Wednesday, June 30, 2010

Schilit and Perler, Financial Shenanigans

With Jeff Skilling (and now Richard Scrushy) back in the news it seems fitting to revisit the world of “creative” accounting. In fact, the third edition of Financial Shenanigans by Howard M. Schilit and Jeremy Perler (McGraw-Hill, 2010) starts with Enron. What were some telltale signs that Enron was engaged in a massive accounting fraud? The simplest was that Enron’s revenue growth (from under $10 billion to over $100 billion in five years) defied reality. Moreover, Enron’s profits never kept pace with its sales. For instance, while sales grew by more than 150% in 2000, profits increased by less than 10%. In the five-year period that witnessed the tenfold growth in sales, profits didn’t even double.

The authors outline a series of financial shenanigans that Enron engaged in, from recording revenue too soon and recording bogus revenue to cash flow antics—e.g., shifting financing cash inflows to the operating section and shifting normal operating cash outflows to the investing section. And we all remember the so-called key metrics shenanigans—showcasing misleading metrics that overstate performance and distorting balance sheet metrics to avoid showing deterioration. (p. 8)

In introducing some warning signs that even those unskilled in deciphering balance sheets can heed, the authors quote from a Warren Buffett annual letter. In it Buffett describes a conversation between a patient, whose X rays showed him to be seriously ill, and his doctor: “I can’t afford the operation, but would you accept a small payment to touch up the X rays?” Buffett continued, “In the long run . . . trouble awaits managements that paper over operating problems with accounting maneuvers. Eventually, managements of this kind achieve the same result as the seriously-ill patient.” (p. 23)

One way that companies fudge their books is by tinkering with time. It’s common practice for salesmen to push hard, often offering incentives to customers so they can meet or beat their quarterly quotas. But if this legal strategy doesn’t work, why not just extend the quarter? It seems that, among its many other sins, Computer Associates “regularly stretched out the last month of the quarter to as much as 35 days.” (p. 48) And Computer Associates was not alone in this practice. Both Sunbeam and Peregrine were known to keep their books open well past the official end of the quarter. At Peregrine this practice became something of a joke, with late transactions described as having been completed on “the thirty-seventh of December.” (p. 50)

Then there are those companies who book revenue prematurely, sometimes very prematurely. Krispy Kreme profited by selling donut-making equipment to its franchisees. But in 2003 the company entered the world of make-believe by “pretending to ship equipment to franchisees. It actually shipped the equipment out, but to company-owned trailers to which the franchisees had no access. Krispy Kreme still recorded the revenue, even though the franchisees had failed to take possession of the machines shipped.” (p. 63)

AIG was involved in bogus transactions long before the most recent financial crisis. They marketed a product known as finite insurance, sometimes used to paper over companies’ earnings shortfalls. In 1998 Brightpoint was coming up short by some $15 million in its December quarter. AIG had a “perfect world” solution. It created a $15 million retroactive insurance policy to cover Brightpoint’s unreported losses, which meant that Brightpoint could immediately book the $15 million as income (“insurance recovery”) and report in line with the guidance it had provided Wall Street at the beginning of the quarter. In turn, it paid “insurance premiums” to AIG over the next three years. As the authors note, “Economic sense dictates that this transaction was not an insurance contract because no real risk had been transferred. Indeed, the transaction was nothing more than a financing agreement.” (p. 77)

Financial Shenanigans is a fascinating book. In more than 300 pages it not only explains accounting ruses, it illustrates them with real-life examples. It shows how companies, even ostensibly reputable ones, try to hide their problems and how the savvy investor can ferret them out. It’s an ideal handbook for short sellers.

1 comment:

  1. Mischaracterization of the underlying economic environment by conflating “risk” and “uncertainty” results in category error. This a semantic or ontological error by which a property is ascribed to a thing that could not possibly have that property.

    In a world of global financial innovation it is “uncertainty” not “risk” that should be the focus of governance.
    • If there is innovation, there is complexity.
    • If there is complexity, there is uncertainty.
    Unfortunately, capital market compliance personnel: accountants, attorneys, and economist tend to be deterministically schooled. They are ill-trained for indeterminate underlying investment environment and ill-positioned two-dimensional metrics in a three-dimensional world. Regulators are using maps when they should be using GPS.

    The dictionary defines “risk” as the chance of loss. Risk is probabilistic and thus presents foreseeable consequences, whereas “uncertainty” is indeterminate and is characterized by unforeseeable consequences (see:

    “Uncertainty” is not a linear extension of a “riskier form of risk,” but a separate and distinct concept. Conflating “risk” with “uncertainty” produces the unintended consequences of contingent and unforeseeable liabilities for market practitioners as they are held to a probabilistic standard when they are dealing with indeterminate circumstances. The mere fact that Enron was extending the deterministically driven cutoff date was a sign that the underlying economic environment was indeterminate.

    You cannot govern uncertainty with the same metrics and mind-set that you use to govern risk. Forget Enron fraud—scienter is a tougher standard to prove. Most would agree that Citi’s failed financial supermarket concept was flawed. If you cannot cross-sell, you cannot cross regulate—non-correlative information problem or category error. For effective and efficient governance, you need to segment regulation into predictable, probabilistic, and uncertain regimes that correlate with the randomness of the underlying economic environment.

    Stephen A. Boyko

    Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” and a series of articles on capital market governance.

    Book Review: Brenda Jubin, Ph.D Thursday, October 8, 2009