A Bloomberg Markets Odd Lots podcast last month featured an interview with Howard Schilit, forensic accounting expert and author of “Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud in Financial Reports.” Schilit discussed ways companies can disguise earnings, how accounting rules have lagged behind the times, and how investors can spot red flags.

Here are some highlights from the interview:

  • Schilit describes accounting within the context of behavioral science, explaining that companies have to “tell a story so investors are impressed.” The investor’s line of defense, he says, comes in the form of the auditors who dictate what the company can and cannot do with their numbers. [Schilit cites the example of Volkswagen which, ten years ago, elected to change the depreciable life of its plant & equipment from 10 to 15 years, thereby significantly reducing its expenses.]
  • A decade ago, Schilit says, there were greater restrictions and potential jail time for accounting “shenanigans”. “Most big stories,” he said, “were mucking around with sales and GAAP (generally accepted accounting principles)-based numbers.” Today, he says, the situation is more dangerous because companies have moved from using GAAP-based to non-GAAP based results. He cites the example of EBITDA (earnings before interest, taxes, depreciation and amortization) which he describes as a “non-GAAP construct that is easily manipulatable.”  It is now easier, he says, for management to “play games and still not be violating rules of law.”
  • If GAAP numbers are available for investors to review, then how can they be fooled? Schilit uses the example of pharmaceutical company Valeant to explain that investors tend to “fall in love” with a company or what they see as an exciting business model and become blinded.
  • Since the accounting rules were written so long ago, Schilit asserts, today’s information-based economy complicates matters further. “It’s harder for an auditor to push back if there are no specific rules” pertaining to treatment of assets, revenue, etc.
  • Regarding the president’s recent suggestion to change corporate earnings reporting requirements from quarterly to every six months, Schilit says “it would be a terrible move.” While he contends that companies should be thinking about their businesses on a long-term basis and quarterly reporting runs counter to such an approach, he says investors need to have current information.  “The problem is not that companies are reporting four times a year,” Schilit argues. “The problem is the circus around the earnings calls and the Wall Street consensus” figures. He believes that the 3-month reporting requirement should remain, but that companies should not be allowed to use any non-GAAP metrics. He also suggested eliminating earnings calls.
  • One way for investors to spot red flags, Schilit says, is to keep an eye out for new metrics being featured in press releases and other media reporting. If management starts shining a light on a metric it has never discussed before, he says, it might inadvertently be “leading you to the shenanigans.”

For more trends, visit the Portfolio Construction Channel

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