Accounting Focus on the Red Flags Written by Richard M Rockwood May 2002 Copyright 2002 FocusI All rights reserved This material is for personal use only It is a violation of federal copyright law to reproduce part or all of this publication without written permission from FocusI 2 The goal of this short article is to show the investor examples of how companies can manipulate their reported earnings This article also provides information on what warnings signs to look for The article has taken information from a variety of sources in order to provide the reader with a quick overview of accounting red flags Focused investors practicing portfolio concentration should be particularly aware of these issues I have written the article for the individual investor who has an intermediate level of accounting knowledge That being said I believe the beginning investor with only a moderate understanding of accounting will benefit from a close reading of this article if for no other reason that to understand what elements of accounting they should study more closely While this article focuses on accounting issues all investors should investigate the management team of a company before investing since the management team has such a strong influence of any companies operations and how they report their results To this end I would strongly urge all investors to first study the way management treats their shareholders Do they provide an accurate picture of their business in their annual report Do they discuss the negative issues in addition to the positive ones If they treat the shareholders like owners and behave ethically then in the vast majority of cases this accounting red flag list will not be needed List of Accounting Red Flags 1 Companies Conducting Large Amounts of Merger Activity Companies that have experienced a slowdown in the growth of their businesses or that have already been practicing accounting deceptions may use merger activity to mask the slowdown in their core business and or use the activity to their advantage by attempting to mask ongoing accounting deceptions In the case of ongoing accounting deceptions management will often try to continue their deceptions by initiating an aggressive acquisition strategy The resulting restructuring charges taken as a result of the acquisitions can be inflated and used to keep the accounting deceptions alive The following quote goes into detail concerning this issue The event provides the acquirer with the opportunity to establish accruals for restructuring the transaction possibly attribute more expense than necessary for the transaction The company may also identify certain expenses that are revalued on the seller s balance sheet increasing goodwill If the conservative valuations prove to be excessive the company is able to reduce its operating expenses in the near term by reducing its estimate for the liability The additional goodwill created would be amortized over a long period of time and not have a significant impact on near term results 1 The following story from the Securities Litigation Regulation Litigation Reporter shows why investors need to watch and study the reasons behind merger activity The Securities and Exchange Commission says that Forbes directed the fraud from its beginning in 1985 and that between 1995 and 1997 pre tax operating income reported to the public by CUC was inflated by more than 500 million Shelton also allegedly perpetrated the fraud starting in 1991 when he joined CUC The SEC asserts that Forbes and Shelton sought out HFS as a merger partner because they believed its reserves would be enough to bury the fraud Soon after CUC merged with HFS to create Cendant Forbes and Shelton congratulated each other on being masterful financial engineers who had been able to continue the fraud through the years the SEC says and they had assured their continued success by duping HFS into agreeing to the merger 1 Earnings Management and Manipulation by Scott McGregor 3 After the manipulation was revealed the stock price fell from more than 40 per share to 19 per share or 47 percent of its value As a result the company lost more than 19 billion in market capitalization in one day How could the investor have discovered that CUC was using aggressive accounting The easiest method would have been to track the acquisitions they were making By this I mean that the investor should have monitored the restructuring charges CUC was taking when it was making its frequent acquisitions By creating these reserves CUC was able to release part of the charges back into income in later periods by determining that they had over reserved when they made the initial estimate of the restructuring costs 2 Companies that Consistently Meet Earnings Targets over an Extended Time Frame or Project High Growth Rates The course of business activity is never this smooth in reality The old saying If it seems to be good to be true it is is still applicable The following comments b