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“Most companies, if not all, use some kind of tricks to smooth out earnings,” remarked Dr. Howard Schilit, Founder & CEO of Schilit Forensics, who has been called the Sherlock Holmes of Accounting, as he recounted his decades of experiences conducting forensic accounting and fraud investigations for global investors to a rapt audience gathered at the Carey Private Equity and Venture Capital Club speaker event.
Dr. Schilit shared his approach when analyzing companies and the importance of adopting the “forensic mindset,” which boils down to asking the fundamental question of whether financial representations are congruent with the underlying performance of the company. This is in contrast to the question that auditors seek to answer as to whether the company’s accounting practices are in line with generally accepted accounting principles (GAAP). In addition, he incorporates the behavioral study of companies and executives and places emphasis on management’s bias to hide problems. To demonstrate this, Dr. Schilit highlighted some examples where investors could pick up telltale signs of accounting irregularities in a company.
Just weeks before the second quarter earnings release in August 2016, Teri List-Stoll, the Chief Financial Officer (CFO) at Dick’s Sporting Goods, abruptly left the company after just a year in the role. While management turnover is part and parcel of a company’s operations, the sudden departure of the CFO prior to earnings release was highly peculiar and should have been a red flag to investors. Subsequently, a few months after that in May 2017, Dick’s Sporting Goods filed a Form 8-K/A to correct a “computational error” that resulted in a $23.4 million overstatement of Adjusted EBITDA.
Dr. Schilit also shared the case of Ulvac, Inc., a semiconductor-equipment company based in Japan, which changed from straightforward revenue recognition—where revenue is recognized when a product is sold and delivered—to percentage-of-completion accounting in 2010. The latter is part of GAAP but more commonly used by construction firms where parts of a project are completed over time. As a result of this change, the company was able to report that sales only declined 1% instead of a 21% decline in revenue. If one did not read the footnote carefully, they would have easily been misled by the company’s earning results.
In his book Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Dr. Schilit details seven earnings manipulations (EM) that are commonly used by companies:
- Recording Revenue too Soon
- Recording Bogus Revenue
- Boosting Income Using One-Time or Unsustainable Activities
- Shifting Current Expenses to a Later Period
- Employing Other Techniques to Hide Expenses or Losses
- Shifting Current Income to a Later Period
- Shifting Future Expenses to an Earlier Period
The first five EMs help make the company’s current financials look better while the last two EMs help make the future financials look better. In addition, Dr. Schilit shared other shenanigans that focus on cash flow and non-GAAP metrics commonly used by companies. To learn more about ways to detect accounting gimmicks and fraud in financial reports, check out Dr. Schilit’s highly informative book.