A few days before Enron's former president, Jeffrey Skilling, was sentenced to 24 years in the joint, I had finished reading an excellent book, Business Fairy Tales, by Dr. Cecil W. Jackson. In only 270 pages, he covers a myriad of accounting blow-ups and provides concrete techniques for how investors can avoid them. Of course, the longest case study is Enron.
Dr. Jackson is a CPA and a professor of clinical accounting at the University of Southern California. Oh, and he has a doctorate in accounting. But he is not a pie-in-sky theoretician. Actually, he has worked at two major accounting firms.
Case by case
In fact, the book is structured like an MBA class, with detailed case studies. There are the famous cases, such as WorldCom, Krispy Kreme
Each case study details the background of the main characters in the shenanigans. Interestingly enough, there is a common theme: The business starts with a great idea, capitalizing on a big market opportunity. There are smart and energetic entrepreneurs who build real companies. But, to keep the growth moving, they push the envelope further and further until there is an implosion.
Along the way, the author describes the shenanigans (and, more importantly, how to spot them on a company's financials). And, at the end of each case study, there is a section called "Are They Living Happily Ever After?" Well, unfortunately, it seems like white-collar crime does pay. A typical sanction for wrongdoing is a small fine, without "admitting or denying the allegations."
The classic: Sunbeam
Interestingly enough, it's the book's first case study that contains many of the key risk factors investors should focus on. It's the tale of Sunbeam, which got its start in 1897.
Like many companies, Sunbeam started to lose momentum and so, in 1996, hired a new CEO, Albert "Chainsaw Al" Dunlap. Dunlap's prior gig was as CEO of Scott Paper, where he fired thousands of people and pumped the stock up -- after which he sold the company to Kimberly Clark
Yet this didn't seem to matter when Dunlap took the helm at Sunbeam, as the stock price surged from $12.50 to $18.63. He wasted little time in launching his slash-and-burn policy, in which he cut half of Sunbeam's workforce (6,000 employees). He shut down 40 of its 61 warehouses, reduced 90% of the product line and eliminated half of its factories.
According to the author, "Sunbeam's vicious cost-cutting plan of closing production plants and cutting products, jobs, and R&D expenditures was not likely to lead to fast sales growth as reported in record numbers in 1997. The implausibility of the reported financial results in relation to Sunbeam's major downsizing plan was a major signal of fictitious financial reporting."
Other than this, there were many signs of manipulation. Examples:
Accounts receivables were increasing as a percentage of sales: That is, if the company is recognizing sales too early, there will need to be an increase in accounts receivable (since cash will be received later, if at all). As for Sunbeam, the percentage went from 29% of sales in the first quarter of 1997 to 49% of sales in the first quarter of 1998.
There were sudden changes in gross margins: This is usually the result of not valuing inventory properly. For example, Sunbeam had gross margins of 19% in the second quarter of 1996 and gross margins of -15% in the fourth quarter of 1996.
Cash flows were far behind net income: Hey, if profits are not resulting in cash, how is this useful for a company? As for Sunbeam, while it had operating income of $132 million in 1997, the cash flows from operations were negative.
Conclusion
There are many more lessons in this book. They are based on real cases, and the author does an excellent job in providing ways to detect possible mischief. And, as a book that can help me avoid trouble with my investment picks, it's certainly a bargain.
Krispy Kreme is a former recommendation of Motley Fool Stock Advisor , where Tom and David Gardner are always on the lookout for the market's best investments. Try it out for yourself -- it's free for 30 days .
Fool contributor Tom Taulli does not own shares of stocks mentioned in this article. He is currently ranked 10 out of 11,654 in CAPS. The Fool has a disclosure policy.
