By Howard M. Schilit and Jeremy Perler
This week, I am reviewing Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below).
I recently had the opportunity to read a book that has been on my “to read” list for a few years, Howard Schilit and Jeremy Perler’s Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. I am now filled with regret for having not read this sooner, and here’s why:
Once you have internalized value investing principles from books like Security Analysis, The Intelligent Investor or Margin of Safety, the next step is application. Applying these principles requires an in-depth understanding of accounting concepts. After all, you can’t value a company if you can’t understand exactly how the business works, and a necessary condition for understanding the business is to understand the financial statements. Most accounting texts do the same thing: they explain the analysis of financial statements as if everyone is playing by the same rules with the same objective of maximum transparency. As such, they teach how accounting is supposed to work, in theory.
In theory, there is no difference between theory and practice. But, in practice, there is. – Jan L.A. van de Snepscheut
Where all these textbooks have gone wrong is that they’ve ignored the rough edges of accounting, where practitioners have twisted theory to reach a desired goal. Sometimes these actions completely flout basic accounting concepts (e.g. the Chinese reverse take-overs), but in many cases they fall well within GAAP. In these latter situations, investors who have relied solely on the usual accounting textbooks will find it difficult to identify if something fishy is going on, and will make loss-causing mistakes. Schilit and Perler, in writing this book, went far beyond the standard accounting textbooks to focus solely on the “financial shenanigans” in which some companies engage, ensuring that readers are aware of the many ways financial statements can be distorted and providing methods of identifying when this has occurred.
I believe this book to be so important to your process of analyzing investments that I am going to devote one post per chapter, which I’ll run on Saturdays and Sundays until each chapter has been reviewed. Obviously I won’t be reproducing the whole book, so you are well advised to read it yourself to get the full value. For example, there are dozens of cases throughout the book that illustrate every point, making clear how companies big and small have perpetrated these shenanigans on unsuspecting investors. Additionally, the authors provide more in-depth explanations of the actual accounting entries that support the shenanigan, and actual quotes from offenders’ financial disclosures that should serve as red flags.
After finishing this book, I have made numerous changes to my own investment analysis checklist to help ensure that I never again fall victim to any of these shenanigans. I think you will find yourself improving your process too. I have come across very few other books in my life that offer the same bang for your buck, so I’d suggest you consider buying it (I would suspect you’ll be referring to it often).
One note: make sure you read the Third Edition, which expands beyond Earnings Shenanigans to include Cash Flow Shenanigans and Key Metrics Shenanigans. If and when they bring out the Fourth Edition, I’ll join you on the pre-order list.
Author Disclosure: This book was provided by the publisher