A few readers asked me if I would review some books dealing with accounting issues. I’m happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.
Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:
- Recording revenue too soon.
- Recording bogus revenues.
- Boosting income with one-time gains.
- Shifting current expenses to a later period.
- Failing to record or disclose all liabilities.
- Shifting current income to a later period.
- Shifting future expenses to the current period.
There are several common factors at play here.
- Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
- Watch revenue recognition policies closely. It is the largest area of financial misstatement. (1-2)
- Look for assets and liabilities that aren’t on the balance sheet, and avoid companies with hidden liabilities. (5)
- When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow. (6,7)
The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of the accounting troubles that occurred. Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings. I wouldn’t say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet. Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two. To do three, it takes fraud.
Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings. That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not. For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.
The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it. For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies. Financial companies are more complex (they are all accruals — the cash flow statement is not very useful), and can’t easily be analyzed for earnings quality from looking at the financial statements alone.
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