Are These 5 Companies Misstating Their Accounts?

It's the corporate announcement no (long) investor wants to hear. When a firm announces that it's restating its financial accounts to correct an error, its stock typically takes a dive. That leaves investors holding the bag, with potentially calamitous consequences.

What if you could identify the firms most likely to misstate their results before they actually 'fess up? Now that would be valuable.

Look out below!
To get an idea of the sort of damage a restatement can do, here are just two examples from the past 18 months:

• On March 18, SunPower (Nasdaq: SPWRA) announced that its Philippines operations had understated its costs of goods sold. Although the total restatement amounted to less than $17.5 million for a seven-quarter period, the company's shares lost 18% over the next seven days. The loss in company market value? Over $380 million. Over a 90-day period post-announcement, the shares went on to underperform the S&P 500 by 33%.

• On March 2, 2009, industrial and foodservice equipment manufacturer Manitowoc (NYSE: MTW) announced that it was taking a $175 million charge on the stated value of the Enodis Ice Group, which it was in the process of selling. Manitowoc was forced to take the charge as the bids it was receiving for Enodis were substantially lower than its book value. The next day, Manitowoc shares lost 21%.

Sniffing for land mines
So how does one sidestep these land mines? The authors of Predicting Material Accounting Misstatements (2010) looked at a population of companies between 1982 and 2005, and the group of companies that received a formal rebuke from the SEC regarding an accounting or audit issue during that period. Based on their data, they constructed three models to predict the likelihood of a misstatement. The simplest one is based on seven variables:

1. Accruals
Publicly traded companies in the U.S. use accrual-basis accounting to calculate their earnings, wherein revenues and costs are recognized as they are incurred, rather than when cash changes hands (cash basis accounting). The evidence suggests that companies generally misstate earnings via the items that reconcile accrual and cash basis accounting. In that regard, two such items are particularly vulnerable: accounts receivable and inventory.

2. Change in receivables
Misstating receivables can produce the illusion of revenue growth.

3. Change in inventories
Misstating inventories can produce the illusion of improvements in the company's gross margin.

4. Percentage of soft assets
Soft assets are defined as assets that are neither cash nor plant, property, or equipment. Soft assets are easier to misstate in order to meet earnings targets.

5. Change in cash sales
Cash sales are defined as revenue less accounts receivable. The change in cash sales shows whether revenues that are not potentially subject to accruals management are growing or declining.

6. Change in return on assets
Return on assets (ROA) is a measure of profitability. Increasing profitability is one of the main motivations behind earnings misstatements.

7. Debt or equity issuance
When a firm relies on issuing debt or equity to finance its operations, managers may have a greater incentive to misstate earnings or balance sheet values in order to reduce the cost of capital.

Five stocks the model doesn't like
I ran the stocks in the Russell 3000 through this model, using the most recent annual financial data. Of the 1,600 stocks for which there was enough data to generate an estimate, the following five are in the top 10% in terms of their probability of an accounting misstatement:

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

Admittedly, the baseline probability for a randomly selected firm in the study population is very small: Out of 133,461 "firm years" (the total number of years for all companies in the sample), the authors found only 494 misstating firms -- a rate of just 0.4%.

The problem is worse than it appears
However, that figure understates the frequency of accounting misstatements, since the study counted only formal actions by the SEC. Given the SEC's limited resources and structural dysfunctions (Bernie Madoff, anyone?), we can be absolutely certain that the actual rate of accounting misstatements is significantly higher.

As such, investors can be burned even if a firm doesn't acknowledge a misstatement; the damage could surface as a negative earnings surprise, for example. Thus, while you shouldn't go out and short these stocks based on the model's results alone, they may deserve a closer look to verify whether something fishy's going on.

Taking action to spot problem stocks
If you're interested in spotting problem companies, either to protect your portfolio or as profitable short opportunities, you'll want to read John Del Vecchio's free report, 5 Red Flags – How to Find the BIG Short. The five red flags John discusses are part of a proprietary model he has spent five years developing. Del Vecchio and his model are battle-tested: As the manager of the Ranger Short Only portfolio from 2007 to 2010, John outperformed the S&P 500 by 40 percentage points. Take the first step toward putting a proven methodology to work for your portfolio, by entering your email in the box below.