Savvy Nickel
by Howard Schilit & Jeremy Perler
Howard Schilit's essential guide to detecting accounting manipulation and financial fraud. Learn the seven earnings manipulation schemes and six cash flow shenanigans that companies use to deceive investors — with real-world examples from Enron to Groupon.
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Howard Schilit founded the Center for Financial Research and Analysis (CFRA), a forensic accounting research firm that identified numerous accounting frauds before they became public — including many of the largest scandals of the 1990s and 2000s. Financial Shenanigans is his guide to the techniques companies use to manipulate reported earnings, inflate revenue, obscure cash flows, and mislead investors. The fourth edition (2018) adds cases from the decade after the financial crisis, including Valeant Pharmaceuticals, Groupon, and Lumber Liquidators. Every investor who reads financial statements should read this book first.
| Attribute | Details |
|---|---|
| Title | Financial Shenanigans (Fourth Edition) |
| Authors | Howard Schilit & Jeremy Perler |
| Publisher | McGraw-Hill |
| First Published | 1993 |
| Fourth Edition | 2018 |
| Pages | 352 |
| Reading Level | Intermediate to Advanced |
| Amazon Rating | 4.6/5 stars |
Hardcover: Buy on Amazon
Kindle: Buy on Amazon
Howard Schilit is the founder of CFRA (Center for Financial Research and Analysis), a forensic accounting research firm that published research identifying Enron's accounting irregularities before the scandal broke. He later founded Financial Shenanigans Analysis Group. Jeremy Perler is a former CFRA analyst. Together they have identified hundreds of companies using the techniques described in this book.
Generally Accepted Accounting Principles (GAAP) provide significant flexibility in how companies report results. This flexibility serves legitimate purposes — different industries have different economics that require different accounting treatment. But it also provides cover for manipulation.
The earnings manipulation spectrum:
Conservative Accounting ←→ Aggressive Accounting ←→ Fraudulent Accounting
(Understate) (Overstate) (Fabricate)
Low risk to investor Yellow flag Red flag / SellMost accounting manipulation is not outright fraud (fabricating numbers). It is aggressive use of legitimate accounting flexibility to paint an optimistic picture. GAAP allows this. Detecting it requires reading beyond the headline numbers.
| Statement | What It Shows | Manipulation Potential |
|---|---|---|
| Income statement | Revenue and expenses over a period | Very High — most manipulation focuses here |
| Balance sheet | Assets and liabilities at a point in time | High — asset inflation, liability hiding |
| Cash flow statement | Cash in and out | Lower — harder to manipulate but not impossible |
The income statement is easiest to manipulate because it involves the most accrual accounting judgments. The cash flow statement is harder to manipulate because cash is cash — you either have it or you don't. Divergence between reported earnings and operating cash flow is one of the most powerful warning signs in financial analysis.
Technique: Channel Stuffing
A company ships more product to distributors than they can sell, recording the revenue immediately. Distributors later return the unsold product, but the original revenue is already recorded in an earlier period.
Warning signs:
The DSO calculation:
Days Sales Outstanding = (Accounts Receivable / Revenue) × 365A company with $1 billion in annual revenue and $200 million in receivables has DSO of 73 days. If DSO rises to 90 days next year with revenue unchanged, $47 million of additional receivables are sitting uncollected — potential channel stuffing.
Technique: Bill and Hold Transactions
Record revenue when a customer "commits" to purchase, even though the product has not been delivered and the customer may have no legal obligation.
Real example — Sunbeam (1997):
Al "Chainsaw Al" Dunlap used bill-and-hold transactions extensively, recording revenue on products stored in Sunbeam's own warehouses. When the fraud unraveled in 1998, Sunbeam filed for bankruptcy within two years.
Technique: Related-Party Transactions
Record revenue from transactions with entities the company controls or has undisclosed relationships with.
Technique: Round-Trip Transactions
Two companies agree to pay each other equal amounts, each recording the payment as revenue. Net economic effect: zero. Reported revenue for each: doubled.
Warning signs:
Technique: Gains From Asset Sales
Record gains on the sale of business units or assets as if they were recurring operating income.
Technique: Investment Income Classification
Classify investment gains within operating income rather than below the line, inflating reported operating earnings.
The normalized earnings test:
For each year's earnings, ask: "If I remove all one-time items (asset sales, litigation settlements, insurance recoveries, write-down reversals), what did this business actually earn from its ongoing operations?" If one-time gains are recurring and growing, the underlying business may be deteriorating while reported earnings look stable.
Technique: Inappropriate Capitalization
Expense items that should be charged immediately are instead capitalized (put on the balance sheet as assets) and amortized over future periods, reducing current-period expense and boosting current earnings.
Classic case — WorldCom (2001):
WorldCom capitalized $3.8 billion in routine network maintenance costs as capital expenditures. This inflated reported earnings by $3.8 billion. When the fraud was revealed, WorldCom filed the largest bankruptcy in U.S. history at the time.
Warning signs:
The capex-to-depreciation ratio:
Capex / Depreciation ratio:
- Above 1.5x for growing companies: normal
- Below 1.0x for growing companies: underinvesting or aggressive expense capitalization
- Dramatically above 2.0x for stable companies: potential expense capitalizationTechnique: Cookie Jar Reserves
Build up excessive reserves during good years, then release them into income during bad years to smooth reported earnings.
How it works:
In a good year: record a $100 million "restructuring charge" that is excessive. Put the $100 million in a liability reserve.
In a bad year when earnings would miss: release $50 million from the reserve into income. Report earnings that beat estimates.
Warning signs:
Technique: Operating Lease Off-Balance-Sheet Financing
Under old GAAP (pre-2019), operating leases could be kept off the balance sheet entirely, hiding the company's true debt obligations. New ASC 842 now requires most leases on the balance sheet — but investors should understand why the change was made.
Companies use this technique when they want to smooth earnings downward (typically when current earnings are unsustainably high, and they want to create reserves for future periods).
Technique: Deferred Revenue Creation
Record current-period revenue as "deferred" even when earned, keeping it off the income statement for future periods.
Warning signs:
Technique: Big Bath Charges
Take enormous write-downs and restructuring charges in a single bad year to "clear the decks" for future periods. Future reported earnings look good because the expenses were front-loaded.
Example pattern:
| Year | Reported Earnings | "One-Time" Charges |
|---|---|---|
| Year 1 | -$500M | $800M restructuring charge |
| Year 2 | +$200M | None |
| Year 3 | +$250M | None |
| Year 4 | +$300M | None |
The company looks like it turned around. In reality, Year 1's overloaded charge artificially deflated that year's results and inflated all subsequent years' results.
Cash flow is harder to manipulate than earnings, but not impossible. Schilit documents six techniques:
Technique: Borrow money but classify the receipt as operating cash flow rather than financing cash flow.
Example: A company receives a $50 million customer deposit and classifies it as operating cash inflow rather than a liability. Future refunds of the deposit appear as operating cash outflows — but by then, management may have moved on.
Technique: Capitalize what should be operating expenses, moving the cash outflow from operations to investing activities.
Effect: Operating cash flow looks better than it is. Investing cash flow looks worse, but investors typically discount investing outflows as "growth investment."
Warning sign: Capital expenditures growing dramatically faster than revenue, especially in businesses that should have limited need for physical assets.
Technique: Acquire businesses primarily for their working capital (receivables, inventory) and classify the acquired working capital as operating cash inflow.
Effect: Operating cash flow spikes in acquisition years, creating the appearance of organic improvement.
Technique: Stretch accounts payable (delay payments to suppliers) or accelerate collections (offer discounts for early customer payment) to temporarily inflate operating cash flow.
Effect: One-time improvement in cash flow that reverses in subsequent periods.
Warning signs:
Like cookie jar reserves for earnings, but applied to cash flow. Release reserves for litigation, warranty, or restructuring into operating cash flow.
Using non-GAAP "adjusted" cash flow measures that exclude legitimate expenses. Free cash flow defined to exclude "growth investments" that are actually maintenance requirements.
Schilit's consolidated red flags for financial statement analysis:
| Red Flag | Calculation | Threshold |
|---|---|---|
| Rising DSO | (AR / Revenue) × 365 | DSO rising >5 days year-over-year |
| Revenue growth outpacing cash collection | Revenue growth vs. cash collected | Cash growth < 80% of revenue growth |
| Related party revenue concentration | Related party revenue / total revenue | Above 5% requires investigation |
| Revenue recognized before delivery | Review revenue recognition policy | Any "bill and hold" language |
| Red Flag | Calculation | Threshold |
|---|---|---|
| Aggressive capitalization | Capex vs. peers | Materially above industry average |
| Declining depreciation rate | Depreciation / PP&E | Declining trend suggests extended asset lives |
| Goodwill growing without acquisition | Goodwill changes vs. acquisition price | Any growth not explained by acquisitions |
| Red Flag | Calculation | Threshold |
|---|---|---|
| Earnings-cash flow divergence | Net income - Operating cash flow | Growing divergence over time |
| Declining cash conversion | Operating cash flow / Net income | Below 0.8x for multiple years |
| Capex exceeds depreciation by large margin | Capex / Depreciation | Above 2.5x for non-growth companies |
Enron used special purpose entities (SPEs) to keep billions in debt off the balance sheet. When the SPEs collapsed, Enron could not meet its obligations. The warning signs:
Groupon went public in 2011 reporting revenues that included the full value of vouchers sold — not just Groupon's commission portion. After SEC scrutiny forced restatement, reported revenues fell by approximately 50%. The warning signs:
Valeant used acquisitions and price increases to generate "organic" growth — growth that was neither organic nor sustainable. When the pharmacy network used to channel prescriptions was revealed, the stock fell 90%. The warning signs:
Rating: 4.6/5
Financial Shenanigans is the essential guide to reading financial statements critically. Every investor who analyzes individual stocks should internalize the seven earnings manipulation schemes, six cash flow shenanigans, and red flags checklist before making any investment decision. It will save you from the next Enron.
Hardcover: Buy on Amazon
Kindle: Buy on Amazon
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