Reality Check: Accounting Alerts Every Investor Should Know by Olstein Funds

The 1998–2000 bubble market, followed by the market crash with its poster child, Enron, created a political and media frenzy relating to the accounting and reporting games that too many companies practice. Investors must stop accepting financial reports and questionable accounting practices at face value. Portfolio managers, analysts, and investors must study the numbers in financial statements and adjust those numbers and the underlying assumptions to reflect the economic reality of a company’s basic business.

Only the adjusted numbers should be used to value a company for investment purposes. A keen understanding of corporate reporting practices, combined with an investor’s ability to identify early warning signs of future earnings disappointments or pleasant surprises, can increase the odds of investment success.

Olstein Funds: The Importance of Excess Cash Flow

It is safer to buy only those companies that generate or are about to generate excess cash flow, and value those companies based on excess cash flow. Excess-cash-flow companies can raise dividends, buy back shares, make strategic acquisitions when credit is tight, ride out hard times without adopting short-term strategies injurious to their future, and are outstanding acquisition candidates. The challenge for investors is to cut through any accounting and financial chicanery and determine a company’s true ability to generate excess cash flow. The numbers are the most important and unbiased indicator of a company’s value. Better to spend one night with a company’s financial statements than two days with its management.

An intensive inferential analysis of financial statements, footnotes, supporting documents, and disclosure practices is the best way to analyze the capabilities of management, the economic reality of the financial information the company provides, the conservatism of its accounting and disclosure practices, its financial strength, and, ultimately, the value of the company. An intensive forensic analysis of financial statements also enables an investor or advisor to determine true financial strength and to screen for potential problems to ascertain a company’s downside risk, a critical consideration before considering its potential for capital appreciation.

For an investor, an equity security is worth the discounted value of the issuing company’s future expected excess cash flow (including capital expenditures and working capital needs).Thus, to value a company according to a model of discounted excess cash flow, one must be able to adjust reported earnings to arrive at true cash earnings (excess cash flow).

Inferential analysis begins with an understanding that GAAP requires a company to report earnings on an accrual basis, which entails two basic premises. First, because accrual accounting states that revenue is recognized when a transaction occurs in which value has been exchanged, this event may lead or lag the exchange of cash. Second, because the cost of a transaction should be recognized over the same period of time as the revenue associated with that cost, this period may also lead or lag the passing of cash.

In reporting GAAP-based earnings, companies have wide discretion, which includes many assumptions about the future. Because management has a vested interest in putting its best foot forward, the numbers produced under GAAP often leave room for unrealistic assumptions and misleading numbers. Most companies use financial accounting and reporting practices to present themselves in the most favorable light, meaning that many companies engage in some type of earnings management or make assumptions that may prove to be unrealistic.

Within limits, earnings management is neither wrong nor illegal. However, as seen during the late 1990s, some companies far exceeded what most would consider reasonable limits. In cases such as Enron, Lucent Technologies, Boston Chicken, and Sunbeam, while the financial statements may have been in accord with GAAP, they were certainly out of touch with economic reality. It is in management’s best interest to report the best earnings possible to preserve financing alternatives, keep their stock options valuable and exercisable, and maintain shareholders through increasing stock prices. Thus, in instances when management identifies a problem which, due to bias or ego, it deems to be temporary, the company can adopt optimistic assumptions or accounting alternatives under GAAP to portray a positive picture until the problem is resolved.

Olstein Funds: Accounting Alerts Help Avert Trouble

An astute investor should be aware of the types of accounting smokescreens that companies use to disguise problems and to misrepresent the company’s economic reality. The following alerts are sometimes clear indicators of future earnings surprises and have proved valuable to investors:

  • Sizable negative divergences between cash flow and net income;
  • Questionable accounting for transactions with unconsolidated affiliates or joint ventures;
  • Prematurely realizing revenue that may not be sustainable;
  • Reversal of past reserves to artificially inflate earnings;
  • Realizing nonrecurring gains, and netting these gains to hide past mistakes;
  • Lowering discretionary expenditures to meet earnings targets;
  • Continual characterization of material expenses as nonrecurring;
  • Unrealistic depreciation schedules;
  • Capitalizing expenses based on unjustified optimism;
  • Serial acquisitions under purchase accounting that overstate internal earnings growth;
  • Lower inventory turns or negative inventory divergences;
  • Accounts receivable rising faster than sales; and
  • Unrealistic pension assumptions.

Olstein Funds: Accounting Alerts Every Investor Should Know

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