I recently completed a book called Financial Shenanigans. I don’t think there are many books which simplify and yet, cover so thoroughly the manipulation techniques employed by the management. The book starts with a very interesting anecdote of a severely ill patient, not wanting to undergo treatment. “Doctor, instead of operating on me, can you just touch up the X-ray?”, the patient asks the doctor. Companies committing financial gymnastics do just that. Instead of treating the ailing business, reports are manipulated to paint a rosy picture to the investors. Management hopes that at best, the company will miraculously fix itself, and at worst, it can keep raking in healthy compensation packages and bonuses before getting caught.
First, readers are given a walkthrough of the simple techniques of messing around with revenue and expense recognition. Pulling revenue to current periods and pushing expenses to a later one are the most common tactics for bumping up the bottom line. By hiding revenues in accounts receivable, a company can easily ride a weak month by showing higher than-realized revenue. Once the bad quarter passes, the receivables can be written off and investors are none the wiser. As investors, we like to see revenues, and by extension profits, originate from a company’s regular economic activities. But many companies ‘source’ their revenues from one-time transactions, transactions that have no real economic meaning like doing business with related parties, recording revenue when the transaction didn’t involve any and so on.
Investors often say that cash flows are much harder to manipulate than account earnings. The author summarily rejects the claim by presenting a number of examples of just that happening. The way to overstate operating cash flows appears to be shifting cash outflows to other sections and moving cash inflows to the operating section. I will walk you through a simple example of a company worth 10 million being bought. Instead of simply paying 10 million, the buyer pays 11 million in exchange for selling 1 million worth of goods to the company that is being acquired at a later date. This transaction has no economic benefit other than adding 1 million to operating cash inflows.
The last type of accounting shenanigans is the one that I like the most. The author calls it the key metric shenanigans. Investors like Buffet and Munbger have also criticized analysts and management for using non-GAAP/non-IFRS metrics to present performance. “Every time you read the word EBITDA earnings, replace it with b*llsh*t earnings”, Munger had said in one of the Berkshire annual meets. And in modern financial reporting, such metrics are everywhere. ARPU, ARPOB, STS, Adjusted EBITDA, community adjusted EBITDA, and growth adjusted EBITDA are some that I found. All of these earnings essentially divert investors’ attention from the economic reality of a company to a number that the company feels is the ‘true’ representation of the company’s performance.
I had taken up this book when I read about the creative adjustments one of the famous American fund managers had done. She had shot to fame when her fund outperformed everything out of covid, betting on new-age technology and hyper-growth stocks. As the pandemic died down, those stocks too returned to their rational valuations. As a result, the fund too corrected by over 50%. Someone with a basic understanding of accounting would realise the double counting and convenient omissions of these calculations. Having read about the ‘Community adjusted EBITDA’ of WeWork a few years back, I wanted to know more about how management can window-dress their numbers.
I would have thought that such practices would only be employed by the likes of Enron and Satyam, but I was surprised to see a lot of prominent names such as Microsoft, Ford, Krispy Kreme and so on.
This book is a must-read for every student of finance who wants to work making or analyzing company financials. If you are planning on appearing for CFA or any similar exam, make sure you give this book a read.
