Behind The Numbers - Unsustainable Boosts To Earnings

Given the importance of choices among accounting treatments, look first for any accounting changes. Management can hide behind them to manipulate earnings quality.

Accounting treatment changes almost always change comparisons of apples to apples to comparisons of apples to kiwi fruit, obscuring reality and earnings quality.

Lengthening of depreciation period boosts EPS in the short term and hurts it in the long term. Track D&A as a percentage of fixed assets. If the percentage declines, the company may have extended the D&A period.

In mergers, the reporting entity changes. This offers management a way to consign all sorts of expenses and charges to the past. Acquisitions are tougher because the reporting entity doesn't change.

Manipulating the allowance for doubtful debts affects receivables, and it carries across the financial statements. If the percentage of allowance for doubtful accounts drops sharply relative to gross AR, it may indicate an artificial boost to revenues and therefore earnings.

Note: businesses just don't see their customers' payment quality increase faster than the rate of new receivables.

When a company makes an acquisition, it is allowed up to 12 mos to adjust the purchase price for the acquired company's carrying value of assets and liabilities. As a result of the purchase price reallocation within a year, expenses are kept off the income statement, artificially boosting earnings in the period of adjustment.

The most conservative treatment (of intangibles) is to immediately expense acquired in-process research and development, patents and licences, direct response marketing, and other R&D.

Software companies may capitalize software development (at their discretion) once technological feasibility is reached (whatever that means).

The frequence of capitalization, the items capitalized, and the relative size of those items tells investors whether capitalization is a serious concern or not.

Deferred revenue - revenue a company receives before it delivers the product or service.

Days in Deferred Revenues (DDR) = (91.25 x deferred revenue)/quarterly revenue.

Reducing reserves for warranties boosts EPS.

Know your company's debt intimately:

1. Avoid all companies whose business models depend on securitizations or consistent access to credit markets. 
2. Debt used to fund dividends and/or stock buybacks must pass the most stringent of tests - and usually fails. 
3. Carefully monitor the uses of debt to determine adequate returns on capital raised. 
4. Only buy companies with large debt to assets where you can model interest coverage, maturity dates and other terms. 

Tangible book value is least valuable when AR and/or inventory are manipulated.

Assuming too high returns on pension investments understates pension liabilities and overstates tangible book value.

Remember. It is normal for gross margins to vary. Be suspicious of any that were unchanging.

Price changes in cost of goods sold inputs are not sustainable as a source of earnings quality, but a dramatic increase in consumer demand and increased volume could make up for it.

To detect problems in input costs requires industry and company specific knowledge.

Recurring one time charges are a bright red flag wrt earnings quality. Serial one time charges may allow a company to establish reserves or bundle normal operating costs, making future results look better than they are.

The long investor should run from those companies with serial restructuring charges. They are not worth the effort to figure out.

Another way for management to manipulate earnings unsustainably is through taxes.  The value of net operating loss carryforwards (NOL - a deferred tax asset) depends on what profits and tax rates management estimate it will have in the future. Investors should compare the expected tax rate indicated by management and forecast by Wall St with what is actually reported in the quarter. An artificially low tax rate may indicate that the tax allowance was reversed, benefitting current EPS.

Behind The Numbers - Aggressive Inventory Management

Inventory is the second most important factor for earnings quality analysis.

The longer inventory ages, the greater the possibility that the company is misallocating cash, misjudging the market and may have to write down inventory.

Inventory affects profitability via gross margin on the income statement and shows demand for a company's products.

Days Sales in Inventory = (91.25 x Inventory/Quarterly Cost of Goods Sold).
Days Sales in Raw Materials = (91.25 x Raw Materials/Quarterly Cost of Goods Sold).
Days Sales in Work in Progress = (91.25 x Work in Progress/Quarterly Cost of Goods Sold).
Days Sales in Finished Goods = (91.25 x Finished Goods/Quarterly Cost of Goods Sold).

In addition to inventory on the balance sheet, the company also records deferred income to distributors, to whom it affords rights of return and price protection for products they don't sell. While deferred income represents some future revenue, in some company's cases it also represents inventory sitting in the sales channel that has yet to be sold and is at risk.

Tracking inventory component divergence gives the investor advance notice of good and bad performance. Focus on negative divergences wherever you find them and understand the business.

Positive divergence occurs when a company knows that business ahead is good, so its raw material inventory picks up while work in progress and finished goods either lag or do not increase at the same rate.

Investors want to avoid negative divergence when finished goods pile up in excess of sales while raw material inventories and work in progress are flat or declining absolutely or relative to sales.

Charlie Munger on technological advances bring products and favorable declining prices that benefit consumers and not shareholders of the producers.

Rising inventory by itself is no indicator of problems. What matters is inventory buildup relative to other factors.

If aging inventory is a greater percentage of total inventory, then mark-downs, write-downs, and obsolescence have a more servere impact. This is especially toubling with consumer products.

LIFO reserve changes - Changes from one method to another for any purpose, such as valuing reserves, are cause for concern. When a reserve is reversed, its a credit to the income statement. Essentially it is 100% margin, so the EPS boost is significant.

The retail method of inventory valuation recognizes markdowns as the products are sold, while the average cost measures markdowns when made. The change from average cost to retail method stretches out the period between markdown and actual reduction in inventory value.

Behind The Numbers - Aggressive Revenue Recognition

Revenue is the top line of the income statement for a reason: it is the lifeblood of any company.

Management persist in massaging revenue in numerous ways to mask underlying weakness because they can. Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the quality or sustainability of revenue throws the rest of the financial model into question.

Accurate revenue is crucial to confidence in cash flow, because the bottom line of the income statement is the top line of the cash flow statement.

Revenue is recognized when it is earned, but the timing is open to interpretation. Revenue can be "realized", "realizable", and "earned" - allows for wiggle room.

The top metric to determine the quality of a company's revenue is days sales outstanding (DSO). DSO = 91.25 x (AR/Quarterly Revenue). We want to compare the quarter's DSO both year-over-year (to account for seasonality) as well as sequentially (quarter-over-quarter). The practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is. Higher DSO has nothing to do with collections but everything to do with revenue recognition.

If management alludes to a "heavily back end loaded quarter" it may mean the company signed deals at generous terms near the end of the quarter in order to feed the Street. Raise your eyebrows if you hear "hockey stick growth" or "non-linear growth" for anything but a hypergrowth company.

Anytime discretion enters into the equation, there is the opportunity to manipulate the numbers. Management my underestimate costs incurred or overestimate the proportion completed in a given period, providing a boost to current results at the expense of future reporting periods (watch out in Percentage of Completion accounting).

When a company derives an increasing portion of its revenue from affiliated entities (related parties of some sort), investors should be concerned.

Keep an eye on the deferred revenue number (liability on the balance sheet offset against a cash asset received but revenue not yet realized).

Watch out for nonmonetary transactions as a boost to reported revenue (barter).

Watch out for bill-and-hold revenue - vendor invoices the customer and recognizes the transaction as revenue, but the products aren't shipped until later.

Watch out for one time gains reported as revenue or interest income falsely counted as regular income. One time revenue events can obscure real underlying growth or organic growth. Strip them out.

Look for growth in sales-type leases (where a company can lease a product but treat it as a sale).

Be wary when a company purchases a distributor - it can slip by some double counting.

Any change in revenue recognition policy should raise eyebrows and warrant increased scrutiny. Even a change to a more conservative policy can boost results by double counting revenue.

Wall St has a nasty habit of seeing write-offs as one time events and forgetting about them, when in fact they are prima facie evidence of weakness in accounting systems. 

Behind The Numbers - The Real Risk of Stock Investing

Most stocks lose money.

Study (1983-2007): 39% of stocks had a negative total return (2 out of 5 stocks are money losing investments); 18% lost at least 75% of their value; 64% underperformed the Russell 3000 (most stocks can't keep up with a diversified index); a small minority of stocks significantly outperformed their peers.

The best performing stocks (top 25%) accounted for all the gains. The bottom 75% collective had a total return of 0%.

It is obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers - and that there are valuable opportunities to profit from shorting.

Beating inflation is likely an accident of birth.

Graham called "firmness of character"  - the ability to keep your own emotional counsel.

To buy any individual stock, let alone take any contrary market position, you have to be able to identify earnings quality concerns in your companies financials, and you have to stay away from anything you don't understand well enough to do so.

Indexes are the best of poor alternatives for anyone not investing in individual stocks. The minute that investors choose stocks, they have to learn about earnings quality.

Poor bases for shorting: Overvaluation (can continue indefinitely); fads (can do very well against the odds for a long time); frauds (hard to identify until after the fact); identifying business models that will fail (when they will fail is all but impossible to know); the short seller who "needs to be right". Short selling on those bases is simply too hard, too risky, and unnecessary.

We recommend waiting until there is aggressive revenue recognition, weakening balance sheets, and deteriorating cash flow trends. Wait until there are negative catalysts for profits in the near future.

Finding a fad and simply shorting it can never be called risk management. It adds risk because it increases the chance of margins calls and being stopped out.

Does it hurt to wait until a stock has cracked before shorting? Ans. No. And this is one fundamental thing about short selling that is so obvious that it is confounding-and ignored. You make as much money shorting a stock that falls from $70 to $5 (93%) as one that falls from $100 to $5 (95%). Waiting for the right time isn't going to cost you money.  The time to short will be only when accounting analysis shows that the revenues aren't real or aren't sustainable.

Short sellers take an unnecessary risk by focusing on fraud because frauds are preceded by accounting issues that can be identified. The problem is that constantly looking for fraud can cloud your judgment.

Our process focuses on revenue. Until we see revenue problems-revenues that may be falling while inventories build and credit terms lengthen-we won't bet on whether a company is a fraud.

It is rational to want to short a fraud, but the correct focus is not on whether a manager is lying, but on whether a company is practicing financial chicanery.

Short sellers rightly look for business models that can fail, but they can't know when to short without a specific catalyst that, if it materializes, will kill the company's model and let them profit from a short.

When the money tap is turned off, a business model that depends on huge leverage suddenly dries up and becomes unsustainable. That's the catalyst.

The time to short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance and when the stock has already begun to fall. 

When buybacks are not opportunistic, they mask options grants or - worse - raise the question of whether they are specifically to transfer shareholder wealth to option holders and insider sellers.

Days Sales Outstanding (DSO): the time between when the company makes a sale and receives the revenue.

Earnings quality analysts don't short without analyzing short interest and days to cover in order to avoid the squeezes that lead to margin calls, covering at any cost, and catastrophic losses.

If a lot of shares are sold short and the stock is thinly traded, the slightest good news could be very bad.

Float means the shares that can be freely traded any given day, excluding restricted shares, insider holdings, and shares held by those with more than 5% ownership.

Instead of needing to be right, wait for the obvious indicator of accounting trouble and act then. You have your negative catalyst.

Financial analysis prevents the mistake where an investor unearths an accounting issue but does not understand whether it matters or not in the real world.

The BEST SITUATION IS AGGRESSIVE REVENUE RECOGNITION MASKING SOFTENING DEMAND.

What's Behind The Numbers - Intro

Every blow up avoided improves the performance of your portfolio.

Management faces crushing pressure to make things appear better than they are.

Management tortures the numbers to "beat by a penny" and to keep the Wall St analyst predators and their dreaded downgrades at bay.

Aggressive accounting may not be illegal, but its chicanery. Sooner or later, hard and long aggressive accounting can try to entomb the bodies, they rise like zombies, until the company misses huge and the zombies suck management brains and investor profits through stock downgrades and selling.

The job is to analyze earnings quality.

The book may place revenue recognition and inventory management next, but every part of the financials connects with another. "Earnings" is the financial picture as a whole.

Rising days sales outstanding or days sales in inventory may be the two great single indicators of trouble in the next quarter or several.