Spot Blowups with an Accounting Checklist

For some reason, reportersand physician-investors askme a lot of questions aboutaccounting. I guess I mustlook really boring. They allwant to know how to spot accountingblowups before they happen and howto distinguish low-quality from high-qualityearnings. So, the following isan accounting checklist to help youseparate the clean numbers from thepotentially dirty ones:

•Perform the sniff test. Thisone's subjective, but it's powerful.Essentially, if something looks wrong,and management can't provide a convincingexplanation, it probably iswrong. Trust your gut—it's better tonot make money on a potentialinvestment that smells funny than tolose money by ignoring your intuitionand investing anyway.

My favorite example of this isSunbeam during Al Dunlap's tenure.When the company posted huge salesof barbecue grills in the fourth quarterof the year, something was definitelyovercooked. People rarely buybarbecues in December, after all. Thisone smelled fishy, and it turned outthat it was. Sunbeam offered retailersmassive discounts to buy grills 6months before they normally would,without having to accept delivery ormake payment. Later, Sunbeam wasforced to restate earnings and pushthose sales into future quarters.

•Cash is always king. Doesaccounting gobbledygook make yourhead spin? Fear not, because there isone very simple thing you can do:Keep an eye on cash flow. Over time,increases in a company's cash flowfrom operations should roughly trackincreases in net income. Cash flowfrom operations measures the amountof cash that a company is generatingfrom its business, and you can find iton the statement of cash flows. It'salways available in quarterly 10-Q filings,and sometimes in earnings pressreleases as well.

If you see cash from operationsdecline even as net income keepsmarching upward, or if cash fromoperations increases much more slowlythan net income, watch out. This isusually a very good recipe for ablowup down the road. The companymight be selling products on creditand not collecting the cash it's owed,it might be padding its bottom linewith reversals from restructuringreserves, or it might be selling offinvestments or other assets—none ofwhich says anything about the truehealth of the firm's operations. Thissimple test will keep you out of troublemore often than you may think.

•Beware overstuffed warehouses.When inventories begin risingfaster than sales, trouble is likelyon the horizon. Sometimes the buildupis just temporary as a companyprepares for a new product launch,but that's usually the exception ratherthan the rule. When a company isproducing more than it's selling,either demand has dried up or thecompany has been overly ambitiousin forecasting demand. Either way,the unsold goods will have to be soldeventually (probably at a discount) orbe written off, which would result ina big charge to earnings.

•Keep an eye on accountsreceivable. There are few things WallStreet loves more than growth, so itshouldn't come as a surprise thatcompanies will go to great lengths tokeep their top line increasing as rapidlyas possible. One of the sneakierways for a company to pump up itsgrowth rate is to loosen customers' credit terms, which induces them tobuy more stuff. Companies can alsosimply ship out more products thantheir customers ask for, but this ismuch rarer, and also fraudulent.

The catch here is that even thoughthe company has recorded a sale—which increases revenues—the customerhas not yet paid for the product.If enough customers don't pay,then the pumped-up growth rate willeventually come back to bite the companyin the form of a nasty write-downor charge against earnings.

You can keep an eye out for thiskind of thing by watching the accountsreceivable (A/R) balance,which measures the amount of bills acompany has outstanding. Roughlyspeaking, watch A/R as a percentageof sales and the growth rate in A/Rrelative to the growth rate of sales. IfA/R is moving up much faster thansales, something may be amiss. Checkthe company's 10-Q filing for anymention of changes in credit terms forcustomers, as well as for any explanationby management as to why A/Rhas jumped.

•Watch the honey pot. Companiesin the midst of big changes willoften take a huge charge to set up arestructuring reserve, and then slowlyreverse some of the charge later on.This is known as a honey pot, becausethe company can dip into it wheneverits operational results aren't looking sohot. The company's point of view isthat if it overestimated the costs of a bigcorporate overhaul, then it needs toaccount for the lowered costs by reversinga portion of the previous charge.

In practice, companies have everyincentive to take one-time chargesthat are as whopping as possiblebecause Wall Street usually views thecharges as nonrecurring events. Downthe road, the company can pad arocky quarter with a couple of centsper share in reversals from the charge.Usually, these reversals don't amountto a lot of money, but they can be thedifference between meeting and missingthe all-powerful consensus earnings-per-share number. To check forthis sort of thing, always read thefootnotes to any earnings release or10-Q if a company has taken severalcharges in the recent past.

Pat Dorsey is the director of stock analysis

for Morningstar, Inc. For more information, or

to arrange an interview with Pat Dorsey,

contact Jared Sharpe (212-593-6467;

sharpej@plannedtvarts.com) or Scott Piro

(212-593-6439; piros@plannedtvarts.com). Article reprinted

with permission.