As the Enron debacle has shown, analysts have been playing their own version of “Dumb and Dumber:” “Management misled us” is a commonly sung refrain.
You can play sleuth, even if your firm's analysts won't. If your clients have significant positions in individual equities, you'd be wise to give a closer read to financial statements. Yes, it's time consuming, and the language in the financials is oblique at best. That said, there are a few simple exercises you can do to help steer your clients clear of some landmines.
Here's what to look for:
Revenue recognition
Global Crossing's recent bankruptcy resulted from an attempt to create the illusion of revenue from back-room swaps of fiber optic capacity, which, like Enron's energy contracts, produced illusory revenue. At Sunbeam, “Chainsaw” Al Dunlap authorized shipment of goods to an empty warehouse just as the quarter ended. Sunbeam blew out the quarter and the stock surged, but later all those earnings were “restated” (read: erased). Other companies deem it a sale once a product is in the hands of a distributor — despite generous return policies.
Try to stick with companies that book a sale when it actually happens. Companies are supposed to explain their revenue recognition policies clearly in the 10-K and the 10-Q forms. If they don't, you should call them directly, or avoid the stock altogether.
Playing the asset shuffle
A surprising number of companies try to remove assets, such as their corporate headquarters, from their balance sheets. These firms use “synthetic leases,” which promise the best of both worlds by keeping debt off the books but still allowing a company to take interest and depreciation expenses. Check the footnotes for special purpose entities or synthetic leases. The companies have to disclose off-balance sheet items explicitly in the footnotes of their 10-Ks. After Enron, they may actually do so.
“Other income” should be below the operating line
Companies often pull in nonoperating gains to juice up their bottom lines. For example, the stock market boom helped fatten many company pension plans, which some reported as “other income.” Of course, those profits don't truly reflect the health of a business and shouldn't be used to give the appearance of strong profit growth. Check out all of the items that go into “other income.” You may need to subtract a few entries to get a true sense of a company's profitability.
Do the numbers jibe?
Companies report summarized financial data in press releases in a way that stresses the positive and glosses over the negative. Bad news may be withheld from the release, but it must be disclosed in financial statements with the SEC. Compare the press releases and the 10-Qs from recent quarters. If they deviate in a meaningful way, you should take future management guidance with an extremely large grain of salt.
Cookie jar accounting
When companies make an acquisition, they sometimes ask their intended target to write off a set of assets before the deal closes. Miraculously, those write-downs are written back up later, giving the appearance of “profits.” (No kidding, this is legal.) Tyco International wrote the book on so-called cookie jar accounting, and its financial statements make for amusing reading.
Uncle Jimmy, Aunt Sue, what are you doing here?
If a company's board is stocked with loved ones and others with close connections to management, you can assume that shareholders aren't getting much love. These folks are probably not independent and may not be in a position to provide the necessary checks and balances on the company's executive team.