myinvestingnotes.blogspot.my (Bullbear Buffett Stock Investing Notes)

Keep INVESTING Simple and Safe (KISS) ****Investment Philosophy, Strategy and various Valuation Methods**** The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.

Showing posts with label cooking the books. Show all posts

Thursday, 13 May 2010

Cooking the Books: Investors, be warned.

This discussion should make you better able to see the clues of fraud and remind you to be vigilant.

Managers most often cook the books for personal financial gain - to justify a bonus, to keep stock prices high and options valuable or to hide a business's poor performance. Companies most likely to cook their books have weak internal controls and have a management of questionable character facing extreme pressure to perform.

All fast-growing companies must eventually slow down. Managers may be tempted to use accounting gimmicks to give the appearances of continued growth. Managers at weak companies may want to mask how bad things really are. Managers may want that last bonus before bailing out. Maybe there are unpleasant loan covenants that would be triggered but can be avoided by cooking the books. A company can just be sloppy and have poor internal controls.

One key to watch for is management changing from a conservative accounting policy to a less-conservative one, for example, changing from LIFO to FIFO methods of inventory valuation or from expensing to capitalizing certain marketing expenses, easing of revenue recognition rules, lengthening amortization or depreciation periods.

Changes like these should be a red flag. There may be valid reasons for these accounting policy changes, but not many. Be warned.

Related:

Cooking the Books: The Auditor's Job

Just as some people cheat on their tax returns, thinking they will not be caught, some companies "cook the books" hoping auditors and regulators will not catch them either.

Like "borrowing" $20 from the till until payday, and then not being able to repay the "loan," small illegalities can snowball into major fraud.

Remember, an auditor's job is only to review systematically the company's accounting and control procedures and then sample its business transaction to see whether appropriate policies and procedures are being followed in practice. But it is quite possible for a dedicated and corrupt management to mask transactions and deceive these auditors.

Cooking the Books: Sweetening the Balance Sheet

Most often both the Balance Sheet and the Income Statement are involved in cooking the books. A convenient cooking is exchanging assets with the purpose of inflating the Balance Sheet and showing a profit on the Income Statement as well!

For example, a company owns an old warehouse, valued on the company books at $500,000, its original cost minus years of accumulated depreciation. In fact, the present value of the warehouse if sold would be 10 times its book value, or $5 million. The company sells the warehouse, books a $4.5 million profit and then buys a similar warehouse next door for $5 million.

Nothing has really changed. The company still has a warehouse, but the new one is valued on the books at its purchase price of $5 million instead of the lower depreciated cost of the original warehouse. The company has booked a $4.5 million gain, yet it has less cash on hand than it had before this sell-buy transaction.

Why would a company exchange one asset for a very similar one ... especially if it cost them cash and an unnecessary tax payment? The only "real" effect of this transaction is the sale of an undervalued asset and booking of a one-time gain. If the company reports this gain as part of "operating income,": the books have been cooked - income has been deceptively inflated. If the company purports that this one-time capital gain is reoccurring operating income, it has misrepresented the earning capacity of the enterprise.

Cooking the Books: Puffing up the Income Statement

Puffing up the Income Statement most often involves some form of bogus sales revenue that results in increased profit.

One of the simplest methods of cooking the books is padding the revenue; that is, recording sales before all the conditions required to complete a sale have occurred. The purpose of this action is to inflate sales and associated profits. A particularly creative technique is self-dealings such as increasing revenue by selling something to yourself.

Revenue is appropriately recorded ONLY after all these conditions are met:

An order has been received.
The actual product has been shipped.
There is little risk the customer will not accept the product.
No significant additional actions are required by the company.
Title has transferred and the purchaser recognizes his responsibility to pay.

The other common route to illegal reporting of increased profit is to lower expenses or to fiddle with costs. A simple method to accomplish this deception involves shifting expenses from one period into another with the objective of reporting increased profits in the earlier period and hoping for the best in the later period.

Cooking the Books: This is very different from "Creative Accounting."

The vast majority of audited financial statements are prepared fairly. They are assembled in accordance with GAAP and evidence sound fiscal controls and integrity of management. However, sometimes this is not the case and financial fraud is committed: illegal payments made, assets misused, losses concealed, expenses under-reported, revenue over-recorded and so forth.

Cooking the books is very different from "creative accounting."

It is creative to use accounting rules to best present your company in a favourable financial light. It is legal and accepted.

"Cooking the books" means intentionally hiding or distorting the real financial performance and/or financial condition of a company. Cooking the books is done for a deceptive purpose and is meant to defraud.

Cooking the Books: Why do managers cook the books?

Managers most often cook the books for personal financial gain -

to justify a bonus,
to keep stock prices high and options valuable or
to hide a business's poor performance.

Companies most likely to cook their books have weak internal controls and have a management of questionable character facing extreme pressure to perform.

"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.

Cooking is most often accomplished by moving items that should be on the Income Statement onto the Balance Sheet and sometimes vice versa.

A variety of specific techniques can be used to raise or lower income, raise or lower revenue, raise or lower assets and liabilities, and thereby reach whatever felonious objective the businessperson desires. A simple method is outright lying by making fictitious transactions or ignoring required ones.

Cooking the Books: Techniques to Sweeten the Balance Sheet

C. Improperly increased or shifted period income.

D. Improperly increased assets and equity.

C. Improperly increased or shifted period income

C1. Current expenses shifted into later period

C1a. Improperly capitalized costs as inventory.
C1b. Assets depreciated or amortized too slowly.
C1c. Worthless asset not written off immediately.

C2. Shift revenue and income into later periods with reserves.

D. Improperly increased assets and equity.

D1. Increased equity through one-time gains

D1a. Report gains on exchange of similar assets
D1b. Report gains by selling undervalued assets
D1c. Retire debt.

D2. Report revenue rather than liability on receipt of cash.

"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.

Related:

Cooking the Books: Why do managers cook the books?

Cooking the Books: This is very different from "Creative Accounting"

Cooking the Books: Puffing up the Income Statement

Cooking the Books: Techniques to Puff Up the Income Statement

Cooking the Books: Sweetening the Balance Sheet

Cooking the Books: Techniques to Sweeten the Balance Sheet

Cooking the Books: The Auditor's Job

Cooking the Books: Investors, be warned.

Cooking the Books: Techniques to Puff Up the Income Statement

A. Improperly increased revenue
B. Improperly lowered cost or expenses.

A. Improperly increased revenue

A1. Sales recorded before completed and final

A1a. Goods shipped before sale final
A1b. Revenue recorded while future services still due

A2. Bogus revenue recorded

A2a. Supplier refunds recorded as revenue
A2b. Revenue recorded from self-dealing
A2c. Revenue recorded from asset exchanges.

B. Improperly lowered costs or expenses

B1. Current expenses shifted into later periods

B1a. Period expenses capitalised onto Balance Sheet
B1b. Assets depreciated too slowly.
B1c. Probable liabilities not accrued.

B2. Operating losses masked in discontinued operations

"Cooking the books" means intentionally hiding or distorting the real financial performance or actual financial condition of a company.

Related:

Cooking the Books: Why do managers cook the books?

Cooking the Books: This is very different from "Creative Accounting"

Cooking the Books: Puffing up the Income Statement

Cooking the Books: Techniques to Puff Up the Income Statement

Cooking the Books: Sweetening the Balance Sheet

Cooking the Books: Techniques to Sweeten the Balance Sheet

Cooking the Books: The Auditor's Job

Cooking the Books: Investors, be warned.

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My 18 points guide to Successfully compounding your money in Stocks

Be a good stock picker.
Think as a business owner.
Always look at value rather than the price. Do the homework.
Buy and hold is alright for selected stocks.
Compounding is your friend, get this to work its magic.
Mr. Market is there to be taken advantage of. Do not be the sucker instead. BFS;STS.
Always buy a lot when the price is low.
Never buy when the stock is overpriced.
It is alright to buy when the selected stock is at a fair price.
Phasing in or dollar cost averaging is safe for such stocks during a downtrend, unless the price is still obviously too high.
Do not time the market for such or any stocks.
By keeping to the above strategy, the returns will be delivered through the growth of the company's business.
So, when do you sell the stock? Almost never, as long as the fundamentals remain sound and the future prospects intact.
The downside risk is protected through only buying when the price is low or fairly priced.
Tactical dynamic asset allocation or rebalancing based on valuation can be employed but this sounds easier than is practical, except in extreme market situations.
Sell urgently when the company business fundamental has deteriorated irreversibly.
You may also wish to sell should the growth of the company has obviously slowed and you can reinvest into another company with greater growth potential of similar quality. However, unlike point 16, you can do so leisurely.
In conclusion, a critical key to successful investing is in your stock picking ability.

http://myinvestingnotes.blogspot.com/2012/07/my-18-points-guide-to-successfully.html

11 Lessons From Peter Lynch

Peter Lynch taught me:

1. Behind every stock is a company. Find out what it’s doing.
2. Never invest in any idea you can’t illustrate with a crayon.
3. Over the short term, there may be no correlation between the success of a company’s operations and the success of its stock. Over the long term, there’s a 100% correlation.
4. Buying stocks without studying the companies is the same as playing poker – and never looking at your cards.
5. Time is on your side when you own shares of superior companies.
6. Owning stock is like having children. Don’t get involved with more than you can handle.
7. When the insiders are buying, it’s a good sign.
8. Unless you’re a short seller, it never pays to be pessimistic.
9. A stock market decline is as predictable as a January blizzard in Colorado. If you’re prepared, it can’t hurt you.
10. Everyone has the brainpower to make money in stocks. Not everyone has the stomach.
11. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Lynch’s advice had a profound effect on my stock market approach. He taught me that investment success isn’t the result of developing the right macro-economic view or deciding when to jump in or out of the market. Success is about researching companies to identify those that are likely to report positive surprises.

Capital Expenditure

A great company with a Durable Competitive Advantage will have a ratio of Capital Expenditures to Net Income of less than 25%. Less is better.

Capital Expenditures are expenses on:
- fixed assets such as equipment, property, or industrial buildings
- fixing problems with an asset
- preparing an asset to be used in business
- restoring property
- starting new businesses

A good company will have a ratio of Capital Expenditures to Net Income of less than 50%.

A great company with a Durable Competitive Advantage will have a ratio of less than 25%.

Less is better.

Benjamin Graham's 113 Wise Words

The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement."

Philip Fisher's Wise Words

"The refusal to sell at a loss, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process.

More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

(Common Stocks and Uncommon Profits)

The Ultimate Hold-versus-Sell Test

Here is the overriding primary test, followed by observations on why it is so critically important:

Knowing all that you now know and expect about the company and its stock (not what you originally believed or hoped at time of purchase), and assuming that you had available capital, and assuming that it would not cause a portfolio imbalance to do so, would you buy this stock today, at today's price?

No equivocation. Yes or no?

Answers such as maybe or probably are not acceptable since they are ways of dodging the issue. No investor probably buys a stock; they either place an order or do not.

Here is the implication of your answer to that critical test: if you did not answer with a clear affirmative, you should sell; only if you said a strong yes, are you justified to hold.

Some thoughts on Analysing Stocks (KISS)

Ideally a stock you plan to purchase should have all of the following charateristics:

• A rising trend of earnings dividends and book value per share.
• A balance sheet with less debt than other companies in its particular industry.
• A P/E ratio no higher than average.
• A dividend yield that suits your particular needs.
• A below-average dividend pay-out ratio.
• A history of earnings and dividends not pockmarked by erratic ups and downs.
• Companies whose ROE is 15 or better.
• A ratio of price to cash flow (P/CF) that is not too high when compared to other stocks in the same industry.

Margin of Safety Concept: Stocks should be bought like groceries, not like perfume

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

myinvestingnotes.blogspot.my (Bullbear Buffett Stock Investing Notes)

Thursday, 13 May 2010

Cooking the Books: Investors, be warned.

Cooking the Books: The Auditor's Job

Cooking the Books: Sweetening the Balance Sheet

Cooking the Books: Puffing up the Income Statement

Cooking the Books: This is very different from "Creative Accounting."

Cooking the Books: Why do managers cook the books?

Cooking the Books: Techniques to Sweeten the Balance Sheet

Cooking the Books: Techniques to Puff Up the Income Statement

All equity security investments present a risk of loss of capital

The Ultimate Hold-versus-Sell Test

Some thoughts on Analysing Stocks (KISS)

Benjamin Graham

Sell the losers, let the winners run.

Investment Style

Warren Buffett

Political and Economic News

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