New York/ July 22, 2017
Howard Schilit is the forensic doctor who gets called for a second opinion by the biggest investors around. Any stimulus that causes anxiety to institutional investors is good for him. His firm Schilit Forensics works with around 50 investment firms and tells them which companies are the ones playing games. He founded subscription-driven Centre for Financial Research and Analysis which proactively published who the bad actors were. After selling it off, he had a non-compete for seven years post which he started Schilit Forensics, which is much quieter about what it does given that company managements have also wizened up over the years. As Schilit told us during the interview, the intent behind the first edition of Financial Shenanigans in 1993 was to have a one-stop guide where investors could read about the different tricks and techniques used in window-dressing. The 90s though seem like a bygone era and now in addition to earning shenanigans, companies are resorting to cash flow shenanigans. They are tweaking key metrics which appeal to the investing community. But the Sherlock Holmes of accounting won’t let them have it easy. Schilit is back with a revised fourth edition to keep in step with the spring-loaders.
Let us start with your seven financial shenanigans. Can you illustrate each of those with examples? Which are the most dangerous according to you?
In the early days of doing research on the subject, in the 1990s, we identified seven categories of how companies can manipulate their earnings. The seven break down into two major sub groups. The first five of those seven deal with how the goal of the company is to make it look more profitable. This is intuitive. If you play games and risk going to jail, why would you do that to make the company look less profitable? But that is the second category — where the company cheats to look less profitable, which we will come to later.
The first two of those seven involve making the firm’s topline/sales or turnover, as you call it, look stronger than it really is. Shenanigan number one is to record the revenue too soon. So, if the transaction really should have been in the third quarter of 2017, but has been pushed to the second quarter of 2017 by the company, that is more or less what this category is about. They are serious, but those are not the situations where they completely make it up. The second category is what we call bogus revenue, and that was what Enron was doing: make up something completely egregious, like borrowing money from a bank and putting it in your books as if it was a sale from a customer. You are just making that up directly. So, one and two are techniques to make the sales look stronger than they are.
The third category is where you take something that is one-time in nature — not the same as revenue per se. Let me use IBM as an example. IBM sold a business to AT&T and they recorded a gain on the sale... perfectly legitimate. You buy something for a billion, sell it for $1.5 billion; you make a $500 million profit. But the trick IBM was playing was that instead of making it clear in their financial statements that this had nothing to do with their business at all, that it was basically a one-time sale of a division of a business to somebody else and was part of their profit but not of their normal operating result, they included it as part of their operating income in a way that was not easy to see because they simply reduced it from their selling and administrative expenses. And then they were bragging about how the profit margins were higher because they had become so much more efficient. But they were lying, their profit margins had increased due to improperly reducing selling expense. The third category therefore is a series of one-time tricks that make your profit look better. If you want to show higher profits, you inflate the good stuff, that is, revenue and gains, and deflate the bad stuff, that is, expenses and losses.
Categories four and five fit into deflating the bad stuff, hiding expenses. So, shenanigan number four talks about a process where you either put something on the balance sheet, say for instance rent, which should be expensed immediately; or, you depreciate plant and equipment much more longer. Shenanigan five is failing to report a legitimate expense. Let’s say at the end of the June quarter, the CFO gets a number of invoices and just puts them in the drawer, and two or three weeks into the new quarter, he says, look at what I got. It could be failing to report something simple, or it could be something more sinister, where you are creating a separate entity and moving your expenses and losses there, which is what Enron was doing.
Shenanigan six and seven are for those situations where you want to make yourself look less profitable. Six is the failure to report a sale that should have been recorded that quarter or period, and seven is to push into that period expenses perhaps pertaining to a later period. Say you are a new CEO who gets hired on June 1. Nobody would judge your performance until a later period, because you were probably hired because the guy you replaced was doing a lousy job. This is a perfect opportunity to load up that quarter with many expenses that could have been charged at you at a later stage. This is called taking a big bath.
Talking about six, the past two years I have been very closely following a company called Valeant. In February 2015, they announced the acquisition of Salix for $15 billion. The deal was not going to close until April 1. Salix had not yet published their December results. Basically, there were going to be two quarters — the last quarter of 2014 and the first of 2015 on which there was going to be nothing reported. In this scenario, what if Valeant goes to their new friends at Salix and says, now that we are going to be part of this big happy family, why don’t you defer revenue? And they did. Sales in Q42013 were $300 million and sales in the first three quarters of 2014 were going up because they were getting themselves ready to sell. That was one of the first five shenanigans, so when it suited their purpose to make themselves look prettier they were stuffing the channels. But they got into trouble for that. In the fourth quarter of 2014, a period during which Valeant was negotiating with them, they ended up reporting sales of $13 million, when it should have been $300 million.
Is Valeant the new poster boy for creative accounting and everything that could go wrong?
In the last decade or so, the accounting tricks have migrated from actual GAAP-based financial statements into non-GAAP-based things that the auditors don’t even review. Press release information and investor day decks are all filled with ridiculous metrics. If you look at the actual audited GAAP-based numbers of Valeant over the years, 2013, 2014, 2015, 2016 in aggregate, they had an accumulated loss of $2.6 billion. And you scratch your head and ask, why is the stock going crazy? They were pushing to investors — and the investors were believing it — something called ‘cash earnings’ that was not anything negative, but positive $8.6 billion, that’s nearly a $12 billion difference. Valeant did have some element of traditional accounting fraud, but that was not what made it such an interesting story. What made it so was those non-GAAP metrics, and that some of the most respected investors went along with it.
Things were horrible in the late 90s and the early 2000s. After Enron, around the year 2002 people were really worried about holding equities. They are not so afraid today, and this sense of complacency may in some ways be even worse. It is not like you can change the DNA of the CEOs of the companies. They are competitive people, and they get rich if the stock price goes up. This will never change. They simply evolved and the evolution has been from strict earnings manipulation to the things on the cash flow because people never imagined that you could fake that.
The conventional wisdom was to compare the CFFO (cash flow from operations) with net income. Say net income is a billion and going up, with cash flow (CFFO) heading in other direction, you think this is not good. The CEOs, CFOs of companies are not stupid people, they know what we are looking at. So we pay attention to CFFO, think of how that can be manipulated. This was my thought process in 2008-09. But I was missing something here. Remember, the cash flow statement has three different sections. So, if I am a clever CFO and I know that investors are paying attention only to the top section, that is, CFFO, then why wouldn’t I move the good stuff from Investing and Financing to CFFO and move the outflows? This was happening not only intra-period but also inter-period.
When Bob Nardelli took over at Home Depot, he said that a year from now, he was going to do such an amazing job that their operating cash flow would be a billion dollars higher. He nailed it. But I looked at the components of the adjustments of the CFFO. It was all adjustments for accounts payable. All he was doing was messing around with the vendors, and instead of paying them every 12 days he was paying them every 20. He was holding on to the cash until the period closed. You can see that total cash is real, but they package it into different sections, between quarters.
Could you talk a little more about non-GAAP tricks? According to you, more and more firms are using them.
I will start with the most widely used non-GAAP metric today, which is Ebitda. You look at the earnings and then say, ignore this and ignore that...in fact, I read a funny mocking description called EBE — Earnings Before Expenses. If you are just going to knock off half a dozen expenses, why stop there? When you start out with something that doesn’t make any accounting sense at all to compute the company’s profit, there should be a really good reason. But there isn’t. Why do you eliminate interest when you are paying cash for it? If you are paying more interest, you have less to pay for other things. For tax it’s the same thing. Then they say depreciation is non-cash. Really? Let’s say you spent $10 million buying a building a few years ago, and let’s say you are depreciating it over 20 years — so, about half a million dollar a year. You probably paid up front for that, but under the accounting rules you don’t expense that. You put it on the balance sheet as an asset. It’s simply a question of when it is paid and when it is reflected as an expense. You cannot tell me that never happens!
If nobody is pushing back against them using Ebitda, then why not adjusted-Ebitda? We were looking at Groupon, which had a metric called adjusted-consolidated segment operating income, which was just a bunch of words strung together. They were showing profits every year as they were not expensing their marketing expense.
It is unbelievable what sell-side brokerage firms would do to ingratiate themselves with the management. But what is most disappointing is what has happened to the buy side, which has allowed them to make it look stupid. This is why I can never forget Valeant. It’s an amazing story because it has so many different components. One of the things that drove bad behaviour there was a compensation plan that the devil probably put together. The theme was skin in the game and pay for performance. All that makes sense: you don’t want to pay a high amount for a terrible job. But of course, how you measure performance is the key question and in every case, it is the stock price.
The other thing I hate having to hear is: it looks strange, but it’s a common practice in the industry. If it looks strange, it probably is strange. That was the case at Linn Energy where the attractive yield was powered by a metric called distributable cash flow. The starting point in their calculation of distributable cash flow was another non-GAAP metric called adjusted Ebitda. Think about how complicated this is and how much subject to manipulation. They start out not from Ebitda, but adjusted Ebitda. Then their capex is divided into growth capex and maintenance capex. I understand why in the private equity space they make that differential — there is a certain portion of money, which is just normal maintenance, and there is the other part, which is acquisitions. When you think about distributable cash dividend, what difference does it make? I look into it and come up with a number, let’s say a billion dollars, and they pay out $900 million. But if you look further down the cash flow statement, they borrowed $3 billion. So the reasonable conclusion is that they are not getting this money from their operations, but from borrowing, which was true. Linn eventually filed for bankruptcy.
What rational measures would you suggest? Wall Street clearly loves Ebitda...
I can’t fight every battle every day with everyone. If my clients are talking about Ebitda or using it as a metric, I am not going to give them a sermon on how stupid they are to be using it. But if I see something that is included in that and is very suspicious, I will flag it. Let me give you an example. I told you what was wrong with depreciation. Now, what about amortisation?
The amortisation of intangible assets doesn’t look like cash. Think from the perspective of management. They are very smart and know what the rules are. There are two different categories of expenses — those that people care about and will penalise me for, and those that they don’t care about. Let me see if I can get some of the traditional expenses and dress them up so that they look like the ones that are ignored. The company FTI Consulting in their calculation of Ebitda put a strange thing under amortisation in the footnote. What was it? Let’s say I am the founder of the business and hire two consultants. I am going to give them a three-year loan. If they leave before the end of the first year, all of that gets paid back to me. If they stay for a year, then they keep a million. In the third year, you get to keep it all. I don’t know if this is in any way unusual. They give executives a big signing bonus, but they don’t call it a signing bonus though it could be called that. Perhaps that kind of a structure is not unusual. Provided the accounting was done properly from a GAAP basis, when I pay the money to them I am crediting cash. I am not debiting the compensation expense because you haven’t done anything yet, so it’s an asset, and we call it a note receivable. You sign a note. That’s what it is, properly. It’s now the end of the year and they are both there. So, for each one of them I am going to be reducing my net receivable. And there’s going to be a credit to net receivable and debit to the amortisation of note receivable.
You can see where this is going. Over three years, out of that $3 million, nothing ever appears as any type of compensation expense. A 100% of it will be included in the amortisation. This implies that they took something which anybody with half a brain would say is a form of compensation with a clawback. They figured out how to move what would have been normally called compensation expense to amortisation. This is the problem. We see it every day; we see the most clever, deceptive practices. If I were advising a client and I didn’t see anything strange like that, I wouldn’t even get into the discussion about you being an idiot for using Ebitda. It doesn’t score any points for me. My general notion is that if I were writing the rules for the world, I would outlaw Ebitda. So you work with the imperfect world we have and most of the time you are not going to see this crazy stuff.
You have to give credit to the management for how clever they are. The bad guys are always going to be one step ahead. If the company gives you a metric, be sure you understand what goes into it and whether or not you feel comfortable using it. There are a lot of honourable managers in every industry but there is a fair share of bad guys amongst them. I feel that industries where the metrics themselves are different, like Master Limited Partnerships and distributive cash flow, are the ones that are most suspicious.
Which sectors are more prone or vulnerable to Valeant-type creative accounting?
It’s not necessarily a sector thing. I would look at characteristics that we could extrapolate. The very acquisitive kind of companies are the ones in which I will always be able to find accounting frauds. This is so simply because there are so many moving parts and so many metrics. If you are looking at the sales growth of a company that bought 20 companies last year, I am going to have to help you understand how much of that growth is organic, as they don’t provide the financials. So, when investors cannot derive key pieces of information on their own, it makes it very problematic. Then there is a question of what level of trust you are going to ascribe to the management, and there are different ways you can test to see if they are being truthful.
In the old days, when I was running my subscription business, we interviewed all companies and always asked questions we knew the answers of, because we got them [the companies] from the filings. It was interesting to see how they would lie even on that. Our reports were always written from the documents. They would never be sourced from the conversation, because they could always say that they never said that or that you misunderstood. In the final process of our editing, we would be careful that every single criticism came directly from the filing. If they denied that, then we would say that you have a bigger problem than me. If this is in the filing and you claim it’s false, then that is a security fraud case. We were threatened with law suits dozens of times. The reason I was always able to walk away from this is because I had a very strong hand. I would say, we are not your big problem, we simply took the information put out there.
Can you give us a few examples or a few pointers about how you can manipulate numbers with acquisitions? How do you know that an acquisition, for instance, is a cover up for some big hole in the main company?
A lot of the times you are not going to have the financial statements of the target company. Let’s say that you get lucky in the case of Salix, Bausch & Lomb, Medicis and Biovail, four big acquisitions that Valeant made compared to the other 50-60 not so consequential. As soon as I get my hands on those filings — the thesis being that the company is growing mainly by acquisitions — I can get a beat on what the company looked like before they were acquired. If I concluded they were healthy, that their accounting was clean, I feel good. It gives you a very big window into what it is going to look like when everything is brought together. There are two parts to it — looking at the target companies separately, and looking at the legacy company before those deals. If you back out, depending on how much disclosure they give you, you can derive the organic growth. The best way to derive that is to take the total growth minus what came in from these acquisitions.
In terms of different types of tricks that can happen, think of the period before the deal closes; the target company could be doing a whole variety of things. It could intentionally hold back sales that would be disclosed after the deal closes, or take big write-offs. Post the acquisition, an important process is the accounting of goodwill. Think about what happens from the debit and the credit standpoint: I am buying your company, I take the balance sheets of both companies, and I have an appraiser who tells me the fair market value vis-a-vis the book value. The game here is that I would want to write the assets down to a more muted amount. That way, I would have a lower depreciation expense. In the goodwill account, a lot of strange things can happen. It is very important therefore to see the before and the after and read the post-acquisition footnotes.
With Medicis, Valeant changed the revenue recognition right after they closed. When you sell a product through a distribution network, there are two different ways to account for the sales. You could either consider the distributor as your customer or you can treat the end-user as your customer. Under accounting rules, there is sell-in and sell-through approach. Medicis as a separate company was using the sell-through approach. When Valeant took over, since they wanted to pick up sales more quickly in the first quarter, they switched.
There are companies that may be window-dressing for years, you might see that there are changes in their depreciation policy, revenue recognition and so on. Yet they may be consistent in delivering their promise of growth. How do you identify such companies?
The probability is pretty high that most companies, if not all, use some kind of tricks to smooth out earnings. If I was running a company, I don’t want to get too close to the foul line, but I also know that investors don’t want to see jerky growth. That doesn’t bother me as much. What you should look for is a recent deterioration in business that is probably not known. For instance, Volkswagen had been depreciating their plant equipment over a short period relative to Toyota and GM. Perhaps others have been depreciating it over 20-25-30 years; Volkswagen has been doing over 10 years. What they did was that they changed the wording in a very subtle fashion, on the footnotes on their accounting policy on depreciation. Instead of saying that we depreciate our plant equipment over 10 years, they simply said that over the next period we will depreciate our plant equipment over 10 to 15 years. They didn’t say we stretched out our depreciable life by 50%, for that would have scared people away. We were able to spot that, though most people asked what the big deal was about as they were still the most conservative in the industry. That’s why industry comparison doesn’t hold sway for me. When there is a change in estimate or change in accounting policy, the question should not be: Is it GAAP compliant and was it disclosed? This is necessary, but it’s not sufficient. The more important questions are why and why now.
Volkswagen could have been using its depreciation life of 20-25 years forever and I never would have said anything. But what was happening at that moment? Did some structural engineer go to the boss and say, we need to? What happened was that they were in jeopardy of missing their earnings for that period. I say that because after making the change, they hit the consensus estimates. I don’t need to be a genius to understand that in the absence of stretching depreciable life, they would have missed their earnings. So, I had an insight that the company was performing at a poor level than was widely understood, and when a company starts to have business problems, it usually persists. It’s not a few weeks or few months, and very often, they move on to something else.
If you look at most of the big stories like WorldCom, it was not fraud number one, it was at least fraud number two. You have to begin to see the change when it happens. For example, we have always been looking for footnotes where they talk about a record streak.
During my sabbatical when I was not working, I was teaching as an adjunct at University of Maryland and we wound up finding a company called Keurig, whose top line was growing at 40%. I asked my class to read all the press releases and the earnings press releases and see what they talked about over there. I had noticed that if a management brags about consecutive streak of quarterly growth, it is a perfect company to short because the management is obsessed with the record streak and 40% annualised on anything, grows very big very fast. I told my class that one of the two things would happen. You will get to the proverbial speed bump pretty soon and the management will either start making acquisitions to keep growing, or they will start mucking around some of the assumptions on how they book revenue. This is exactly what they did.
The easiest companies to make money shorting on are those that have a slimy and stupid management. Slimy and smart doesn’t leave as many fingerprints. We would do searches on consecutive streaks to find companies where they set the bar high. Smart management do just the opposite — they talk it down because they win if they get over the hurdle. You would only be stupid if you set the hurdle very high. Initially, Keurig’s business had a footnote that they book sales upon receipt by the customer. Then they changed the wording very subtly, it was something about delivering or shipping. Then there was the treatment for rebates on refills, which initially they treated as sales discounts, thereafter changing the wording to subtraction to sales and in some cases as an operating expense, and so they moved it down to SG&A. It wasn’t hard to figure out that the company was using these artificial means to prop its growth. Then again, it wouldn’t be a terrible business if they told us that sales was no longer growing at 40%, but at 25%. But when a management is trying so hard to sell a certain myth, they are likely to use accounting tricks along the way.
Where do the auditors figure in all this?
They don’t have the skill set because they are so used to GAAP rules. So with Volkswagen, they would argue with me and say, 10 years or 15 years, what difference does it make, they are fully disclosed and they are the most conservative in the industry. It’s not enough to say that it is GAAP-compliant, and was fully disclosed. People always ask me, why don’t the auditors pick it up? Because everything I look at is from an audited financial statement, usually from a big accounting firm.
So these are considered best of the best on a global basis, and they have so much more information than I will ever have. All the internal documents and conversations and why did they miss it? Part of it is they have a business relation. If you were the auditor for Volkswagen, why in the world would you piss off management by raising this issue if you know its GAAP-compliant and fully disclosed; what more are you supposed to do? They don’t really view the world from the eyes of an investor and I would look at the picture from the eyes of an investor and I would say that was a disgusting thing. You knew the business was deteriorating and you helped management deceive the investors. That’s why I don’t have a whole lot of friends in the accounting world.