Sample frameDay 109·Finance · Scrutiny

Good morning. Somebody chose your profit, inside the rules. Today you find out which choices they made.

Finance.

The Quality of Earnings

5 min read·Apply by lunch

The question

Of the profit your last accounts reported, how much arrived as money in the bank and how much arrived as a judgement somebody made about timing? Both lines are already sitting in accounts you've filed. Leave them on separate pages and you're steering by a figure that was partly chosen for you.

The idea

Howard Schilit was an accounting professor turned forensic analyst when he published Financial Shenanigans in 1993, a field guide to the ways a reported profit gets manufactured. His catalogue went through them one at a time — revenue recorded too soon, revenue that was never real, revenue held back from a strong period to lift a weaker one, expenses shifted into a later period, expenses dragged into the current one, liabilities left unrecorded, one-off gains dressed up as trading income — and every one of them moves the profit line without moving a dollar. That's the part most operators miss. Accounting is a set of choices made inside rules: when revenue is recognised, whether a cost becomes an asset or an expense, how long a machine is assumed to last, how much of a provision counts as prudent. Two businesses with identical bank accounts can lawfully report materially different profits, and neither of them has broken anything. Schilit's most useful instrument is also his simplest: track reported profit against cash generated from operations across several periods, because the gap between them is where the choices accumulate.

The framework

01
Two numbers, and only one of them is a bank statement.
Reported profit is assembled from choices. Cash generated from operations is what the bank agrees happened. Set the two side by side for the last eight quarters and read the relationship rather than the level. Profit that consistently runs ahead of operating cash means value is being recognised faster than it's being collected — sometimes legitimately, through growing receivables or work in progress, sometimes not. Direction is what matters. A gap that widens quarter after quarter is the cheapest warning signal in accounting, and watching it costs you one row of a spreadsheet.
02
Name your six dials, and write down where each one is set.
Revenue recognition: at order, at delivery, or spread across the contract. Capitalise or expense: which costs become assets on the balance sheet rather than costs in the year. Useful lives: how long equipment and intangibles are assumed to last before they are written off. Provisions: bad debt, warranty, stock obsolescence, every one of them an estimate somebody chose. Stock and work in progress: what basis values them, and when a write-down gets taken. Classification: which gains and costs get called one-off and lifted out of the trading result. Six legitimate choices, six ways the profit line moves while the bank balance sits still.
03
Turn the same six on anyone whose numbers you're about to trust.
You'll read someone else's accounts this year: an acquisition target, a supplier asking for terms, a partner proposing a venture, a company you're considering joining. Ask which dials they've moved and when, because the tell is almost never the setting itself — it's a change of setting inside the period being sold to you. A useful life extended. A provision released. A cost newly capitalised. A definition of adjusted profit that grew a fresh exclusion this year. Ask for the same statements prepared on last year's basis, and read whatever closes the gap.
04
Who is served by the setting?
Almost everything you find will be entirely within the rules, which is why 'is this allowed' is the wrong question to ask of it. Follow the incentive instead: a bonus tied to reported profit, a covenant that must be cleared by June, a sale process eighteen months out, an investor update that has already promised a trend. Then turn the same eye on your own house, because a dial set to improve the number you report to yourself also stops that number telling you anything. An operator managing to a figure they've quietly shaped has stopped receiving information from their own accounts.

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