Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition

Senior management at publicly traded companies, no doubt, yearn to report positive news and impressive financial results that will please investors and drive the share price higher. While most companies act ethically and follow prescribed accounting rules when reporting their financial performance, some take advantage of gray areas in the rules (or worse, ignore the rules altogether) in order to portray their financial results in a misleadingly positive way.

Management’s desire to put a positive spin on financial results has been around as long as corporations and investors themselves. Dishonest companies have long used these tricks to prey on unsuspecting investors, and it is unlikely that they will ever cease to do so. As King Solomon observed in the book of Ecclesiastes, “What has been will be again, what has been done will be done again.”

With the never-ending need to please investors, the temptation for management to exaggerate the positive through the use of financial shenanigans will always exist. The lure of accounting gimmickry is particularly strong at companies that are struggling to keep up with their investors’ expectations or their competitors’ performance. And while investors have become more savvy to these gimmicks over the years, dishonest companies continue to find new tricks (and recycle old favorites) to fool investors.

The original 1993 edition of
Financial Shenanigans
introduced readers to the world of corporate chicanery in the form of the seven Earnings Manipulation Shenanigans. The 2002 edition built on the original framework by identifying new techniques and presenting the worst offenders of the 1990s. With the wave of accounting frauds, restatements, and other financial reporting improprieties over the last decade, this third edition identifies many new techniques companies use to mislead investors. This book expands the discussion of Earnings Manipulation Shenanigans, introduces entirely
new categories
of shenanigans (Cash Flow Shenanigans and Key Metrics Shenanigans), and investigates
new industries
(banks and insurance companies) and
new regions
of the world (Europe and Asia) that have been hit with financial frauds.

Structure of the New Edition

This edition goes far deeper into the corporate bag of tricks than the earlier ones did, to give readers a comprehensive look at the various kinds of scams that are prevalent today. We have grouped these financial reporting shenanigans into three categories:

•
Earnings Manipulation

Shenanigans
reveals how companies manipulate the Statement of Income to report higher revenue, inflated profits, or improperly smoothed income.

•
Cash Flow Shenanigans
discusses tricks used by companies to report misleadingly high cash flow measures, including cash flow from operations and free cash flow.

•
Key Metrics Shenanigans
exposes how companies fool investors by showcasing misleading metrics that are being billed as key measures of business performance or economic health.

Postmortem: Lessons Learned from Financial Reporting Failures

We believe that the best training for professionals who are involved in preparing, auditing, or evaluating financial reports is an immersion in case studies to learn lessons from real-world financial reporting failures. Robert J. Sack, former chief accountant of the Division of Enforcement at the U.S. Securities and Exchange Commission (SEC), underscored this point by suggesting that accountants be trained more like medical students, who study cadavers to learn from history, stating:

The objective of a medical autopsy is simply to learn what went wrong, and to make a judgment as to what might have been done differently. The medical profession tries to learn from those failures to expand the list of answers. Unfortunately, the financial reporting process sometimes fails too . . . we must find a way for accountants to use those financial reporting failures in the expansion of our knowledge base.

This book uses such an approach, shining a light on the most shocking frauds in recent times and on other companies that tricked investors by reporting false or misleading financial results. Using illustrations culled from SEC enforcement actions, securities class-action litigation, and forensic accounting research by the Center for Financial Research and Analysis (now a part of RiskMetrics Group), we present the most relevant and instructive anecdotes of companies that have employed financial shenanigans to hide business deterioration. These vignettes offer valuable lessons that teach investors how to identify when a company’s reported results fail to represent economic reality.

Who Will Benefit from Reading This Book

While we regularly refer to investors in addressing readers throughout this book, we believe that many other parties will also benefit from a rigorous lesson in how to study financial reports to find misleading reporting practices. For example, any party with an economic interest (e.g., commercial bankers, bondholders, insurance underwriters, and other credit providers) needs accurate financial reports that portray the underlying economic reality in order to make informed decisions about an organization. In addition, independent auditors must understand the accounting tricks used by management in order to provide a reasonable opinion on the fairness of financial reports. Boards of directors cannot serve as effective fiduciaries for investors without carefully searching for signs of financial shenanigans. Government regulators must understand accounting gimmickry in order to properly enforce their rules. Influential credit rating organizations will fail to protect bondholders and others if their evaluation of an issuer’s financial reports lacks rigor. And corporate executives themselves, who need to monitor both their own performance and that of the competition, would benefit from the lessons in this book.

Universal Message about Financial Shenanigans

While most companies report their results honestly to investors, a significant number use accounting or financial reporting tricks to hide the truth. Since they are likely to be unaware of management’s integrity level, smart investors would do well to maintain a healthy skepticism and perform rigorous due diligence with regard to financial reports. Additionally, financial shenanigans occur in every industry and know no geographic borders. Thus, investors following companies headquartered in China, for example, will benefit as much as those interested in companies based in the United States, Brazil, or any other country. Our universal message is that investors should assume that the urge to exaggerate the positive and hide the negative will never disappear. And where temptation exists, shenanigans often follow.

ACKNOWLEDGMENTS

From Howard

Many wonderful and generous people have been invaluable in nurturing and shaping my career dedicated to studying and teaching others about ethics in financial reporting.

First thank you to my parents, Irving and Ethel Schilit, for giving me the confidence to believe anything was possible with hard work.

To my siblings, Audrey, Keith, and Rob, for your lifelong friendship and support in all my endeavors.

To my wife, Diane, for accompanying me on a very interesting journey, from life as a professor and author to one as a globetrotting businessman.

To my children, Jonathan, Suzanne, and Amy, for laughing at my corny jokes and
not
always laughing at my nerdy accounting-like appearance.

To my inspirational teachers at Queens College, Binghamton University, and the University of Maryland for providing me both the direction and tools to pursue my dreams.

To my students and colleagues at American University, who challenged me intellectually as I first researched and taught about financial shenanigans.

To my former colleagues and friends at the Center for Financial Research and Analysis (CFRA) (particularly, Jeremy Perler, Marc Siegel, Jay Huck, Debbie Meritz, and Yoni Engelhart) for helping me build a very special place.

To my clients, who became my most challenging “students.”

And finally, to the dedicated team at McGraw-Hill (notably Leah Spiro, Joe Berkowitz, Janice Race, and Jennifer Ashkenazy) for their tireless effort to shape and polish the book.

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