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Financial Shenanigans 101

Definition
“Financial shenanigans are acts or actions designed to mask or misrepresent the true financial performance or actual financial position of a company or entity.

Financial shenanigans can range from relatively minor infractions involving creative interpretation of accounting rules to outright fraud over many years. In almost every instance, the revelation that a company’s stellar financial performance has been due to financial shenanigans rather than management prowess will have a calamitous effect on its stock price and future prospects.

Depending on the scale and scope of the shenanigans, the repercussions can range from a steep sell-off in the stock to the company’s bankruptcy and dissolution.” (Source – Investopedia)

Best Books on the Subject
Howard Schilit’s Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Charles Mulford’s Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance and The Financial Numbers Game: Detecting Creative Accounting Practices.

Why Firms/Managers Indulge In It

  • Firms need to raise capital at cheap rates and thus need to look better to credit rating agencies and lenders
  • Shenanigans can have huge paybacks (higher profits, performance linked bonuses etc.)
  • Companies omit things to prevent negative outcomes
  • Omissions are made to dispel negative market perceptions (especially during bull markets)
  • These are easy to do
  • It’s unlikely the wrongdoers will get caught

Hotbeds

  • Firms under pressure to maintain high growth rate in earnings or revenues
  • Firms that trumpet earnings projections and growth expectations
  • Firms that need constant capital infusion to sustain growth or survive
  • Managers with large part of compensation tied to stock options whose value depend largely on earnings growth than quality of those earnings
  • Companies raising money through IPOs so that they look best before they make their public appearance
  • Businesses with a lot of regulations
  • Firms making a lot of acquisitions (most are done for bad reasons anyways)
  • Real estate and construction companies (politicians, banks…all are involved in most cases)
  • Banks and financial institutions (don’t get me started here!)

A Struggling Artist’s Impression



[Click on the images to download their larger versions]

Easy to Spot Shenanigans?
No. It’s difficult. Perpetrators of accounting frauds and shenanigans are reading the same books that you are, and some may also be reading this post.

Safety Measures

  • Be suspicious of firms in which you are considering an investment. Your investment in any stock could be subject to a major loss as a result of unethical or incompetent management.
  • Recognize your limitations…because you cannot necessarily detect firms that use deceptive accounting or that waste cash because of the unethical or incompetent behavior of their managers.
  • Diversify…so that you are not excessively exposed to any single investment whose value may ultimately be affected by misleading accounting or other unethical behavior on the part of the firm’s executives.
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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Venkatesh says:

    Hi Vishal, The article is very nice. Incidentally i have read all the three recommended book. But need to re-read them again as it is years since i read them. I put forth a suggestions that you consider sharing a few blogs in this “Financial Shenanigans” as a Series similar to your Annual report series/Mental model series. Just the core and easily identifiable ones, may be with a few examples in Indian context. Many must be aware of reading financial statements by ease, but not identifying shenanigans and the creating account practices.

    Thanks Venkatesh.

  2. It is a great post. Will be helpful if you can go deep in the matter of Financial Shenanigans and do a series on it.

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