A chat with Howard Schilit, author of Financial shenanigans
Howard Schilit, a former professor at American University and founder of the Center for Financial Research & Analysis (CFRA), is an expert in forensic accounting and corporate governance, and the author of Financial shenanigans: how to detect accounting gimmicks & fraud in financial reports.
Dan Dykens: A lot has changed
in the capital markets since the original version of Financial shenanigans was published in 1993. Have the accounting tricks evolved, too?
Howard Schilit: The opening line of the new edition is a quote from the book of Ecclesiastes, which says essentially there is nothing new under the sun. One of the new sections in the third edition of the book deals with cash flow manipulation. Going back to the second edition in 2002, I said a good way for investors to see whether there was manipulation in the earnings would be to compare the earnings with the cash flow from operations. But it’s always a cat and mouse game where the good guys figure out the bad guys’ tricks, then the bad guys come up with new tricks.
DD: I was one of your apostles, and I always compared cash flow with net income. But cash flow seems a more difficult thing to manipulate. How can they inflate cash flow from operations?
HS: Think of the cash flow statement as being divided into three sections. The first is cash flow from operations, which is the section people pay the most attention to. Then you have cash flow from investment activities like capital equipment or things related to selling businesses. Finally there is cash flow from financing activity.
So here’s the plan: you move all the good stuff into operating cash flow, and anything that is going to be a minus to cash flow you move into the second or third section (investing or financing).
DD: CFRA was sold to a private equity firm in 2003 and then to RiskMetrics in 2007. You have been enjoying the retired life for the last few years, but are you now coming back to teach people how to catch these bad guys?
HS: The name of my new firm is Financial Shenanigans Detection Group. I should be up and running with the new business in October, and I’ll be targeting a pretty wide group including investors, creditors, IROs, auditors and audit committee members. The aim is to help those who can be hurt by misleading information, or those auditing that information, or those directors who aren’t catching that information. We’ll show them what the tricks are and how to spot them.
DD: What advice can you give IROs to help identify aggressive accounting within their own companies?
HS: At CFRA, when we did a research exposé on a company, we would always call the company before the report went out. Nine times out of 10, the people on the phone with us would be the IROs, and they were typically being duped as well. If I made my living as an IRO, I would want to know as much as possible about whether the information in the financial statements is a fair representation of what’s really happening.
DD: I remember being on the trading desk back in those days and you almost couldn’t get out of the way if you were long or get any stock off if you were trying to put on a short position.
HS: Exactly. I saw that the unintended result was that I was doing something very harmful. I was not helping clients to whom I was trying to give a heads-up as the damage was already done. And clients who were looking for short ideas were frustrated because the stock moved before they could even open the report.
DD: In most instances, the companies you published research on refused to talk to you or your analysts. How did you deal with that when issuing research?
HS: Actually, we spoke to at least 75 percent of the companies and we would make at least three separate overtures to them. We always wanted to document everything and have it on the record that we made every reasonable attempt to talk to them because I was at risk if I got the facts wrong. We didn’t always speak to the CFO – in many instances, it was the IR people who called us back, and you know what? In most cases they were very nice.
Dan Dykens is a former hedge fund manager and founder of Meet the Street, an online
network for booking non-deal roadshows (www.meet-the-street.blogspot.com).
