Five Tips for Spotting Financial Fakery

For some reason, reporters and investors ask me a lot of questions about accounting. I guess I must look really boring. (I do wear glasses, after all.) They all want to know how to spot accounting blowups before they happen and how to distinguish low-quality from high-quality earnings.

So, here is a short checklist to help you separate the clean numbers from the potentially dirty ones.

Do the Sniff Test
This one's subjective, but it's powerful. Essentially, if something looks wrong, and management can't provide a convincing explanation, it probably is wrong. Trust your gut--it's better to not make money on a potential investment that smells funny than to lose money by ignoring your intuition and investing anyway.

My favorite example of this is Sunbeam during Al Dunlap's tenure. When the company posted huge sales of barbecue grills in the fourth quarter of the year, something was definitely overcooked. People don't buy barbecues in December, after all.

This one smelled fishy, and it turned out that it was--Sunbeam offered retailers massive discounts to buy grills six months before they normally would, without having to accept delivery or make payment. Later, Sunbeam was forced to restate earnings and push those sales into future quarters.

Remember that Cash Is Always King
Does accounting gobbledygook make your head spin? Fear not--there is one very simple thing you can do: Keep an eye on cash flow. Over time, increases in a company's cash flow from operations should roughly track increases in net income. (Cash flow from operations measures the amount of cash that a company is generating from its business, and you can find it on the statement of cash flows. It's always available in quarterly 10-Q filings, and sometimes in earnings press releases as well.)

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 is usually a very good recipe for a blowup down the road. The company might be selling products on credit and not collecting the cash it's owed, it might be padding its bottom line with reversals from restructuring reserves (see "Watch the Honeypot," below), or it might be selling off investments or other assets--none of which says anything about the true health of the firm's operations. This simple test will keep you out of trouble more often than you may think. 

Beware Overstuffed Warehouses
When inventories begin rising faster than sales, trouble is likely 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 is producing more than it's selling, either demand has dried up or the company has been overly ambitious in forecasting demand. Either way, the unsold goods will either have to get sold eventually--probably at a discount--or written off, which would result in a big charge to earnings.

Keep an Eye on Accounts Receivable 
There are few things Wall Street loves more than growth, and so it shouldn't come as any surprise that companies will go to great lengths to keep their top line increasing as rapidly as possible. One of the sneakier ways for a company to pump up its growth rate is to loosen customers' credit terms, which induces them to buy more stuff. (Companies can also simply ship out more products than their customers ask for, but this is much more rare. It's also fraudulent, by the way.)

The catch here is that even though the company has recorded a sale--which increases revenues--the customer has not yet paid for the product. If enough customers don't pay--think of those looser credit terms, which are probably attracting financially shakier clientele--then the pumped-up growth rate will eventually come back to bite the company in the form of a nasty write-down or charge against earnings.

You can keep an eye out for this kind of thing by watching the accounts receivable (A/R) balance, which measures the amount of bills a company has outstanding. Roughly speaking, watch A/R as a percentage of sales, and watch the growth rate in A/R relative to the growth rate of sales. If A/R is moving up much faster than sales, something may be amiss. Check the company's 10-Q filing for any mention of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped. (You'll want to look in the "Management's Discussion and Analysis" section for the latter, and in the accounting footnotes for the former.)

Watch the Honeypot
Companies in the midst of big changes will often take a huge charge--which Wall Street is supposed to look right through, because, hey, it's a one-time thing--to set up a "restructuring reserve," and then slowly reverse some of the charge later on. This is known as a "honeypot," because the company can dip into it whenever its operational results aren't looking so hot. The company's point of view is that if it overestimated the costs of a big corporate overhaul, then it (properly) needs to account for the lowered costs by reversing a portion of the previous charge.

In practice, companies have every incentive to take one-time charges that are as whopping as possible because Wall Street usually views the charges as nonrecurring events--kind of like a hurricane, or something. Down the road, the company can then pad a rocky quarter with a couple of cents per share in reversals from the Big Whopper charge. Usually, these reversals don't amount to a lot of money, but they can be the difference between meeting and missing the all-powerful consensus earnings per share number. To check for this sort of thing, always read the footnotes to any earnings release or 10-Q if a company has taken several charges in the recent past.

Shameless Plug
Morningstar's first full-length book on stock investing is out--look for it in your favorite bookstore, on BN.com, and on Amazon.com. It's titled The Five Rules for Successful Stock Investing, and it was written by yours truly in conjunction with Morningstar's stock analyst staff. The first half of the book covers the basics of fundamental analysis: a discussion about developing an investment philosophy, a mercifully short introduction to reading financial statements, a primer on valuation, and a guide to evaluating company management and assessing economic moats. The second half is a series of chapters on each sector of the market--from hardware to health care to banking--that explains industry jargon and helps you analyze complicated companies.