WEBVTT - A Forensic Accounting Expert Explains How Companies Trick Investors 0:00:10.720 --> 0:00:14.600 Hello, and welcome to another episode of the podcast on 0:00:14.720 --> 0:00:18.799 Tracy Allowett and I'm Joe Wisenthal. Joe, what is my 0:00:18.960 --> 0:00:23.160 all time favorite topic? I know the answer to this fraud? 0:00:23.360 --> 0:00:28.440 Financial fraud. Yeah, yeah, you're actually right. I'm actually right. 0:00:28.800 --> 0:00:31.920 It's such a surprise that I would get this quite sure. 0:00:31.960 --> 0:00:34.720 You you asked it so definitively and we've been doing 0:00:34.760 --> 0:00:37.360 this for a while. But thank you, thank you for 0:00:37.400 --> 0:00:40.000 giving me that credit. I only say that because you 0:00:40.040 --> 0:00:42.760 didn't know my age, uh in that one episode that 0:00:42.800 --> 0:00:45.639 we did. Uh, So thank you for um. Even if 0:00:45.640 --> 0:00:47.280 you don't know how old I am, you know what 0:00:47.320 --> 0:00:50.080 I'm interested in and that means a lot. So yes, 0:00:50.280 --> 0:00:54.120 I am definitely interested in financial fraud. And one of 0:00:54.160 --> 0:00:57.680 the most interesting aspects of financial fraud, in my humble opinion, 0:00:58.200 --> 0:01:03.160 is usually the counting let's say, chicanery that goes along 0:01:03.200 --> 0:01:08.199 with it. Right, Because business happens and people buy stuff 0:01:08.240 --> 0:01:12.240 and sell stuff. But between the time something happens and 0:01:12.360 --> 0:01:15.120 the time when it actually gets recorded on paper and 0:01:15.200 --> 0:01:19.200 recognized as us cells and cash coming in and out 0:01:19.200 --> 0:01:22.880 of the business, a lot can happen. Yeah, that's right, 0:01:22.920 --> 0:01:26.479 And if you think about it, finance wall Street. It's 0:01:26.520 --> 0:01:29.240 all a numbers game, right, And the way that we 0:01:29.440 --> 0:01:33.839 think about that those numbers is uh well, basically dictated 0:01:33.880 --> 0:01:37.040 by something that we like to call accounting, and there 0:01:37.080 --> 0:01:41.120 are various accounting rules that govern how people are supposed 0:01:41.160 --> 0:01:45.200 to report their earnings and the wider goings on of 0:01:45.280 --> 0:01:48.040 their businesses. But of course there's also a lot of 0:01:48.120 --> 0:01:50.120 leeway in the way that you can come up with 0:01:50.160 --> 0:01:53.800 those numbers, and even if you're not committing outright fraud, 0:01:54.200 --> 0:02:00.440 you can definitely utilize disingenuous accounting practices. Practice is that 0:02:00.600 --> 0:02:06.280 can either deliberately mislead your investors or maybe unintentionally, but 0:02:06.400 --> 0:02:09.720 usually deliberately. You know, it's funny. I'm really excited about 0:02:09.720 --> 0:02:13.240 this topic as well. He was just reading the autobiography 0:02:13.280 --> 0:02:17.680 of the Nike CEO, Phil Knight, and he was previously 0:02:17.720 --> 0:02:20.440 an accountant, and he talked about that it was through 0:02:20.520 --> 0:02:24.600 being an accountant that he really learned what made businesses 0:02:24.919 --> 0:02:28.799 fail or thrive. And it got me thinking that whereas 0:02:28.800 --> 0:02:32.440 we often think of something happening in reality and then 0:02:32.760 --> 0:02:35.720 the accounting being this sort of reflection of reality, that 0:02:35.840 --> 0:02:39.480 maybe the accounting is the reality, and that there's nothing 0:02:39.520 --> 0:02:42.720 more real in a sense than the process of writing 0:02:42.760 --> 0:02:47.080 down a number. So I'm very excited. Uh, we're talking 0:02:47.080 --> 0:02:49.960 about accounting, and so why don't you tell us what 0:02:49.960 --> 0:02:53.160 we're gonna be talking about today specifically? Yeah? Wow, okay, 0:02:53.200 --> 0:02:55.480 so we're definitely going to go deep in this episode. 0:02:55.720 --> 0:02:59.639 Our guest today is actually someone who's come through by 0:02:59.720 --> 0:03:03.799 a listener suggestions, So thank you to Harvard Winters on 0:03:03.800 --> 0:03:07.440 Twitter for suggesting him. Our guest for today is Howard 0:03:07.520 --> 0:03:10.560 schill It. He is the founder and CEO of schill 0:03:10.560 --> 0:03:13.680 Itt Forensics. He's also the author of a book called 0:03:13.840 --> 0:03:18.480 Financial Shenanigans. We're gonna be talking with him about exactly 0:03:18.880 --> 0:03:22.679 what those accounting shenanigans might be, and also about the 0:03:22.760 --> 0:03:40.600 importance of accounting in general. To your point shows, Howard, 0:03:40.680 --> 0:03:44.120 thank you so much for coming on, Tracy and my pleasure. 0:03:44.920 --> 0:03:48.160 So I guess this is a general starting point. Do 0:03:48.200 --> 0:03:52.040 you think accounting gets enough credence when it comes to 0:03:52.120 --> 0:03:54.880 the way we think about business or the wider economy. 0:03:56.240 --> 0:04:00.360 So let me talk about accounting in the way it 0:04:00.840 --> 0:04:05.760 fits into UH investors process of figuring out which company's 0:04:05.760 --> 0:04:08.320 to own, which company is not to own. Think of 0:04:09.000 --> 0:04:12.520 think of it more as a behavioral science and a 0:04:12.960 --> 0:04:18.039 sort of diagram the players and what their objectives are 0:04:18.320 --> 0:04:21.840 and who's winning and who's not winning. So as we know, 0:04:22.200 --> 0:04:27.520 every public company four times a year has to present 0:04:27.600 --> 0:04:31.719 themselves to the investment community, to the constituents who have 0:04:31.760 --> 0:04:37.440 to make decisions, and the mindset of the of the 0:04:37.520 --> 0:04:41.920 public companies, the senior executives is to tell the story 0:04:42.160 --> 0:04:45.720 in such a way that the investors are very impressed. 0:04:47.040 --> 0:04:50.600 So we could say it's not providing the information in 0:04:50.680 --> 0:04:54.880 a balanced fashion, it's always trying to have a very 0:04:54.920 --> 0:04:59.680 positive spin. There are rules, there are generally accepted accounting 0:05:00.080 --> 0:05:04.240 rules g A a P or called gap. But beyond that, 0:05:04.839 --> 0:05:09.800 companies have a whole second universe of information they provide, 0:05:09.839 --> 0:05:13.440 which is non gap metrics. Okay, The other constituents are 0:05:13.480 --> 0:05:16.479 the consumers, the readers, So those are the people who 0:05:16.720 --> 0:05:19.280 are part of my universe and trying to help them 0:05:19.720 --> 0:05:25.120 figure out whether the representations from the company is a 0:05:25.200 --> 0:05:31.120 consistent congruent with the underlying reality as Joe was describing before, 0:05:31.800 --> 0:05:38.240 or whether it is information that is demonstrably different and misleading. 0:05:38.800 --> 0:05:41.279 So the account so think of the accounting and how 0:05:41.320 --> 0:05:46.520 that fits in as how management can tell the story. 0:05:47.000 --> 0:05:49.839 So it's it's it became a fascinating subject to me. 0:05:49.880 --> 0:05:52.960 I was an accounting professor, but it became a fascinating 0:05:53.000 --> 0:05:56.520 subject to me when I began to understand it. Not 0:05:56.680 --> 0:06:01.600 in some mechanical way of just putting numbers on on paper, 0:06:02.160 --> 0:06:06.679 but it's how management can choose to tell the story 0:06:07.360 --> 0:06:12.279 to advance what their interest is. Let's get into different 0:06:12.320 --> 0:06:16.680 ways of telling the same story, because in theory it 0:06:16.720 --> 0:06:19.680 should be simple. If you're a car company, you're like, Okay, well, 0:06:19.720 --> 0:06:25.360 we sold cars this quarter, and our medals costs were 0:06:25.400 --> 0:06:28.600 this much, and our labor costs were this much, and 0:06:28.640 --> 0:06:31.320 we take the revenue and subtract the costs of their 0:06:31.960 --> 0:06:36.120 dear shareholder, was your profit for the quarter. I know 0:06:36.240 --> 0:06:40.080 it's not that simple. But where in the process does 0:06:40.200 --> 0:06:44.000 the discretion of the accountants or management start to enter 0:06:44.000 --> 0:06:51.279 the picture? Okay, wonderful question. So that the information gets 0:06:51.520 --> 0:06:55.480 recorded typically when there's a transaction. So let's use an 0:06:55.480 --> 0:07:00.279 example of somebody who's selling cars. It's your Volkswagen and 0:07:01.200 --> 0:07:05.040 you are in the fourth quarter of two thousand and seventeen, 0:07:05.240 --> 0:07:09.320 and you know, the Wall Street community has a consensus 0:07:09.480 --> 0:07:12.000 estimate of what your revenue and what your sales will be. 0:07:12.680 --> 0:07:16.080 You get a call from a customer Volkswagen, it's like 0:07:16.160 --> 0:07:21.880 a dealer where they say, the cars that you were 0:07:21.920 --> 0:07:26.720 going to be shipping out to us December? Uh, why 0:07:26.720 --> 0:07:30.360 don't we hold off on that until because our business 0:07:30.400 --> 0:07:33.040 is slow and we don't have any place for it. Okay, 0:07:33.040 --> 0:07:37.920 So here's the pressure that Volkswagen has. The numbers that 0:07:38.040 --> 0:07:44.280 everybody's expecting include that delivery sales get recorded when you 0:07:44.360 --> 0:07:49.000 ship them out. So the decision Volkswagen has to make 0:07:49.000 --> 0:07:51.560 it The point is what do we do? The customer says, 0:07:51.600 --> 0:07:56.760 don't ship the goods? Do they ship them to a 0:07:56.760 --> 0:08:01.160 another location? So in order to trick the auditors, Remember 0:08:01.200 --> 0:08:04.600 the line of defense for the investors is the auditor 0:08:04.680 --> 0:08:08.720 can say, no company, you can't do this. So in 0:08:08.840 --> 0:08:13.040 order to uh solve the problem that Volkswagen has, they'll 0:08:13.080 --> 0:08:17.920 miss their numbers if the sales are short. So do 0:08:18.000 --> 0:08:22.680 they act honestly and announced to their put out a 0:08:22.720 --> 0:08:25.200 press release to the investors and basically say this is 0:08:25.240 --> 0:08:29.480 what happened. The sales of say fifty million dollars that 0:08:29.560 --> 0:08:32.360 we expected in the fourth quarter, it's not going to 0:08:32.440 --> 0:08:34.440 come in until the first quarter of next year because 0:08:34.480 --> 0:08:37.120 of you know this episode where the customer called out, 0:08:37.520 --> 0:08:40.679 that's the honest way to do it, or do they 0:08:40.720 --> 0:08:44.080 come up with an artificial way of making the numbers? 0:08:44.080 --> 0:08:46.080 So that's when it gets really interesting. So the the 0:08:46.120 --> 0:08:52.280 accounting itself is simply solving a business problem. So that 0:08:52.400 --> 0:08:55.120 was what they would have to do if the sales 0:08:55.280 --> 0:08:59.280 are a problem. Well, let's take something which actually happened 0:08:59.320 --> 0:09:05.280 about or so years ago at Volkswagen where they change 0:09:05.400 --> 0:09:08.960 their depreciable life of their planted equipment. So, as you know, 0:09:10.000 --> 0:09:16.080 most companies have uh certain assets that depreciate and that 0:09:16.240 --> 0:09:21.480 is reflected as an expense. They Volkswagen was depreciating their 0:09:21.559 --> 0:09:25.560 planted equipment over ten years, a short period, so they 0:09:25.600 --> 0:09:29.680 seem very conservative. And then you read the footnote in 0:09:29.720 --> 0:09:33.440 the next period and you see a slight change in 0:09:33.480 --> 0:09:37.400 wording where the depreciation which had been over a ten 0:09:37.480 --> 0:09:41.640 year period, the wording was it's now ten to fifteen years. 0:09:42.240 --> 0:09:46.760 Get very subtle one. What's going on there? The company 0:09:47.120 --> 0:09:51.160 was struggling. See we figured it out because you don't 0:09:51.200 --> 0:09:55.560 just whimsically change your your accounting policies if if you 0:09:55.559 --> 0:09:59.720 don't need to, and by stretching out their depreciable life 0:09:59.720 --> 0:10:06.480 by AFT, they obviously lowered their expenses and they were 0:10:06.480 --> 0:10:09.200 able to meet the numbers. So so the accounting I 0:10:09.200 --> 0:10:12.640 gave one example on the revenue side, one example on 0:10:12.720 --> 0:10:15.600 the expense side. But each one of these situations is 0:10:16.240 --> 0:10:20.520 there's a problem. The company has a choice of do 0:10:20.600 --> 0:10:24.360 we disclose what's really going on to the investors or 0:10:24.400 --> 0:10:27.280 do we try to cover it up? Right, So how 0:10:27.280 --> 0:10:30.720 are you just described two examples, and of course there 0:10:30.720 --> 0:10:33.920 are various ways to do these cover ups as you 0:10:34.120 --> 0:10:38.319 describe them. I'm wondering, given that you've been an accounting 0:10:38.360 --> 0:10:42.160 professional for a long time, have you noticed that the 0:10:42.600 --> 0:10:46.640 common sort of accounting fludges or cover ups have changed 0:10:46.800 --> 0:10:49.280 over the years. Is there one that used to be 0:10:49.840 --> 0:10:54.160 quite pervasive or popular and now it's maybe something else? Yeah, 0:10:54.400 --> 0:10:58.199 very very interesting questions. So the book that I described 0:10:58.920 --> 0:11:03.200 Financial Shenanigan, the twenty five anniversary edition was is published, 0:11:03.240 --> 0:11:05.320 so I could sort of give you a retrospect. So 0:11:05.320 --> 0:11:09.000 so the first edition came out while I was still 0:11:09.040 --> 0:11:12.880 a professor. So so in terms of the tricks and tracy, 0:11:12.960 --> 0:11:15.720 let me get to that. So in the in the 0:11:15.760 --> 0:11:19.960 earlier years, we'll say, up until Sarbanes Oxley came out 0:11:20.400 --> 0:11:24.160 a little bit over a decade ago, which placed greater 0:11:24.280 --> 0:11:29.240 restrictions and the possibility of jail time for the CEO 0:11:29.400 --> 0:11:33.040 and CFO if they sign off on financial statements that 0:11:33.120 --> 0:11:37.040 are not in compliance with the rules. Uh back, I'd 0:11:37.040 --> 0:11:40.240 say until roughly a little more than a decade ago, 0:11:41.520 --> 0:11:47.520 most of the big stories were mucking around with sales 0:11:47.600 --> 0:11:50.839 and expenses, things that are part of what we call 0:11:50.920 --> 0:11:56.280 the gap based numbers. Okay, after that and and this, uh, 0:11:56.440 --> 0:12:00.920 the takeaway should be things are more dangerous today and 0:12:01.400 --> 0:12:08.120 the so so the accounting trickery has largely migrated from 0:12:08.240 --> 0:12:13.800 the gap based results to what's called non gap that is, 0:12:14.200 --> 0:12:19.599 things that start with ibida. So if there's one takeaway 0:12:19.920 --> 0:12:24.960 your listeners should embrace, that is, if you could ignore 0:12:26.080 --> 0:12:32.000 ibada because ibada is simply a non gap construct which 0:12:32.040 --> 0:12:38.400 is easily manipulatable. So I'd say that's again, things are, are, 0:12:38.400 --> 0:12:42.480 in my judgment, moving in a in a very bad 0:12:42.559 --> 0:12:47.840 direction because the it's so much easier for management to 0:12:47.960 --> 0:12:51.719 play games and still not be violating the rules or 0:12:51.760 --> 0:12:55.240 the laws because there are no rules. Howard, I want 0:12:55.280 --> 0:12:58.400 to press you on this point because it has become 0:12:58.440 --> 0:13:01.240 a really hot topic in recent a people talk about 0:13:01.280 --> 0:13:04.880 the gap between basically adjusted earnings what you're talking about 0:13:05.200 --> 0:13:09.760 do versus the gap numbers these sort of official, legally 0:13:09.880 --> 0:13:14.400 required numbers um. And we've seen some pretty let's say 0:13:14.440 --> 0:13:18.720 strong examples of adjusted earnings recently. The one that springs 0:13:18.760 --> 0:13:20.719 to mind have to be we work when they have 0:13:20.920 --> 0:13:25.600 something called community adjusted EBITDA, which seemed to be ebit 0:13:25.679 --> 0:13:30.080 don minus the cost of sales, which seemed really really 0:13:30.120 --> 0:13:33.440 weird to me. So how much of a problem is 0:13:33.520 --> 0:13:38.199 this and why did adjusted earnings become so pervasive when 0:13:38.240 --> 0:13:43.959 it comes to business reporting? So the question of why, 0:13:44.080 --> 0:13:49.559 I think it's the executive community have just gotten more 0:13:49.600 --> 0:13:56.600 clever and the investor community have not really kept up 0:13:56.679 --> 0:14:00.160 with sort of what what they need to do. So, 0:14:00.240 --> 0:14:02.720 just to sort of put this in the context of, uh, 0:14:02.880 --> 0:14:06.240 the last twenty five years, I told you that's the 0:14:06.240 --> 0:14:09.360 the when the first book came out. So over that 0:14:09.400 --> 0:14:14.280 period I've also been working helping institutional investors. And what 0:14:15.040 --> 0:14:20.160 you know, what's become clear is that the the category 0:14:20.440 --> 0:14:25.520 of tricks identifying keeps growing, or another way of saying it, 0:14:26.240 --> 0:14:32.560 management has continued to evolve in terms of the creativity 0:14:32.600 --> 0:14:36.800 of tricking investors. I try to help the good guys 0:14:37.120 --> 0:14:40.320 and say these are the tricks I've learned. Now starts 0:14:40.360 --> 0:14:45.080 stepping up your game to protect yourself. But the what's 0:14:45.240 --> 0:14:52.720 fallen pretty far behind is once management figured out that 0:14:53.120 --> 0:14:58.600 ibadah and other non gap derivative measures of that and 0:14:58.640 --> 0:15:02.080 your example, if we were it fits exactly into that category. 0:15:02.600 --> 0:15:06.200 You started out with the gap based earnings, and you decide, 0:15:06.240 --> 0:15:10.960 as management, we're going to tell investors to ignore this expense, 0:15:11.320 --> 0:15:14.280 and that expands. Yeah, with with we work. They're basically 0:15:14.320 --> 0:15:18.320 saying the only expense that investors should pay attention to 0:15:18.920 --> 0:15:21.120 is the cost of good soul and all of the 0:15:21.240 --> 0:15:24.520 selling and marketing and R and D. To ignore it's 0:15:24.560 --> 0:15:29.600 it's ridiculous. I have so many questions listening to this, 0:15:29.720 --> 0:15:32.760 but one of them is, and I'm kind I'm not 0:15:32.800 --> 0:15:36.240 like a hardcore efficient markets hypothesis kind of guy, but 0:15:36.320 --> 0:15:40.520 I generally think markets are somewhat efficient. If they put 0:15:40.560 --> 0:15:42.840 out the gap numbers. I mean, I know, they say, 0:15:42.840 --> 0:15:45.760 here's the non gap numbers with our preferred adjustments that 0:15:45.760 --> 0:15:48.240 they'd like you to they'd like you to look at. 0:15:48.520 --> 0:15:51.960 But the gap numbers are all there, So preadjustments and 0:15:52.000 --> 0:15:56.040 just buy the book. Accounting in theory sits there right there. 0:15:56.200 --> 0:16:00.120 Why how can investors really get fooled? And Matt, it's 0:16:00.160 --> 0:16:02.040 like I could see some people not looking. But for 0:16:02.120 --> 0:16:05.760 serious investors, isn't the data there for them? Okay? So 0:16:06.200 --> 0:16:08.680 let me use one company as a case study to 0:16:08.920 --> 0:16:13.400 sort of help us, you know, get our hands around understanding. 0:16:13.800 --> 0:16:17.000 So Valiant was the big story of the last decade. 0:16:17.400 --> 0:16:19.400 It was a company that went from a two billion 0:16:19.440 --> 0:16:22.240 dollar market value to ninety billion, which was big of 0:16:22.240 --> 0:16:25.520 an en Ron back down to three billions, nineties six 0:16:25.560 --> 0:16:29.760 percent of its value. Over we'll say a five year 0:16:29.800 --> 0:16:35.880 period from roughly two thousand, twelve thirteen until sixteen, there 0:16:36.800 --> 0:16:42.000 gap based results cumulatively. Again, this is a company that 0:16:42.040 --> 0:16:45.200 went up. How many times you would have assumed that 0:16:45.240 --> 0:16:48.440 their gap based results would have been pretty amazing. Their 0:16:48.600 --> 0:16:53.080 cumulative gap based earnings during that period was around negative 0:16:53.200 --> 0:16:56.680 three billion dollars. Okay, it was there, It was audited. 0:16:56.720 --> 0:16:59.560 It was you know, you look at every ten k 0:17:00.040 --> 0:17:02.320 and you add up the total bottom line, and that 0:17:02.440 --> 0:17:07.119 was it. The alternative universe that the company was putting 0:17:07.160 --> 0:17:11.040 out with something called cash earnings. You do the exact 0:17:11.040 --> 0:17:14.119 same drill. You add up for that five year period 0:17:14.520 --> 0:17:18.959 the total each year it was positive nine billion. It 0:17:19.040 --> 0:17:24.000 was so easy to see that if it's essentially measuring 0:17:24.040 --> 0:17:28.760 the same underlying health of the business. One was gap 0:17:28.760 --> 0:17:32.840 based earnings, the other was this surrogate measure they call 0:17:32.960 --> 0:17:37.480 cash earnings. So how does it make sense if, uh, 0:17:37.680 --> 0:17:42.359 your non gap metric is shooting to the stars and 0:17:42.520 --> 0:17:47.760 the audited gap based measure is plummeting deep into the sea. 0:17:48.000 --> 0:17:51.439 So Joe, you know, the question is how did people 0:17:51.440 --> 0:17:55.400 not see this? It was there, but for some reason, 0:17:56.119 --> 0:18:01.040 the the love affair that they had with the company, 0:18:01.200 --> 0:18:05.000 they kept pointing to a metric that didn't make any 0:18:05.040 --> 0:18:09.200 sense with billion. There was also an exciting story. People 0:18:09.280 --> 0:18:12.560 thought they had found some new model riot of buying 0:18:12.640 --> 0:18:16.320 up drugs using debt and slashing the R and D expenses, 0:18:16.320 --> 0:18:19.040 And people thought this could be the new model of 0:18:19.080 --> 0:18:23.480 how format works. So, yes, it's true that the non 0:18:23.560 --> 0:18:27.480 gap numbers a accelerated and be there was a huge 0:18:27.480 --> 0:18:30.480 gap between non gap and gap, But people also fell 0:18:30.520 --> 0:18:33.440 in love with Let me sort of jump in and 0:18:33.520 --> 0:18:36.159 say that's the problem where they fell in love with 0:18:36.200 --> 0:18:41.479 a story. Right, you use the term platform company, people 0:18:41.600 --> 0:18:45.680 melt right. The term platform company is sort of the 0:18:45.760 --> 0:18:49.160 current iteration of what in the sixties was called a conglomerate, 0:18:49.680 --> 0:18:52.560 in the nineties was called a roll up. So you're 0:18:52.600 --> 0:18:56.840 absolutely right. For people who who fall in love with 0:18:57.000 --> 0:19:03.400 stories and don't actually look at the numbers, that's that's 0:19:03.400 --> 0:19:06.199 exactly what was happening in that situation. They fell in 0:19:06.240 --> 0:19:08.720 love with the story and they they saw the two 0:19:08.720 --> 0:19:11.760 point nine billion or whatever that losses I was describing, 0:19:12.560 --> 0:19:16.840 but they said, but their cash earnings, and they built 0:19:16.880 --> 0:19:20.919 a better mouse trap. Right, instead of being like Merk 0:19:21.040 --> 0:19:24.040 or the other big pharmaceuticals where they spend so much 0:19:24.040 --> 0:19:26.920 on R and D and most of it doesn't result 0:19:27.000 --> 0:19:31.719 in successful products, h Valiant figured out a better model. 0:19:31.840 --> 0:19:34.080 And I looked at that and said, you really think 0:19:34.080 --> 0:19:36.720 that people that Fiser and Merk are so stupid that 0:19:36.760 --> 0:19:40.080 they didn't know that there was an alternative by versus 0:19:40.200 --> 0:19:44.199 make Why did they figure something out which seems so 0:19:44.280 --> 0:19:48.160 obvious but it wasn't. Because when you are a drug company, 0:19:48.200 --> 0:19:51.080 you know the cost of being in that business is 0:19:51.119 --> 0:19:53.000 you have to spend a lot of money in the 0:19:53.119 --> 0:19:58.000 drug discovery and uh, So if you want to de 0:19:58.160 --> 0:20:02.560 risk yourself, which is Alliance Pitch, you buy Bosh and Loom, 0:20:02.760 --> 0:20:07.440 you buy other companies forty billion dollars, Well, nobody's giving 0:20:07.480 --> 0:20:11.120 it to you for free, so you are buying. Yeah. 0:20:11.280 --> 0:20:15.879 So the the notion was I think completely misguided, right. 0:20:15.960 --> 0:20:19.200 And in the case of Valiant, from what I remember 0:20:19.280 --> 0:20:23.320 and to Show's point, the story was almost embedded in 0:20:23.359 --> 0:20:25.719 the numbers, right because a big part of what they 0:20:25.760 --> 0:20:30.199 were doing were add backs based on the acquisitions that 0:20:30.280 --> 0:20:34.320 they were making, so sort of immediately embedding that growth 0:20:34.359 --> 0:20:38.159 story into their numbers. One of the things that I 0:20:38.200 --> 0:20:41.280 want to press you on, just on that note is, um, 0:20:41.320 --> 0:20:43.800 you know, we talked about how Valiant would basically borrow 0:20:43.880 --> 0:20:46.720 from capital markets at a very cheap rate or a 0:20:46.760 --> 0:20:50.679 relatively cheap rate, predicated on this notion that it was 0:20:50.720 --> 0:20:55.120 this huge growth company that was going to monetize any second. 0:20:56.240 --> 0:21:00.840 Is there a sort of feedback loop between capital markets 0:21:00.920 --> 0:21:06.840 and market valuations that tends to be aided by loose accounting. 0:21:08.080 --> 0:21:12.080 So uh, if you were trying to put together a 0:21:12.160 --> 0:21:18.359 portfolio of what would be interesting shorts, you probably would 0:21:18.400 --> 0:21:21.080 want to get a list of the companies that are 0:21:21.160 --> 0:21:24.719 the biggest customers of the investment banks, that is, the 0:21:24.760 --> 0:21:29.119 ones that uh true, it's you know, Endron back in 0:21:30.880 --> 0:21:35.360 thousand was probably the most profitable client for the investment 0:21:35.400 --> 0:21:39.080 banks because if you think of it, companies that are 0:21:39.600 --> 0:21:45.800 really generating substantial cash flow, they're funding most of their 0:21:45.840 --> 0:21:51.680 operations and their expansion through their cash flow. Whereas companies 0:21:51.720 --> 0:21:55.920 that have a dearth of cash flow coming from their business, 0:21:56.160 --> 0:21:58.920 they always have their hand down, they always need more 0:21:58.960 --> 0:22:03.640 and more. So sort of this this virtuous loop where 0:22:03.680 --> 0:22:07.040 the ones that are are in need of cash, right, 0:22:07.119 --> 0:22:10.480 the ones who keep coming back to the capital markets 0:22:11.080 --> 0:22:15.240 are probably not the strongest players. In fact, just the opposite. 0:22:15.680 --> 0:22:17.920 And when you think about the ones that are pitched 0:22:18.000 --> 0:22:22.480 the most vociferously by the analyst of the firm, doesn't 0:22:22.560 --> 0:22:25.399 make sense that they're going to be pitching the companies 0:22:25.440 --> 0:22:28.080 for investors to buy of the ones that they have 0:22:28.160 --> 0:22:31.160 the most merchandise to sell, you know, think of the Uh, 0:22:31.240 --> 0:22:35.199 the investment bank no different than merchants. They they are 0:22:35.600 --> 0:22:38.440 would deny that they're right. They would say, oh, there's 0:22:38.480 --> 0:22:41.280 definitely a wall between you know. But but I'm saying, 0:22:41.280 --> 0:22:43.879 just look at the reality of the business. Whatever the 0:22:44.040 --> 0:22:47.439 whatever the the constructs are inside is not the point. 0:22:47.960 --> 0:22:52.000 It's if your job is to raise a large amount 0:22:52.119 --> 0:22:56.520 of capital for X y Z company, what does that mean? 0:22:56.560 --> 0:22:59.760 Not just put together the the consortium of who's going 0:22:59.800 --> 0:23:02.200 to be buying it, but you have to sell a 0:23:02.200 --> 0:23:05.199 whole bunch of shares, right, So your your client is 0:23:05.280 --> 0:23:09.520 the corporate American expressesn't pick any company and you need 0:23:09.600 --> 0:23:12.080 to sell that. So that I'm saying that sort of 0:23:12.080 --> 0:23:14.480 the analogy to a merchant is you have a whole 0:23:14.480 --> 0:23:17.880 bunch of inventory that you have to move. In order 0:23:17.920 --> 0:23:20.280 to move the inventory, you have to get people excited 0:23:20.280 --> 0:23:23.080 about it, and you get people excited by saying, we've 0:23:23.160 --> 0:23:26.200 upped our opinion on this company from you know, neutral 0:23:26.320 --> 0:23:29.280 to buy, from buy to strong buy. So that's so again, 0:23:29.280 --> 0:23:31.639 I don't care what kind of you know, structural walls. 0:23:31.680 --> 0:23:36.480 There are Chinese, French, Italian walls, whatever you're gonna call them. Um, 0:23:36.600 --> 0:23:42.520 the the the companies that uh generate the great fees 0:23:42.920 --> 0:23:46.840 from investment banking are the ones that I would put 0:23:46.880 --> 0:23:50.360 on the list of be careful. You mentioned in Valiant, 0:23:50.600 --> 0:23:53.240 and that brings me back to another question I had, 0:23:53.280 --> 0:23:57.280 which is how much of the the fudges or the 0:23:57.320 --> 0:24:01.280 cover ups changed since you first wrote the book thanks 0:24:01.359 --> 0:24:06.359 to the growth of intellectual property based business models. So 0:24:06.560 --> 0:24:08.560 you know, it's one thing if you're selling cars and 0:24:08.720 --> 0:24:11.400 you record the sale when the car leaves the factory gate, 0:24:12.200 --> 0:24:17.360 versus companies that don't really have much factories and instead 0:24:17.440 --> 0:24:20.960 maybe they have a drug or some sort of really 0:24:20.960 --> 0:24:23.720 strong brand, or they sell ads or something like that. 0:24:24.000 --> 0:24:27.680 How much has that changed the type of fudges that 0:24:27.720 --> 0:24:30.240 you've seen. Yes, that that's actually a very interesting question 0:24:30.400 --> 0:24:34.560 in that the accounting rules were written many many years ago, 0:24:35.080 --> 0:24:38.399 before the information based society. So think of back in 0:24:38.440 --> 0:24:42.040 the forties and fifties and the railroads and so okay, 0:24:42.040 --> 0:24:45.679 So so that's the time the accounting rules were written. 0:24:46.040 --> 0:24:48.119 Now we're in a world where you have, you know, 0:24:48.160 --> 0:24:50.760 a group on coming on and you know, just different 0:24:50.800 --> 0:24:56.280 type of models where uh, the there are no specific 0:24:56.800 --> 0:25:00.280 thou shout nots in the accounting rules for type of 0:25:00.320 --> 0:25:04.720 transactions that were not envisioned back when the accounting rules 0:25:04.760 --> 0:25:10.280 are written. So think about the opportunity set for companies 0:25:10.320 --> 0:25:14.920 to play games, where in the accounting rule book there 0:25:15.080 --> 0:25:18.440 is no thou shall not do this, right, So you 0:25:18.680 --> 0:25:22.960 then as management come up with a funky way of 0:25:23.000 --> 0:25:27.480 recording revenue, you then have it reviewed by your auditor, 0:25:28.600 --> 0:25:30.960 and the auditor it's hard for the auditor to push 0:25:30.960 --> 0:25:33.879 back and say, well, this is a violation of the 0:25:33.960 --> 0:25:38.080 rule if there's no thing, nothing specific in any rule 0:25:38.119 --> 0:25:42.000 book that addresses that type of transaction. So, in terms 0:25:42.000 --> 0:25:45.760 of what makes the challenges so great is that there's 0:25:45.800 --> 0:25:50.320 a lot of interpretation of whether it's GAP compliant or 0:25:50.320 --> 0:25:53.719 whether it's non gap compliants. Right, Howard, I would love 0:25:53.760 --> 0:25:56.240 to press you more on the role of the auditors 0:25:56.280 --> 0:26:00.159 and also the accounting standards bodies, but I'm aware that 0:26:00.640 --> 0:26:02.680 we if we start going down that road, will probably 0:26:02.680 --> 0:26:06.000 go on for an hour. And there's something slightly more 0:26:06.040 --> 0:26:08.879 immediate that I want to ask you, which is lately 0:26:08.920 --> 0:26:13.120 there's been some discussion prompted by a tweet from Donald 0:26:13.160 --> 0:26:17.520 Trump where he's sort of vaguely mused about maybe changing 0:26:17.920 --> 0:26:21.680 the quarterly reporting period to maybe a sort of bi 0:26:21.760 --> 0:26:25.840 annual one, so companies reporting earnings every six months instead 0:26:25.840 --> 0:26:30.320 of every three months as it is currently. As an accountant, 0:26:30.920 --> 0:26:33.399 how how do you feel about that and would it 0:26:33.640 --> 0:26:39.240 ultimately be a good or a bad thing for investors. Okay, 0:26:39.240 --> 0:26:43.080 so short answer, it would be a terrible move. But 0:26:43.200 --> 0:26:46.160 let me give a little more flavor to that. So, 0:26:47.840 --> 0:26:54.639 the way companies should be thinking about their business is 0:26:55.000 --> 0:27:00.080 long term. So having pressure to every quarter on a 0:27:00.200 --> 0:27:05.040 very short basis uh report to the investors puts a 0:27:05.040 --> 0:27:08.440 lot of pressure on short term thinking versus long term. 0:27:08.560 --> 0:27:11.080 So there is a problem, and I'll sort of tell 0:27:11.119 --> 0:27:13.679 you what I think the solution is, but it's not 0:27:13.880 --> 0:27:17.119 why Donald Trump had suggested. So again, so long term 0:27:17.920 --> 0:27:22.720