The Sherlock Holmes of Accounting: Howard Schilit Explains the Mystery of His Art

Because of his track record in detecting the manipulation of financial results, Howard Schilit has been called the Sherlock Holmes of accounting. Whereas most forensic accountants come in after the fact for the investigation and litigation, Schilit is the rare exception who comes in to detect accounting manipulation before it is widely discovered.

Currently, Schilit works as the CEO of Schilit Forensics, a New York–based forensic accounting consultancy, founded by him. Working for large institutional investors, Schilit has not only made accounting interesting but also made a highly profitable business out of it. Once an academic who taught accounting, Schilit is the lead author of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. To find out what it is this modern-day Sherlock Holmes does and how exactly he does it, we recently interviewed him. Here is an edited version of the interview.

CFA Institute: What is the difference between accounting fraud and accounting manipulation?

Howard Schilit: The horrendous accounting fraud — what we saw in Enron, Tyco, and WorldCom — is relatively rare. It breaks the law and violates accounting standards. Accounting manipulation that I like to call accounting shenanigans is different. It tends to be done within the letter of the law and technical interpretations of accounting standards but present a misleading picture of the economic performance of the company. Sadly, this is quite common. I deal with accounting shenanigans. This is my world. There are no smoking guns here. You have to find signs of companies camouflaging problems. I pick up these signs by doing a behavioral analysis of the management of the company.

Give us some examples of accounting manipulation.

Let me first clarify that in any example I give, I make no assertion that the company concerned is doing anything illegal or willful to violate accounting standards. I am just sharing my analysis without alleging wrongdoing. Let me give you two examples.

First, a great example is a US company Equinix (EQIX). In the second quarter of 2013, it announced that it was switching to a relatively conservative accounting practice in recognizing part of its revenue — say, recognizing revenue over four years instead of two years. But a few months later, it announced that it would regard this switch as a correction of an error instead of a change in estimate. This way, in the third quarter, the company changed revenues for prior years going back to 2006, which enabled it to bring millions of dollars of revenue to the current year that did not have to anything to do with the current year.

A second example is a Japanese company, Ulvac (6728). Around 2011, it reported its sales were down 1% and operating profit was up 38%. In the aftermath of the tsunami and Fukushima disaster in Japan, this was a great result. In reality, company sales were down 21% and instead of a profit there was a large loss. The company switched to aggressive accounting, using percentage of completion method for revenue recognition, picking up revenue much earlier. Though it did disclose in a footnote that had it used the same revenue recognition method as before, its sales would have been down 21% and there would be a loss.

In your second example, because the company had made the implication of the change in accounting practice known in a footnote, did it still mislead anyone?

Yes, the company was still able to paint a rosier picture. I looked at all the sell-side research reports on the company, and none had figured it out. The quality of analysis was just not good enough. They probably overlooked the footnote. Perhaps they could not cover the issue for other reasons, such as closeness to the company’s management.

What has been the role of the external auditor in cases of accounting manipulation?

In most cases, auditors give the opinion that they give. It is more or less the same language everywhere, that in their view, the financial statements fairly present the financial position of the company. “Present fairly” are the two key words. In my view, in the examples I gave you, a well-thinking honest person would not agree that this is fair presentation. I don’t want to make any sweeping statement that the auditor is the problem. There is no reason to assume that auditors are not good decent people trying very hard to do their job well. What I think is that the auditor is not well trained to take into account such issues from the perspective of the investors.

I can tell you that those who take the CFA exams are quizzed on these types of shenanigans. I know that CFA Institute has been buying my book. I am almost certain those writing questions for CFA exam have been making good use of the contents of my book. In contrast, there is not a single question in the CPA exams on these types of issues. Accountants have a different culture, they learn the accounting rules and the tax rules and so on but they don’t learn how to analyze things from the perspective of investors.

What do you think are the motivations of management of a company manipulating its financial statements?

Just as I have a pretty benign evaluation of auditors as good decent people, I don’t think business executives are crooks either. There is tremendous pressure from the market on short term results. Picture yourself in the position of a company’s management. Every three months, you have to disclose the quarterly results to the market. If the results are not to Wall Street’s liking, your stock could get crushed. See what recently happened to the 3D Systems Corporation (DDD). It is down by something like 26% after its quarterly results did not meet expectations. It’s a tough call: miss the number or game the numbers. Sometimes, cooler heads prevail. At other times, management can’t resist the temptation. If management has been boasting of a long streak of growth, as it did in case of Equinix, they may find it hard to announce that the streak has been broken. Companies have ups and downs for no fault of the management, but CEOs are very competitive, very successful people, who do not like to lose, who can’t declare defeat. A lot of it is hubris.

How do you find warning signs of potential accounting manipulation?

What I do is really a behavioral analysis of the preparers of financial statements, the management of a company. I love the kind of work Richard Thaler does in behavioral finance, what investors are supposed to do and what they end up doing. Its also about the kind of analysis that I do, but I do it for the management rather than investors. I have to pick up signs of change in the behavior of the management — what they highlight, what they don’t. Why would they stop reporting something that they were voluntarily reporting previously? You have to find out a change in accounting practice. Once you have found it, the questions to ask are not “Is it legal?” and “Is it permissible?” The questions to ask are “Why?” and “Why now?”

What are your views on the ability of short sellers to detect accounting manipulation?

Over the years, I have worked with more than 500 investment managers. I can tell you that if you are a short seller and you have the skill set to detect accounting manipulation, you will probably have a very successful career. The market may keep moving against you when it is focused on macro issues, such as whether the US Federal Reserve is tightening the monetary policy or not. But when market is focused on a company’s fundamentals, short sellers have to win over other investors who can’t do such deep analysis.

What’s your advice to analysts who would also like to detect accounting manipulation?

Have real deep training in accounting analysis. Have a strong understanding of basics. Do things like the Intermediate Accounting sequence. Make use of the books available out there. The granddaddy of my field is Abraham Briloff, who also led me into this career. His books are still in print. Then there is my book and there are books by Thornton O’Glove and Charles Mulford. Technical training aside, just be a curious person, read carefully, ask good questions, have a healthy dose of skepticism. Look for a change in accounting practices by the management, and always ask these two questions: “Why?” and “Why now?”

What are your thoughts on forensic accounting as a career for young professionals?

The vast majority of people in forensic accounting, perhaps as much as 99%, work on assignments after the fact, after something bad has already happened. In these cases, forensic accountants support the two sides in litigation. There is even a certification in this area. But that has got absolutely nothing to do with my work. I am from the 1%, those who have to find the train wreck before it has happened, before a company gets into trouble with its auditors, before the SEC asks it to restate earnings. Investment managers hire in-house staff for this type of analysis. Others also outsource is to firms like ours. This is a phenomenal and a highly desirable specialty.

After conducting this interview with Howard Schilit, I was left with the feeling that if the fictional detective Sherlock Holmes, who also worked for clients for a fee, were a real person today, he probably would have preferred Schilit’s line of work on Wall Street. It makes more money, and it probably makes more news, even if it won’t sell as many books.

If you would like to learn more from Schilit, watch the video interview below, in which he reviews a few cases of accounting fraud and discusses techniques on how to identify accounting irregularities.

In the presentation below, recorded at the 2010 CFA Institute Annual Conference, Schilit discusses seven earnings manipulation shenanigans and points to specific examples of how companies use financial statements to disguise economic reality.

A free text version of Schilit’s presentation is also available.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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