Outright fraud: Even worse than aggressive accounting is outright fraud. The hucksters of the world are naturally attracted to the stock market because it is the perfect arena for profiting from the greed and carelessness of others. Knowing the signs of potential fraud can save you a lot of financial pain.
It is not hard either. Although you might need a CPA to understand exactly how an aggressive or fraudulent firm is exaggerating its results, you don’t need to be an expert to recognize the warning signs of accounting chicanery.
SIX (6) Red Flags
Watching for these 6 warning signs will help you avoid maybe two-thirds (2/3) of potential accounting-related blowups.
1. Declining Cash Flow
Watch cash flow. Over time, increases in a company's cash flow from operations should roughly track increases in net income.
2. Serial Chargers
Be wary of firms that take frequent one-time charges and write-downs. Frequent charges are open invitation to accounting hanky-panky because firms can bury bad decisions in a single restructuring charge.
3. Serial Acquirers
Firms that make numerous acquisitions can be problematic - their financials have been restated and rejiggered so many times that it's tough to know which end is up. Acquisitions increase the risk that the firm will report a nasty surprise some time in the future.
4. The Chief Financial Officer or Auditor Leave the Company
Who watches the watchmen? When it comes to financial reporting, those watchmen are the chief financial officer (CFO) and the corporate auditors. If you see a CFO leaves a company that's already under suspicion for accounting issues, you should think very hard about whether there might be more going on than meets the eyes. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out.
5. The Bills Aren’t Being Paid
You should track how fast the A/R are increasing relative to sales - the two should roughly track each other. A/R measures goods that are sold, but not yet paid for. It is simply not possible for A/R to increase faster than sales for a long time - the company is paying out more money (as finished goods) than it is taking in (through cash payments). On the credit front, watch the "allowance for doubtful accounts."
6. Changes in Credit Terms and Accounts Receivable.
Check the company's filing for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped.
SEVEN (7) Other Pitfalls to Watch Out for.
Watch out also for the following ways that firms can embellish their financial results.
1. Gains from Investments
An honest company breaks out these sales, and reports them below the “operating income” line on its income statement. The most blatant means of using investment income to boost results is to include it as part of revenue.
2. Pension Pitfalls
Pensions can be a big burden for companies with many retirees because if the assets in the pension plan don't increase quickly enough the firm has to divert profits to prop up the pension.
3. Pension Padding
To find out how much profits decreased because of pension costs or increased because of pension gains, go to the line in the pension footnote labeled either “net pension/postretirement expense,” “net pension credit/loss,” “net periodic pension cost,” or some variation.
4. Vanishing Cash Flow
If you are analyzing a company with great cash flow that also has a high flying stock, check to see how much of that cash flow growth is coming from options-related tax benefits.
5. Overstuffed Warehouses
When inventories rise faster than sales, there’s likely to be touble on the horizon.
6. Change is Bad
Firms can make themselves look better by changing any one of a number of assumptions in their financial statements.
7. To expense or Not to Expense
Companies can fiddle with their costs by capitalizing them.
Investor’s Checklist: Avoiding Financial Fakery
- The simplest way to detect aggressive accounting is to compare the trend of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there is a good chance of trouble lurking.
- Companies that make numerous acquisitions or take many one-time charges are more likely to have aggressive accounting. Be wary if a firm’s chief financial officer leaves or if the firm changes auditors.
- Watch the trend of accounts receivable relative to sales. If accounts receivable is growing much faster than sales, the company may be having trouble collecting cash from its customers.
- Pension income and gains from investments can boost reported net income, but don’t confuse them with solid results from the company’s core operations.
