Podcast Summary
Understanding Accounting's Role in Shaping Financial Narratives: Accounting significantly impacts financial narratives through practices and rules. Principal Asset Management uses a 360-degree perspective to identify opportunities, while Wall Street relies heavily on accounting with some leeway in reporting.
Accounting plays a crucial role in shaping the financial narrative of businesses and the economy as a whole. While it may be seen as a reflection of reality, it can also shape it through various accounting practices and rules. Principal Asset Management, a real estate manager, leverages a 360-degree perspective to identify investing opportunities, demonstrating the importance of understanding the financial intricacies of businesses. Meanwhile, in the world of finance and Wall Street, the numbers game relies heavily on accounting. However, there's a significant amount of leeway in reporting earnings and financial statements, making it essential to be aware of potential disingenuous accounting practices. In this episode of Odd Lots, Howard Shilot, the founder and CEO of Shilot Forensics and author of "Financial Shenanigans," will discuss the importance of accounting and the various shenanigans that can occur within it.
Management's role in shaping investor perception through accounting: Management can manipulate accounting information to meet investor expectations and present a favorable narrative
Accounting goes beyond just following rules and reporting numbers; it's about how management tells the story to influence investor perception. Companies face pressure to meet expectations, and sometimes they may choose to manipulate accounting information to meet those targets. For instance, Volkswagen might hold off on shipping cars to a dealer if sales are expected to fall short of the consensus estimate. In such cases, the company could either report the delay honestly or find an artificial way to make the numbers. The accounting process becomes a tool for management to navigate business challenges and present a favorable narrative to investors.
Manipulating Financial Statements: From Sales and Expenses to Non-GAAP Measures: Companies increasingly manipulate non-GAAP measures like EBITDA due to the lack of clear rules, making it harder for investors to make informed decisions based on accurate financial information.
Over the years, accounting practices have evolved, and with that evolution, the methods used to manipulate financial statements have changed. While in the past, companies primarily manipulated sales and expenses to meet financial targets, today, the focus has shifted to non-GAAP measures like EBITDA. The lack of clear rules governing non-GAAP measures makes it easier for companies to manipulate these figures without violating any laws. A notable example is WeWork's community adjusted EBITDA, which raised eyebrows by excluding costs related to sales. This trend towards adjusted earnings is a cause for concern, as it makes it more challenging for investors to make informed decisions based on accurate financial information.
Misinformation from Management's Non-GAAP Metrics: Investors can be misled by management's preferred non-GAAP financial reporting if they don't understand the underlying GAAP financials and context.
While management's creativity in reporting non-GAAP financial metrics has evolved over the last 25 years, investors have not kept pace, leading to potential misinformation and deception. The case of WeWork is a prime example, where management asked investors to ignore certain expenses, presenting a skewed picture of the company's financial health. The gap between management's preferred reporting and GAAP-compliant financials can be vast, as demonstrated by the company Valiant, whose gap-based earnings plummeted while its preferred "cash earnings" soared. Despite the availability of audited GAAP financial statements, investors can be fooled by non-GAAP metrics if they don't understand the underlying financials and context. It's crucial for investors to be vigilant, ask questions, and demand transparency to make informed decisions.
Investors' infatuation with a compelling story can overshadow financial risks: Investors should focus on strong cash flows and solid business models, not just compelling stories, and be wary of loose accounting practices.
The love for a compelling story in the business world can sometimes overshadow the importance of financial metrics. In the case of Valiant, investors were drawn to the idea of a new pharmaceutical business model that involved buying up companies, using debt, and cutting R&D expenses. However, the financials raised red flags with large discrepancies between non-GAAP and GAAP numbers. The investors' infatuation with the story led them to overlook the risks and potential pitfalls. It's important to remember that companies with strong cash flows and solid business models are typically more attractive to investors than those constantly seeking external funding. Additionally, loose accounting practices can create a feedback loop with capital markets, where investment banks profit from the inflated valuations, and the companies in need of cash continue to return to the markets, perpetuating the cycle.
Investment banks act as merchants, pitching companies to generate fees and sales: Investment banks play a crucial role in connecting companies with investors, but their incentives lie in generating fees and sales. Accounting rules can be interpreted creatively, making it challenging to determine if transactions comply with GAAP or non-GAAP rules.
Investment banks, like merchants, pitch the companies they believe will generate the most interest and fees from investors. This is because their job is not only to assemble a buying consortium but also to sell a large number of shares. The comparison to merchants is that they need to move inventory to make sales, and they excite potential buyers by upgrading their opinions on companies. The accounting rules, written before the information age, leave room for interpretation and allow companies to come up with creative ways to record revenue, making it challenging to determine if such transactions are compliant with GAAP or non-GAAP rules. The role of auditors and accounting standards bodies in regulating these transactions is a complex issue that could lead to a lengthy discussion. Recently, there have been discussions about changing the quarterly reporting period to a biannual one, but the implications of such a change are yet to be fully understood.
Impact of less frequent earnings reports: Reducing earnings reports to twice a year could lead to less transparency, making it harder for investors to make informed decisions. Eliminating non-GAAP metrics and quarterly earnings calls could help, but investors must stay vigilant and question any unusual financial reporting.
Requiring companies to report earnings every six months instead of every three months could lead to negative consequences. While long-term thinking and managing businesses is good, investors need current information to make informed decisions. Eliminating quarterly earnings calls and non-GAAP metrics in filings could be a solution to reduce the focus on short-term performance. However, investors should remain vigilant and question any unusual or different information presented by companies. For instance, if a company starts emphasizing new metrics or makes significant changes in the way they report financial data, it could be a red flag. Companies may try to hide issues by drawing attention to something else. Therefore, it's essential to stay alert and ask questions to ensure transparency and accurate understanding of a company's financial situation.
Paying attention to unexpected company announcements: Investors should scrutinize unexpected company announcements for hidden significance, and not just accept what's said on the surface. Understanding why companies make certain statements is crucial for informed investment decisions.
Investors should pay close attention to unexpected announcements or "screams" from companies, as they may be hiding something more significant in the fine print. Howard Shillett, the founder and CEO of Shillett Forensics and author of "Financial Shenanigans," emphasized the importance of not just believing what companies say, but understanding why they're saying it. The conversation also touched on the significance of accounting in business and the need for more discussion around it. Additionally, the topic of whether current accounting rules are well-adjusted for the modern economy, with its emphasis on intangible assets like intellectual property and brand value, was raised as an intriguing area for further exploration. The hosts also expressed curiosity about the potential use of machine learning to identify patterns in financial reporting. Overall, the conversation highlighted the importance of digging deeper into financial statements and asking critical questions to make informed investment decisions.
