Financial Shenanigans
Posted on October 22, 2008 by Richard Beddard
Filed Under Reading list |
Uh oh. Analysts say Wells Fargo, a big American bank, is putting a positive sheen on its results by cutting its loan-loss reserve in the same quarter it booked a £1bn increase in non-performing loans.
Writing off non-performing loans against a reserve has no impact on profits, but reducing the reserve boosts them, allowing the bank to beat expectations this quarter, possibly at the expense of future profits. Given the economic climate, it might need the reserve to absorb losses in future. Without it, the bank will have to put money aside if it reveals more bad loans. If it increases the reserve, it will have to decrease profits.
I understand how this works, because I’ve just read Financial Shenanigans, a book on accounting gimmicks and fraud by Howard Schilit.
As financial shenanigans go, it’s not up there with Enron, but when companies face ruin, or expectations of growth they just cannot meet, they’re most likely to be tempted to use accounting to prop up profits. Since conditions are perfect now, and Financial Shenanigans is the only current How-To financial book I know that targets creative accounting*1, I asked our bookshop for a review copy.
Howard Schilit, its author, seems to have devoted his career to revealing the dirty secrets hidden in company accounts. He founded the Center for Financial Research and Analysis (CFRA), which uncovered many of the examples used in his book.
Mr Schilit has arranged the shenanigans into a taxonomy. Playing around with reserves is an example of shenanigan number four of seven; shifting current expenses to a later or earlier period. The seven chapters in the book devoted to the seven shenanigans are quite dry. Although Mr Schilit tries to break it up with charts, tables and case studies, one shenanigan blurs into another.
Having waded through them, and developed a sense of what companies do to fool investors, I am more aware. But only practice will make me a shenanigan sleuth. Chapters near the end of the book explain techniques for detecting shenanigans, and a tutorial on understanding the basics of financial reporting. These are straightforward and succinct, and could be used as a guide to analysing a company’s accounts to find the nasties*2.
That’s what I’ve started doing with Wogen’s (WGN) accounts. I have a small shareholding in the metal trading company. Recent weakness in its price probably reflects the general decline in commodity prices and anticipates slowing demand for metals as the global economy falters, but I am concerned about Wogen’s cash flows.
As you might expect, one of Mr Schilit’s main major warning signs is poor cash flow in relation to net income (profit). Wogen’s cash profits do not seem to match up with its accounting profits. In fact in recent years its cash flow has sometimes been negative. My attempts to solve the problem of Wogen’s cashless profit should be a good test for the book.
Just in case you’re thinking of buying it, a couple of caveats:
- It’s American, so you’ll be constantly translating the terminology. The shenanigans though, need no translation.
- It’s getting on. The second edition was published in 2001 and tells us a lot about the last wave of shenanigans.
My favourite shenanigan in the book dates from the 1960s. It’s the Great Salad Oil Swindle, one of a number of potted histories in chapter 15. Allied Crude Vegetable Oil Refining Corporation overstated the company’s stock of salad oil by filling its vats with water. An ingenious network of underground pipes ensured a layer of oil on top shifted from vat to vat ready for inspection. The company raised loans using its oil stock as collateral and by the time the auditors caught up with the company after almost a decade, it had sold its financiers $175m of water.
The modern world of off-balance sheet shenanigans just doesn’t seem as creative, except in an accounting sense.
- OK, there’s Terry Smith’s ‘Accounting for Growth’, which is British, but it’s so old it’s not in our bookshop. There are two on sale on Amazon, the cheapest for £275. To think, I gave my copy away.
- For more instruction on analysing company accounts, I recommend The Economist Guide to Analysing Companies by Bob Vause, my favourite book on accounting. How to Figure Out Company Accounts by Michael Brett is also very good for the beginner.
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