A Modest List of Financial Analysis 'Red Flags'

My blog 'readership' (shame on me for using such a stuffy term!) primarily consists of preparers, auditors and journalists. But, for those intrepid analysts who actually do read my blog, this week I have something especially for you! I humbly offer you a list of red flags to think about adding to your own personal collection.

But first, permit me this minor rant.

I have given some thought as to why analysts may be somewhat indifferent to my commentary – or more importantly, why very few submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one's core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

My objective in pointing this out is to make the point that it is a grave mistake for policy makers to believe that analysts are interested in accounting rules that make the world a better place. Just like most everyone else, financial analysts are focused like laser beams on creating value for themselves. The policy implication is that, instead of pining for more comment letters from investors, the FASB and SEC (and IASB) should acknowledge the free rider problem in their 'due process' deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense a la Justice Louis Brandeis' sunlight being the best disinfectant rule of thumb, and policymakers should have the gumption to act accordingly. Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.  

Now, on to the red flags.

#5 – Younger companies meeting growth projections for the umpteenth time in a row. I am suspicious when a relatively young company has consistently generated above average returns even while its product portfolio is clearly maturing, and its industry has become more competitive. It is often the case that management seeks to extend its recent record of rapid growth in sales and profitability by unconventional means, because it has not been able to identify investment opportunities within its historical core competency (generally, some form of cost reduction or product differentiation strategy). That's when the earnings games begin: aggressive estimates, drawing down 'earnings banks', selling assets for accounting gains, taking on excess leverage, or entering into byzantine financial transactions.

The Apollo Group, which I wrote about regarding the SEC's investigation into its revenue recognition policies, seems to fit the profile. It entered the for-profit college degree business when it was still young, and appears to have established the model for later entrants to emulate. Moreover, one of its more distinctive products, online classes, seems to be becoming commoditized as non-for-profits have undertaken changes in their "business models" to better respond to the needs of part-time and geographically distant students.

#4 – Management has adopted a minimalist approach to disclosure. My suspicions, and my hackles, are raised by multibillion dollar companies claiming that they have only one reportable segment. Some might say that that management, by evading segment disclosure, is fighting the good fight so as to prevent actionable information from falling into the hands of competitors. But, something is rotten in Denmark when companies alter their internal communications for the apparent purpose of floating a disingenuous tale that their "chief operating decision maker" is willingly in the dark when it comes to significant components of its operations.

When ITT Educational Services Inc. reports having an executive officer of its "online division," yet implicitly claims that it has no obligation to provide disaggregated information on that part of their business (either in MD&A, or the financial statement notes), I become suspicious. Although Apollo does provide some segment disclosures, its annual report is notably silent on the effects of online courses on recent earnings trends. (Some unsolicited advice to both companies: I respectfully suggest that they read the SEC's enforcement release regarding Sony's MD&A deficiencies and take heed. All it could take is one impairment charge or restructuring to put the Enforcement Division on their tails for similar omissions.)

I also blanch at boilerplate MD&As, particularly when no overview section is provided, the summaries of critical accounting policies are rote recitations of standard GAAP, and mechanical recitations of numbers masquerade as "analysis."

Here's a portion of Apollo's MD&A that caught my attention, and which I did not to mention in my earlier post. To set the stage, you should know that Apollo reported gross student accounts receivable of $380 million less an allowance for doubtful accounts of $110 million. Total revenues reported were $3,974 million.

"For the purpose of sensitivity, a one percent change in our allowance for doubtful accounts as a percentage of gross student receivables as of August 31, 2009 would have resulted in a pre-tax change in income of $3.8 million. Additionally, if our bad debt expense were to change by one percent of total net revenue for the fiscal year ended August 31, 2009, we would have recorded a pre-tax change in income of approximately $39.7 million."

Even ignoring the wow factor of Apollo's gigunda allowance for doubtful accounts, SEC rules imply that a sensitivity analysis should flex base estimates by a minimum of 10% (see Regulation S-K, Item 305, on sensitivity analysis for "market risk sensitive instruments) to be reasonably indicative of the underlying risks being modeled; Apollo's is only 3.5% (= 3.8/110); by comparison, a grudging token.

On the other hand, Apollo does report that if their allowance were an additional 1% of revenues, net income would be reduced by a much more significant sum. However, that statistic hardly qualifies as a "sensitivity analysis." That's because cash flows underlying revenues can come from either tuition payments made in advance (a very substantial amount in Apollo's case), or from payments made in arrears. Multiplying a non-collection rate, however determined, by cash flows that have already been collected makes no sense.

Finally, another pet peeve of mine is when there are no substantial differences between this year's and last year's MD&A, except for different numbers inserted between the words.

#3 – Management is obsessed with earnings reports. Beware of companies whose management appears to be fixated on reported earnings, usually to the detriment of attending to real drivers of value. Indicators include the aggressive use of "non-GAAP measures of performance," "special items" or "non-recurring charges." Watch out as well for highly decentralized operations where division managers' compensation packages are heavily weighted toward the attainment of reported earnings or those non-GAAP measures of performance.

Here are two examples of apparently obsessed managers. The older example is one that I have written about in the past. GE, under Jack Welch's leadership, had acquired Kidder-Peabody in the mid-1980s.  It was ultimately determined that much of the earnings that Kidder had reported were bogus.  As a consequence, GE was would announce within two days that it would take a non-cash write-off of $350 million.  Here is how Jack, "there was only one way – the straight way," Welch described the ensuing meeting with senior management in his memoir, Straight from the Gut:

"The response of our business leaders to the crisis was typical of the GE culture [my emphasis].  Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap.  Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise.  Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people." [p. 225]

I doubt if, in this post-Enron and S-OX 404 environment, a CEO today would so openly express such a blatant disregard for reporting to investors, but I also doubt if things have changed much at many companies – especially those where the CEO and board chair are one and the same, stock options to the CEO have the potential to dwarf the other compensation components, and the audit committee lacks gumption and sophistication.

A more current example is Overstock.com, which Floyd Norris very colorfully described in his NYT blog. In brief, their CEO fired the company's newly-appointed auditor before it could even render its first opinion on the company's annual financial statements. The auditor's crime, it appears, was to have changed course on the treatment of a non-recurring gain: whether it should be reported as income in the current year, or should have been pushed back to a prior year. In other words, no cash flow effect, and no discernable consequences on future operations. I would not be surprised if the accounting treatment directly affected the CEO's 2009 cash bonus, or tips the company toward the wrong side of a loan covenant.

#3 – Restructuring and/or impairment charges. Years ago, it was often the case that a company's stock price would rise after it recognized a "big bath" charge to the current period's earnings. The conventional wisdom was that accounting recognition signaled either that management was now ready to part with the lagging portion of a company, so as to re-direct its attention and talents to the potential 'stars'; and/or the earnings charge itself should be ignored, because it related to past events of no relevance to an assessment of the company's future earnings potential.

My take, however, is that the events leading ultimately to the big bath on the financial statements didn't happen overnight, even though the accounting for those events sure makes it look like the world was destroyed in one fell swoop. Management may want you to believe that the balance sheet cleanup will put the company back on the old path, but the problem is that the old path of reported earnings wasn't itself real. Restructuring charges and impairments mean that expenses of prior years' earnings were very likely overstated relative to economic earnings, even if all was strictly according to the letter of GAAP. When I had students, I counseled that if one cared to extrapolate historic earnings trends, one should make a pro forma haircut of prior years' earnings for a reasonable share of the current period's restructuring and impairment charges.

#2 – Management has the M & A bug. Business combinations accounting has forever been a fertile ground for earnings management. Take Tyco. According to SEC documents, from 1996 to 2002 it acquired more than 700 companies. First, beware of a growth-at-any-cost corporate culture and the likely ineffectiveness of both operational and financial reporting controls to efficiently absorb all of those changes. Second, the SEC claimed that Tyco used just about every business combinations accounting trick in the book to juice earnings. Granted, the rules of the game have been changed somewhat by FAS 141R, the newest business combinations standard, but opportunities to juice earnings and to create 'earnings banks' still abound by understating assets acquired and overstating liabilities assumed.

#1 – An SEC investigation.  The SEC's investigation of Apollo may only have as its initial focus one particular area of revenue recognition. But, where there is smoke, there could be a forest fire. The SEC may find grounds to challenge Apollo's entire revenue recognition policy. Or, with their subpoena powers wielded broadly, the SEC could stumble onto other questionable areas as well. Is Apollo willfully hiding lackluster performance of, say, its online programs a la Sony; or is it juicing consolidated earnings with questionable accounting for recent acquisitions? Who knows?

For that matter, will Apollo's public company competitors (like ITT) get caught up in the SEC's web? Who knows?

A Final Caveat

Numerous commentators and researchers before me have discovered some pretty powerful systems for extracting negative indications of financial health from accounting data. I am in no way trying to replicate that work, nor am I suggesting that the red flags I have proffered are the product of a similarly rigorous and systematic approach, or the state of the art. My goal has been only for each reader to think just once, "I hadn't thought of that one; it could make sense."

  

Comments

[Edith Orenstein]

From relevance to specific standards, to impact on Big Picture standard-setting, I think your rant is worthwhile and highly topical reading, in that using 'analysts' as a proxy for the common 'investor' or 'user' is not a slam dunk, for the reasons you cite. Other challenges in use of such a proxy include judging 'understandability' of a particular standard and its output, and judging different points of view on what information is 'relevant' and 'reliable' and the tradeoffs therein.

[David Merkel]

Careful, Tom. If you mention OSTK to prominently, you get on the "Sith Lord helpers list." ;)

Good post, and a helpful reminder to investors like me.

[Independent Accountant]

TS, my comments on your rant:
5. Absolutely. Any company which knocks out 20-25% a year increases in earnings, sales, EPS, etc., five or more years in a row, goes to the top of the "possibly cooked books list".
4. Agreed, except for the critical accounting summaries. I think they should be eliminated. If you want to read accounting policies, go to the footnotes.
3. Agreed. For decades I have believed GE's financials were works of fiction.
3. Agreed. (Three twice?.
2. I still remember Charlie Bludhorn. Lots of mergers are a big red flag.
1. Here I am cautious. Anything can spur an SEC investigation, including the SEC's looking to divert attention from some other entity. Really. Where are the SEC investigations of: Citigroup, AIG, Goldman, etc.? I won't hold my breath.

Good show

[Tony Frank]

Excellent article! Many more similar articles are urgently needed. The average investor is clueless when it comes to accounting issues and based on current trends, the need will continue to grow exponentially.

In contrast to prior years, foreign investors have grown more concerned about our accounting standards and their application than the other way around as was previously the case.

[online Forex trading]

Great article! I am not a fan of vastly growing "at any cost" companies myself. Thank you for these Red Flags - they are all very interesting and might be very relevant in different situations. I would love to copy and keep them for future references if you don't mind.

[JS Mackie]

Personally I do not think it to be a rant at all, but rather a very very valid and insightful input - what is the real problem? Too used to following rules that input is lacking?

With respect to the red flags, these too are indeed the source of consternation and certainly need to be addressed, but how would one go about it?

[Skye @ operational restructuring]

I am one of the people who is afraid of the company who focus their attention on their earning instead of performance. It is really dangerous to be on that team. This is red flag is really true.

My idea for this is they are more likely to fall. Though, their intention is grow, they are pulling their company down.

[Tony Smith]

Great read! Thanks for the red flags. This would be a useful resource of relevant information for certain situations.