EBC Book #4 - Smartest Guys in the Room by Bethany McLean and Peter Elkind (Starts Aug 21)

Great. By the way, pacing for this one is 20% per week.

I think their point is that Wall Street values steadily increasing profits more so than profits that may be identical in the aggregate but otherwise exhibit a more volatile pattern. Having worked in equity research and asset management, I can confirm investors like little more than companies whose earnings steadily increase each and every quarter/year. One portfolio manager I used to work for called them "Steady Eddies." From a theoretical perspective, the higher the volatility, the higher the risk. The higher the risk, the larger the discount rate you'd use to discount the company's cash flows. The higher the discount rate used, the lower the net present value of the company. Seasonality is generally frowned upon by investors.

The tax issue that is also referenced is likewise interesting. Remember, the income statement can be gamed, but the cash flow statement dictates how much money an owner can put in his pocket. And companies pay taxes based on their reported income statement profits. So, if you shift profit on the income statement from one quarter into a later quarter, you're deferring your tax liability even though your pre-tax cash from operations would be identical. Since cash taxes are lower now that your income statement profit is lower, you can put more cash in your pocket than you'd be able to if you paid the full amount in taxes today. Notice your quote says bonuses were approved as if the profits were earned in the current year. They were essentially evading taxes temporarily by not realizing the associated liability until a later date, thereby reducing the net present value of the tax liability. Unlike legal means for doing this (such as accelerated depreciation), doing this by intentionally understating taxable profits is fraudulent.

I haven't read this one yet but I read All The Devils Are Here by McLean (about the 2008 financial crisis) and enjoyed it immensely. I will put this one on my list for the future.

Willie, having now read before and after the section you described, it appears there was a third reason they were shifting profits (in addition to showing Wall Street steadily increasing earnings and for tax reasons). Their debt covenants required them to maintain 1.2x interest coverage and that ratio would apply to each and every period. With the volatile nature of their earnings, showing 1.8x one quarter but 1.0x the next (even though the average would be 1.4x) would still trip their covenants. So in the periods where they had more than enough income to cover their 1.2x interest coverage covenant, they would "save some earnings" for periods in which they expected to fall below 1.2x.

I've seen the documentary but have never read the book. had a to do a fraud triangle analysis on Enron. I remember reading about the SPE schemes in my financial statement analysis course. I also remember having an assignment on Sherron Watkins the whistleblower.

I may pick it up when I buy Money the Unauthorized biography by Felix Martin

I'm looking forward to watching the film after next week when we've finished the book.

Lou Pai is the scummiest IMHO.

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My view is that Fastow, so far, is the scummiest of the bunch.

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I've been away from the book thanks to Harvey but I'm hoping to get back on track soon. I'm looking forward to the focus on Fastow. I've been in his home, spent time with him after his arrest and I'm familiar with his criminal conduct. But I've always been curious about how he was characterized in this book.