Financial Shenanigans — Schilit: COMPLETE

Schilit's definition is the starting point: financial shenanigans are deliberate acts — by commission or by omission — on the part of management, intended to mislead investors and creditors about the company's true results and financial position. Note three words. Deliberate: this is not about honest estimation errors but about choices.

Omission: some of the worst tricks consist of not recording anything. Mislead: the target is the picture of the company, not necessarily any single number. Most courses live in the gray zone between aggressive but legal financial reporting and ruthless fraud — and that is where the person who knows the categories holds the edge.

Why do managements do this? Schilit points out that companies treat reported earnings like any other product: it is manufactured, packaged, and sold to the market. The drivers are concrete — meeting the market's expectations (guidance), bonus programs tied to results, loan covenants that trigger if earnings fall, and personal share holdings waiting to be monetized.

Cressey's classic fraud triangle sums up the mechanics: pressure, opportunity, and rationalization. The pressure is eternal, the opportunity is provided by complex reports and weak controls, and the rationalization always sounds reasonable: “we will earn it back next quarter”.

Schilit's catalogue has grown with the editions, but the backbone is seven categories. Three live on the revenue side: recording revenue too early or before it is certain, recording entirely fictitious revenue, and dressing one-off gains as recurring revenue. Two live on the cost side: understating costs and losses, and pushing costs into the future through capitalization or big bath accounting.

One lives in the balance sheet: hiding liabilities and obligations outside the report. And the seventh, added later, lives in the cash flow statement: abusing the classification of cash flows. According to Schilit, the revenue side is the most tempting — revenue is the number the market multiplies.

The detective's working method is Schilit's real gift to the investor. Step one: understand the business so well that you know which margins, cash flows, and balance sheet items are normal. Step two: recognize the early warning signals — aggressive accounting choices, strange transactions, weak internal control. Step three: know the games, that is, the categories in this course.

Step four: apply the tools — read the entire report including the footnotes, compare earnings with cash, and track receivables and inventory over time. In AKM1 this is precisely the mission of source criticism — with V12 (revenue stability) as the nearest variable: the quality of the reports, where complexity in itself is a risk measure.

The basic rule in both IFRS 15 and US GAAP is that revenue is recognized when the performance obligation is fulfilled — when the customer has obtained control of the good or service. Shenanigan number one moves that point backward in time. What makes the category dangerous is that it is easy to rationalize: the deal is about to happen anyway, and the accounting merely comes a few quarters too early.

But revenue recorded in the fourth quarter to save the year is a loan from next year — and like all loans it must be repaid, now with an interest rate in the form of discounts, returns, or next year’s hole that has to be filled.

Channel stuffing is the classic technique: in the final weeks of the quarter, distributors and retailers are pressed to take in large volumes with deep discounts, extended payment terms, or the right to return unsold goods. The result is a pretty quarterly report and a distributor system that is saturated. Sunbeam did it with grills and patio furniture during the winter of 1997-1998 — products with seasonal sales pushed out to trade long before the season.

Krispy Kreme was accused by the SEC of a similar pattern with donuts in 2004-2005, and according to the SEC's investigation (2021), Under Armour shifted about 408 million dollars in existing orders between quarters in 2015-2016 to keep the growth figure intact.

Bill-and-hold is the more advanced cousin: the customer is invoiced and title formally passes, but the goods remain in the seller's inventory. In some industries this is legitimate (the customer requests storage), but the criteria are strict, and Schilit shows how they get bent. Sunbeam's fourth quarter of 1997 was full of bill-and-hold sales that the SEC later determined were illusory.

A technique in the same family applies to long-term contracts — construction, defense, software — where revenue is booked continuously according to percentage of completion. There the trick lives in the estimates: how much is done, and what remains in cost? A small adjustment of the degree of completion moves millions between quarters.

Xerox is the category’s mastodon case. Between 1997 and 2000 the company accelerated its financial reporting of copier contracts — large parts of the value of multi-year agreements on equipment and service were booked already at signing instead of being spread over the contracts’ duration. The SEC’s investigation (2002) showed that 6,4 billion dollars in revenue had been improperly accelerated, and Xerox paid what was then the largest fine in SEC history — 10 million dollars — and restated its accounts.

Note the general lesson: the company did not need to invent business. It only needed to move the timing. That is why Xerox is the best schooling in why you should examine the quality of growth, not just its size.