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 Book Review from the Aleph Blog
A few readers asked me if I would review some books dealing with accounting issues. I'm happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.
Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:
1. Recording revenue too soon.
2. Recording bogus revenues.
3. Boosting income with one-time gains.
4. Shifting current expenses to a later period.
5. Failing to record or disclose all liabilities.
6. Shifting current income to a later period.
7. Shifting future expenses to the current period.
There are several common factors at play here.
* Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
* Watch revenue recognition policies closely. It is the largest area of financial misstatement. (1-2)
* Look for assets and liabilities that aren't on the balance sheet, and avoid companies with hidden liabilities. (5)
* When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow. (6,7)
The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of the accounting troubles that occurred. Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings. I wouldn't say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet. Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two. To do three, it takes fraud.
Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings. That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not. For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.
The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it. For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies. Financial companies are more complex (they are all accruals -- the cash flow statement is not very useful), and can't easily be analyzed for earnings quality from looking at the financial statements alone.
Perfect to learn more on Fraud
I have done fraud investigation in a previous job and as a business owner now, not only do I watch for it in my business but also in my client's businesses. I do accounting work for my clients & try to maintain the proper protections for them especially since I work "virtually" with them and their accounts. I am always watching for ways to protect their business, that's what makes me stand-out from the rest of my peers and how I retain my loyal, happy clients. This book taught me some things that I need to watch for that I did not have on my security checklist.
Protect your investment
Financial Shenanigans is not a quick read. But, it elevates an investor to a completely different level. Warren Buffett said Rule No. 1: Never lose money, Rule No. 2: Never forget rule No 1. If you are serious about investing, and most importantly, protecting yourself from losing a lot of money, you need to read this book because it teaches you what managers can do to fool investors by playing the financial numbers game.
- Mariusz Skonieczny, author of Why Are We So Clueless about the Stock Market? Learn how to invest your money, how to pick stocks, and how to make money in the stock market
 Covers All The Basics
This is a great summary of the most-used tricks to sliding around in the gray areas of GAAP accounting in the US. These specific techniques likely represent 80% or more of the different tricks used from 1990-2007 by large corporations to manipulate their earnings and other performance, one of the main benefits of which is increasing their stock price. If the book was used by rank and file investors to look in detail at annual reports of their portfolio companies, they'd have a good early warning signal for the typical practices. And it includes sometimes shocking but always interesting true case studies of these techniques. A drawback might be that it is dated or does not include some more sophisticated techniques.
Not the Best, But Good
As a college-level lecturer in Forensic Accounting, I seriously considered using this book, but decided not to. While it is clearly the most readable book in the area of forensic accounting, it is lean on examples and does not include citations to the cases and other materials it describes.
A far better, though more difficult, book on the narrow subject of financial fraud is The Financial Numbers Game: Detecting Creative Accounting Practices and a better book on Forensic Accounting generally is Forensic and Investigative Accounting (Third Edition).
In any event, you'll be better off avoiding Fraud Examination (with ACL CD-ROM), which spends most of its time (i.e., your time) moralizing and psychoanalyzing those who commit fraud.
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(based on 40 reviews)
