As Warren Buffett correctly states,
“If you are in a poker game and after 20 minutes, you don’t know who the patsy is, then you are the patsy.”
The same principle applies to investing and financial analysis. If you are unable to determine who is cooking (or warming) the books via deceptive practices, then you will be left holding a bag of losses as tears of regret pour down your face. The name of the stock investing game (not speculation game) is to accurately gauge the financial condition of a company and then to correctly forecast the trajectory of future earnings and cash flows.
Unfortunately for investors, many companies work quite diligently to obscure, hide, and distort the accuracy of their current financial condition. Without the ability of making a proper assessment of a company’s financials, an investor by definition will be unable to value stocks.
There are scores of accounting tricks that companies hide up their sleeves to mislead investors. Many people consider GAAP (Generally Accepted Accounting Principles) as the laws or rules governing financial reporting, but GAAP parameters actually provide companies with extensive latitude in the way accounting reports are implemented. Here are a few of the ways companies exercise their wiggle room in disclosing financial results:
Depreciation Schedules: Related to GAAP accounting, adjustments to longevity estimates by a company’s management team can tremendously impact a company’s reported earnings. For example, if a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year ($10m ÷ 10 years). If for some reason the Chief Financial Officer (CFO) suddenly changes his/her mind and decides the building should last 40 years rather than 10 years, then the company’s annual expense would miraculously decrease -75% to $250,000. Voila, an instant $750,000 annual gain created out of thin air! Other depreciation tricks include the choice of accelerated or straight-line depreciation.
Capitalizing Expenses: If you were a management team member with a goal of maximizing current reported profitability, would you be excited to learn that you are not required to report expenses on your income statement? For many the answer is absolutely “yes”. A common example of this phenomenon occurs with companies in the software industry (or other companies with heavy research and development), where research expenses normally recognized on the income statement get converted instead to capitalized assets on the balance sheet. Eventually these capitalized assets get amortized (recognized as expenses) on the income statement. Proponents argue capitalizing expenses better matches future revenues to future expenses, but regardless, this scheme boosts current reported earnings, and delays expense recognition.
Stuffing the Channel: No, this is not a personal problem, but rather occurs when companies force their goods on a distributor or customer – even if the goods (or service) are not requested. This deceitful practice is performed to drive up short-term revenue, even if the reporting company receives no cash for the “stuffing”. Ballooning receivables and substandard cash flow generation can be a sign of this cunning, corporate custom.
Accounts Receivable/Loans: Ballooning receivables is a potential sign of juiced reported revenues and profits, but there are more nuanced ways of manipulating income. For instance, if management temporarily lowers warranty expenses and product return assumptions, short-term profits can be artificially boosted. In addition, when discussing financial figures for banks, loans can also be considered receivables. As we experienced in the last financial crisis, many banks under-provisioned for future bad loans (i.e. didn’t create enough cash reserves for misled/deadbeat borrowers), thereby overstating the true, underlying, fundamental earnings power of the banks.
Inventories: As it relates to inventories, GAAP accounting allows for FIFO (First-In, First-Out) or LIFO (Last-In, Last-Out) recognition of expenses. Depending on whether prices of inventories are rising or falling, the choice of accounting method could boost reported results.
Pension Assumptions: Most companies like their employees…but not the expenses they have to pay in order to keep them. Employee expenses can become excessively burdensome, especially for those companies offering their employees a defined benefit pension plan. GAAP rules mandate employers to contribute cash to the pension plan (i.e., retirement fund) if the returns earned on the assets (i.e., stocks & bonds) are below previous company assumptions. One temporary fix to an underfunded pension is for companies to assume higher plan returns in the future. For example, if companies raise their return assumptions on plan assets from 5% to a higher rate of 10%, then profits for the company are likely to rise, all else equal.
Non-GAAP (or Pro Forma): Why would companies report Non-GAAP numbers on their financial reports rather than GAAP earnings? The simple answer is that Non-GAAP numbers appear cosmetically higher than GAAP figures, and therefore preferred by companies for investor dissemination purposes.
Merger Magic: Typically when a merger or acquisition takes place, the acquiring company announces a bunch of one-time expenses that they want investors to ignore. Since there are so many moving pieces in a merger, that means there is also more opportunities to use smoke and mirrors. The recent $8.8 billion write-off of Hewlett-Packard’s (HPQ) acquisition of Autonomy is evidence of merger magic performed.
EBITDA (Earnings Before Interest Taxes Depreciation & Amortization): Skeptics, like myself, call this metric “earnings before all expenses.” Or as Charlie Munger says, Warren Buffett’s right-hand man, “Every time you see the word EBITDA, substitute it with the words ‘bulls*it earnings’!”
This is only a short-list of corporate accounting gimmicks used to distort financial results, so for the sake of your investment portfolio, please check for any potential tricks up a company’s sleeve before making an investment.
AUTHOR'S DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in HPQ/Autonomy, or any other security referenced in this article. No information accessed through this article constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision.
About the author
Wade Slome, CFA, CFP®, is President and Founder of Sidoxia Capital Management. Sidoxia is a full service investment management and advisory firm that provides a wide range of financial services to high-net-worth individuals, family trusts and institutions.