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How to Detect Creative
Accounting
Detecting accounting shenanigans
Almost every
day we’re hearing about how corporations have played fast and loose
with accounting rules to hype their reported earnings. So it’s not
surprising that quality of earnings is top of mind for many investors
these days.
However most
investors, including me, haven't been trained how to scrutinize
financial statements. Fortunately, a new book, “The Financial
Numbers Game” by Charles W. Mulford and Eugene E. Comiskey, tells
you how. Mulford and Comiskey are both college professors at the Georgia
Institute of Technology in Atlanta, but they also do “real world”
consulting on financial statement analysis, so they have their feet on
the ground.
The book
tells you everything you need to know to detect when company executives
are resorting to creative accounting practices to meet their numbers.
The book covers a lot of territory and from time to time I’ll describe
how you can put their concepts into practice when you’re analyzing a
stock.
Nonrecurring
Accounting Shenanigans
One such concept involves “nonrecurring items.” According to Mulford
and Comiskey, nonrecurring items are supposed to be income or expenses
that are “not expected to recur on a regular basis,” and the “term
is often used interchangeably with special items.”
Pro Forma
Earnings
The beauty of nonrecurring
expenses in the eyes of some corporate managers is that they don’t
have to count them when they tabulate “pro forma” earnings.
Pro forma
originally meant “as if” and was mainly employed to present the
results of recently merged companies “as if” they had always been a
single company. In recent years, though, some corporate managers figured
out that they could make their earnings look better by emphasizing pro
forma results in their quarterly reports. Unfortunately the analyst
community decided that was a good idea and analysts base their published
earnings forecasts on pro forma earnings. So when you hear that a
company beat analysts’ forecasts by two cents, it means that the
company’s pro forma earnings were two cents higher than analysts’
forecasted pro forma earnings.
Since the pro
forma calculation doesn't deduct nonrecurring costs to come up with
earnings, the more expenses that can be defined as nonrecurring, the
higher the reported earnings. Waste Management took that concept to the
limit when it decided that the $24 million that it spent for painting
trucks and other signage costs were nonrecurring and excluded them when
it calculated its December 2000 quarter pro forma earnings.
Spot
Habitual Users
Obviously, most firms will from time to time incur costs that are truly
nonrecurring such as costs associated with losing a lawsuit, closing
factories, writing off worthless patents, etc. The trick is to
differentiate the companies that persistently come up with nonrecurring
expenses to boost pro forma earnings.
That’s
doable because both Multex Investor (www.multexinvestor.com)
and MSN MoneyCentral (moneycentral.msn.com)
list nonrecurring items on a separate line of each company’s income
statement. The entries are labeled Unusual
Expense/Income on Multex and Special
Income/Charges on MoneyCentral.
Divide by
Sales
The raw numbers don’t mean much alone, so I compare a firm’s
nonrecurring expenses to its total sales. Both are shown on the annual
income statement. I do it by dividing the nonrecurring expenses by the
sales and compute the result as a percentage. For instance, the ratio
would be 10 percent if a company recorded sales of $1,000 and listed
$100 in nonrecurring charges (100/1000). A single fiscal year’s data
isn’t significant since the object of this exercise is to pinpoint
firms that consistently rack up big nonrecurring charges. Both
MoneyCentral and Multex list five year’s worth of data, so I compute
the ratios for each of the five years, and then average them.
Clean
Accounting Examples
Here are a few sample five-year average ratios for companies that in my
view practice clean accounting, that is, they have a low incidence of
nonrecurring charges: Bed Bath & Beyond 0%, Dell Computer 1%, Home
Depot 0%, Intel 1%, and Microsoft 0%.
Suspects
I consider any company with a ratio of three percent or higher as a
suspected nonrecurring expense abuser. Here are the ratios for some
firms that persistently record nonrecurring charges: Cisco Systems 7%,
Computer Associates 9%, Tyco International 4%, Waste Management 10%, and
Yahoo 13%.
Amazon
Example
I’ll demonstrate how to calculate the ratios by analyzing Amazon.com
using Multex Investor. Enter Amazon’s ticker symbol (AMZN) on
Multex’s homepage, select Income Statement, and then use the dropdown
menu to select the annual income statement.
On the
unusual expense/income line, positive numbers are expenses and negative
numbers represent unusual income. Multex listed nonzero expense figures
for each of the last four years for Amazon (1997 was zero).
For instance,
it listed $181.6 million in unusual expenses and $3,122.4 million
revenue (sales) for Amazon’s December 2001 fiscal year. The
nonrecurring (unusual) expense to sales ratio for that year is 5.8
percent (181.6 divided by 3122.4).
The ratios
for each of the five year’s starting with 2001 and working back to
1997 are: 5.8%, 7.3%, 0.5%, 0.6% and 0%, respectively. The five ratios
averaged three percent. Using the five-year average, Amazon just
qualifies as a suspected nonrecurring expense abuser, but the two most
recent year’s ratios signal a trend towards increasing reliance on
nonrecurring expenses.
Helpful
Tool
No single number works to define a stock’s future performance, and a
company may have a legitimate reason for its persistent nonrecurring
expenses. Consider the nonrecurring expense ratios as another tool to
help you evaluate the risks and rewards of owning a stock.
published 4/29/02 |
