Chapter 23

Keeping Score When Companies Play Games with Numbers

In This Chapter

Discovering the methods of creative accounting

Finding massaged company earnings

Recognizing beefed-up revenues

Spotting expense-cutting strategies

Detecting cash flow games

Companies cooking the books — and I don't mean throwing them in a raging fire in disgust — fuel an ongoing game of hide-and-seek among company outsiders that results in millions, and sometimes billions, of dollars of losses for investors every year. In some cases, company insiders use numerous tactics to deceive their shareholders and pad their own pockets. The mortgage mess in 2007, when mortgage-related securities were held off the books, destroyed the stock value of many major financial institutions, such as Citigroup and Merrill Lynch.

Throughout most of this book, I concentrate on reading financial reports that accurately portray the financial status of a company, but unfortunately, not all reports fall into this category. The pressure companies face to meet the quarterly expectations of Wall Street drives many firms to play with their numbers. When a company doesn't meet expectations, its stock price is beaten down, which lowers the company's market value. Sometimes this game to meet expectations goes beyond legal methods to fraud and deception.

In this chapter, I review the primary tools that companies use to hide their financial problems and to deceive the public and the government.

Getting to the Bottom of Creative Accounting

Enron, once the world's largest energy trader, now lives in infamy as the host of one of the world's largest accounting scandals. After the company declared bankruptcy in 2001, Congress enacted legislation to correct the flaws in the U.S. financial reporting system and protect investors and consumers from misleading accounting practices. But corporate lobbyists are powerful, and Congress continues to get pressure to weaken the legislation passed after the Enron scandal because the companies think the new laws are too burdensome.

In the meantime, the public's faith in corporate financial accounting has taken a nose dive, in large part because of the glut of creative accounting that came to light during the late 1990s and continued to rear its ugly head in 2007 during the scandals related to the mortgage mess. More rules for Wall Street were added with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Companies that practice creative accounting deviate from generally accepted accounting principles (GAAP). The financial reports they issue use loopholes in financial laws in ways that are, at the very least, misleading and, in some cases illegal, to gain an advantage for the company over the users of those financial reports.

Defining the scope of the problem

In the hundreds of cases in which companies restated their earnings (that is, when companies changed the numbers they originally reported to the general public to correct “accounting errors”), company insiders used creative accounting techniques to cook the books. And when trying to unearth the accounting problem, you have to be creative yourself.

In these scandals, some company insiders used corporate accounts for personal purposes, such as buying expensive cars or numerous houses and taking luxury trips — all at the expense of shareholders. Instead of using profits to grow the company and increase the stock's value for the stockholders, these insiders lined their own pockets. How did they get away with that? Well, most board members were closely tied to the corporate chiefs, which means that no one was really watching the cookie jar — or the hands going into it. In some cases, these close ties were members of the same family who didn't question their father or brother. In other cases, the board members were close friends and didn't want to question a buddy. You can find more details about these scandals in Chapter 24.

Company insiders use different techniques to cook the books. In some cases, earnings are managed, meaning that companies use legitimate accounting methods in aggressive ways to get the bottom-line results they need. Other companies present revenues that are pure fiction. Still others toy with how they handle their capital financing, or overvalue their assets, or undervalue their liabilities. Insiders who want to deceive company outsiders can use a variety of these tactics.

Seeing through cooked books

Former Securities and Exchange Commission (SEC) chairman Arthur Levitt groups these creative techniques — which he calls “accounting hocus-pocus” — into the following five categories.

I discuss how company insiders use these various techniques, but too often, you don't find out about the deception until someone inside the company decides to blow the whistle or the company seeks bankruptcy protection.

Big-bath charges

Company insiders use this technique to clean up their balance sheet by giving it a “big bath,” meaning they wash away past financial problems. When earnings take a big hit, some executives hope that Wall Street will look beyond a one-time loss and focus on future earnings.

A good time to use this practice is when the company decides to restructure some parts of its business — for example, when two divisions of a company merge or a single division is split into two. During the restructuring process, executives can clean up any problems in previous reporting. This cleaning process may include hiding past financial reporting problems. The accounting problems washed off the books can be deliberate or nondeliberate accounting errors made during previous reporting periods.

Creative acquisition accounting

Levitt also calls this category “merger magic” because it includes the technique in which companies use acquisitions to hide their problems. It's particularly useful when the acquisition is merely a stock exchange rather than a cash exchange. By setting a stock price for an acquisition that enables a company to hide previous problems, a lot of past accounting problems can disappear like magic because the higher stock price covers up the problems, such as previous losses that the company didn't accurately report. Most times, company insiders can erase the problems in a popular write-off called in-process research and development, which is a one-time charge mentioned in the notes to the financial statements detailing an acquisition. Getting rid of problems with this charge removes any future earnings drag, and future earnings statements look better.

Miscellaneous cookie jar reserves

Companies that use liabilities rather than revenue to hide problems do so by using what Levitt calls “cookie jars.” When using this technique, company insiders make unrealistic assumptions about company liabilities. In a good year, a firm assumes that its sales returns will be much higher than they have been historically. These higher assumptions are “banked” as a liability, which means they're added to an accrual account that can be adjusted in a later year. When a business has a bad year and needs to manage its earnings, it can massage those earnings by reducing the actual sales returns, using some of the banked sales returns from the cookie jar.

Materiality

In accounting, the generally accepted principle is to report only financial matters that can have a material effect on a company's earnings. Whether an item has a material effect on the company's bottom line is purely a judgment call made by company executives and the auditors. For example, a $1 million loss in inventory may have a material effect on a company's bottom line if the company's total profits are $10 million. But that same million-dollar loss for a company that reports multibillion-dollar earnings may not be considered material because that loss has less impact on the company's bottom line.

Firms that play the materiality game set a percentage ceiling under which errors don't matter because they're not material. For example, the multibillion-dollar company may decide that as long as errors reflect less than 5 percent of any department's revenues, the error isn't material to the company's results. But those little errors can add up when spread carefully across a firm's financial reports. Sometimes small errors can help a business make up for the 1- or 2-cent loss per share that may miss Wall Street expectations and cause the stock price to drop. Anytime a company misses Wall Street expectations — even by pennies — the stock price takes a drop, and the company's overall value on the market may also fall by millions of dollars.

Revenue recognition

Companies using this technique boost their earnings by manipulating the way they count sales. For example, these companies recognize a sale before it's complete or count something as sold even though the customer still has options to terminate, void, or delay the sale.

Unearthing the Games Played with Earnings

All companies manage earnings to a certain extent because they want their bottom lines to look as good as possible, and they use whatever accounting method gets them there. For example, a company can improve its earnings by using different methods for valuing assets and costs. As I discuss in Chapter 9, the accounting policies and methods that a company uses can have a great impact on its bottom line.

In accrual accounting, revenue is recognized when it's earned (when the sale of the product or service is complete and payment for the product or service is due), and expenses are recognized when they're incurred (when the purchase is complete, even if cash hasn't yet been paid). See Chapter 4 for more details. Cash doesn't have to change hands for revenue to be earned or expenses incurred. The key is whether the revenue is actually earned and the expenses are actually incurred or whether a company is reporting them prematurely or fictitiously.

The generally accepted accounting principles (GAAP; see Chapter 18) that govern reporting practices are pretty flexible. Managing earnings becomes abusive when it involves using tricks that distort a company's true financial picture to present the desired view to outsiders. And the games that companies play along those lines are numerous. The only limit to these games is the creativity of the people who manage the company's finances.

Companies usually play with numbers that impact revenue recognition or expense recognition. The bottom line for any company is really the amount of revenue that a company takes in or the amount of expenses that it pays out to generate that revenue. All the other numbers that a company reports are based on either its revenue or its expenses.

Reading between the revenue lines

In this section, I cover the gamut of revenue recognition games, from slight misrepresentations to gross exaggerations. Unfortunately, many of these problems are difficult for readers who are company outsiders to find. Still, if you're an investor, you need to be familiar with the terms I discuss in this section so you can understand news reports about problems that may exist inside a company.

Goods ordered but not shipped

In some cases, a company considers goods that have been ordered but not yet shipped to be part of its revenue earned. In the long term, this system can create not only an accounting nightmare, but also a nightmare for managers throughout the company. Orders can get severely backlogged, and ultimately, the company may have a lot of problems satisfying its customers.

Additionally, this practice can have a big impact on a company's bottom line. Accrual accounting is specifically designed to match revenue with expenses each accounting period. As more goods build up that are ordered but not shipped, financial reports overstate the firm's revenue and understate expenses until the deception is exposed. Eventually, the firm has to admit its game-playing and restate its net income, which then likely results in a profit reduction or possibly even a loss.

Executives and managers just delay the inevitable when they practice this game. Some do it to maintain their bonuses as long as possible. Others do it because they don't want to face the reality of the company's financial position. And I'm sure companies make many more excuses when the game is finally exposed.

Goods shipped but not ordered

Some companies get even more aggressive with their deception, counting goods that they've shipped but that customers haven't ordered yet. Companies that use this technique commonly ship items for inspection or demonstration purposes in the hope that customers will buy the product. This tactic can help a company meet its revenue for the upcoming reporting period because it counts these unordered goods as sales, even though the products haven't really been sold. However, if some customers receive the goods, decide not to purchase them, and return the merchandise, the company must subtract these sales from its revenue during the next period.

As the problem snowballs, the company has to ship more orders without actually having the sales to meet its revenue expectations. Each month, it has to reverse a greater percentage of its revenue, and as a result, it has to make up the shortfall by shipping an even greater number of units without actual orders. Eventually, the company can't keep up the deceptive practices and must correct its financial statements, lowering the amount it reported as revenue and reducing its net income. That correction usually sends shockwaves through the stock market, and the stock price drops dramatically.

Extended reporting period

Some companies try to meet Wall Street's revenue expectations by keeping their books open for a few days — or even a few weeks — into the next reporting period to generate last-minutes sales. This tactic eventually creates major financial reporting problems for the company because it takes the sales from what should have been reported as income during the next reporting period. Eventually, the company has to reveal its deceptive practices because it has to leave its books open longer and longer each period to meet the next period's expectations.

Pure fiction

The most outrageous acts are the ones that involve reporting purely fictional sales. How do companies do this? Well, they recognize revenue for sales that were never ordered and never shipped. Company insiders fill financial records with false order, billing, and shipping information. Eventually, the lack of actual cash forces the company to reveal its games, and the business probably goes bankrupt.

Channel stuffing

Channel stuffing is a way for companies to get more products out of their manufacturing warehouses and onto distributors’ and retailers’ shelves. The most common method is to offer distributors large discounts so that they stock up on products. Distributors buy more product than they expect to sell because they can get it so much cheaper. Then distributors sell the product to their customers; however, several months or even a year may pass before they sell all the products. If the products don't sell, in some cases, companies are given the right to return the product.

Although this strategy is a legitimate type of revenue, it can come back to haunt the company in later accounting periods, when distributors have so much product on their shelves that they don't need to order more. At some point in the future, new orders drop, which means fewer sales and a drop in revenue reported on the income statement. Less revenue translates to lower net income, which Wall Street sees as a bad sign, and the stock price takes a dive.

Side letters

Sometimes companies make agreements with their regular customers outside the actual documentation used for the corporate reporting of revenue. This agreement is called a side letter. The side letter involves the company and customer changing terms behind the scenes, such as allowing more liberal rights of return or rights to cancel orders at any time that can essentially kill the sale. Sometimes these agreements go as far as excusing the customer from paying for the goods.

In all cases, the side letter terms eventually result in turning revenue that was recognized on a previous income statement into a nonsale, either by the return of goods or by the extension of credit beyond a 12-month payment period. This practice makes revenue from these sales look better initially, but the revenue is later subtracted when the goods are returned.

Rights of return

Giving customers liberal return rights is another way of getting them to order goods, even when they're not sure whether they'll be able to resell them. By offering distributors or retailers terms that allow them to order goods for resale that they can return as much as 12 months later if they don't sell, the sales, in essence, aren't really sales and shouldn't be recognized as revenue on a company's financial report. Rights of return are offered to most customers, but when payment for goods depends on the need for the distributor or retailer to first resell the goods, the recognition of that revenue is questionable.

Related-party revenue

Related-party revenue comes from a company selling goods to another entity in which the seller controls the management of operating policies. For example, if the parent company of a tissue manufacturer sells the raw materials needed for manufacturing that tissue to its subsidiary, the parent company can't count that sale of raw materials as revenue. Whenever one party to the transaction can control or significantly influence the decision of the entity that wants to buy the goods, a company can't recognize the sale as revenue.

These related-party sales don't meet the SEC's requirement for an arm's-length transaction, which is a transaction that involves a buyer and a seller who can act independently of each other and have no relationship to each other. The SEC does require that companies recognize only sales with third parties that are at arm's length and that can't be controlled by the party planning to recognize the sale as revenue. Companies aren't permitted to record sales to their affiliates or other related entities as part of their recognized revenues.

Bill-and-hold transactions

Sometimes a buyer places an order but asks the company to hold on to the goods until it has room in its store or warehouse. So the company has sold the goods but hasn't shipped them yet. This sale is called a bill-and-hold transaction.

The SEC has a set of criteria that a company must meet for it to recognize revenue for items it hasn't shipped yet. These criteria include the following:

• The seller passes the risks of ownership to the buyer: If anything happens to the goods while the seller is holding them, the loss is the buyer's responsibility, not the seller's.
• The customer makes a fiscal commitment to purchase the goods: This commitment should preferably occur in writing.
• The buyer, not the seller, requests the bill-and-hold transaction: The buyer must have a business purpose, such as planning a future sales event and not wanting to receive the goods until just before the event, to justify ordering the goods on a buy-and-hold basis.
• The buyer and seller set up a fixed schedule for the delivery of the goods: Determining dates for delivery indicates that the sale is real and not a scam.
• The seller separates the ordered goods from its inventory so that it won't use the goods to fill other orders: If it doesn't clearly separate these goods and hold them, the company can't prove that the goods were actually bought, so the sale can't be counted.
• The seller has the goods complete and ready for shipment: Only goods being held and ready for shipment can be counted as a sale.

Up-front service fees

Companies that collect up-front service fees for services that they provide over a long period of time, such as 12, 24, 36, or 60 months, must be careful about how they recognize this revenue. If the company collects fees to service equipment up front, it can't count these fees as revenue when the money is collected. The SEC requires that such companies recognize their revenue over time as the fees are earned. Companies that recognize this type of revenue all at once are prematurely recognizing revenue.

Detecting creative revenue accounting

With so many tricks up so many corporate sleeves, you may feel that you're at the mercy of the tricksters. You can get to the bottom of many of the common creative accounting tactics by carefully reading and analyzing the financial reports, but you have to play detective and crunch some numbers.

Reviewing revenue-recognition policies

The financial report section called the notes to the financial statements is a good source for finding out at what point a company actually recognizes a sale as revenue. Some companies recognize revenue before they deliver the product or before they perform the service. If you come across this scenario, try to find details in the notes to the financial statements that indicate how the company really earned its revenue. If you can't find this info, call the company's investor relations department to clarify its revenue-recognition policies, and be sure that you understand why it may be justified in recognizing revenue before delivery or performance has been completed.

When a firm indicates in the notes to the financial statements that it recognizes revenue at the time of delivery or performance, that timing may seem perfect to you, but you must look further to find other policies that may negate a sale. Dig deeper into the revenue-recognition section of the notes to find out what the company's rights-of-return policy is and how it determines pricing. Some companies may allow a price adjustment or have a liberal return policy that may cancel out the sale.

Take note if you find that the company recently changed its revenue-recognition policies. Just the fact that the company is changing those policies can be a red flag. Many times this change comes about because the firm is having difficulty meeting its Wall Street expectations. It may decide to recognize revenue earlier in the sales process, which may mean that more of this revenue reported on the income statement may have to be subtracted in later reporting periods. Scour the revenue-recognition section of the financial report until you understand how the change impacts the company's revenue recognition. You may want to review the annual reports from the past few years to compare the old revenue policies with the new ones.

Evaluating revenue results

Reported revenue results for the current period don't tell the whole financial story. You need to review the revenue results for the past five quarters (at least) or past three years to look for any inexplicable swings in seasonal activity. For example, extremely high numbers for retail outlets in the last quarter of the year (October to December) aren't unusual. Many retailers make about 40 percent of their profits during that quarter due to holiday sales.

Be sure you understand the fluctuations in revenue for the company you're investigating and how its results compare with the results of similar companies and the industry as a whole. If you see major shifts in revenue results that normal seasonal differences can't explain, an alarm needs to go off in your head. Take the time to further investigate the reason for these differences by reading reports by analysts who cover the company and by calling the company's investor relations office.

Monitoring accounts receivable

Accounts receivable tracks customers who buy on credit. You want to be sure that customers are promptly paying for their purchases, so closely watch the trend in accounts receivable. In Chapter 16, I show you how to calculate accounts receivable turnover. Compare the turnover ratio, which measures how quickly customers pay their bills, for at least the past five quarters to see whether a major change or trend has occurred. If you notice that customers are taking longer to pay their bills, it can be a sign that the company is having trouble collecting money, but it can also indicate revenue management. Either way, this raises a red flag for you as a financial report reader.

While you're investigating, check the percentage rate of change for accounts receivable versus the percentage rate of change for net revenue over the same period. For example, if the balance in accounts receivable increases by 10 percent and net revenues increase by 25 percent, that would be a sign of game playing. Normally, these two accounts increase and decrease by similar percentages year to year unless the company offers its customers a significant change in credit policies. If you see significant differences between these two accounts, it may be another sign of revenue management.

Check to see if the changes you're seeing match trends for similar companies or the industry as a whole. If not, ask investor relations people to explain what's behind the differences. If you don't like the answers or can't get answers that make sense to you, don't buy the stock, or consider selling the stock you already have.

Assessing physical capacity

Evaluating physical capacity, the number of facilities the company has and the amount of product the company can manufacture, is another way to judge whether the company is accurately reporting revenue. You need to find out whether the firm truly has the physical capacity to generate the revenue it's reporting. You do so by comparing the following ratios:

• Revenue per employee (Revenue ÷ Number of employees): If the annual report doesn't mention the number of employees, you can call investor relations or find it in a company profile on one of the financial websites, such as Yahoo! Finance (finance.yahoo.com).
• Revenue per dollar value of property, plant, and equipment (Revenue ÷ Dollar value of property, plant, and equipment): You can find the dollar value of property, plant, and equipment on the financial report's balance sheet.
• Revenue per dollar value of total assets (Revenue ÷ Dollar value of total assets): You can find the number for total assets on the financial report's balance sheet.
• Revenue per square foot of retail or rental space, if appropriate (Revenue ÷ Square foot of retail space): You can find details about retail or rental space in the managers’ discussion and analysis or the notes to the financial statements, or in the company's profile on a financial website.

Compare these ratios for the past five quarters, and also compare the ratios to ones of similar companies and ones for the industry as a whole. If you see major differences from accounting period to accounting period or between similar companies, it may be a sign of a problem. For example, if revenue per employee is much higher, or if revenue per dollar value of property, plant, or equipment far exceeds figures for similar companies or for previous periods, it may be a sign of abusive revenue management.

Exploring Exploitations of Expenses

If a company is playing games with its expenses, the most likely place you'll find evidence is in its capitalization or its amortization policies. You can find details about these policies in the notes to the financial statements. For further explanation of amortization, see Chapter 4.

Companies that want their bottom lines to look better may shift the way that they report depreciation and amortization, which are the tools they use to account for an asset's use and to show the decreasing value of that asset. To make their net incomes look better, companies can play games with the amounts they write off. They do so by writing off less than they should and lowering expenses.

In addition to depreciation and amortization schedules, companies can play games with expenses when reporting some types of advertising, research and development costs, patents and licenses, asset impairments, and restructuring charges. In some cases, companies can capitalize (spread out) their expenses over a number of months, quarters, or years. Spreading out expenses can certainly improve a company's bottom line because the expenses will be lower in the first year they're incurred, and lower expenses mean more net income.

So the key question is whether a company is spreading out its expenses properly or is improperly managing its bottom line. You can find details in the accounting policies section in the annual report. I point out the key policies to review, but if the company is playing games, detecting anything out of the ordinary is difficult to do by using the annual reports. You have to depend on reports in the financial press or from the SEC to see if problems are detected or exposed by a whistle-blower.

Advertising expenses

Companies report most advertising expenses in the accounting period when they're incurred. However, for some types of advertising, such as direct-response advertising, companies can spread the expense over a number of quarters. Direct-response advertising is mailed directly to the consumer. For example, when a business sends out an annual catalog, it can legitimately spread out the costs for that direct-mail piece over the year, as long as it can show that it receives orders from that catalog throughout the year. To find out a firm's policy on advertising expenses, look in the notes to the financial statements.

Research and development costs

Companies are supposed to report research and development (R&D) costs in the current period being reported on the financial statements, but some companies try to stretch out those expenses over a number of quarters so the reduction in net income isn't necessary all in the same year. If fewer expenses are subtracted from revenues, net income is higher, which makes the company look more profitable. However, the SEC has ruled that because these expenditures are so high-risk and a company isn't certain when the R&D activities may benefit its revenue, the company must immediately report R&D expenses rather than spread them out over months or years. One notable exception occurs when a company is developing new software, in which case it can spread its expenses over a number of periods until the software development is technically feasible.

To see how the company expenses its R&D, read the notes to the financial statements. If you're uncertain about the accounting policies that the notes present, don't hesitate to call investor relations and ask questions until you understand what you're reading.

Patents and licenses

Understanding the accounting for patents and licenses can be difficult. Most times, the expenses a company incurs during the research and development phase — before it receives a patent or license — must be written off in the year when they occurred, and the expenses can't be capitalized (written off over a number of years). But the company can capitalize some expenses — for instance, those it incurs to register or defend a patent. The company can also list a patent or license it purchases as an asset at the purchase price and capitalize it. Companies like to capitalize a patent or license because such a large purchase can significantly reduce their net income; most prefer to write it off over several years, if they can, to reduce the hit.

All patents and licenses that a company purchases are listed as assets on the balance sheet. In addition, the balance sheet lists the costs of registering patents or licenses for products developed in-house. The value of these patents and licenses is amortized over the time period for which they're economically viable (meaning for as long as the company benefits from owning that patent or license).

Companies can play games with the value of patents and licenses, as well as with the time periods for which they'll be considered economically viable. To see what a company says about its patent and license accounting policies, read the notes to the financial statements. Compare its policies with the policies of similar companies to see whether they appear reasonable or whether the company may be overstating its value or capitalizing its expenses in a way that differs from its competitors. For example, if Company A makes widgets and says the patent for its type of widget is good for 10 years, and Company B makes a different kind of widget and says its patent is economically viable for 20 years, you probably want to call investor relations and find out why Company B believes it has an economically viable widget for so much longer than its competitor.

Asset impairment

Tangible assets depreciate based on set schedules, but not all intangible assets face a rigid amortization schedule. For example, goodwill is an intangible asset that's no longer amortized each year. This line item on the balance sheet has long had potential for creative accounting practitioners. Today most companies have goodwill on their balance sheets because many large public companies are formed by buying smaller companies.

Any company that acquires another company can list goodwill on its balance sheet. A firm's value of goodwill is based on the amount of money or stock that it pays for the acquisition, over and above what the net tangible assets were worth.

In the past, companies amortized goodwill and wrote off its expenses each year. Today a company must prove that the value of its goodwill has been impaired (worth less than it was in a previous year) before it can write it off. The SEC requires that companies test goodwill before they write off any value to see if any impairment to its value has occurred.

The value of goodwill is tested based on a number of factors, including

• Competition and the ability of competitors to negatively affect the profitability of the business that a company acquires
• The current or expected future levels of industry consolidation
• The impact that potential or expected changes in technology may have on profitability
• Legislative action that results in an uncertain or changing regulatory environment
• Loss of future revenue if certain key employees of the acquisition company aren't retained
• The rate of customer turnover, or how fast old customers leave and new customers arrive
• The mobility of customers and employees

If you see that a company has written off goodwill or any other asset under the rules of impairment, look for an explanation about how it calculated that impairment in the notes to the financial statements. If you don't understand the explanation, ask the investor relations office questions.

Restructuring charges

Restructuring charges is one of the primary ways companies can hide all sorts of accounting games. A company can restructure itself by combining divisions, having one division split off into two or more, or dismantling an entire division. Any major change in the way a company manufactures or sells its products usually entails restructuring.

Whenever a company indicates restructuring charges on its financial statements, carefully scour the notes to the financial statements for reasons behind those charges and how the company determines how much it will write off. Find out what costs the firm allocated to the restructure, and carefully read the details for those costs. The restructuring method is a great way for a company to get rid of losses in one-time charges and clean out the books. Luckily, this is a red flag that the SEC closely watches for, and SEC staff question company reports if they believe a company's charges and its explanations seem fishy.

In the notes to the financial statements, you usually find a note specifically detailing the restructuring and its impact on the financial statements. You may also find mentions of restructuring charges or plans in the management's discussion and analysis section of the financial report. Many times when a company restructures, it incurs costs for asset impairment, lease termination, plant and other closures, severance pay, benefits, relocation, and retraining, giving creative accountants a lot of room to fiddle with the numbers.

The company must specify costs not only for the current period, but also costs for all future years in which the company anticipates additional costs and any related write-offs in periods prior to the one being reported. The SEC watches these charges very closely, too, and tries to close any loopholes that allow companies to charge recurring operating expenses to their restructuring, which companies do to improve the appearance to outsiders of the earnings results from business operations.

Finding Funny Business in Assets and Liabilities

Overvaluing assets or undervaluing liabilities can give a distorted view of a company's earning power and financial position. These practices can have a devastating impact when the company must finally admit to its game playing.

Recognizing overstated assets

Overstated assets make a company look financially healthier to annual report readers than it truly is. The company may report that it has more cash due than it really does, or that it holds more inventory than is actually on its shelves. The company may also report that the value of its inventory is greater than it really is.

Accounts receivable

The accounts receivable section of the financial report is the place where you may find an indication of premature or fictitious revenue recognition. One way a company can overstate its accounts receivable is to post sales to customers who will return the items early the following month without paying for them. The dollar value of those goods reduces the accounts receivable during the next accounting period, but the deception makes the current period look like more revenues were received than should actually have been counted because the sales are premature or fictitious.

That deception isn't the only way a company can overvalue its accounts receivable. Another account attached to accounts receivable is the allowance for doubtful accounts. At the end of each accounting period, the company identifies past-due accounts that probably won't get paid and adds the value of these past-due accounts to the allowance for doubtful accounts, which reduces the value of accounts receivable.

A company that wants to play with its numbers and indicate that its financial position is actually better than it appears reduces the amount it sets aside for doubtful accounts. Gradually, the number of days the company takes to collect on its accounts receivable goes up as more late- or nonpayers are left in accounts receivable. Eventually, the number of days it takes for the company to collect on its accounts receivable goes up, and the amount of cash it takes in from customers who are paying off their purchase bought on credit slows down.

You can test the trend for accounts receivable by using formulas I explain in Chapter 16. Test the trend by calculating days in accounts receivable for the past three to five quarters. If you see the number of days in accounts receivable gradually rise, it's a sign of a problem, and it may represent an attempt to recognize revenue prematurely or fictitiously. But it may also represent a problem of credit policies that are too liberal. I discuss that issue in greater detail in Chapter 16.

Inventory

As I discuss in Chapter 15, companies can use one of five different inventory valuation methods, and each one yields a different net income for the company. Inventory policy isn't the only way a company can shift the value of its inventory on the balance sheet. Other common methods used include the following:

• Overstating physical count: Although this method is absolute fraud, companies take this route to improve the appearance of their balance sheets. Sometimes they alter the actual count of their inventory; other times they don't subtract the decrease in inventory from the physical count. Companies may also leave damaged goods in the inventory count, even though they have no value.
• Increasing reported valuation: Some businesses don't even bother messing with their inventory counts. A simple journal entry increasing a firm's inventory valuation and decreasing its costs of goods sold can improve appearances on both the balance sheet and the income statement. The assets side of the balance sheet looks better, and the net income figure improves, too — which ultimately raises retained earnings to hide the existence of the journal entry and keep the balance sheet in balance.
• Delaying an inventory write-down: Company management periodically writes down the value of inventory when it determines that the products are obsolete or slow moving. Because the decision to write down inventory is purely up to management, during a rough year, the company may delay writing down inventory to make its numbers look better.

Any time you suspect that inventory may be the object of financial game playing, you can test your theory by calculating the number of days inventory sits around the company (I show you how to test the number of days inventory sits around in Chapter 15). Look for trends by running the numbers for the past three years. If you see that the number of days that inventory sits around gradually increases, definitely suspect a problem. The problem may not be creative accounting; it may be a sign of other problems, such as reduced consumer interest in the product or a bad economic market. The only way to find out is to ask your questions to the company's investor relations department.

Undeveloped land

Land never depreciates. But shareholders don't have any details about where the land that a company owns is located, so they can never truly assess the value of undeveloped land on a balance sheet. This fact allows a lot of room for creative accounting and leaves the financial reader in the dark when it comes to finding this problem. Unfortunately, in a sketchy situation like this one, all you can do is wait for a whistle-blower to expose it.

Artwork

As is the case with undeveloped land, financial reports don't detail the value of artwork that a company holds, so a lot of room exists for doctoring the numbers. Unless you're looking at the financial statements for a company that regularly sells artwork, be wary when you see a large portion of its assets listed on the balance sheet in a line item called artwork. This line item shouldn't be a major one for most companies that aren't in the art business.

If you see a non-art business with a significant level of assets tied up in artwork, ask investor relations why the company is spending so much money on art. Frankly, a firm that ties up its money in art instead of using it to grow the business is not one I'd want to own stock in.

Looking for undervalued liabilities

Undervaluing liabilities can certainly make a company look healthier to financial report readers, but this deception is likely to lead the company down the path to bankruptcy. Games played by misstating liabilities frequently involve large numbers and hide significant money problems.

Accounts payable

Most times, an increase in accounts payable is directly related to the fact that the company is delaying payments for inventory. To test for a problem, you need to calculate the accounts payable ratio, which I show you how to do in Chapter 16. If you find a trend indicating that the number of days the company takes to pay its accounts payable is steadily increasing, test the number of days in inventory, as I show you in Chapter 15.

If the company fails both tests, investigate further. Even though the company may not be playing games with its numbers, take these signs as an indication of a worsening problem. With the trends you're noticing, definitely call investor relations and ask for explanations about why the company has been paying its bills more slowly or why the inventory has been sitting on the shelves for longer periods of time.

If investor relations doesn't answer the questions to your satisfaction, don't buy the stock. If you already do own the stock, you may want to consider selling it if you believe the company is hiding the truth.

Accrued expenses payable

Any expenses that a company hasn't paid by the end of an accounting period are accrued (posted to the accounts before cash is paid out) in the current period, so these expenses can be matched to current period earnings. This amount is added to the liability side of the balance sheet.

Unpaid expenses can include just about any expense for which the company gets a bill and has a number of days to pay, such as these expenses:

• Administrative expenses
• Benefits
• Insurance
• Salaries
• Selling costs
• Utilities

If the bill arrives during the last week before a company closes its books, the company most likely will accrue it rather than pay it. Most firms cut off paying bills several days before they close their books so the staff can concentrate on closing the books for the period.

If a firm needs to improve its net income, it can manage its numbers by not accruing bills and instead paying them in the next accounting period. The problem with this strategy is that the next accounting period has more expenses charged to it than the company actually incurred during that accounting period. The expenses will be higher, and therefore, the net income will be lower in the next reporting period.

You can test for this particular game by watching the trend for accrued expenses payable. Check to see whether accrued expenses payable is going up or down from accounting period to accounting period. Usually, accrued expenses payable stay pretty level from year to year. If you see a steady decline, the company may be doing some creative accounting, or maybe the company's decrease in expenses is simply due to discontinued operations or other changes. If you see a declining trend, look deeper into the numbers to see whether you can find an explanation. If not, call investor relations to find out why the trend for accrued payables shifts from accounting period to accounting period.

Contingent liabilities

Contingent liabilities are liabilities that a company should accrue when it determines that an event is likely to happen. For example, if the company is party to a lawsuit that it lost and the winner was awarded damages, the company should accrue the liability as a contingent liability.

A company must determine two factors before it can list a contingent liability on its balance sheet. Factor one: The company deems it probable that it will be held liable. Factor two: The company can reasonably estimate the costs that it will incur.

If the company hasn't determined these two issues, you'll probably find a note about the contingency in the notes to the financial statements. Read the notes about contingencies and research further any items you think the company may not be fully disclosing. You can do so by reading analysts’ reports on the company or by calling the investor relations department to ask questions about any issues mentioned in the notes to the financial statements.

Pay-down liabilities

Another way that the firms involved in the scandals of the past three years played with their numbers was by indicating that they paid down their liabilities when they actually didn't. To make its balance sheet look better, a company may transfer debt to another entity owned by the company, its directors, or its executives to hide its true financial status.

You probably won't have any way of knowing whether this is happening until a company insider decides to expose the practice or the SEC catches the company.

Playing Detective with Cash Flow

The statement of cash flows (which I discuss in detail in Chapter 8) is derived primarily from information found on a company's income statement and balance sheet. You usually don't find massaged numbers on this statement because it's based primarily on the numbers that have already been shown on these other documents. But you may find that the presentation of the numbers hides cash flow problems.

Discontinued operations

Discontinued operations occur when a company shuts down some of its activities, such as closing a manufacturing plant or putting an end to a product line. Many companies that discontinue operations show the impact it has on their cash in a separate line item of the financial report. Companies that have cash flow problems with continuing operations may not separate these results on their cash flow statements. Because the accounting rules don't require a separate line item, this strategy is a convenient way to hide the problem from investors — most of whom don't do a good job of reading the small print in the notes to the financial statements anyway.

If discontinued operations have an impact on a company's income statement, you see a line item there listing either additional revenue or additional expenses related to the shutdown. You can find greater detail about those discontinued operations in the notes to the financial statements. Anytime you see mention of discontinued operations on the income statement or in the notes to the financial statements, be sure that you also see a separate line item in the statement of cash flows. If you don't, use the information you glean from the income statement and the notes to calculate the cash flow from operations.

To calculate the cash flow from operations (cash received from the day-to-day operations of the business, usually from sales), subtract any cash generated from discontinued operations (which you find noted on the income statement) from the net income reported on the statement of cash flows. When looking at a company's profitability from the cash perspective, you want to consider only cash generated by ongoing operations.

When you take on the role of detective, you may uncover a cash flow problem that the financial wizards carefully concealed because the rules allow such a misleading presentation. In Chapter 17, I show you numerous calculations for testing a company's cash flow.

Income taxes paid

Just like with discontinued operations, the amount of income taxes that a company pays can distort its operating cash flow. The reason is that, in some situations, companies pay income taxes as a one-time occurrence, such as taxes on the net gain or loss from the sale of a major asset. The income taxes a company pays for these one-time occurrences shouldn't be included in your calculations related to operating cash flow.

By reviewing the sections on investing or financing activities in the statement of cash flows, you can find any adjustments you may need to calculate the operating cash flow. Here are two key adjustments you need to make to find the actual net cash from operations (the amount of cash generated from the company's day-to-day operations):

• Gains from sales of investments or fixed assets: If a company gains from the sale of investments or fixed assets (for example, buildings, factories, vehicles, or anything else the company owns that it can't quickly convert to cash) that weren't part of operations, add back in the taxes paid on a gain from the sale of an investment or fixed asset. Taxes paid on one-time gains distort the true cash flow from operations.
• Losses from sales of investments or fixed assets: If a company loses from the sale of investments or fixed assets, the tax savings the company gets from the loss increase its cash flow. You need to subtract these tax savings from the net cash so your operating cash flow accurately reflects the cash available from operations.