A Forensic Accounting Expert Explains How Companies Trick Investors

Tracy Alloway (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:15)

And I'm Joe Weisenthal.

Tracy Alloway (0:17)

Joe, what is my all-time favorite topic?

Joe Weisenthal (0:21)

I know the answer to this, fraud, financial fraud.

Tracy Alloway (0:25)

Yeah, yeah, you're actually right.

Joe Weisenthal (0:27)

I'm actually right, as if it's such a surprise that I would get this question. You asked it so definitively, and we've been doing this for a while. Thank you, thank you for giving me that credit.

Tracy Alloway (0:38)

I only say that because you didn't know my age in that one episode that we did.

So thank you for, even if you don't know how old I am, you know what I'm interested in, and that means a lot. So yes, I am definitely interested in financial fraud, and one of the most interesting aspects of financial fraud, in my humble opinion, is usually the accounting, let's say, chicanery that goes along with it.

Joe Weisenthal (1:04)

Right, because business happens, and people buy stuff and sell stuff. But between the time something happens, and the time when it actually gets recorded on paper and recognized as sales and cash coming in and out of the business, a lot can happen.

Tracy Alloway (1:21)

Yeah, that's right. And if you think about it, finance, Wall Street, it's all a numbers game, right? And the way that we think about those numbers is, well, basically dictated by something that we like to call accounting, and there are various accounting rules that govern how people are supposed to report their earnings and the wider goings-on of their businesses.

But of course, there's also a lot of leeway in the way that you can come up with those numbers. And even if you're not committing outright fraud, you can definitely utilize disingenuous accounting practices, practices that can either deliberately mislead your investors or maybe unintentionally, but usually deliberately.

Joe Weisenthal (2:07)

You know, it's funny, I'm really excited about this topic as well. I was just reading the autobiography of the Nike CEO, Phil Knight, and he was previously an accountant and he talked about that it was through being an accountant that he really learned what made businesses fail or thrive. It got me thinking that whereas we often think of something happening in reality and then the accounting being this sort of reflection of reality, that maybe the accounting is the reality and that there's nothing more real in a sense than the process of writing down a number. So I'm very excited that we're talking about accounting. So why don't you tell us what we're going to be talking about today specifically?

Wow.

Tracy Alloway (2:53)

So we're definitely going to go deep in this episode. Our guest today is actually someone who's come through via listener suggestion. So thank you to Harvard Winters on Twitter for suggesting him. Our guest for today is Howard Schilit. He is the founder and CEO of Schilit Forensics. He's also the author of a book called Financial Shenanigans.

We're going to be talking with him about exactly what those accounting Shenanigans might be and also about the importance of accounting in general, to your point Joe.

Howard Schilit (3:26)

Thank you.

Tracy Alloway (3:40)

Howard, thank you so much for coming on.

Howard Schilit (3:42)

Tracy, my pleasure.

Tracy Alloway (3:44)

So I guess this is a general starting point. Do you think accounting gets enough credence when it comes to the way we think about business or the wider economy?

Howard Schilit (3:56)

So let me talk about accounting and the way it fits into investors' process of figuring out which companies to own and which companies not to own. Think of it more as a behavioral science and a sort of diagram, the players and what their objectives are and who's winning and who's not winning. So as we know, every public company, four times a year has to present themselves to the investment community, to the constituents who have to make decisions and the mindset of the public companies, the senior executives is to tell the story in such a way that the investors are very impressed.

So we could say it's not providing the information in a balanced fashion, it's always trying to have a very positive spin.

There are rules. There are generally accepted accounting rules, G-A-A-P, or called GAP. But beyond that, companies have a whole second universe of information they provide, which is non-GAP metrics. Okay, the other constituents are the consumers, the readers. So those are the people who are part of my universe and trying to help them figure out whether the representations from the company is consistent, congruent with the underlying reality, as Joe was describing before, or whether it is information that is demonstrably different and misleading. So think of the accounting and how that fits in as how management can tell the story. So it became a fascinating subject to me. I was an accounting professor, but it became a fascinating subject to me when I began to understand it, not in some mechanical way of just putting numbers on paper, but it's how management can choose to tell the story to advance what their interest is.