Howard Schilt on Seven Shenanigans

At the invitation of the Investment Club, Howard Schilit, Founder and President of the Center for Financial Research and Analysis (CFRA), came to speak to the students on campus. As author of Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports, Mr. Schilit is easily one of the most authoritative figures in accounting. A featured article in Business Week referred to him as the “Sherlock Holmes of Accounting //”

If there is one thing that Mr. Schilit is most known for, it is the “seven shenanigans” that he identified in the first edition of his book. Back in 1994, when he first codified the seven shenanigans, he managed to find sixteen different tactics that companies used to achieve these shenanigans. In 2002, when he wrote his second edition replica watches, he managed to find thirty varieties of tricks that companies routinely used to impact their accounting. It seems that Corporate America will always be one step ahead of the regulators.

The seven shenanigans that Mr. Schilit identified are: First, some companies record revenue too soon or record revenues that are of questionable quality. Second, some companies go a step further and record bogus revenue. Third, there have been instances where companies have boosted income with one-time gains. Fourth, sometimes companies shift current period expenses to a later or earlier period. Fifth, some companies fail to record or improperly decrease liabilities. Sixth, it has been known for companies to shift current revenue to a later period. Seventh, somtimes companies shift futures expenses to the current period (as a one-time charge).

As an example, Mr. Schilit mentioned one of his favorite cases, AOL, because it managed to commit two shenanigans in one shot. Back in 1994, Steve Case and his team decided that they no longer wanted to fully expense marketing and advertising costs because those costs were so big they were hurting the bottom line. So, they capitalized those costs and amortized them over twelve months (Shenanigan #4 in the list above). Over the next two years, as investors and analysts alike kept pumping up their stock, AOL decided that there was no harm in extending the amortization period to eighteen months. A few months later, AOL, true to form, decided that twenty four months seemed a better number than eighteen. By 1996, these intangible capitalized marketing costs had ballooned to billions of dollars and made up a significant portion of their book value.

AOL was now in a dilemma since these huge assets were going to hurt their future earnings for a long, long time as they amortized over time. So they did the only smart thing to do: they wrote off all those capitalized marketing costs in one year (Shenanigan 7 in the list above). Lo and behold, future AOL earnings became rosier as the amortization costs disappeared.

Mr. Schilit next challenged the common assumption that cash flows cannot lie. Cash flows, according to him, can lie and do lie a lot. Investors commonly compare the net income of a company to its operating cash flow to ascertain its quality. It is generally believed that net income that is in line with operating cash flow is a healthy one. Companies apparently became wise to that rule of thumb very early on. An often-used-trick: to transfer cash flows between operating and investing cash flows. Tyco, it seems, was a master at that game. When acquiring a company, Tyco accounted for the negative cash flows from purchasing the working capital under investing cash flows while at the same time putting the positive cash flows generated from selling those inventories or receiving those accounts receivable under operating cash flow. Multiply that by the tons of acquisitions that Tyco did and Tyco’s cash flows grew impressively, masking the poor cash flows of its existing businesses.

Another cash flow example Schilit warned students to watch out for was stretching working capital to boost cash flows. Home Depot, under new CEO and ex-GE man, Bob Nardelli, used its size to pay its suppliers later and later. As a result of increasing the number of days payable, Home Depot made its operating cash flows look better. There is no doubt that increasing days payable or reducing days receivable was basically a smart business move. but the problem was that Home Depot had to keep stretching them every quarter to create positive cash flows. If they had let up for a moment, those positive cash flows would have turned negative pretty quickly. So an investor should always try to find normalized or sustainable cash flows for the basis of valuation.

At the end of the talk, Mr. Schilit kindly offered to let students at HBS have free access to the CFRA where they can browse through past reports of shenanigans. The accounting department is currently working to make that available. Hopefully, the talk helped the students protect their investments and, for some of you, to find great shorts!