Clues that a company may be heading for trouble include:
- Earnings problems. One of the most significant red flagsis a downward trend in earnings. Companies are required to disclose earnings for the last three years in the income statement, so don’t look just at the “bottom line.” The trend in operating income is just as important as the trend in earnings.
- Reduced cash flow. To a certain extent, management can exploit GAAP to produce the appearance of increased earnings. Some popular shenanigans include booking sales on long-term contracts before the customer has paid up, delaying the recording of expenses, failing to recognize the obsolescence of inventory as an expense, and reducing advertising and research and development expenditures. You can use the cash flow statement to check the reliability of earnings. If net income is moving up while cash flow from operations is drifting downward, something may be wrong.
- Excessive debt. Crucial to determining whether a company can weather difficult times is the debt factor. Companies burdened by too much debt lack the financial flexibility to respond to crises and to take advantage of opportunities. Small companies with heavy debt are particularly vulnerable in economic downturns. Investment professionals pay special attention to a company’s debt-to-equity ratio, the total debt to stockholders’ or owners’ equity. While the optimum ratio varies from industry to industry, the amount of stockholders’ or owners’ equity should significantly exceed the amount of debt by a significant amount. This information should be available on the balance sheet, but Enron hid millions of dollars of debt in special purpose entities.
- Overstated inventories and receivables. Look at the ratio of accounts receivable to sales and the ratio of inventory to cost of goods sold. If accounts receivable exceeds 15 percent of annual sales and inventory exceeds 25 percent of cost of goods sold, be careful. If customers aren’t paying their bills and/or the company is saddled with aging merchandise, problems will eventually arise. Overstated inventories and receivables are often at the heart of corporate fraud, resulting in future declines in profits. As significant as the ratios are, trends overtime are also important. Although there may be good reasons for a company to have bloated or increasing inventory or receivables, it is important to determine if the condition is a symptom of financial difficulty.
- Inventory Plugging. Inventory fraud is an easy way to produce instant earnings and improve the balance sheet. Crazy Eddie, an electronic equipment retailer, allegedly recorded sales to other chains as if they were retail sales (rather than wholesale sales)
- Balancing Act. Inventory, sales, and receivables usually move in tandem, because customers do not pay up front if they can avoid it. Neither inventory or accounts receivable should grow faster than sales. Furthermore, inventory normally moves in tandem with accounts payable, since a healthy company does not often pay cash at the delivery dock as purchases are received.
- Off-Balance Sheet Items. Enron had more than 2,500 offshore accounts and around 850 special purpose entities.
- Unconsolidated Entities. Enron did not tell Arthur Anderson that certain limited partnerships did not have enough outside equity and more than $700 million in debt should have been included on Enron’s statements.
- Creative or Strange Accounts. For their 1997 fiscal year, America Online, Inc. showed $385 million in assets on its balance sheet called deferred subscriber acquisition costs.
- Barter deals. A number of Internet companies used barter transactions (or non-cash transactions) to increase their revenues.
- Look at revenues. Compare the trend in sales with the trend in net income. For example, from 1999 to 2001, HealthSouth’s net income increased nearly 500%, but revenues grew only 5%. On March 19, 2003, the SEC said that HealthSouth faked at least $1.4 billion in profits since 1999 under the auditing eyes of Ernst & Young.
- Hockey stick pattern. Look for aggressive revenue recognition policies (Qwest Communication, $1.1 billion in 1999-2001) which form a hockey stick pattern.
- Nonrecurring charges. Beware of the ever-present nonrecurring charges (e.g., Kodak for at least 12 years).
- Avoid Buying Shares of a Mutual Fund Just Before it Pays Dividend. Merrill Lynch says to wait until after the fund’s record date before making your investment. Otherwise, you’ll owe taxes on the dividend, even though that dividend is, in a sense, return of the principal you’ve just invested. Also, the share price is typically lowered by the amount of the dividend after it is paid. So, by waiting, you may acquire more shares for the same investment amount.
- Be Careful of Your Cost Basis When Selling or Exchanging Fund Shares. Merrill Lynch gives an example of this caution flag. Suppose you originally invested $10,000 in a mutual fund several years ago and that your shares are now worth $20,000. Does that mean that you’d have a $10,000 taxable gain to report on your tax return if you were to sell or exchange all of your shares today ? Not necessarily. According to Merrill Lynch, you may increase your cost basis by any sales charges you paid to acquire your shares. And if you have reinvested dividends and/or capital gains, you may increase your cost basis by the amounts reinvested. Increasing the cost basis may help reduce your tax liability.
- Choose the Most Favorable Method From Among These Three Options to Calculate Your Cost Basis When Selling or Exchanging Some of Your Shares.
1.The Average Cost Method:
- According to Merrill Lynch, you calculate the average cost basis per share among all of your shares and multiply that figure by the number of shares sold. (If you choose this method, you must use it whenever you sell or exchange shares of that fund in the future.) Changing from this method requires IRS approval.
2. The Specific Identification Method:You identify specific shares to be sold (before you sell or exchange them). You may choose the shares with the highest cost basis to reduce taxes on the transaction.
3. If You Don’t Use One of the Above Methods, the IRS’ “Default” Method (First-In, First-Out) is Applied: The IRS assumes you are selling the first shares you purchased, which may result in a higher tax liability than necessary if you purchased shares later at a higher price.
- CPA Switching. Auditor switching and the financial condition of a company are dependent to a limited extent. Firms in the midst of financial distress switch auditors more frequently than healthy companies.
- Underwriter Broker Basis. The long run performance of initial public stock offerings that are recommended by their underwriters is dramatically worse than the performance of firms recommended by non-underwriters. Roni Michaely and Kent Womack found significant evidence of bias– and possible conflict of interest — between the analyst’s responsibility to his investing clients and his incentive to market stocks underwritten by his firm. Contrary to the conventional wisdom, they found that the market does not come close to recognizing the full extent of this bias.
- Hyped Sales. According to court documents, CEO Emanuel Pinez used a form of trickery rarely seen: He hyped sales by using his ample personal fortune to fund purchases. ‘Any auditor would have had a hard time catching that,’ says William Coyne, an accounting professor at Babson College. Centennial Director John J. Shields, a former CEO of Computervision Corp., says in an affidavit that Pinez admitted to him that he altered inventory tags and recorded sales on products that were never shipped. Pinez’ lawyer says he is innocent. (Geoffrey Smith, “Why Didn’t Anyone Smell a Rat at Centennial?” Business Week, March 24, 1997, p.190.)
- Board of Directors. The “Heard on the Street” column in the April 25, 1997 issue of the Wall Street Journal, written by E. S. Browning, discusses red flags that relate to a company’s board of directors. Wharton Professors John Core, Robert Holthausen and David Larcker published a study that found six different board characteristics linked to both higher CEO pay and weaker performance of the company’s common stock. These factors cause poor governance systems and ultimately lead to poor financial performance by the firm, according to the authors. The characteristics of boards that are danger signals for a company’s common stock are the following:
- Chairman and Chief Executive are the same person
- Large board
- Chief Executive himself appoints outside directors
- Outside directors who have business dealings with company
- Outside directors over the age of 70
- “Busy” outside directors who serve on many other boards
- Index Funds. According to the April 29, 1997 Deloitte & Touche Review, index funds do not alleviate market risk–the possibility that stocks and bonds will decline in value. If the market that a particular index fund is tracking declines, the value of shares of the index fund will decline. Many index funds have achieved excellent returns as a result of the strong overall performance of the U.S. market in recent years. When the U.S. stock market experiences a correction or decline, stock index funds may not performas well as actively managed equity funds, because stock index funds are fully invested in equity security at all times. During market declines, actively managed equity mutual funds may have a larger percentage of their assets in cash and investments other than stocks. Investment risk is reduced through the diversification achieved by investing in mutual funds (index or actively managed funds). Most mutual funds hold securities of many different companies; therefore, the risk that an individual security loss will negatively impact the overall return of a mutual fund is reduced.
Statements on Auditing Standards No. 82 and 99
Before the Sarbanes-Oxley Act, the American Institute of Certified Public Accountants was responsible through its Auditing Standards Board in developing auditing standards that had to be satisfied by public accounting firms. The SEC required publicly traded firms to be audited by public accounting firms to provide reasonable assurance of presentation in conformity with generally accepted accounting principles. In conducting an audit, public accounting firms had to observe generally accepted auditing standards as promulgated by the Auditing Standards Board. Today the PCAOB is responsible for developing auditing standards.
One of the most highly publicized statement on fraud auditing standards in recent years was published in early February of 1997. Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit, provided guidance to the auditor in the detection of financial statement fraud. This statement, effective December 15, 1997, clarified the auditor’s responsibility to detect fraud.
The statement is rather lengthy but it has an interesting discussion of what it calls risk factors (what we call red flags) that should be of interest to our readers. Although subsequent SAS No. 99 replaced SAS No. 82, the following section of SAS No. 82 is still of particular relevance:
Risk Factors relating to management’s characteristics and influence over the control environment. Examples include:
A motivation for management to engage in fraudulent financial reporting. Specific indicators might include:
- A significant portion of management’s compensation represented by bonuses, stock options, or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position, or cash flow.
- An excessive interest by management in maintaining or increasing the entity’s stock price or earning trend through the use of unusually aggressive accounting practices.
- A practice by management of committing to analysts, creditors, and other third parties to achieve what appear to be unduly aggressive or clearly unrealistic forecasts.
- An interest by management in pursuing inappropriate means to minimize reported earnings for tax-motivated reasons.
- A failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Specific indicators might include:
- An ineffective means of communicating and supporting the entity’s values or ethics, or communication of inappropriate values or ethics.
- Domination of management by a single person or small group without compensating controls such as effective oversight by the board of directors or audit committee.
- Inadequate monitoring of significant controls.
- Management failing to correct known reportable conditions on a timely basis.
- Management setting unduly aggressive financial target and expectations for operating personnel.
- Management displaying a significant disregard for regulatory authorities.
- Management continuing to employ an ineffective accounting, information technology, or internal auditing staff.
- Nonfinancial management’s excessive participation in, or preoccupation with, the selection of accounting principles or the determination of significant estimates.
- High turnover of senior management, counsel, or board members.
- Known history of securities law violations or claims against the entity or its senior management alleging fraud or violations of securities laws.
- Risk factors relating to industry conditions. Examples include:
- New accounting, statutory, or regulatory requirements that could impair the financial stability or profitability of the entity.
- High degree of competition or market saturation, accompanied by declining margins.
- Declining industry with increasing business failures and significant declines in customer demand.
- Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence.
Risk factors relating to operating characteristics and financial stability. Examples include:
- Inability to generate cash flows from operations while reporting earning and earnings growth.
- Significant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity — including need for funds to finance major research and development or capital expenditures.
- Assets, liabilities, revenues, or expenses based on significant estimates that involve unusually subjective judgments or uncertainties, or that are subject to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity — such as ultimate collectibility of receivables, timing of revenue recognition, realizability of financial instruments based on the highly subjective valuation of collateral or difficult-to-assess repayment sources or significant deferral of costs.