Ignore This Red Flag at Your Own Risk

"Aggressive" can be an inspiring word in investing, one that could point to positive returns over time. A company's management could be aggressively embarking on growth initiatives, for example. Investors could find themselves full of admiration for a company's aggressive competitive moves to fend off or even vault ahead of its rivals.

When "aggressive" is paired with the word "accounting," though, investors should look out and think twice.

The power of pattern recognition
Enron is probably the most well-known example of accounting fraud, but accounting problems, irregularities, and even fraud aren't as uncommon as we may think.

Accounting methods have occasionally come into the public eye, even long after the late 1990s dot-com bubble's bursting raised awareness of the dangers associated with aggressive and "creative" accounting. Remember all those financial restatements?

Lately, there's been a resurgence in accounting-related controversies. Groupon burst right out of the IPO gate with accounting issues that raised eyebrows. Green Mountain Coffee Roasters (Nasdaq: GMCR  ) is still under investigation by the Securities & Exchange Commission for questionable revenue accounting.

GMI Ratings, the leading provider of research on environmental, social, governance, and accounting-related risks affecting the performance of public companies, released a report (link opens PDF file) last week diving deep into the pitfalls of improper expense recognition in corporate accounting.

GMI Ratings assigns Accounting & Governance Risk, or AGR, ratings to the companies in its database, setting its algorithms to conduct pattern recognition of factors that over the course of 13 years have indicated fraud. Although GMI Ratings doesn't claim its results are correct in all cases, the red-flagged companies bear watching, since in quite a few cases companies that have scored low on its AGR have been more likely to suffer from regulatory scrutiny and have also showed stock underperformance to boot.

Massaging the numbers
GMI Ratings gave several case studies of well-known companies that have raised the SEC's attention due to the expense recognition issue. Let's refresh our memories with two examples from the report.

In July 2010, Dell (Nasdaq: DELL  ) was accused of having various disclosure and accounting violations from 2001 through 2006. Although its accounting made it appear that Dell was lowering its operating expenses, in fact the company was offsetting its costs with rebates from Intel.

In June 2010, Diebold was charged with having conducted earnings management fraud from 2002 through 2007. It participated in a litany of shady manipulations of its numbers, including delaying and capitalizing expenses, manipulating finished goods inventory and putting off expenses to spread them over several reporting periods, and writing up the value of its used ATM inventory. 

Many investors in our current marketplace are fairly short term and fairly speculative in nature, so memories are brief. Those of us who are long-term investors shouldn't forget corporate managements' urges to make their numbers look better than they truly are, nor should we ignore warnings about possible serious problems on the horizon.

Companies on GMI Ratings' current watchlist for "Aggressive" or "Very Aggressive" AGR ratings due to expense recognition issues include Cisco (Nasdaq: CSCO  ) , Abbott Labs (NYSE: ABT  ) , and General Electric (NYSE: GE  ) .

Spreading the word
Granted, most of us individual investors aren't formally trained in accounting. However, it's not impossible to spot trouble. In 2010 my colleague Matthew Argersinger outlined ways to identify bad companies, and recommended one go-to tome: Dr. Howard Schilit's Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports. Matthew also outlined some basic takeaways for ferreting out problems, including red flags in revenue recognition.

Meanwhile, we should do exactly what speculators and traders tend not to do: Keep a close eye on the news about companies we own and always question whether we truly believe managements are serving shareholders' interests and not just their own. We should also take data and warnings from organizations like GMI Ratings seriously.

There's a lot more to investing than a ticker symbol and a company's daily stock price. Fortunately, given the communications tools we have today and organizations and individuals that track issues like these and disseminate their findings further than ever before, investors have more information on hand than ever before. That's good for long-term investing.

It might be good for corporations, too, in the sense that it might begin to dissuade the use of accounting funny business. When it comes to financial reporting, let's not look for aggression; let's demand the truth.

The Fool's premium report on Green Mountain Coffee Roasters can shed some light on the company's prospects. Get your copy today.

Check back at Fool.com for more of Alyce Lomax's columns on environmental, social, and governance issues.

Alyce Lomax does not own shares of any of the companies mentioned. The Motley Fool owns shares of Abbott Labs, Cisco Systems, Green Mountain Coffee Roasters, and Intel. Motley Fool newsletter services have recommended buying shares of Green Mountain Coffee Roasters and Intel, as well as creating a lurking gator position in Green Mountain Coffee Roasters. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (6) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2012, at 10:07 AM, cruzn59 wrote:

    Can't everyone see these guys are scaring you into selling your stock so it will go down. We have a real blood bath on our hands today, down 5% at 10pm. You see these writers (or their friends) are short. They make money if they retell a story and get the stock to react. They have made writing a ponsi scheme. Either they really know something about GMCR and won't tell or are just pushing the stock down because they are short. I have read these blogs for years and they make art out of rehashing old news. Tell us your position, then tell us the facts. Old stories and maybes are for the wild west and snake oil.

  • Report this Comment On August 30, 2012, at 5:56 PM, xetn wrote:

    You could have just said "buyer beware".

  • Report this Comment On August 30, 2012, at 9:05 PM, colleran wrote:

    krr711, I am not which "guys" you are taliking about but services like GMI Ratings are needed for investors to make informed decisions about stocks they are buying or they hold. I have investigated GMI Ratings before and the idea that they are in business to make money by shorting stocks is ludicrous. Also, Alice Lomax is a Fool employee who has written on many topics about investing. The idea that she is shorting GMCR is beyond belief.

    I have no idea why GMCR is down, but the information about their issues with the SEC has been reported for many months. It is not news.

    Get a grip.

  • Report this Comment On August 31, 2012, at 8:06 AM, TMFLomax wrote:

    colleran, thank you for pointing out that I have written on all kinds of investing topics and indeed I am not short GMCR or any other company I mentioned in this article. We have disclosure rules and we do disclose ANY related financial position we have at the ends of our articles. GMCR is just cited here as an example of a company that is recently under investigation for accounting issues. (The company has many other issues recently, but that's been covered in other articles.)

    Best,

    Alyce

  • Report this Comment On August 31, 2012, at 8:41 AM, dbtheonly wrote:

    Ms. Lomax,

    You are far too young to remember the old rock & roll song that goes, "Paranoia strikes deep. Into your life it will creep."

    I can only urge you to not let the paranoid rantings get to you personally.

  • Report this Comment On September 02, 2012, at 12:04 PM, lowmaple wrote:

    dbtheonly: Don't confuse paranoia with caution.

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