Odd Lots - A Forensic Accounting Expert Explains How Companies Trick Investors

Episode Date: September 10, 2018

Companies have all kinds of discretion in how they recognize revenue and costs. Some of this is legit. Some of this is fraud. On this week's episode of the Odd Lots podcast, we speak with Howard Schilit, an expert in forensic accounting and the author of “Financial Shenanigans: How To Detect Accounting Gimmicks & Fraud in Financial Reports.”See omnystudio.com/listener for privacy information.

The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Rafini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off.

And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television.

Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, and wherever you get your podcasts. And welcome to another episode of the Oddlots podcast. I'm Tracy Allaway.

And I'm Joe Wisenthal. Joe, what is my all-time favorite topic? I know the answer to this. Fraud. Financial fraud. Yeah. Yeah, you're actually right. I'm actually right, as if it's such a surprise that I would get this question. You asked it so definitively, and we've been doing this for a while. Well, thank you.

Thank you for giving me that credit. I only say that because you didn't know my age in that one episode that we did. So thank you for even if you don't know how old I am, you know what I'm interested in and that means a lot. So yes, I am definitely interested in financial fraud. And one of the most interesting aspects of financial fraud in my humble opinion is usually the accounting, let's say, chicanery that goes along with it. Right, because business happens and people buy stuff and sell stuff, but between the time something happens and the time when it actually gets recorded on paper and recognized as sales and cash coming in and out of the business, a lot can happen. Yeah, that's right. And if you think about it, finance, Wall Street, it's all a numbers game, right? And the way that we think about those numbers is, well, basically dictated. by something that we like to call accounting, and there are various accounting rules

that govern how people are supposed to report their earnings and the wider goings on of their businesses. But of course, there's also a lot of leeway in the way that you can come up with those numbers. And even if you're not committing outright fraud, you can definitely utilize disingenuous accounting practices, practices that can either deliberately mislead your investors, or maybe unintentionally, but usually deliberately. You know, it's funny. I'm really excited about this topic as well.

He was just reading the autobiography of the Nike CEO, Phil Knight, and he was previously an accountant, and he talked about that it was through being an accountant that he really learned what made businesses fail or thrive. And it got me thinking that whereas we often think of something happening in reality and then the accounting being this sort of reflection of reality, that maybe the accounting is the reality and that there's nothing more real in a sense

than the process of writing down a number. So I'm very excited that we're talking about accounting. And so why don't you tell us what we're going to be talking about today specifically? Yeah, wow. Okay, so we're definitely going to go deep in this episode. Our guest today is actually someone who's come through via listener suggestion. So thank you to Harvard Winters on Twitter for suggesting him. Our guest for today is Howard Schillet. He is the founder and CEO of Schillet Forensics. He's also the author of a book

called Financial Shenanigans. We're going to be talking with him about exactly what those accounting shenanigans might be and also about the importance of accounting in general, to your point show. Howard, thank you so much for coming on. Tracy, my pleasure. So I guess this is a general starting point. Do you think accounting gets enough credence when it comes to the way we think about business or the wider economy? So let me talk about accounting in the way it fits into investors' process of figuring out which companies to own and which companies not to own. Think of it more as a behavioral science.

And I'll sort of diagram the players and what their objectives are and who's winning and who's not winning. So as we know, every public company four times a year has to present themselves to the investment community, to the constituents who have to make decisions. and the mindset of the public companies, the senior executives, is to tell the story in such a way that the investors are very impressed. So we could say it's not providing the information in a balanced fashion. It's always trying to have a very positive spin. There are rules. There are generally accepted accounting rules, GAAP, called GAP,

But beyond that, companies have a whole second universe of information they provide, which is non-gat metrics. Okay, the other constituent are the consumers, the readers. So those are the people who are part of my universe and trying to help them figure out whether the representations from the company is consistent, congruent with the underlying reality, as Joe was describing before, or whether it is information that is demonstrably different and misleading. So think of the accounting and how that fits in as how management can tell the story. So it became a fascinating subject to me. I was an accounting professor, but it became a fascinating subject to me when I began to understand it, not in some mechanical way of just putting numbers on paper,

but it's how management can choose to tell the story to advance what their interest is. Let's get into different ways of telling the same story, because in theory, it should be simple. If you're a car company, you're like, okay, well, we sold 30,000 cars this quarter, and our metals costs were this much. And our labor costs were this much, and we take the revenue and subtract the cost, and their dear shareholder was your profit for the quarter. I know it's not that simple, but where in the process does the discretion of the accountants

or management start to enter the picture? Okay. Wonderful question. So the information gets recorded typically when there's a transaction. So let's use an example of somebody who is selling cars. It's your Volkswagen and you are in the fourth quarter of 2017 and you know the Wall Street community has a consensus estimate of what your revenue and what your sales will be. You get a call from a customer, Volkswagen, say a dealer, where they say the cars that you were going to be shipping out to us, December 20th, why don't we hold off on that until because our business is slow and we don't have

any place for it. Okay, so here's the pressure that Volkswagen has. The numbers that everybody's expecting include that delivery. Sales get recorded when you ship them out. So the decision Volkswagen has to make it. The point is, what do we do? The customer says don't ship the goods. do they ship them to another location?

So in order to trick the auditors, remember the line of defense for the investors is the auditor can say, no company, you can't do this. So in order to solve the problem that Volkswagen has, they'll miss their numbers if the sales are short. So do they act honestly and announce to their, put out a press release to the investors and basically say this is what happened. The sales of, say, $50 million that we expected it in the fourth quarter, it's not going to come in until the first quarter of next year because of this episode where the customer called out. That's the honest way to do it. Or do they come up with an artificial way of making the numbers? So that's when it gets really interesting. So the accounting itself is simply solving a business problem.

So that was what they would have to do if the sales are a problem. Well, let's take something which actually happened about 10 or so years ago at Volkswagen where they change their depreciable life of their planted equipment. So as you know, most companies have certain assets that depreciate and, that is reflected as an expense, Volkswagen was depreciating their planted equipment over 10 years, a short period. So they seem very conservative. And then you read the footnote in the next period,

and you see a slight change in wording where the depreciation, which had been over a 10-year period, the wording was it's now 10 to 15 years. Very subtle. What's going on there? The company was struggling. See, we figured it out because you don't just whimsically change your accounting policies if you don't need to. And by stretching out their depreciable life by 50%, they obviously lowered their expenses.

And they were able to meet the numbers. So the accounting, I gave one example on the revenue side, one example on the expense side. but each one of these situations is there's a problem. The company has a choice of do we disclose what's really going on to the investors or do we try to cover it up? Right. So, Howard, you just described two examples. And, of course, there are various ways to do these cover-ups as you describe them. I'm wondering, given that you've been an accounting professional for a long time, have you noticed that the common

sort of accounting fludges or cover-ups have changed over the years? Is there one that used to be quite pervasive or popular, and now it's maybe something else? Yeah, very, very interesting question. So the book that I described, financial shenanigans, the 25th anniversary edition, which is published. So I could sort of give you a retrospective. So the first edition came out in 1993 while I was still a professor. So in terms of the tricks, And Tracy, let me get to that. So in the earlier years, we'll say up until Sarbanes-Oxley came out a little bit over a decade ago, which placed greater restrictions and the possibility of jail time for the CEO and CFO if they sign off on financial statements that are not in compliance with the rules. back, I'd say, until roughly a little more than a decade ago, most of the big stories were mucking around with sales and expenses, things that are part of what we call the gap-based numbers.

Okay. After that, and this, the takeaway should be things are more dangerous today. and the so the accounting trickery has largely migrated from the gap-based results to what's called non-gap. That is things that start with Ibida. So if there's one takeaway your listeners should embrace, that is if you could ignore Ibidae, because Ibidaa is simply a non-gaping. construct, which is easily manipulable. So I'd say that's, again, things are, are in my judgment, moving in a very bad direction because it's so much easier for management to play games and still not be violating the rules or the laws because there are no rules. you on this point because it has become a really hot topic in recent years. People talk about the gap between basically adjusted earnings, what you're talking about, EBITDA, versus the gap numbers, these sort of official legally required numbers. And we've seen some pretty, let's say, strong examples of adjusted earnings recently. The one that springs to mind has to be we work when they have something called community adjusted EBITDA, which seemed to be.

EBITDA minus the cost of sales, which just seemed really, really weird to me. Yeah. So how much of a problem is this? And why did adjusted earnings become so pervasive when it comes to business reporting? So the question of why, I think it's the executive community have just gotten more clever. and the investor community have not really kept up with sort of what they need to do. So just to sort of put this in the context of the last 25 years, as I told you, that's when the first book came out. So over that period, I've also been working, helping institutional investors.

And what's become clear is that the category, of tricks identifying keeps growing. Or another way of saying it, management has continued to evolve in terms of their creativity of tricking investors. I try to help the good guys and say, these are the tricks I've learned. Now start stepping up your game to protect yourself. But what's fallen pretty far behind is once management, figured out that IBEDA and other non-GAP derivative measures of that.

And your example of WeWork fits exactly into that category. You start out with the gap-based earnings and you decide as management, we're going to tell investors to ignore this expense and that expense. Yeah, with WeWorks. They're basically saying the only expense that investors should pay attention to is the cost of goods sold and all of these selling and marketing and R&D to ignore. It's ridiculous. I'm Francine Lacqua, an award-winning journalist, and I've got a new podcast, leaders with Francine Laquois from Bloomberg Podcasts.

I've interviewed everyone from Heads of State to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is all. Always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts.

I have so many questions listening to this. But one of them is, and I'm not like a hardcore, efficient markets hypothesis kind of guy, but I generally think markets are somewhat efficient. If they put out the gap numbers, I mean, I know they say, here's the non-gap numbers with our preferred adjustments that they'd like you to look at. But the gap numbers are all there. So pre-adjustments and just by the book accounting in theory. Since they're right there, why, how could investors really get fooled in mass?

Like I could see some people not looking, but for serious investors, isn't the data there for them? Okay. So let me use one company as a case study to sort of help us, you know, get our hands around understanding. So Valiant was the big story of the last decade. Right. It was a company that went from a $2 billion market value to $90 billion, which was bigger than Enron, back down to $3 billion. It was 96% of its value. Over, we'll say, a five-year period from roughly 2012, 13 until 16, their gap-based results, cumulatively.

Again, this is a company that went up, how many times you would have assumed that their gap-based results would have been pretty. amazing. Their cumulative gap-based earnings during that period was around negative $3 billion. It was there. It was audited. It was, you know, you look at every 10K and you add up the total bottom line and that was it. The alternative universe that the company was putting out was something called cash earnings. You do the exact same drill. You add up for that five-year period, the total each year, it was positive $9 billion. It was so easy to see that if it's essentially measuring the same underlying health of the business, one was gap-based earnings, the other was this surrogate measure they call cash earnings. So how does it make sense if your non-gap metric is shooting to the stars

and the audited gap-based measure is plummeting deep into the sea. So, Joe, you know, the question is, how did people not see this? It was there, but for some reason, the love affair that they had with the company, they kept pointing to a metric that didn't make any sense. With Valiant, there was also an exciting story. People thought they had found some new model, right? of buying up drugs, using debt and slashing the R&D expenses, and people thought this could be the new model of how pharma works.

So, yes, it's true that the non-gap numbers, A, accelerated, and B, there was a huge gap between non-gap and gap, but people also fell in love with what they thought was in. Let me sort of jump in and say, that's the problem where they fell in love with a story. Right. Right. You use the term platform company. Right. people melt.

The term platform company is sort of the current iteration of what in the 60s was called a conglomerate, in the 90s was called a roll-up. So you're absolutely right for people who fall in love with stories and don't actually look at the numbers. That's exactly what was happening in that situation. They fell in love with the story and they saw the $2.9 billion or whatever that losses. as I was describing, but they said, but they're cash earnings and they built a better mousetrap, right? Instead of being like Merck or the other big pharmaceuticals where they spend so much an R&D and most of it doesn't result in successful products, Valian figured out a better model. And I looked at that and said, you really think that people at Pfizer and Merck are so stupid

that they didn't know that there was an alternative, buy versus make. Why did they figure something out, which seems so obvious, but it wasn't. Because when you are a drug company, you know the cost of being in that business is you have to spend a lot of money in the drug discovery. And so if you want to derisks yourself, which is Valiant's pitch, you buy Bosch and Lum, you buy other companies for $40, $50 billion. dollars, well, nobody's giving it to you for free. So you are buying the... Yeah, so the notion was, I think, completely misguided. Right. And in the case of Valiant, from what I remember, and to Joe's point, the story was

almost embedded in the numbers, right? Because a big part of what they were doing were ad backs based on the acquisitions that they were making. So sort of immediately embedding that growth story into their numbers. Right. One of the things I want to press you on, just on that note, is, you know, we talked about how Valiant would basically borrow from capital markets at a very cheap rate or a relatively cheap rate predicated on this notion that it was this huge growth company that was going to monetize any second.

Is there a sort of feedback loop between capital markets and market valuations that tends to be aided by loose accounting? So if you were trying to put together a portfolio of what would be interesting shorts, you probably would want to get a list of the companies that are the biggest customers of the investment banks. That is the ones that, true, it's, you know, Enron back in 99, 2000 was probably the most profitable client for the investment banks. Because if you think of it, companies that are really generating substantial cash flow,

they're funding most of their operations and their expansion through their cash flow. Whereas companies that have a dearth of cash flow coming from their business, they always have their handout. They always need more and more. So sort of this virtuous loop where the ones that are in need of cash, right, the ones who keep coming back to the capital markets are probably not the strongest players. In fact, just the opposite. And when you think about the ones that are pitched the most vociferously by the analyst of the firm, doesn't it make sense that they're going to be pitching the companies for investors to buy of the ones that they have the most merchandise to sell? Think of the investment bank, no different than merchants.

They are. The firms would deny that they're, right, they would say, oh, there's definitely a wall between. You know, but I'm saying just look at the reality of the business. Whatever the constructs are inside is not the point. It's if your job is to raise a large amount of capital for XYZ company, what does that mean? not just put together the, you know, consortium of who's going to be buying it, but you have to sell a whole bunch of shares, right? So your client is the corporate, American Express.

You don't pick any company. And you need to sell that. So I'm saying the sort of the analogy to a merchant is you have a whole bunch of inventory that you have to move. And in order to move the inventory, you have to get people excited about it. And you get people excited by saying we've upped our opinion on this company from, you know, neutral to buy from buy to strong buy. So again, I don't care what kind of, you know, structural walls. There are Chinese, French, Italian walls, whatever you're going to call them.

The companies that generate the great fees from investment banking are the ones that I would put on the list of be careful. You mentioned in Valiant. And that brings me back to another question I had, which is how much have the fudges or the cover-ups changed since you first wrote the book, thanks to the growth of intellectual property-based business models. So, you know, it's one thing if you're selling cars and you record the sale when the car leaves the factory gate versus companies that don't really have much factories and instead maybe they have a drug or some sort of really strong brand or they sell ads or something. like that, how much has that changed the type of fudges that you've seen? Yes, that's actually a very interesting question in that the accounting rules were

written many, many years ago before the information-based society. So think of back in the 40s and 50s and the railroads and sort of, okay, so that's the time the accounting rules were written. Now we're in a world where you have, you know, a coupon coming on and, you know, just different type of models where there are no specific thou shalt nots in the accounting rules for type of transactions that were not envisioned back when the accounting rules were written. So think about the opportunity set for companies to play games where in the accounting rule book there is no thou shalt not do this, right?

So you then, as management, come up with a funky way of recording revenue. You then have it reviewed by your auditor. And the auditor, it's hard for the auditor to push back and say, well, this is a violation of the rule. If there's nothing specific in any rule book that addresses that type of transaction, so in terms of what makes the challenge is so great, is that there's a lot of interpretation of whether it's gap compliant or whether it's non-gap compliant. Right. Howard, I would love to press you more on the role of the auditors and also the accounting standards bodies. But I'm aware that if we start going down that road, we'll probably go on for an hour.

And there's something slightly more immediate that I wanted to ask you, which is lately there's been some discussion prompted by a tweet from Donald Trump, where he's sort of vaguely mused about maybe changing the quarterly reporting period to maybe a sort of bi-annual one. So companies reporting earnings every six months instead of every three months as it is currently. As an accountant, how do you feel about that? And would it ultimately be a good or a bad thing for investors? Okay. So short answer, it would be a terrible move.

But let me give a little more flavor to that. So the way companies should be thinking about their business is long term. So having pressure to every quarter on a very short basis report to the investors puts a lot of pressure on short-term thinking versus long-term. So there's a problem, and I'll sort of tell you what I think the solution is, but it's not what Donald Trump had. suggested. So again, so long-term of thinking and managing business, good, short-term gaming toward whatever

bad. However, it is very important that investors have current information in order to make decisions. So if you stretch out what's now every three months, every six months, the

void, the information void is going to be filled by folks who are trying to drive the stock price. So there are always unintended consequences. So the problem is not that companies are reporting four times a year. I think the problem is the circus around the earnings and, you know, sort of the earnings call and the Wall Street consensus estimate.

I think if I were going to change the events, I would. I would say absolutely you keep the requirement that companies file with the SEC every three months in accordance with GAAP and not allowed to say anything about non-GAP metrics. Go back to when the rules were written. The rules were written for a reason that all these numbers, certainly the annual numbers are audited, but even the quarterly, those are going to be reviewed by the outside. site auditor. So again, the best solution is continue to have the quarterly filings with the SEC, eliminate non-gap in any document, and eliminate the earnings calls. So give people the information, but then don't make a big circus of explaining it and massaging it. I want to sort of make this

very useful to our listeners. So earning season is perpetually right around the corner. So short of reading your book, which I'm actually going to go out and buy your book now because I'm very interested in this and want to learn more. But what is the sort of basic guide you would give to investors to spot red flags? I touched on the point about behavioral analysis. When you're reading any document, you just want to be alert to see if there's any. anything unusual or different. Give you an example. So a company in a press release.

So a press release is different than the 10Q. The press release around that can begin with whatever title, you know, heading you want to have for that. So if the standard way the company begins that and how they structure that information is the company, the company, the revenue, gap-based revenue is, up 10% and the profits are up this, which is more standard. If you see it changed and they start talking about, oh, the DSOs, the day sales of receivables, improved by 20 days, your listeners should say, hmm, why is this different? Why are they starting to push a metric that they never talked about before? It's just spotting things that they haven't done before.

You need to simply be alert and question something. A company is often trying to cover something up. But when they, the cover up, often is putting a spotlight on something that they want you to look at. And by them putting the spotlight on it, they're actually leading you to where they're playing the game. So, unbeknownst to the company that's playing the game, just by them jumping to the top of the mountain and screaming something that's so proud of, they're actually telling you as the investor pay close attention. Not necessarily believe what they just said, but why are they screaming about something that they've never mentioned before? And often the irony is they've just led you to where the shenanigan is. Definitely sounds like magicians tricks of something exciting going on in one hand while the more interesting thing happens in the other.

All right. Well, that was Howard Schillett, the founder and CEO of Schillet Forensics and also the author of Financial Shenanagan. Thank you so much for being on Howard. It's really a fascinating conversation. Well, thank you so much, Tracy, and thank you, Joe. Thank you. That was great. So, Joe, based on that conversation, I'm a slightly temer.

to do an odd-thought spinoff called Audit Trails. I love it. I think let's do more accounting. Let's do more accounting related episodes because I really do feel like accounting probably is sort of denigrated in the world of business in terms of people realizing its significance. But the more I hear about it, read about it, and listen to people like Howard, the more I suspect that there's a lot of the real important stuff about business is how much.

happening on the accounting side and that, I don't know, it just feels like there's a, we need to be talking about accounting more, basically. No, you're absolutely right. And I think we alluded to this in the intro, but if you think about investing in finance as a numbers game, well, then you better be thinking about how those numbers are actually created and presented. But the other really interesting thing I thought was a point that you brought up, which is about whether or not the current accounting rules are well adjusted for the way our economy is

heading in terms of intellectual property and, you know, so much of the value of the economy now being through intangible items like the importance of the brand. And that just leads down a really interesting sort of wormhole into all sorts of things. Yeah. And, you know, we had an episode, I think it was a couple of years ago. Remember, we talked to those accounts, professors about why valuation models weren't working. And they also talked about that. So I feel like that also is a pretty interesting rabbit hole to explore. There's actually a lot more I'm now curious about and thinking about. I'm curious about whether machine learning can help identify some of those patterns that get broken all of a sudden, such as the depreciation schedules or other areas like

that. So let's revisit this topic soon. All right, accounting series coming up. That has been another episode of the Allop Podcast. I'm Tracy Allo. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you can follow Howard on Twitter at Howard Schillet.

And you should follow our producer, Tofer Forges. He's on Twitter at Forges T, as well as the Bloomberg head of podcasts, Francesca Levy, at Francesca today. As always, thanks for listening. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed.

Yes, there are other products like this from a variety of news organizations. But they usually rerun their radio newscasts throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts

we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify or anywhere you listen.