As value and quality investors, company financials play a critical role in finding great companies and knowing what price to pay for them. One question that might come up during the due diligence period is, can we trust the numbers that are being presented by the company? While accounting standards set certain requirements for financial reports, there is some judgement/wiggle room that can lead to variation in the quality of earnings that are reported.
Financial Shenanigans, Fourth Edition: How to Detect Accounting Gimmicks
and Fraud in Financial Reports, reviews common ways in which companies
manipulate their financial statements to present an overly optimistic
view of earnings. The book is an invaluable tool to better understand how
companies mislead investors to prop up stock prices and secure
large executive compensation packages.
The book goes through a series of different techniques that companies use to
massage their earnings, and gives historical examples of companies that have
used the accounting tricks. Some accounting shenanigans, like
GE’s underestimated liabilities on long-term care policies, cannot be easily
found on a financial statement; however, below are a few tips from the book to look out for when evaluating financial statements.
Earnings Manipulations
Some companies inflate current earnings by capitalizing operating
expenses, thereby reducing operating costs for the reporting period. This
gimmick is most easily found by noting an abnormal increase in capital
expenditures or deferred costs that are not explained elsewhere. The violation of ethics is bad enough, but it also hurts owners who have to wait to capture the cost as a business expense over several years of depreciation instead of the year the money was spent.
Other times, companies will record revenue too soon by doing things like
recognizing all of the revenue from a long-term contract upfront, while they are not recognizing the corresponding expenses. This is most likely to show up as an increase in long-term and unbilled receivables on a financial statement. Incomes can also be inflated by including one-time gains in earnings, such as the sale of part of the business or the settlement of a lawsuit. Look out for these one-time items by looking for gain on sale or settlement in the operating section of the cash flow statement.
Cash Flow Manipulations
Cash flow from operations is sometimes inflated by companies that perform
serial acquisitions. This is achieved by having the acquired company delay
billing in the quarter prior to the acquisition closing so that the cash can be
collected after closing. To diagnose this transgression, look out for
receivables increases that differ on the balance sheet investment cost and the operating cash flow statement.
Cash flows can also be manipulated with one-time or unsustainable gains,
such as by reducing inventories to levels below what is required to routinely
operate the business. One-time gains from litigation are another way that
cash flows are artificially inflated. Look out for a surge in accounts payable
and abnormally low inventories when companies are manipulating their cash
flow statement.
Warning Signs
There are many things that investors should look out for as early warning
signs that companies are not operating on the up-and-up. Below are some of
the key questions to ask when looking into a company’s finances:
-Does the company participate in transactions with a related party or a board
member?
-Are there board members that don’t seem to make sense with the company’s
business? Theranos was a textbook example, with a board that was heavy on political connections with little manufacturing or diagnostic experience.
-Are receivables growing faster than sales?
-Did the company make a change in accounting policies that was not being
driving by changes in GAAP standards? For example, did they change their
fiscal year end?
-Does the company record loans as revenue?
-Are liability reserves being reduced without a corresponding reason why,
such as the expiration of warranties or the settlement of a major lawsuit?
-Are operating expenses being shifted to capital expenses?
-Is the company using joint ventures to hide operating expenses and
liabilities?
-Has the depreciation schedule been changed to reduce costs in a quarter?
-Does the company grant vendor credits/rebates that will be a drag on future
earnings?
-Are there changes being made to pension returns assumptions, leases or
other assumptions that are not justified? For example, some companies
expect excess returns from pension plans, such as greater than 8%
returns, when the asset allocation and previous return history indicate that this assumption is too aggressive.
-Does the company stretch out the recognition of a windfall gain, such as a
lawsuit settlement, in order to smooth out earnings? Similarly, has the
company created a reserve that they continually draw from to make up for
shortcomings in earnings? Companies that have especially smooth earnings
track records are prone to use these techniques to hit their earnings guidance.
-Has the company changed the definition of any key terms or reduced
disclosure information. For example, Apple stopped disclosing the
number of phones that it sold per quarter back in 2018. While Apple has done fine since then, it may be an indication that things are trending in the wrong direction.
-Does the company frequently acquire other companies? This was a warning
sign for Newell Rubermaid, a problem that caught up with the company when
they acquired Jarden.
-Are accounts payable increasing faster than sales or is the company using
accounts payable financing?
Parting Thoughts
There are many ways that companies can manipulate earnings in order to
achieve short-term goals. Many of these techniques can be discovered by
carefully reviewing a company’s earnings statements and annual reports, a
practice that can save investors a great deal of heartache. In addition to the list above, reading the 10-K all the way through can reveal a number of issues that would surprise many stockholders. Financial Shenanigans is a good reference to use when you are first learning how to spot questionable accounting practices.
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