with you the latest accounting tricks as well as a more considered account of the most important lessons from the last quarter century. But before turning the pages forward to begin this new edition of Financial Shenanigans, let’s turn back the clock 25 years to share the beginning of my search for “shenanigans” and the unexpected and exciting journey since 1990.
The Beginning—the Early 1990s
As a professor of accounting at American University in Washington, D.C., I began researching the most prominent accounting frauds over the prior 40 years. Many have been documented in Accounting and Auditing Enforcement Releases (AAER) at the U.S. Securities and Exchange Commission (SEC). I began using many of those interesting vignettes in teaching my Intermediate Accounting and Auditing classes.
As I saw that the students found those stories fascinating, I started publishing articles on this subject to share with a larger group. And, of course, the next logical step to reach an even greater audience was to write a book.
Publication of Financial Shenanigans and Early Years as Entrepreneur
Shortly after my forty-first birthday, in early 1993 McGraw-Hill published the first edition of Financial Shenanigans. The book introduced readers to seven broad categories of earnings misrepresentations, identified 20 discrete techniques that management might employ, and sprinkled in many examples of actual companies that had been sanctioned for tricking investors. A few pleasant surprises emerged after the book was released. First, lots of readers reached out to thank me for shedding light on the steps that investors could take to safeguard their wealth. Second, the book had made its way into the ranks of big institutional investors, who sought to hire me to train their analysts on how to spot companies playing accounting games. Eventually they began asking me to examine the companies in their portfolios. Fortunately, on several occasions, I was able to use these techniques to alert them of major problems, and they were very thankful for keeping them out of harm’s way.
Founding the Center for Financial Research & Analysis (CFRA) in 1994
While 1993 was an eventful year with the publication of Financial Shenanigans and my introduction to some influential investors, it would have been impossible to predict the dramatic changes that followed in 1994 as I launched the Center for Financial Research and Analysis (CFRA). Out of the spare room in my house, I began publishing a monthly newsletter highlighting companies I believed to be struggling but that were using accounting tricks to hide the problems. On the fifteenth of each month, I sent reports via overnight mail to our subscribers. (Remember, we were still living in the “dark ages” before the Internet and e-mail.) Thankfully, the service was well received, and over 60 investment firms became subscribers during our first year.
The Transition from Professor to Full-Time Entrepreneur
In 1995 I resigned my tenured teaching position at American University in order to devote myself fully to the growing business. I leased office space and began hiring a team of analysts; CFRA was off to the races. By 1999, we began posting our warnings for clients online and sending out e-mails. (Yay, no more printing and collating reports and sending them via overnight mail.) Our client count grew substantially as we became a major player on Wall Street and around the world, with clients on five continents and offices in Washington, D.C., London, New York, and Boston.
The Later Years Running CFRA and the Sale
During the early 2000s, accounting scandals proliferated, with frauds revealed at Enron, WorldCom, and Tyco. The Governmental Affairs Committee of the U.S. Senate investigating the Enron fraud asked me to testify in February 2002. I was regularly interviewed on TV and in print about the growing usage of accounting tricks.
In April 2002, the second edition of Financial Shenanigans was released, and sales spiked as the stock market was spooked by a seemingly endless parade of companies using accounting tricks. As you might imagine, those were golden times for CFRA. Over 200 new subscribers signed up for our research product in 2002 alone, and by the end of the year we were serving over 500 clients. Investment firms needed more help in monitoring their portfolio companies, and short sellers were on the prowl forthe “next Enron.” During this busy period at CFRA, we hired additional analysts, and fortunately, both Jeremy and Yoni joined the firm and quickly became leaders. Jeremy eventually became the global head of research, and Yoni led our quantitative research team and headed business strategy for the company.
In early 2003, several potential acquirers came knocking, and I decided to sell a majority stake to the Boston-based private equity firm TA Associates. Jeremy and Yoni remained at CFRA for several more years, while I left the day-to-day job of running the business and started my “years in hibernation,” adhering to a long noncompete, which was in effect until late 2010. Yoni left for Harvard Business School in 2008, and upon graduation, he worked for an investment management firm in Boston. Jeremy remained at CFRA until 2011 and then became a forensic accounting specialist at a prominent hedge fund.
The Quiet Years and the Release of the Third Edition of Financial Shenanigans
My retirement years involved a lot of traveling, still giving seminars to investment groups and MBA students. By 2009, I was eager to share some of my new ideas and I approached Jeremy about partnering with me to coauthor a third edition of Financial Shenanigans. We worked very closely on the book during the summer and early fall of 2009, and the book was released the following April. Knowing that my noncompete would end later that year, I became much more active on the speaking circuit, giving seminars and interviews and doing in-depth research on companies. I was very excited about coming out of retirement and building a new business from scratch.
Building a Second Business: Schilit Forensics LLC
By late 2010, my noncompete had ended, sales of the third edition of Financial Shenanigans were brisk, and the media took note of my return from retirement. Barron’s published a piece entitled “A Financial Sleuth Finds a World of Abuse.”
So in 2011 I founded Schilit Forensics LLC on a small scale, taking on just a few clients to dip my toes in the water. I purposefully took it slow, as going from a life of leisure to a full-time commitment seemed daunting. Clients signed three-month agreements for my help in unraveling complicated accountingfocused problems. In contrast to my first business, Schilit Forensics operates as a consultancy engaged to work on custom research projects, not as a subscription service selling a newsletter.
I was really enjoying the nature of the work and close interactions with a small group of wonderfully appreciative clients. In March 2013, Jeremy surprised me with an auspicious phone call. He was still working at the same hedge fund, and while he was very happy there, he was thinking about more entrepreneurial ways to deploy his forensic accounting expertise. It quickly became clear to both of us that we should team up to further build Schilit Forensics. That weekend, he flew to my winter home in Florida, and we formalized our partnership. Just a couple of months later, Jeremy and I approached our close friend and former colleague Yoni about joining us as a third partner. He was enjoying great success at a prestigious investment firm but harbored a strong desire to harness his entrepreneurial spirit. Yoni’s enthusiasm mirrored ours, and he joined Schilit Forensics in July 2013. The three of us are now into our fifth year of working together, and we have developed an impressive team of analysts and diverse roster of clients. Each and every day we read through the fine print of regulatory filings, investor presentations, and other documents to identify signs of business problems before they surface. In doing so we are able to help our clients make better investment decisions.
My partners and I truly love teaching our clients and eager students about spotting companies trying to hide operating problems by using creative accounting games. And, with this same excitement, we are thrilled to impart our quarter-century of learnings and experiences with you, our readers and friends, in this special new edition of Financial Shenanigans. Enjoy reading and feel free to be in touch!