Financial Shenanigans | Howard Schilit

Summary of: Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports
By: Howard Schilit

Introduction

In the age of Enron and other high-profile corporate disasters, it’s crucial to understand the red flags that may signal accounting gimmicks and fraud in financial reports. Financial Shenanigans by Howard Schilit provides a comprehensive guide to detecting these unethical practices, organizing the information into 30 techniques and seven categories. By diving into this book’s summary, you will learn how companies inflate or deflate earnings, the motivations behind such manipulations, and the warning signs to watch out for. Additionally, you’ll explore various tricks and techniques used by deceptive managers and accountants, along with tools and resources to help investors assess the veracity of financial statements. Equip yourself with the knowledge to protect your investments and stay ahead of potential fraudulent activities.

Seeing Through Financial Shenanigans

Learn how companies use accounting tricks to manipulate their financial statements and the ways to avoid being duped as an investor.

Gray-suited economists and accountants might not seem to be the best storytellers, but they’ve told some big whoppers on Wall Street, and investors have lost billions as a result. Financial transparency and honesty are critical to the proper functioning of financial markets. Unfortunately, some companies resort to manipulative measures that intentionally distort their reported financial performance and financial condition. These measures, known as financial shenanigans, range from innocent changes in accounting estimates to egregious fraudulent recognition of bogus revenue.

According to the Center for Financial Research and Analysis (CFRA), unscrupulous companies use thirty techniques, grouped into seven categories, to dupe investors. However, all accounting trickery has one common goal – to either inflate or deflate earnings. The former can be achieved by exaggerating current period revenue or underestimating current period expenses. Alternatively, deflating or underestimating earnings is the less intuitive second strategy. This approach works by minimizing current profits to inflate future profits and make the company’s performance appear better than it is.

There are three reasons why companies manipulate financial statements. First, it’s relatively easy to do so as managers typically select the accounting methods their firms will use. While managers with integrity find the best reporting method that accurately reflects their company’s performance, unscrupulous executives see the available choices as opportunities to benefit themselves and their companies. Second, these manipulations often pay off handsomely for corporate managers as bonuses and stock options are often tied to reported financial profiles. Finally, the likelihood of them getting caught is low because quarterly financial statements are unaudited and companies can structure transactions to promote the achievement of their accounting goals.

It’s important to consider the misguided incentives of management while evaluating a company’s reporting validity. A heavy emphasis on bonuses and options tied to financial statements can create temptations for cheating and call into question the accuracy of a firm’s numbers. Ultimately, shenanigans that inflate revenue should be considered more severe than those that affect expenses.

In summary, financial shenanigans are dishonest practices that companies use to manipulate their financial statements, and investors need to be aware of them. By understanding the ways that companies use accounting tricks to camouflage their true financial performance, investors will be better equipped to safeguard their investments and make decisions that are beneficial to their finances.

Early Warning Signs of Financial Report Distortion

In the book, warning signs of financial report distortion are discussed. A company with a weak oversight environment or closely held board, lacking an independent auditor, under competitive pressure, or with executives of dubious character is concerning. Additionally, if a previously high-flying company’s growth slows, or a struggling company has inner turmoil, be wary. Take note of these indicators to detect the distortion of financial reports.

Red Flags in Financial Statements

Learn how to interpret audit opinion letters and identify red flags in compensation structures, audit committees, and financial statements. A qualified opinion and absence of an independent audit committee are two indicators of financial misrepresentation. Companies heavily emphasizing the bottom line may engage in accounting chicanery. Most publicly traded companies are not required to have audit committees, making them vulnerable to financial fraud.

Spotting Accounting Fraud

Discover how companies manipulate financial reports and what you can do to protect your investments.

As an investor, you rely on financial reports to make informed decisions about where to put your money. Unfortunately, some companies use deceptive accounting practices to make their balance sheets look better than they really are. In this informative book, you’ll learn how to spot the warning signs of accounting fraud and protect your investments from harm.

One way companies deceive investors is by recording bogus revenue. This can take many forms, from counting rebates from suppliers as revenue to cleverly recording cash received in lending transactions. Another tactic is to release revenue that was improperly held back, perhaps prior to a merger. Failing to report future liabilities accurately is another ploy used to make a company look more profitable than it really is. By failing to record an obligation or improperly reducing the list of liabilities, a company can owe less money and appear more attractive to investors.

Expense-shifting is another way companies manipulate financial reports. By manipulating current expenses to fall into a later reporting period, a company can make its results appear stronger than they really are. This can include reducing reserves, taking too long to amortize expenses, or changing accounting policies. Income-shifting is a similar tactic, involving shifting current revenue to a later period to make future results appear stronger.

Inflating the amount of a special charge, writing off R&D costs related to an acquisition, and accelerating discretionary expenses are just a few of the other tricks of the trade used to mislead investors. The bottom line is that companies with weak internal controls make it easy for deceptive managers or accountants to pull the wool over investor’s eyes.

If you have reason to believe a company has engaged in accounting fraud, it’s time to protect your investments and flee to safer opportunities. By understanding the warning signs and keeping a watchful eye on financial reports, you can stay ahead of the game and protect your hard-earned money.

Detecting Corporate Fraud

Learn to spot signs of corporate fraud using online databases like Compustat and Factset that screen for malfeasance in financial reporting through analysis of operational and financial data. Gain insights on companies exhibiting sharp declines in cash flow, significant year-to-year sales growth followed by declining or negative growth, large increases in inventory compared to sales, deterioration in gross margins, large jumps in soft assets, and increases in deferred revenue. By studying and comparing footnotes, management discussions, and news releases, you can protect yourself from corporate scams and make more informed investment decisions.

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