Category Archives: Due Diligence

Watchdog or Lapdog?

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Take a guess how many corporate accounting fraud cases the SEC has prosecuted through the first half of this year.

Give up? The answer is 79. And that’s the lowest level in over a decade, according to the Wall Street Journal.

A couple months ago, Craig M. Lewis, who heads the SEC’s risk division, unveiled the SEC’s “new”, pro-active approach – an accounting quality model that helps “assess the degree to which registrants’ financial statements appear anomalous.” The analysis will also look at the wording in financial reports concerning companies’ results and future prospects, particularly those under “management discussion and analysis.”

Sounds like a good idea, but…this is “new”?  I’m a bit surprised no one has thought of this before, but apparently that is the case. The SEC acknowledges that its previous means of uncovering fraud have been primarily passive and market-based (i.e., trading irregularities). Really? Isn’t that akin to always closing the stable door after the horse has bolted? Even my $30 tax software has an algorithm that alerts me to audit risk, based on the numbers in my return, before I file my taxes.

I don’t mean to cast stones. I appreciate that accounting fraud is actually very difficult to find, prove, and successfully prosecute. Gathering evidence requires detailed, often forensic accounting work to see whether a company has failed to report its results according to the then prevailing “accounting rules” (my emphasis). And proving there actually was a violation – most often relative to generally accepted accounting principles (GAAP) – includes an additional layer of difficulty because GAAP itself is often vague and malleable.

Case in point…in a recent accounting fraud prosecution in California involving a high-tech company, the United States Court of Appeals for the Ninth Circuit overturned the conviction of the company’s chief financial officer because the government could not prove that his aggressive accounting in recognizing revenue violated GAAP. On the contrary, the appeals court actually opined that the government’s evidence showed he was “doing his job diligently” by skating right up to the line.

Mary Jo White, the SEC’s new chairwoman, has said that she wants to turn the agency’s attention back to what was once seen as its core mission: policing corporate disclosure to ensure everyone is protected. I wish her luck. It’s a crazy world out there, and there’s not much active oversight. Caveat emptor, my buyside brethren. Good thing I’ve got my trusty copy of Financial Shenanigans handy…

Posted by: Mory Watkins

Due Diligence – How to Avoid Financial “Shenanigans”

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It’s an unfortunate fact of life that there are people out there willing to bend the rules of accounting in order to maintain the illusion of profitability on paper. My posting today discusses how to avoid becoming a victim of accounting gimmicks and financial trickery when evaluating an M&A target.

As I’ve previously discussed, fully understanding a target’s cash flow is the name of the game in corporate M&A. Easier said than done. Components of cash flow come from all areas of the financial statements and encompass the full spectrum of business operations. How then does one go about breaking down and evaluating the veracity of cash flow?

Start by understanding that some of the most important cash flow information comes from the profit and loss statement. Just to state the obvious, if you have a high degree of confidence in a company’s (book) accounting earnings, you’re well ahead of the game in determining the overall truthfulness and reliability of cash flow.

Okay, but how then do you best evaluate whether someone’s cooking the books or playing games with the P&L? Answer: all earnings-related accounting fraud falls into one of just seven categories. Hard to believe, but true. Understand, recognize, and watch out for these seven financial slights-of-hand and you’ll never be fooled.

This nifty idea comes from a book that I consider to be the seminal work on the subject of fraudulent financial statement analysis – Financial Shenanigans (How to Detect Accounting Gimmicks and Fraud in Financial Reports) by Howard Schilit. I’ll come right out and say it: I absolutely love this book. I was first exposed to it back in business school during an early accounting course. Over the course of my career, I’ve come to rely on it as my go-to reference for spotting and diagnosing accounting issues in the companies I buy. The essential elegance of Financial Shenanigans is that it reduces the seemingly limitless ways of fraudulently manipulating accounting earnings into just a couple principles that are easy to remember and use on an every day basis. Moreover, the book illustrates each of the principles with memorable real life corporate vignettes and examples.

Here are the seven types of accounting shenanigans:

  1. Recording revenue too soon
  2. Recording bogus revenue
  3. Boosting income with one-time gains
  4. Shifting current expenses to a later or earlier period
  5. Failing to disclose all liabilities
  6. Shifting current income to a later period
  7. Shifting future expenses into the current period

And these seven shenanigans can be further reduced to just two fundamental tricks: boosting current profits (numbers 1 through 5) and shifting current profits into future periods (numbers 6 and 7).

This book and its classifications of accounting tricks offers a comprehensive framework for evaluating the real quality of a prospective M&A target’s P&L. Are they too aggressive with revenue recognition issues? Have they recorded unusual or one-time gains on exchanges of assets? Have they properly capitalized certain costs? Have they reasonably accrued for expected and contingent liabilities? Have they set up accurate sales reserves for unearned revenues? The list, and the potential for shenanigans, goes on and on and on…

Common sense is and will always be, of course, your best bet for avoiding being taken by an accounting scam. But remember and use the framework proposed by Schilit in Financial Shenanigans during your financial due diligence. In my opinion, there is no better or easier to use system for heading off “creative” accounting issues that could really crater your acquisition.

Posted by: Mory Watkins