In Stephen Kings book – On Writing, he mentioned that the writer has a variety of tools in his/her toolbox. The fundamental tools are vocabulary, grammar and the elements of style. To be a good writer, you must have these tools easily within reach in your toolbox. They must also be in good shape, ready to be called upon when needed.
In investing, the three essential tools are:
- Understanding financial statements
- Understanding business models and valuation
- Being rational
This article is focused on the first point – understanding financial statements. One of the reasons I started this website was to improve my knowledge of financial accounting and business valuation.
“If you want to be a writer, you must do two things above all others: read a lot and write a lot. There’s no way around these two things that I’m aware of, no shortcut.”
Stephen King, On Writing
You can replace ‘writer’ with ‘investor in the above quote and the advice will still be sound. Reading is essential. Writing isn’t essential, but it helps to organise your thoughts and forces you to explain things clearly.
Understanding Financial Statements
Recently I read Financial Shenanigans by Howard Schilit. It explains the myriad of ways by which companies can exaggerate their financial performance.
I’ll split the main points of the book into three parts.
Part 1 – Overstating Revenue
Overstating revenue often works like a time machine – the aim is often to pull revenue from a future date to the present and to push expenses to the future. This presents an overly optimistic view of the financial health or growth prospects of a company.
1. Recording revenue too soon
Percentage of completion (POC) accounting allows a company to record revenue before receiving payment from the customer. The company estimates the percentage of completion of the project – this could be based on cost incurred so far. For example, if an elevator manufacturer has spent 50% of the planned budget to make the elevator, the project is regarded as 50% completed and it books 50% of the revenue during that financial period even though no cash has actually exchanged hands. The problem with this is it gives leeway for the management to artificially increase revenue in any period by simply understating the cost of the project or overstating actual progress made. For example, imagine an order costs £100 million to deliver and the company has spent £50 million so far, it can increase its revenue using POC accounting by simply reducing the estimated cost of the project to £60 million. Now 83% of the order is ‘completed’ and the company can book 83% of the revenues tied to that order.
Another trick used to inflate revenue is using bill and hold arrangements. This is when the seller doesn’t ship the goods to the customer but records the revenue. This can occur for legitimate reasons if it is initiated by the buyer, for example if they buyer does not have enough space to take the products. If initiated by the seller, it could be an attempt to record revenue too early.
Shipping products to an intermediary instead of the customer may also be a sign of more aggressive accounting as it gives management some leeway to make up revenue without any cash exchanging hands.
Companies selling through distributors also have to choose when to record revenue. The “sell in” approach books sales when the product is shipped to the distributor while the “sell through” approach books sales when the distributor ships to the customer. Neither of these is necessarily good or bad but the “sell through approach” is more conservative. If there is a switch from “sell in” to “sell through”, it is a sign of more aggressive accounting. This change towards more aggressive accounting occurred in one of Valeant’s acquisitions, allowing sales to be recognised earlier and giving the illusion of growth. With a “sell in” approach, management can also be incentivised to stuff the channel i.e. ship a lot of product to distributors and record the sales immediately.
Companies extending credit to the customers is also an obvious red flag. The ratio of receivables to revenue should be monitored and any large spike could be indicative of management booking sales too early. During a conference call by the CFO of Fitbit, he mentioned that payment terms were extended for some Asian customers. After this, the share price fell by 50%. Loosening credit policy with customers can often be a red flag.
2. Recording bogus revenue
Using something called “finite insurance” a company can make up revenue in a given period to cover up a struggling business. It works like this. The company pays a premium to an insurance company and in a bad year, the insurance company pays out to the company thereby offsetting any losses.
You should also watch out for related party transactions for example transactions with customers who are also joint venture partners with the company. Another example would be a company whose main customer is its parent company. For example, Company X sells to Company Y and Company Y is a majority owner of company X. Another example would be the CEO of a company leasing his own personal property to the company he runs. This has occurred at WeWork. It doesn’t necessarily suggest something nefarious is happening however, it should raise eyebrows. Often, a pair of raised eyebrows is all the evidence you need to stay away from a questionable investment.
Enron and Groupon also exaggerated revenues by booking the notional value of trades as revenue. This would be similar to a bank booking all of the transactions it facilitates as revenue, which common sense dictates to be completely meaningless.
3. Using one-time unsustainable activities
If a company sells off a part of its business, this is usually recorded as a non-recurring one time item. Sometimes, a company can record the sale via a reduction in SG&A (selling, general and admin) expense which will improve operating margins. This occurred with IBM in 1999. However, simply looking at the footnotes of the income statement would have shown the trick used by IBM. Companies that exaggerate their performance in a given quarter or year will typically shift the ‘undesirables’ from operating to non-operating items while shifting the ‘desirables’ the other way around on the income statement. This is done to inflate operating income. For example, a company can report one-time write-off of a factory or a piece of equipment thereby shifting the related expenses into the non-operating section. This can be a problem if these ‘one time’ charges are always present, which by definition makes them the opposite of ‘one time’. In general, any one-time charges that are recurring should be viewed with scepticism.
Part 2 – Understating Expenses
The choice between capitalising or expensing a cost can have a big impact on the amount of profit reported by a company. As usual, the things to look out for is a change in accounting policy from one year to another. The same cost that was previously expensed but now capitalised on the balance sheet is a red flag. Ultimate software Group went from not capitalising software development costs to capitalising these costs in amounts reaching up to 40% of reported net income. The trick used by companies here is to inappropriately capitalise an operating cost thereby artificially boosting earnings.
Increasing the useful life of an asset (tangible or intangible) will decrease depreciation and amortisation costs. This is why its important to read the annual reports of other companies in the same industry as the company you are analysing. This will inform you about the ‘normal’ life of an asset. For long lived tangible assets, this is especially important because inflation can significantly increase the real replacement cost of the asset as explained here.
Failure to write-off impaired tangible assets will also falsely boost reported profits. For example, if a distillation column in an oil refinery has a useful life of 20 years and 10 years in, is completely damaged, it needs to be written off and cannot be continuously depreciated at 5% a year (assuming straight line depreciation and a 20-year useful life).
A sharp decline in allowance for doubtful accounts coupled with a sharp rise in receivables could be a signal that a company is overstating reported earnings. This occurred with Scholastic in 2002. Accounts receivable jumped by 5% while allowance for doubtful accounts fell by 11%. A sharp fall in the long-term ratio of doubtful accounts to total receivables is a red flag. Naturally, a certain percentage of receivables will likely go bad and if a company is recording a sharp decline in this percentage, it could be trying to boost earnings.
For financial companies or any company whose primary source of income is from lending, a sharp decline in loan loss reserves could also be a red flag. A loan loss reserve is an expense set aside as an allowance for uncollected loans. Reducing this figure will artificially boost earnings. A decline in loan loss reserves as a percentage of nonperforming loans is a red flag.
Exaggerated restructuring reserves (cookie jar accounting) can also inflate reported earnings. It works like this – say a company is laying off 1000 workers who will have to be paid a severance package. A restructuring reserve of £10 million is recorded. However, only 500 workers are actually being let go so the reserve has been exaggerated by £5 million. This £5 million can then be brought forward as a reduction in expenses and voila, earnings have increased by £5 million.
A company could also build up reserves to make itself look weaker than it really is. This was possibly carried out by Microsoft in the past while it was under investigation for alleged anti-competitive practices. Showing stronger numbers could increase the focus of regulatory scrutiny on the company. In the short period of 5 quarters starting in 1999, Microsoft’s deferred revenue doubled from $2bn to over $4bn. This is a nice problem to have but, as one can imagine, quite rare. Not many companies are as so strong as to actively understate revenue growth.
Part 3 – Smoothening Earnings
This is achieved by – creating cookie jar reserves (briefly discussed already), improper accounting of derivatives and recording current period sales in a later period. The aim here is to give an illusion of consistent growth.
Cookie jar reserves were used by Enron to smooth out volatility in its earnings. Enron had a big gain in the 2000-2001 period and decided to store some of this as a reserve on the balance sheet, allowing the company to draw from it during more difficult periods which subsequently came.
Classifying normal operating expenses as a restructuring charge (or one-time charge) can also pull expenses from the future and bring it to the present. This creates an illusion of profit growth since expenses in the future will now be less than current period expenses. This could occur right before an acquisition closes to give the impression that ‘synergies’ and ‘operational streamlining’ has occurred. It works like this. The acquired company books a large restructuring charge and the value of some tangible and intangible assets is written off thereby reducing future depreciation and amortisation expenses. Not only will the next period earnings be materially higher after the acquisition (simply because the previous write-downs artificially deflated earnings, there is nowhere to go but up) but future depreciation and amortisation expenses will be non-existent.
In all these examples, one accounting method if not necessarily superior to another. What you are looking for is an obviously bad methodology that does not pass the hurdle of common sense. Ideally, it should not give management too much leeway to make subjective interpretations. A change in how revenue, operating cash flow, expenses or other metrics are recognised that leads to less conservative numbers is also a red flag.
It is also important to not get too bugged down by small exaggerations in earnings. What you want to spot is significant manipulation of the financials. A small but obvious exaggeration of financial performance doesn’t automatically mean the entire investment thesis should go to the bin. You are looking for significant exaggerations that paints a severely distorted image of a company’s financial health.