The very mention of Enron, WorldCom, Global Crossing, Tyco (NYSE:TYC), or Adelphia Communications causes pain. These companies, and dozens more, are in our Hall of Shame not just because of their accounting irregularities, but also for driving many people away from investing entirely by shaking their faith in the honesty of the markets.
With a seemingly never-ending procession of negative headlines, it's sometimes hard to stay centered and remember that the U.S. stock market is still an overwhelmingly honest instrument, and still the best place for most of us to seek wealth over the long term.
That doesn't mean, however, that you shouldn't stay on the lookout for accounting shenanigans. In fact, you should actively try to ferret out wrongdoing, especially for stocks you've poured your hard-earned dollars into.
Discovering that one of your companies is cooking the books before everyone else does and the stock price plummets is much, much, much easier said than done, though. But there are some things you can watch out for: red flags that -- while certainly not proof of any wrongdoing -- can point to possible aggressive accounting, or worse.
Recognition factor
Many accounting tricks center around the issue of revenue recognition. In fact, more than half of all fraud involving financial reporting involves overstating sales.
Revenue recognition is simply a matter of when a company officially records a sale. (Remember that revenue and sales are just different terms for the same thing.) Let's say you sell oranges on the side of the road. If a customer stops by and pays you $1 for a bag of oranges, it makes sense to record the sale right then and there (and then you should think about raising your prices).
However, let's say someone stops and says, "I want to buy 500 bags. Please ship them to me, and then bill me." Now it's more complicated. Do you record the revenue in your books immediately? Do you wait until you ship, or until you've received payment?
You can see how this leaves room to play games with the books. If you consider a company with a far more complicated business -- one with several divisions spread the world over, that makes and sells hundreds of different products -- you'll see there's a lot of gray area, and a lot of leeway for when revenue is actually recognized.
SEC says...
The SEC has issued some guidelines for the proper recording of a sale. Generally, four conditions must be met:
- Persuasive evidence of an arrangement exists
- Delivery has occurred or services have been rendered
- The seller's price to the buyer is fixed or determinable
- Collectibility is reasonably assured
While that seems simple enough, unscrupulous managers may ignore one or more of these criteria and either record revenue too early or record revenue that doesn't even exist.
Appliance maker Sunbeam provides a good example. When turnaround artist "Chainsaw" Al Dunlap took over as CEO in 1996, he worked out deals whereby retailers agreed to purchase gas grills at a large discount months before they were needed, but would not have to pay for them until six months after they were delivered. Sunbeam would actually ship the grills to warehouses it had leased in order to hold them until requested. Even though it was several months before it had any hope of seeing money for the transactions, the company booked the revenue, thus inflating earnings.
Dunlap pulled some other ploys, and was charged with fraud by the SEC. He settled for $500,000 last year, well after Sunbeam filed for bankruptcy after being forced to restate results. The SEC estimated $60 million of the company's reported $189 million in earnings in 1997 were the result of improper accounting.
Another example of a company playing revenue tricks comes to us courtesy of Xerox (NYSE:XRX). It, too, "accelerated" revenue by prematurely booking equipment sales over a five-year period. What harm did that do? It made the company look healthier than it was, thereby deceiving investors. According to the SEC, "If not for these [improper] accounting actions, Xerox would have fallen short of market expectations, often by a wide margin, in almost every reporting period from 1997 through 1999."
Go with the flow
So, we know overly aggressive revenue recognition can paint a deceiving picture and, if it turns fraudulent, can send a company into bankruptcy with investors suffering huge losses.
One clue that management may be too aggressive in this area is if reported net income consistently exceeds operating cash flow (also called cash from operations) on the cash flow statement. Net income is a rather shady figure that can be understated using conservative accounting techniques, or overstated using aggressive ones (as in the Sunbeam and Xerox cases). Operating cash flow, on the other hand, represents the actual cash the business collected over the specified time period.
Here's a look at Xerox's numbers, as reported in its 1999 10-K:
Xerox Statement of Cash Flows (in thousands)Year ended 1999 1998 1997
---------- ---- ---- ---- Net income $1,424 $585 $1,452Cash from operations $1,224 -$1,165 $472
The bottom figures show the actual cash flowing into the company during this period was far less than reported income.
Sunbeam's results for 1997 -- a year when almost a third of its reported revenue was fraudulent -- are particularly telling:
Sunbeam Statement of Cash Flows (in thousands)Year ended 1997
---------- ---- Net income $109,415Cash from operations -$8,249
As you might guess, it's a very positive sign when a business shows consistently higher operating cash flow than net income. Some companies that fall into this category are IBM (NYSE:IBM), Cisco (NASDAQ:CSCO), Wal-Mart (NYSE:WMT), Johnson & Johnson (NYSE:JNJ), and Coca-Cola (NYSE:KO).
It's a wrap
If a company shows operating cash flow at a much lower level than net income for one year, it doesn't automatically imply aggressive accounting or wrongdoing. Myriad factors go into the calculation of these numbers. Still, an investor should strive to understand why it happened.
If the same pattern repeats itself over a period of two or more years, that's a major red flag.
Rex Moore never tried to burn any bridges, though he knows he let some good things go. At time of publication, he owned no companies mentioned in this column. The Motley Fool is investors writing for investors.
