Schilit's Guide to Accounting Shenanigans
Howard Schilit says his 13-year-old daughter thinks he's a "nerdy guy." But that didn't wash with the analysts and fund managers milling around The Princeton Club in New York on Apr. 2. Many showed up without a $45 ticket, hoping to snag a seat at the accounting guru's sold-out seminar on spotting financial shenanigans. "I don't need the lunch," said one Schilit fan. "I just want to hear what he has to say."
Who doesn't these days? Even before the scandals at Enron and Tyco International put funny money in the spotlight, Schilit was the pied piper of forensic accounting, giddily guiding investors to trouble spots in financial reports. As head of the Center for Financial Research & Analysis, the former accounting professor's work has long been compelling. Now, when Xerox is merely the latest marquee name to be connected to bad bookkeeping, his insights seem critical.
And Schilit knows it. His center already serves 3,700 professionals and 470 institutional clients. He says he signed up twice as many clients in January as he did the year before. His services doesn't come cheap, either -- while he declines to be specific, the cost, priced for institutions, is in the "tens of thousands of dollars."
Schilit himself has become ubiquitous in the media as an authority on what's wrong with corporate accounting. He has also just released an updated version of his 1993 book, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports (published by The McGraw-Hill Companies, parent of BusinessWeek Online).
In fact, the Apr. 2 seminar sponsored by the New York Society of Security Analysts was just one stop on a national tour to promote the revised work. Among the additions: a chapter on Enron entitled "As Bad As It Gets." Schilit didn't spot Enron before it happened -- he says was too busy on other things -- but he has sounded the whistle on accounting debacles at Cendant and other companies.
Despite all the fears about opaque accounting and misleading numbers, Schilit says it's relatively easy to spot problem areas. For him, the first clue is a sudden change in accounting practices. Such shifts may be ploys to cover a deteriorating core business, Schilit says.
FIRST SIGN OF TROUBLE.
Ditto for companies that have a dramatic fluctuation in key indicators such as cash flow, accounts receivable, or assets. In Schilit's experience, the rough percentage of each part of the business pie usually stays stable. When one part of the equation changes, that could be the first sign of trouble -- especially if it produces dramatically improved results. As Schilit puts it: "You don't go from being sick to running the marathon the next day."
He recalls looking at IBM's financial statements a few years ago, searching for signs of a one-time $3.7 billion gain. It was nowhere to be found on the cash-flow statement. Instead, Big Blue had included it as a reduction of selling, general, and administrative expenses. That, Schilit charges, gave investors the impression that IBM had greatly reduced costs through improved efficiencies rather than through a big influx of capital.
Watch out for vague categories that allow companies to fudge the numbers, Schilit advises. Some of his favorites include "prepaid expenses and other current assets," "noncash revenue," or "unbilled receivables." Meanwhile, large write-offs can be legitimate reflections of a plant closure -- or an excuse to lower the value of assets so future performance looks even better. Hidden reserves can also provide a nice secret fund to tap when times turn bad, giving a misleading boost to the bottom line.
In short, investors should be suspicious of anything that has the potential to hide a company's true earnings picture. That means questioning accounting shifts that stem from so-called "changes in strategy," as well as understanding what makes up the different categories on a company's financial statement.
To help guide people through the labyrinth of corporate bookkeeping, Schilit has distilled the most common tricks into seven categories. At the very least, he says, these maneuvers should set off alarm bells.
SCHILIT'S SEVEN SHENANIGANS
Shenanigan No. 1: Recording Revenue Too Soon or of Questionable Quality
a) Recording revenue when future services remain to be provided
b) Recording revenue before shipment or customer's unconditional acceptance
c) Recording revenue although customer is not obligated to pay
d) Selling to an affiliated party
e) Giving customer something of value as a quid pro quo
f) "Grossing-up" revenue
Shenanigan No. 2: Recording Bogus Revenue
a) Recording sales lacking economic substance -- side agreements
b) Recording as revenue cash received from lender
c) Recording as revenue investment income
d) Recording as revenue supplier rebates tied to future required purchases
e) Release revenue improperly "held back" before a merger
Shenanigan No. 3: Boosting Income With One-Time Gains
a) Recording gains selling assets recorded at deflated book value
b) Including investment income or gains as revenue
c) Including investment income as reduction in operating expenses
d) Creating income by reclassification of investment gains
Shenanigan No. 4: Shifting Current Expenses to a Later or Earlier Period
a) Capitalizing normal operating costs, particularly if recently changed from expensing
b) Changing accounting policies and shifting current expenses to an earlier period
c) Amortizing costs too slowly
d) Failing to write-down or write-off impaired assets
e) Releasing asset reserves into income
Shenanigan No. 5: Failing To Record (or Improperly Decreasing) Liabilities
a) Failing to record expenses (and related liabilities) when future obligations remain
b) Reducing liabilities by changing accounting assumptions
c) Releasing questionable liability reserves into income
d) Creating sham rebates
e) Recording revenue when cash is received, yet future obligations remain
Shenanigan No. 6: Shifting Current Revenue to a Later Period
a) Creating reserves and releasing them into income in a later period
b) Improperly holding back revenue just before an acquisition closes
Shenanigan No. 7: Shifting Future Expenses to the Current Period (as a One-Time Charge)
a) Improperly inflating amount included in special charge
b) Improperly writing off in-process R&D costs from acquisition
c) Accelerating discretionary expenses into the current period
By Diane Brady in New York
Edited by Douglas Harbrecht