Book: The Financial Numbers Game
Author: Charles Mulford / Eugene Comiskey
This is a well-researched but a very average book for an investor. I have two main qualms about the book–first, it is very repetitive and authors take so much time going over the same concepts that the important items can often miss the spotlight that they deserve, and second, their kitchen sink approach to every nook and cranny of the “numbers game”. To elaborate further on the second point, I think the authors wrote the book more for accountants than for investors, because they often have 50-bullet long checklist for every kind of creative accounting practice without taking into account the scale of issue; they also go over a multitude of previous scandals but rarely talk about how an investor could have caught these while these frauds were in progress. It is useful to see the “creativity” of fraudsters, but for an average investor the only message from these examples often is that these can be very hard to detect, especially because the management, when inclined to manipulate #s, have become more and more shrewd and avoid scrutinized numbers as A/R, inventory and sales and instead hide the nasty stuff in PP&E and other liability accounts because they’re less scrutinized and it is harder to interpret change in these line-items. Having said all of that, following are some interesting takeaways from the book.
Why Do Companies Massage Numbers?:
Apart from obvious reasons such as compensation (need to read proxy, or equivalent, statements to see what the management’s compensation is tied to), survival, covenant avoidance etc, companies are more likely to massage numbers when valuation is high, thus supporting a possibly false narrative, furthering the already high valuation.
What are the common items being manipulated?
SEC Chairman Arthur Levitt identified 5 areas that are most susceptible-(a)big bath charges, (b)creative acquisition accounting, (c)cookie jar reserves, (d)materiality and errors and (e)revenue recognition. The authors did a very survey where they asked the CFOs and CPAs for the areas that they have seen most often touched. As we’d expect, a number of them are related to timing of operating expenses (warranty reserve adjustment, manipulation of accruals etc.), and revenue recognition (which includes keeping “open” the first few days of the following year). Cookie jar reserves appear to be most commonly used tactic. Inventory valuation was a category of its own with valuation featuring prominently. Then there’s a section for real actions taken to massage numbers–halting R&D, channel stuffing, timing of plant maintenance, selling receivables, and selling assets at gains, among others.
When is earnings management especially hard to locate?:
When the company earns significant amount of finance-related income, it’s very hard to locate earnings management because in there lie significant assumptions, e.g. for a bank there are assumptions on rate of default, rate at which loans will be repaid, and interest rate used.
For companies that do sales-type lease accounting (e.g. Xerox) where companies record up-front gross profit based on assumptions such as interest rate, and reliability of payments, similar issues come into play.
I have come to realize this over time while covering various companies that it is useful to see accounting practices under different regimes. It is also useful to check if the regimes move as CFOs move from one company to the other.
When to Restate?:
Restatements are made in relatively rare cases–e.g. (a)Expenditures capitalized in error, and (b) Revenue recognized in error. Note that if the change from capitalizing vs. expensing cost is made in principle (vs. an error), a restatement is usually not done, and a cumulative-effect adjustment is done.
One can search for archives under SEC’s Accounting and Auditing Enforcement Releases (http://www.sec.gov/divisions/enforce/friactions.shtml) to see if SEC has identified any accounting-related infractions by the company.