Showing posts with label red flags. Show all posts
Showing posts with label red flags. Show all posts

Tuesday 8 August 2017

Red Flags

Red flags

1) Declining cash flow: 
  • if cash from operations decline even as net income keeps marching upwards or 
  • if cash from operations increase much more slowly than net income. 
  • AR increased to a large percentage of sales.
  • Inventories increase

2) Serial chargers: 
  • frequent chargers are an open invitation to accounting hanky panky because forms can bury bad decisions in a single restructuring charge. 
  • Poor decisions that might need to be paid for in future quarters all get rolled into a single one-time charge in the current quarter, which improves future result.

3) Serial acquirers: 
  • acquisitive firms don’t spend as much time checking out their targets as they should.

4) CFO or auditors leave the company: 
  • If a company fires its auditors after some potentially damaging accounting issue has come to light, watch out.

5) The bills aren’t being paid:  
  • One way to pump up its growth rate is to loosen customers’ credit terms, which induces them to buy more products or services. 
  • If they don’t get paid, it will come back to haunt them in the form of a nasty write-down or charge against earnings. 
  • Track how A/R are increasing relative to sales. 
  • On the credit front, watch the ‘allowance for doubtful accounts’. 
  • If the amount doesn’t move up in sync with A/R, the company may be artificially boosting its results by being overly optimistic about how many of its new customers will pay its bill.

6) Changes in credit terms and account receivable: 
  • Check the company’s 10-Q 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. 
  • ( Look in the management’s discussion and analysis section for the latter and in the accounting footnotes for the former.)

7) Gains from investments: 
  • an honest company breaks out these sales, however, and reports them below the ‘operating income’ line on its income statement. 
  • The problem arises when companies try to boost their operating results- performance of their core business-by shoehorning investment income into other parts of their financial statements. 
  • Finally, companies can hide investment gains in their expense accounts by using them to reduce operating expenses, which makes the firm look more efficient than it really is.

8) Pension pitfalls: 
  • If assets in the pension plan don’t increase quickly enough, the firm has to divert profits to prop up the pension. 
  • To fund pension payments to future retirees, companies shovel money into pension plans that then are invested in stocks, bonds, real estate, and so forth. 
  • If a company winds up with fewer pension assets than pension liabilities, it has an underfunded plan, and if the company has more than enough pension assets to meet its projected obligations to retirees, it has an overfunded plan. 
  • To see whether the company has an over-or underfunded pension plan, go to the footnotes of a 10-K filling and look for the note labeled ‘pension and other postretirement benefits’, ‘employee retirement benefits’, or some variation. Then look at the line labeled ‘projected benefit obligation.’ This is the estimated amount the company will owe to employees after they retire.
  • Second key number is ‘fair value of plan assets at the end of year’. If the benefit obligation exceeds the plan assets, the company has an underfunded pension plan and is likely to have shovel in more money in future, reducing profits.
  • Pension padding: When stocks and bonds do really well, pension plans go gangbusters. And if those annual returns exceed the annual pension costs, the excess can be profits. Flowing gains from an overfunded pension plan through the income statement is a perfectly legal practice that pumped up earnings at GE. You should subtract it from net income when trying to figure out just how profitable a company really is.
  • 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’. 
  • Companies usually break out the contribution of pension costs to profits for the trailing three years; therefore, you can see not only the absolute level of pension profit or loss, but also the trend. Won’t see these numbers in the income statement.

9) Vanishing cash flow: 
  • you can’t count on cash flow generated by employees exercising options.  
  • The amount is labeled ‘tax benefits from employee stock plan’ or ‘tax benefits of stock options exercised’ on the statement of cash flows. 
  • When employees exercise their stock options, the amount of cash taxes their employer has to pay declines. 
  • If the stock price takes a tumble, many people’s options will be worthless and, consequently, fewer options will be exercised. 
  • Fewer options are now exercised, the company’s tax deduction gets smaller, and it has to pay more taxes than before, which means lower 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.
  
10) Overstuffed Warehouses: 
  • When inventories rise faster than sales, there is likely to be trouble on the horizon.  
  • Sometimes buildup is just temporary as a company prepares for a new product launch, usually exception.

11) Change is bad: 
  • another way firm can make themselves look better is by changing any one of a number of assumptions in their financial statements. 
  • Look skeptically on any optional change that improve results. 
  • One item that can be altered is depreciation expense (see if extend depreciation period). 
  • Firms can also change their allowance for doubtful accounts. 
  • If it doesn’t increase at the same rate as accounts receivable, a firm is essentially saying that its new customers are much more creditworthy than the previous ones-which is pretty much unlikely. 
  • If the allowance declines as AR rises, the company is stretching the truth even further. Current results are overstated. 
  • Firms can also change things as basic as how expenses are recorded and when revenue is recognized.

12) To expense or not to expense:  
  • Company can fiddle with their costs by capitalizing them. 
  • Any time you see expenses being capitalized, ask some hard questions about just how long that ‘asset’ will generate an economic benefit.

https://docslide.us/documents/pat-dorsey-5-rules-for-successful-stock-investing-summary.html

Tuesday 11 April 2017

Late filing of financial accounts

Unfortunately, a small minority of companies file their accounts late or even not at all.

This is an offence for which the directors can be punished and the company incur a penalty, but it does happen.

It is often companies with problems that file late.

Sunday 15 January 2017

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:
The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.




There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.


2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.


3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).





When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 
  • liquidation value would be more useful for a company with losses that trades below book valuewhile 
  • net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.




Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.





Read also:


Tuesday 19 July 2016

The Five Rules for Successful Stock Investing 9

Avoiding Financial Fakery

Over time, increases in a company's cash flow from operations should roughly track increases in net income. If you see cash from operations decline even as net income keeps marching upward – or if cash from operations increases much more slowly than net income – watch out. This usually means that the company is generating sales without necessarily collecting the cash, and that's a very good recipe for a blowup down the road.

[...] firms that make numerous acquisitions can be problematic [...]. Aside from muddying the waters, acquisitions increase the risk that the firm will report a nasty surprise some time in the future, because acquisitive firms that want to beat their competitors to the punch often don't spend as much time checking out their targets as they should.

When inventories rise faster than sales, there's likely to be trouble on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that's usually more the exception than the rule. When a company produces more than it's selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually – probably at a discount – or written off, which would result in a big charge to earnings.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Wednesday 19 September 2012

Study suggests that different warning signals can be identified, particularly for smaller firms and borrowers with small versus large loans.


Small firms 'more likely' to default on their loans


By Peter Flanagan
Wednesday September 19 2012


VERY small companies are far more likely to default on their loans, a Central Bank report released yesterday reveals.
The level of indebtedness on an SME only has a real effect on very small companies and not on SMEs with larger balance sheets, it found.
The report on loan defaults by Central Bank economists Fergal McCann and Tara McIndoe-Calder also shows there is a clear link between how long a manager has been with the particular company and the chances that company will default on its debts.
The research is based on the status of nearly 7,000 small to medium enterprise (SME) loans at the end of 2010. Details of the loans were made available by the banks to the Central Bank as a sample of their entire loan book last year.
Nearly one-fifth of loans in construction were in default by the end of 2010, while between 10pc and 15pc of lending involving the real estate, hospitality and manufacturing sectors had defaulted by that time.
Those rates are believed to have risen substantially since then, however.
The research paper demonstrates what it calls the "irrelevance" of financial ratios in trying to predict a default on small loans, but these ratios become much more useful when assessing larger loans.
"Among the largest firms, where the default rate is below 4pc, no borrower level information significantly predicts default.
"The majority of borrower-level determinants are found to have more predictive power among smaller firms and among larger loans, suggesting that particular attention must be paid to the financial health of small firms and borrowers with large exposures," the authors state.
Profitability
When dealing with smaller loans, the report finds that ratios, "such as the loan to total assets, leverage ratio, liquidity and profitability, are found to be significant predictors of default".
The experience of an SME's managers also plays a large role, with companies far more likely to default when management are less experienced.
"Further, the length of time the borrowing firm's owner or manager has been with the firm mitigates the likelihood of default.
"The study suggests that different warning signals can be identified, particularly for smaller firms and borrowers with small versus large loans."
This is the first Central Bank paper on SME lending since a paper by the same authors compared Irish lending rates to the rest of Europe.
That report caused a huge storm after it showed lending conditions in Ireland were among the toughest in Europe.
Small business groups have repeatedly claimed the banks aren't lending.
Both AIB and Bank of Ireland have maintained they are providing credit to sustainable businesses.
- Peter Flanagan
Irish Independent

Wednesday 12 September 2012

The number the directors don't want you to find






FCF (Free Cash Flow)

You can use this FCF in the following manners, by comparing it with the EPS, DPS and Market Price per share:

1.  Compare FCF/share with EPS
e.g.  FCF/share divided by EPS = 80%.

2.  Divide FCF/share by the DPS (Dividend per share)
e.g.  FCF/share divided by DPS = 1.6x
This looks at the ability of the company to distribute dividends by looking at its free cash flow.

3.  FCF yield.
e.g.  FCF/share divided by Market share price/share = 5.3%.
Where the FCF yield is high, the investors should be attracted to the stock.

Why do profitable firms go bust?


Wednesday 4 May 2011

Investor backlash


Investor backlash


Published: 2011/05/04











Kuala Lumpur: Companies that were red-flagged by auditors and those that reported stark difference in their audited net earnings, saw their stocks punished by investors yesterday.

The selldown in some of the companies was systematic, as inves-tors were wary of their long-term prospects.

Since Friday, some 16 companies either had their books qualified by external auditors, or had revealed significant variance in their audited net earnings.

From the 16, eight companies saw their share prices fall, while two closed unchanged. Shares in the other six companies were untraded yesterday.

Sumatec Resources Bhd saw its share price fall by as much as 48 per cent to close the trading day 13 sen a share.
The Sumatec warrant, which also one of the top 10 actively traded securities fell by more than 50 per cent to 7 sen.

Sumatec's auditors SJ Grant Thornton was not convinced of the company's ability to secure new contracts.

The auditor highlighted that Sumatec did not impair goodwill on its subsidiary's consolidation and deferred tax assets of RM33.48 million and RM13.15 million respec-tively.

It also added that the company's trade receivables of RM5.91 million have been long outstanding and not impaired.

"I think, in most cases, the auditors are just making sure that provisions are being made on uncollectable debts. The rule of thumb today is to make provision for debts that can't be collected in six months," said Jupiter Securities head of research Pong Teng Siew.

Other notable stocks that fell include DBE Gurney Resources Bhd and Alam Maritim Resources Bhd.

DBE's shares fell by more than 5 per cent after it reported an audited net loss of RM3.71 million, more than 17 times of its unaudited net loss of RM202,000.

Meanwhile, Alam Maritim's shares fell by 4 per cent after it announced an audited net loss of RM12.9 million for the financial year ended December 2010, as compared to its unaudited net profit of RM2.2 million.

According to analysts, these variance between unaudited and audited numbers will, to a certain extent, change investors' long-term view of the companies.

"As you can see in today's selldown in some of the stocks, investors do take into account all these. Variations like these will make investors cautious of a company's sustainability and the credibility of its unaudited accounts," OSK Research head of research Chris Eng added.

While most analysts feel that most of these "incidents" are mainly driven by companies' misinterpretation of the new accounting standards, some feel that it could be a sign of more bad news to come.

"I think we can't discount the fact that it may be a prelude to bigger adjustments later," said Pong.


Read more: Investor backlash http://www.btimes.com.my/Current_News/BTIMES/articles/redred/Article/index_html#ixzz1LKi3cT2u

Friday 17 December 2010

7 Red Flags That Say It's Time to Sell

By David Sterman Thursday, November 18, 2010

Few investors have an unlimited supply of money to keep buying new stocks. So to maintain a healthy dose of cash for the next stock purchase, most investors need to keep an eye out for opportunities to sell existing holdings (hopefully with a nice gain).

In some instances, you'll have a clear sense of what a stock is worth, and can simply sell your investment when shares have risen to your target price. But in most instances, no clear-cut exit exists. When that's the case, keep holding your shares as long as business is going well. Just keep monitoring these seven red flags that may signal it's time to sell.

1. Watch the insiders. From time to time, an officer or a director at a company may look to sell shares -- especially if the stock has steadily risen in recent weeks. That's perfectly understandable. But when several of them do so at the same time, you should probably follow their lead. On November 9, three separate insiders at Dreamworks Animation (Nasdaq: DWA) sold a collective 114,000 shares netting them a cool $5 million. If they don't think the stock holds value anymore, why should you?

[History shows that stocks heavily purchased by corporate insiders outperform the broader market averages by roughly 2-to-1. To learn more about this and other market timing techniques, read How to Excel at Timing the Market.]

2. The analyst disconnect. One of the most common mistakes an investor can make is holding onto a stock that seems fishy, but is still liked by analysts. As you listen to a company's quarterly conference call, you may get a sense that business is tumbling, and management is trying to put a positive spin on things. Analysts often buy into that positive spin, and will stick with their Buy ratings as a result. Go with your gut. If you think something is amiss, you are probably right.

3. Industry pressures. It's also important to hear what the competition is saying. If the management of the company in which you are invested says industry conditions are just fine, but a key rival says that business is getting tough, stick with the cautious view. Increasingly difficult conditions at a rival may simply signal company-specific execution problems, but that beleaguered rival may need to take desperate steps such as a price war to maintain sales levels. And in a price war, nobody wins.

4. SEC investigation. You'd be surprised how many investors hang on to a stock after hearing that a company is being investigated by the Securities and Exchange Commission. They're being foolish. In most instances, there is a real problem at hand even as companies typically look to downplay any investigation as seemingly minor. Even in a best case scenario where there is no wrongdoing, investigations can drag on for months, causing a stock to stay out of favor. This is a clear case where it's best to "shoot first and ask questions later."

5. Decelerating sales growth. As a young company grows larger and larger, it's inevitable that sales growth will need to slow down. It's a lot easier to boost sales +40% when you only have $25 million in sales than it is when you have $1 billion in sales. But such a slowdown should be measured and orderly. When sales growth slows sharply, or even turns negative, it could be a sign that a company has hit a serious wall. Management will likely explain any slowdown as a mere hiccup, but you'll need to dig deep to find out the root cause.

6. Shrinking profit margins. The first rule of business is that as sales grow, a company can generate leverage off of its fixed expenses. And that means that profit margins (gross, operating and net) should always be expanding. But if profit margins shrink, even as sales turn higher, then it's a clear sign that a company is losing pricing power. And once profit margins start to slip, they often keep falling as rivals fight harder and harder to steal market share.

7. An abrupt management change. We recently discussed this notion, highlighting the risks that arise when a top member of the management team suddenly departs.

It's not always a cause for alarm, (for example when someone is simply retiring), but you'll want to hear a good explanation of the change, and hopefully about a successor that has already been lined up.

As a good rule of thumb, once you own a stock, you should be looking for reasons to sell. If no such reasons emerge, then you can sit tight on that investment for an extended period. But if any of these seven red flags arise, it may be a clear sign to get while the getting is good.

http://www.investinganswers.com/a/7-red-flags-say-its-time-sell-1987

Sunday 6 June 2010

How to be a wiser investor



Saturday June 5, 2010

How to be a wiser investor
Review by ERROL OH
errol@thestar.com.my

How to Smell a Rat: The Five Signs of Financial Fraud

Author: Ken Fisher, with Lara Hoffmans

Publisher: John Wiley & Sons

WHICH kind of investor are you – Confident Clark, Hobby Hal, Expert Ellen, Daunted Dave, Concerned Carl or Avoidance Al? If you’re one of the first three, there’s little chance that you’ll lose money in a scam, according to Ken Fisher, head of Fisher Investments, a California-based money management firm, and a longtime Forbes columnist.

But he believes that Dave, Carl and Al ought to be extra vigilant in making investment decisions, particularly when it comes to choosing advisers.

He warns: “Con artists love Dave, Carl, even Al. If you see yourself in one of them, you’re more likely to hire a pro, but you’re also more likely to be conned.”

Having spent decades managing money, and writing and speaking on investments, Fisher has learnt plenty about investors. With some clever use of alliteration, he divides them into six categories .

Clark is the sort who thinks he’s the best person to decide where to put his money; he won’t trust somebody else to do that job. Hal is dead serious about investing and is always honing his skills and knowledge in this field. Even when he has an investment adviser, he’ll be in the thick of things. Fraudsters tend to stay away from Hal because he’s too involved in his investments.

Like Clark and Hal, Ellen knows a thing or two about investments and enjoys the challenge of extracting the best returns. However, she’s usually too busy to do it all on her own and will leave it to the professionals. Still, because she’s not easily fooled by fake profits and she’s more questioning than most investors, she’s not your typical fraud victim.

But Dave is, because he’s intimidated by the complexity of investing and prefers to hand his funds over to others to manage. Carl is similar except that his dependence on professional help is driven mainly by the worry that he can’t achieve his investing goals on his own.

Then there’s Al, who will have nothing to do with investments if he can help it. He doesn’t even like thinking about hiring an adviser, but when he does appoint one, he won’t bother keeping track at all.

“Rats are looking for financial illiterates. They want victims who won’t question too hard – either because they’re busy, intimidated, or easily distracted by outsized performance claims,” wrote Fisher.

Not-so-common sense

If you see yourself as Clark, Hal or Ellen, don’t be too quick to think that you’ll never be cheated. Fisher likens such false sense of security to a guy not taking care of his health just because his doctor has declared that he has a low risk of heart failure.


Ken Fisher

He explains: “You may feel like Clark or Ellen right now. But the same investor can actually morph over time into someone else – happens all the time. The way investors see their needs can easily change.”

For example, during bull markets, investors may be assured and aggressive in wanting growth, but when the bears are on the prowl, the same investors sing a different tune as they turn wary and instead focus on capital preservation.

It’s this kind of deep insight and understanding that makes How to Smell a Rat a worthwhile read. It essentially peddles common sense, but Fisher’s vast experience and expertise makes all the difference.

There will always be crooks on the prowl for easy marks, and there will never be a shortage of people who can be seduced by promises of generous returns on their money. As such, anything that helps us avoid investment scams is useful.

Fisher shows the goods very early in the game. On page 5, he lists the five signs (see box) referred to in the book’s subtitle.

“Note: Just because your manager displays one or a few signs, it doesn’t mean they should immediately be clapped in irons. Rather, these are signs your adviser may have the means to embezzle and a possible framework to deceive. Always better to be suspicious and safe than trusting and sorry,” he advises.

If you had committed these signs to memory, you might be tempted to ditch the book at this point, but you would have extracted only a fraction of its value.

Mere awareness of the red flags is inadequate protection; an enlightened and responsible investor should have a reasonable grasp of how con artists operate and of the weaknesses they exploit.

Critical signs

This is where the book comes in most handy. When elaborating on the five signs, Fisher illustrates with examples that highlight commonalities among infamous swindlers such as Charles Ponzi, Ivar Kreuger, Robert Vesco, Bernard Madoff and R. Allen Stanford.

Through this, you appreciate the fact that though the specifics vary, the scamsters’ game plans are pretty much alike. The investment schemes are typically structured in such a away that the advisers have way too much control over the money and the investments.

The advisers promise returns that are almost too good to be true, and they often have trouble articulating their strategies in simple terms. They prey upon the same types of people. If you’re wholly mindful of what these warning signs mean, consider yourself inoculated against the investment fraud virus.

How to Smell a Rat is in part a self-improvement title. It is enriching because Fisher discusses the foibles and circumstances that enable con games to thrive.

When writing about how the culprit behind a hedge fund scam used impressive-sounding gobbledygook to dupe people, Fisher is actually telling us that our pride can lead us down the path to financial ruin.

“Remember, his victims weren’t stupid. But folks who consider themselves smart may not always question -- they don’t want to reveal they don’t understand. Many smart people have a hard time getting their egos to openly admit they don’t understand,” he tells the readers.

Another lesson: The investor himself must do due diligence before handing over his money to the adviser. “(Due diligence is) not complicated, but enough folks won’t do the check – and con artists count on that. It’s your money – you alone must do the check. Don’t let anyone in the middle,” urges Fisher.

Of knights and the Net

Often droll and cutting, the author is an engaging guide and teacher.

A target of his barbs is Stanford, chairman of Stanford Financial Group. In February last year, the US Securities and Exchange Commission filed an action, alleging that Stanford and his companies orchestrated a US$8bil fraud and that he was conducting a Ponzi scheme.

In making his point that fraudsters are fond of crafting flashy facades, Fisher likens Stanford’s knighthood from Antigua to a Cracker Jack box prize. “Elton John’s been knighted – but at least he was knighted by the Queen of England. Still, do you want him managing your money?” he asks.

His opinions are always firm and passionately argued, but at times, they can be rather eccentric, such as his blithe dismissiveness towards the influence of New Media.

“I would never believe things I read on blogs about anyone, ever, good or bad. You have no way to know what’s behind them, and often it’s nonsense. Actually, more often than not, it is nonsense! The Internet and its natural feature of anonymity bring out the very worst in a great many people,” he grumbles.

“Don’t ever believe Internet blog postings or comments on articles on even major websites. There isn’t integrity there, so don’t buy it, either way – whether it’s helping the reputation or defaming it.”

Here he sounds out of step with what’s happening out there, but this shouldn’t detract from the wisdom that Fisher offers in How to Smell a Rat.

According to Ken Fisher, there are ways to tell if your investment adviser may be a swindler or may evolve into one. In How to Smell a Rat, he provides a checklist:

1. The biggest red flag – your adviser also has custody of your assets.

2. Returns are consistently great.

3. The investing strategy isn’t understandable.

4. Your adviser promotes benefits (such as exclusivity) that don’t impact results.

5. You didn’t do your own due diligence, but a trusted intermediary did.


http://biz.thestar.com.my/news/story.asp?file=/2010/6/5/business/6327254&sec=business

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.


Related:

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.


Related:

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:

  1. An order has been received.
  2. The actual product has been shipped.
  3. There is little risk the customer will not accept the product.
  4. No significant additional actions are required by the company.
  5. 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.