My Complete Interview with Howard Schilit

The great people over at IR Magazine were kind enough to print an interview that I conducted with Forensic Accounting icon Howard Schilit in their April edition.

For publishing purposes IR Magazine ran only a portion of the interview. The entire interview is here for those who are interested.

Dan: I’m here with an old friend of mine, Howard Schilit. Howard holds a CPA designation and has earned a Ph.D. in accounting. Howard is a former professor at American University and was the founder of the Center for Financial Research and Analysis, commonly known as CFRA. Howard is also the author of “Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.”

Your book, Financial Shenanigans, was required reading for me at one of the hedge funds that I worked at early in my career and I made it required reading for all of the analysts that worked for me at my fund, Clipper Capital Management. This book is thought by many to be the book of record for short sellers. In it you identify seven categories that companies typically use to overstate financial performance. You have also broken those categories down into 30 specific techniques. Please explain how you identified all of these techniques.

Howard: The original version of the book was published in 1993 and it did indeed have the seven categories of what I call “financial shenanigans”, and a second edition was published in 2002. As we’re speaking, a 3rd edition is being finished which will be out in April of this year and will have a broader structure.

So what I called “financial shenanigans”…think of them as earnings manipulation tricks so all of those seven categories are things that would misstate company’s earnings. As I did research for the 3rd edition of the book the structure of the practices was much broader than I originally thought. That is, in addition to the seven earnings manipulation categories there are two new categories.

There’s cash flow manipulation and I’ve identified four different categories of that and the other new grouping is what I call key metrics shenanigans there are two new groupings of those which include things that are found more in the narrative that are considered non GAAP. For example a company might disclose same store sales or they may disclose EBITDA or cash earnings, things that are not specifically included in the GAAP rules and I’ve noticed quite a bit of manipulation in those, and believe me, investors pay a lot of attention to non GAAP metrics. So the new book has a lot of additional trickery that certainly the 1st and 2nd edition did not include.

Dan: Great, that leads to my next question. We’ve known each other a long time. I think that it was nearly 15 years ago when I flew down to Rockville, MD to sit with you and your analysts and learn exactly how you screen for aggressive tactics and connect the dots to uncover financial deception. A lot has changed in the capital markets since then. Have the accounting tricks evolved as well? If so, how? And it sounds like you’ve identified some new cash flow manipulation and I wasn’t sure if there were derivative instruments involved in these manipulations as well, so I guess my question is: What’s new under the sun?

Howard: That’s an interesting question…what’s new under the sun. The opening line in the new book begins with a quote from the book of Ecclesiastes which says essentially there is nothing new under the sun. And I try to explain that if there is nothing new under the sun, why do I need to write a 3rd edition? Well, I clarify and expanded upon that, and I examine that fact that what’s not new under the sun is the yearning for management to always put a positive spin on the results. That whether we’re talking about 2010, 1950 or 2070, there will almost certainly be the human quality of trying to accentuate the positive. Now, that being said, there are always new techniques that deviant management will come up with.

For example, in the last decade we had big frauds at Freddie Mac and Fannie Mae. The fascinating thing about Freddie Mac was that they had a reputation and even a nick name related to that; it was called steady Freddie, meaning they wanted to have as smooth and steady an earnings release as possible and that’s what the market paid a lot of attention to and gave them a very high valuation based on.

There was a little monkey wrench thrown into their plan when the FASB came out with a new rule on accounting for derivatives and their business, however. It related so much to interest rate movements and derivative instruments were very important. Well, they had done some calculation to figure out what impact converting to the new accounting rule would have to their earnings. To their surprise, it would have created an enormous initial increase in their earnings from the gain on derivative contracts.

Well, for most companies having a big increase in profits is a happy event, but Freddie started really freaking out, saying “we can’t show that!” As a result they held back enormous amounts of that gain that should have been realized in that first year and they set up these reserves on their balance sheet and over the next few years they would try to release portions of that each and every quarter to give them very smooth earnings.

The reason why this is such an interesting story is they got caught before they used most of their reserves. Most companies such as WorldCom, Enron – you know, the typical big frauds – are in a situation where company has inflated its profits to investors. Freddie got nailed during this period where they had actually under reported their profits by something in excess of $5 billion.

So what I learned over the years is that each company has a specific game plan. Just like we’re sitting and talking the day before the Super Bowl, you know, you do a lot of planning for your opponent. Each company knows who their constituents are and what they are looking at, almost like a student trying to size up a teacher. And if they had a copy of the test in advance, they would always get the A.

So I mentioned one of the new sections in the 3rd edition deals with cash flow manipulation. Going back to the earlier writing of the book, in 2002, I said a good way for investors to see if there was manipulation in the earnings is to compare the earnings with the cash flow from operations. Well, not only did good guys, like you, read “Financial Shenanigans”, but probably a lot of bad guys read it as well. And they probably said “hmmm, Schilit is teaching the world that a good way to assess whether the company’s earnings are clean or not is to compare the earnings to cash flow from operations…why don’t we make the cash flow from operations as high as possible?”.

Once the bad guys figured out that the intelligent analysts had figured out all of these earnings manipulation tricks and the investors are now paying more of a premium for cash flow from operations they started migrating to the statement of cash flow to manipulate that.

It’s always like a cat and mouse game where the good guys figure out the tricks of the bad guys, so the bad guys have to come out with new tricks and they do. Fortunately I am spending a lot of time going back and studying the last 30 years of the most important accounting scandals. I have over 100 companies I have done research on and at each one I have been able to identify what screens could have found these tricks. You have to keep on top of it. You have to keep looking because the bad guys keep getting more and more clever about how to showcase themselves in the most favorable light.

Dan: I was definitely one of your apostles. I would always go and compare cash flow to net income as you taught, but cash flow seems like a more difficult thing to manipulate. What are some of the things that the bad guys are doing today to manipulate that number?

Howard: Great question. Think of the cash flow statement as being divided into three groups. The first one is cash flow from operations, which is the one that people pay the most attention to. Then you have cash flow from investment activities. This is capital equipment or things related to selling businesses; things related to long term assets. The third category is…

Dan: …cash flow from financing activity.

Howard: Exactly. So, directionally, you want to move all of the good stuff – anything that is going to be a plus to cash flow – into the first group, and anything that is going to result in a minus to cash flow you want to move into the second or third groups. It is simply a matter of shifting the good stuff into the operating section and the things that would be a drag on cash flow out of that.

Take WorldCom, for example. They were spending billions of dollars on normal operating costs related to leasing lines to transmit long distance calls. Those were normal operating expenses. They decided to shift those off of the statement of income, which obviously goes to the operating section, and turn them into a long term asset, almost like property plant and equipment. And they were writing that off over say…30 years.

So not only were the earnings manipulated because they threw the expenses on the balance sheet, but on the cash flow statement they moved it from the first section to the second section. Now how would you have known they were manipulating their books? Instead of looking at the cash flow to net income, what you have to do is also then subtract out capital expenditures and you would have seen it immediately. They started doing this in 2000. So if you look at each of the four quarters in 1999 and each of the four in 2000 – so the year before and the first year they started to capitalize those billions of dollars – and you computed the free cash flow, which is the cash flow from operations minus the capital expenditures, you’d see that they had a positive free cash flow before and every quarter after they had huge deficits in free cash flow.

Another example is companies that sell off their receivables. Now, not all of these things are necessarily illegal, since some of it is how you are categorizing things on the different statements.

Dan: How did you decide to start CFRA?

Howard: Interesting question. I was not an entrepreneur by birth or by disposition. I was an accounting professor; a full time tenured professor at American University. For about 16 years my research interest was on accounting loop holes and I started doing research and eventually wrote Financial Shenanigans in 1993. I was still a full time professor and it was just a matter of luck that many of the people that began reading my book turned out to be investing managers.

So in 1993, after the book came out, I was hired to do some seminars with some big mutual funds like with Fidelity and Putnam and others. And then investment managers began to pay me to do some research on specific companies, and I did about eight of those customized reports, which took me to the end of 1993. And I said: “you know this is not that great of a business model…waiting for somebody to call me up to write a report.” So at the beginning of the following year, 1994, I officially launched the business. Before I knew it I had a following of a dozen or so investment managers and I thought that it would be a better approach to identify companies where I thought there were issues and sell that research on a subscription basis.

Dan: At the height of CFRA, how many clients did you have?

Howard: We had over 500 clients. It grew into a pretty big operation.

Dan: Every person that I knew in the business had a very healthy respect for your work. That’s one of the things that I want to point out in this blog: if investor relations officers think that investors aren’t looking at these things, they need to think again and they really need to educate themselves on these practices because they have to answer to these analysts and portfolio managers.

Howard: Actually, even though the majority of our clients were investment management firms, less than half were hedge funds. In addition to investment management professionals we had the big accounting firms as clients. We had regulators like the SEC. We had credit rating agencies, law firms and insurance companies, so the reason our client roster grew so large was because it was an eclectic group.

The clients were anyone who may have had exposure from an investment standpoint, a credit standpoint or an underwriting standpoint. We also had some customized projects for firms. For example, if there was a hostile takeover of a software company and there were some messy accounting issues that were involved, we would be hired to get involved in some of those transactional deals.

We were mostly a subscription model but we also had quite a number of training activities that we did as well.

Dan: I think that it is important to know, in fairness, that CFRA became branded somewhat as the short seller service firm but really the bulk of your revenue also came from long-only investors who were just looking to avoid bad situations.

Howard: I’m glad that you noted that. Even though you come out of the hedge fund space – the short seller space – and we had a lot of folks using the product like you were, those types of firms were never the majority of our clients. We basically were giving people a heads up when we found a problem.

I remember having conversations with some of our larger hedge fund clients and I would ask them, as I got to know them, how they used our product. I was at first surprised when people would say: “Well, we don’t use this for short ideas because so many hedge funds are shorting the names and the shorts get crowded so we look at this almost like your long clients would – to help us identify problems in companies that we have a position or we get out of it.”

Dan: That’s a great point because crowded shorts are a very dangerous area to play. They usually wind up revealing themselves by ultimately imploding. But to a short seller there is a lot of pain that can go along the way in a crowded short, as squeezes can persist…but that’s very interesting.

Howard: I very much want to help companies avoid doing things where they end up shooting themselves in the foot. So to the extent I can help the company or the auditor identify practices that are perceived as very negative by the investment community, I want to be in the middle of that. I want to work with the auditing firm or speak directly to the CFO or the IR person and let them know what practices are frowned upon. I want to explain to them that if they do certain things, they will be seen as not playing fair. At the same time, I am always interested in speaking to the investors and pointing out the companies whose top priority is making their numbers by any means necessary.

I just recently gave a speech where I began with a quote that I got from the litigation involving a company that was accused of cooking their books a few years ago. Basically, their CEO said that there was nothing more important than making their number. He essentially said that he didn’t care how they did it.

Dan: We’re going to hit that number one way or the other.

Howard: That’s right! So in terms of how an investor should be evaluating a company, in many ways you’re just trying to size up the management of the company. And there are some slimy people out there.

If I were advising IROs I would say if you guys are honest people, if you are competent and you really want to grow the long term value of the company, then you just don’t want to do things that are stupid.

Dan: I agree with that. In the last two versions of your book you acknowledge that there are varying degrees of aggressiveness and that not every accounting gimmick is the handy work of a fraudster but when you start it’s a slippery slope.

Howard: Exactly.

Dan: And that it’s a lot safer to be perceived by Wall Street as being on the conservative side of accounting rather than walking that grey line.

Howard: That’s it. Once you lose the trust of Wall Street and they see you as a Walter Forbes type or as somebody who is not playing fair, well the stock is going to be traded at a discount for a very long time.

Dan: You CFRA sold to a private equity firm in 2003, and it was then later sold to Risk Metrics in 2007. You seem to have been enjoying the retired life for the last few years but you are now coming back to teach people how to catch these bad guys. So you’re releasing the new version of Financial Shenanigans and have also started a new firm, which is called?

Howard: Financial Shenanigans Detection Group, LLC. I’ve also agreed to teach a seven week course in the fall at the University of Maryland, where I have my doctorate. I should be up and running with the new business by the later part of October.

Dan: Are you going to start the new business back in Maryland or are you going to do it in Florida?

Howard: No, it will probably be in Maryland and maybe New York also; you know wherever the talent is. In terms of doing the research I’m here in Key Biscayne during the winter months and up north the rest of the year.

Dan: And the new company will target whom?

Howard: We’ll be targeting a pretty wide group including investors, creditors, regulators IROs, auditors and audit committee members.

Dan: So it’s important for people to know that this isn’t a short selling service. This is really an educational service.

Howard: It is meant to help those who can get hurt by those who disseminate misleading information. We will also target the insurance underwriters who have to pay these big tickets when there is a fraud, as well as the users of that information, so investors, creditors and regulators.

Dan: The entire ecosystem.

Howard: Exactly, and doing it from an educational perspective. We show them what the tricks are, and how to spot them.

Dan: What advice can you give IROs to help identify aggressive accounting within their own firms, because in many cases the accounting decisions are made by the firm’s CFO and the internal audit committees? The Investor Relations Officer is charged with conveying information to Wall Street and often times, I suspect the IROs find themselves in situations where some aggressive accounting practices are being used without them really knowing and they wind up finding out after the fact when they start fielding calls from analysts and PMs .

Howard: When we would do a research expose on a company, we would always call the company before the report went out. And nine times out of ten, the person who would be on phone with us would be the IR person.

Dan: Right, and in some cases when it comes to fraud and aggressive accounting they are almost the last to know.

Howard: Exactly.

Dan: Because these aggressive accounting practices are intended to deceive and people who are looking to deceive others often don’t surround themselves with large groups of people and tell everyone what they are up to.

Howard: And that underscores why I like to have a relationship with the IRO, because they are typically the ones who are being duped as well. They are made to look really, really bad and deceitful if I ask them a number of questions and they have to go back and speak to the CFO to get answers to some of these technical things and they become the conduit for lying to us and lying to the investors.

I think to the extent that they really don’t have as much technical background in this as the CFO and the people who are involved in making these accounting policy decisions, the IRO’s reputation is certainly on the line if they are answering questions and that information goes into my report and it’s false.

I then communicate that information to the investors. If I made my living as an investor relations person I would want to know as much as I can about whether the information in the financial statements that the company is portraying in a press release or in an SEC filing is a fair representation of what really happened.

Dan: And as aggressive accounting continues to evolve and become more complex, the investor relations officer’s job becomes more difficult as well. So I’m glad that I have the opportunity to talk to you and for you to share your thoughts. I think that Financial Shenanigans should be required reading for every IRO out there.

Switching gears a bit, I remember early on when you were issuing reports, you would do so on a monthly basis. Investors would eagerly await the report and it would often have a very dramatic and immediate impact on stock prices. You later you switched up your model a little bit and began producing smaller reports that were more like maintenance reports. What was behind the decision to do that?

Howard: The reports from 1994 until November of 1999 all were, as you described, reports that we sent out the middle of each month in a FedEx package. They typically came out on the 16th of the month and it was almost like D-Day.

We would put these reports out in a specific ranking – a number one alert, a number two alert, etc. – and we’d do maybe a dozen companies in each packet. We started to get a big following and we were getting more and more influential, and it built up into a crescendo in 1999.

Stocks were getting hit immediately and I was starting to get very concerned that we were starting to do a lot of damage. We became this bludgeon to hurt the stock price, which was not our intention at all because, as I said, most of our clients were not hedge funds.

Our clients who were on the long side were getting angry because we wrote a report and their stock was down 15 percent. But I saw my role as being somebody who should give a heads up by saying “hey I think there is a problem here; take a look at this and if you agree with us do something about it.” So I looked at this and determined I was doing something very harmful. I thought: “I’m not helping my clients who I’m trying to give a heads up to because the damage is already done.” And my clients who were looking for short ideas were frustrated because the stock moved before they could even open the report. So it was sort of like this rush to judgment, and people were getting very angry at me.

In the chat rooms people were writing all kinds of bad stuff and I came close, honestly, to closing the business down because I was scared because I had created this monster, which was never my intent. But I realized that many of my clients we starting to adopt the Internet; remember, we are talking about 1999 – 11 years ago – so not everybody was into using the Internet to conduct research.

I decided to do analysis on companies that were widely held, in addition to the companies where my screens were telling me there were problems. The idea was that I was covering companies that a lot of people hold and if they are clean then that is valuable information, because I’m always looking for problems.

So I started writing reports every day – sometime one a day and sometime two – that were educational in nature. I changed the whole focus so that I wasn’t simply writing the “Wow!” kind of story but it was sort of blended in. I stopped ranking them and I didn’t put them in any kind of order, which helped the rush to judgment. I was very successful in doing that, but it caused certain clients to say, “I don’t have time to read all of these reports.”, which changed the whole nature of the relationship, particularly with the shorts.

Dan: You became a victim of your own success. You became so influential in the market that the fact that you were negative on a company meant that they were guilty until proven innocent.

Howard: Absolutely. In fact, there was an article written about me that called me the most hated man on Wall Street. I was really so vilified. I was saying, “What did I do?”

I was just a teacher, but I guess I was really good at convincing people. I might have had 500 clients but there were 5,000 people in the information loop because everybody speaks to everybody and even though I didn’t sell it to the sell side, believe me, they were getting copies and they were writing rebuttals. It was crazy.

The stocks would trade down and then up because there were situations where there would be a rumor of a report that we were about to publish. The stock starts trading down. A few of the sell side analysts start writing rebuttals.

Dan: For a report that you had never written.

Howard: Exactly, for a report never came out. Because what happens is, before we put the report out, we call the CFO and have a long conversation. The CFO probably knows who I am and he calls his buddies at the sell side and says, “Do something about this”. Based upon the questions that I asked the CFO, the sell side guy would try to respond to each of those. It was the funniest thing because there were rebuttals to these phantom reports.

Dan: In most instances the companies that you published research on refused to talk to you or your analysts. How did you deal with that when issuing research?

Howard: No, that’s not so. I would say we spoke to at least 75% of them, and we would make at least three separate overtures to them because we would always want to document and be on the record. We made every reasonable attempt to talk to them because the liability to me if I got something wrong was enormous. I always wanted to be sure that I had all of my facts right but also there was a lot of additional information that I could glean by speaking to the company. Now, we wouldn’t always speak to the CFO, but in many instances the investor relations people would call us back and in most cases they were very nice.

Dan: Thank you for your time Howard and good luck with your new ventures.

NIRI Annual Conference

I am happy to announce that I have been asked by the National Investor Relations Institute’s Investment Process Subcommittee to speak on a panel at the upcoming NIRI Annual Conference.

The name of the session is “The Changing Sell Side, and Buy Side Expectations of the IRO.”

The learning objectives for this panel include:

• Better understand why research quality and depth has declined over past several years;
• Understand impact on company as fundamental value drivers may not be well understood;
• Learn typical information gaps and blind spots resulting from diluted sell side coverage;
• Methods IROs can use to increase interaction and impact with the buy side.

During my years on the buy side I lived through many of the events that have changed the way that the buy and sell side operate with each other. I have also written a white paper on this topic, and am very excited to share my knowledge with others.

If anyone has any thoughts or comments related to this topic that you would like me to consider or share, please leave me a comment.