A Forensic Accounting Expert Explains How Companies Trick Investors

we did. Uh, So thank you for um. 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 counting 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 us cells 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 that those numbers is uh 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. Practice is 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. Uh, we're talking about accounting, and so why don't you tell us what

we're gonna 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 by a listener suggestions, So thank you to Harvard Winters on Twitter for suggesting him. Our guest for today is Howard schill It. He is the founder and CEO of schill Itt Forensics. He's also the author of a book called

Financial Shenanigans. We're gonna be talking with him about exactly what those accounting shenanigans might be, and also about the importance of accounting in general. To your point shows, Howard, thank you so much for coming on, Tracy and 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 UH investors process of figuring out which company's to own, which company is not to own. Think of think of it more as a behavioral science and a 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 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 g A a P or called gap. But beyond that, companies have a whole second universe of information they provide,

which is non gap metrics. Okay, The other constituents 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 a consistent congruent with the underlying reality as Joe was describing before, or whether it is information that is demonstrably different and misleading. So the account so think of the accounting and how that fits in as how management can tell the story.

So it's it's 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 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 cars this quarter, and our medals costs were this much, and our labor costs were this much, and we take the revenue and subtract the costs of 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 that the information gets

recorded typically when there's a transaction. So let's use an example of somebody who's selling cars. It's your Volkswagen and you are in the fourth quarter of two thousand and seventeen, 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, it's like a dealer where they say, the cars that you were

going to be shipping out to us December? Uh, 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 a

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 uh solve the problem that Volkswagen has, they'll miss their numbers if the sales are short. So do they act honestly and announced to their put out a press release to the investors and basically say this is

what happened. The sales of say fifty million dollars that we expected in the fourth quarter, it's not going to come in until the first quarter of next year because of you know 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 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 or so years ago at Volkswagen where they change their depreciable life of their planted equipment. So, as you know, most companies have uh certain assets that depreciate and that is reflected as an expense. They Volkswagen was depreciating their planted equipment over ten 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 ten year period, the wording was it's now ten to fifteen years. Get very subtle one. What's going on there? The company

was struggling. See we figured it out because you don't just whimsically change your your accounting policies if if you don't need to, and by stretching out their depreciable life by AFT, they obviously lowered their expenses and they were able to meet the numbers. So 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 how are 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 questions. So the book that I described Financial Shenanigan, the twenty five anniversary edition was is published, so I could sort of give you a retrospect. So so the first edition came out while I was still a professor. So so in terms of the tricks and tracy,

let me get to that. So in the 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. Uh 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 and this, uh, the takeaway should be things are more dangerous today and the so 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 ibada because ibada is simply a non gap construct which

is easily manipulatable. So I'd say that's again, things are, are, in my judgment, moving in a in a very bad direction because the 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. Howard, I want to press you on this point because it has become a really hot topic in recent a people talk about the gap between basically adjusted earnings what you're talking about do versus the gap numbers these sort of official, legally

required numbers um. And we've seen some pretty let's say strong examples of adjusted earnings recently. The one that springs to mind have to be we work when they have something called community adjusted EBITDA, which seemed to be ebit don minus the cost of sales, which seemed really really weird to me. 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 what they need to do. So, just to sort of put this in the context of, uh, the last twenty five years, I told you that's the the when the first book came out. So over that

period I've also been working helping institutional investors. And what you know, what's become clear is that the the category of tricks identifying keeps growing, or another way of saying it, management has continued to evolve in terms of the creativity of tricking investors. I try to help the good guys and say these are the tricks I've learned. Now starts

stepping up your game to protect yourself. But the what's fallen pretty far behind is once management figured out that ibadah and other non gap derivative measures of that and your example, if we were it fits exactly into that category. You started out with the gap based earnings, and you decide, as management, we're going to tell investors to ignore this expense,

and that expands. Yeah, with with we work. They're basically saying the only expense that investors should pay attention to is the cost of good soul and all of the selling and marketing and R and D. To ignore it's it's ridiculous. I have so many questions listening to this, but one of them is, and I'm kind 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 they'd like you to look at. But the gap numbers are all there, So preadjustments and just buy the book. Accounting in theory sits there right there. Why how can investors really get fooled? And Matt, it's 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. It was a company that went from a two billion dollar market value to ninety billion, which was big of an en Ron back down to three billions, nineties six percent of its value. Over we'll say a five year period from roughly two thousand, twelve thirteen until sixteen, there

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 three billion dollars. Okay, it was there, It was audited. It was you know, you look at every ten k and you add up the total bottom line, and that was it. The alternative universe that the company was putting

out with 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 nine 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, uh, 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 the love affair that they had with the company, they kept pointing to a metric that didn't make any sense with billion. There was also an exciting story. People thought they had found some new model riot of buying up drugs using debt and slashing the R and D expenses, And people thought this could be the new model of

how format works. So, yes, it's true that the non gap numbers a accelerated and be there was a huge gap between non gap and gap, But people also fell in love with Let me sort of jump in and say that's the problem where they fell in love with a story. Right, you use the term platform company, people melt right. The term platform company is sort of the current iteration of what in the sixties was called a conglomerate, in the nineties was called a roll up. So you're

absolutely right. For people who who fall in love with stories and don't actually look at the numbers, that's that's exactly what was happening in that situation. They fell in love with the story and they they saw the two point nine billion or whatever that losses I was describing, but they said, but their cash earnings, and they built

a better mouse trap. Right, instead of being like Merk or the other big pharmaceuticals where they spend so much on R and D and most of it doesn't result in successful products, h Valiant figured out a better model. And I looked at that and said, you really think that people that Fiser and Merk are so stupid that they didn't know that there was an alternative by 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 uh, So if you want to de risk yourself, which is Alliance Pitch, you buy Bosh and Loom, you buy other companies forty billion dollars, Well, nobody's giving it to you for free, so you are buying. Yeah. So the the notion was I think completely misguided, right.

And in the case of Valiant, from what I remember and to Show's point, the story was almost embedded in the numbers, right because a big part of what they were doing were add backs based on the acquisitions that they were making, so sort of immediately embedding that growth

story into their numbers. One of the things that I want to press you on, just on that note is, um, 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 uh, 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 uh true, it's you know, Endron back in thousand 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 hand down, they always need more and more. So sort of this this virtuous loop where the ones that are 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 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, you know, think of the Uh, the investment bank no different than merchants. They they are would deny that they're right. They would say, oh, there's definitely a wall between you know. But but I'm saying,

just look at the reality of the business. Whatever the whatever the the constructs are inside is not the point. It's if your job is to raise a large amount of capital for X y Z company, what does that mean? Not just put together the the consortium of who's going to be buying it, but you have to sell a whole bunch of shares, right, So your your client is the corporate American expressesn't pick any company and you need

to sell that. So that I'm saying that sort of the analogy to a merchant is you have a whole bunch of inventory that you have to move. 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 that's so again, I don't care what kind of you know, structural walls.

There are Chinese, French, Italian walls, whatever you're gonna call them. Um, the the the companies that uh 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 of the 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 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 forties and fifties and the railroads and so okay, So so that's the time the accounting rules were written.

Now we're in a world where you have, you know, a group on coming on and you know, just different type of models where uh, the there are no specific thou shout nots in the accounting rules for type of transactions that were not envisioned back when the accounting rules

are written. So think about the opportunity set for companies to play games, where in the accounting rule book there is no thou shall 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 no thing, nothing specific in any rule

book that addresses that type of transaction. So, in terms of what makes the challenges so great is that there's a lot of interpretation of whether it's GAP compliant or whether it's non gap compliants. 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 we if we start going down that road, will probably

go on for an hour. And there's something slightly more immediate that I want 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 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 uh report to the investors puts a lot of pressure on short term thinking versus long term. So there is a problem, and I'll sort of tell you what I think the solution is, but it's not

why Donald Trump had suggested. So again, so long term thinking and managing business is 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 with 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 they're always unintended consequences. So the problem is not

that companies are reporting four times a year. I think the problem is a circus around the earnings and you know, sort of the the earnings call and the Wall Street consensus estimate. I think if if I were going to change the events, I would say, absolutely, you keep the requirement that companies file with the SEC every three months in accordance with gap 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 audit the annual numbers are audited, but even accordly, uh, those are going to be reviewed by the outside auditor. So again, the best solution is continue to have h 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 am actually going to go out and buy your book now because I'm very interested in this and want to learn more. But what are 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 anything unusual or different. Give you an example, so the company in a press release, So a press release is different than the tank you the press release around that can begin with whatever title you know heading you want to

have for them. So if the the standard way the company begins that and how they structure that information is the company the revenue gap based revenue is up ten and the profits are up this, which is more standard. If you see a change and they start talking about, oh, the d S O S the day sales of receivables improved by twenty days, your listeners should say, why is this different? Why are they starting to push a metric that they never talked about before. It's 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 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 so un unbeknownst to the company that's playing the game, just by them jump, you know, climbing 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 a magician's tricks of something exciting going on in one hand while the more interesting thing happens in the other. All right, well, um, that was Howard chill It, the founder and CEO of Chilett Forensics and also the author of Financial Shenanigan. 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. I was great, so Joe. Based on that conversation, I'm slightly tempted to do an All Thoughts spinoff called Audit Trails. I love it. I think I want 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 it's 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 happening on the accounting side, and that I don't know, it just feels like there's, uh, we need to be talking about accounting more. Basically, No, you're 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 and that just leads down a really interesting sort of wormhole um 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 the those accounting professors about why valuation models weren't working, and they also talked about so I feel like that

also is pretty interesting rabbit hole to explore it. 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 let's revisit this topic soon. All right, accounting series coming up that has been another episode of the podcast. I'm Tracy Alloway. You can follow me on Twitter at

Tracy Alloway, and I'm Joe wise of Thought. You could follow me on Twitter at the Stalwart, and you can follow Howard on Twitter at Howard schill It. And you should follow our producer to for Foreheads. He's on Twitter at for hest, as well as the Bloomberg head of podcasts, Francesca Levi at Francesca Today. As always, thanks for listening. Three year