Book: Financial Fine Print
Author: Michelle Leder
Key takeaways: A lot of books on discovering financial malfeasance in company’s reports focus a lot on financial ratios, which can be repetitive after a point, OR go into gory details about frauds already disclosed (which is uninteresting to me after a point because I details disclosed in the court are not available to investors beforehand, so it’s interesting as a financial voyeur but not as an investor) . I like this book very much because it is very different from other books on this topic, as it is written for investors and not accounting forensics.
“If you read a financial disclosure three times and cannot understand it, it is intentional.” – Jim Chanos
“I’m sure that Enron’s management probably didn’t want to write that related party transaction footnote, but they were probably forced by the lawyers.” – Jim Chanos
One month after SOX was signed, CFO magazine said that 17% of CFOs were asked to mis-represent #s (11% said that they were pressured more than 3 times)
Some investors have a go-to section (tax footnotes, pension assumptions etc.), but many like to plow straight-through beginning with the major accounting policies. Pension accounting can be a strong (and relatively quick) signal of aggressive accounting. Just the expected return from the pension assets can be a quick signal of how far the management is pushing the envelope (on the other end of the spectrum, BRK/A lowered the expected rate of return from 8% to 6.5% in 2001) . But, it is useful to remember that different things will move the needle for different type of companies. For example, lease accounting will be significant for retailers like Home Depot, R&D footnotes for pharma cos., M&A and restructuring for acquisitive companies, and so on. It is also useful to compare and contrast the details provided in revenue recognition policies (simpler, the better; lengthy policies should be a cause for a little more caution).
No matter what industry, related party transactions should always be looked at carefully.
Pensions in Wonderland: Check whether the pension plan is overfunded or under-funded–both are cause for concern. If it is over-funded, the pension assets are helping to pump up the net income. If under-funded, the pension plan is a liability that will lead to charges against equity. In fact, it’s a more immediate concern, because in the U.S., Federal laws require that companies make sure that there’s enough money (~90%) to cover their obligations. Thus, cos. with under-funded plans are required to divert cash to these plans, lest they have to pay a penalty to Pension Benefit Guaranty Corp, which cos. try to avoid at all costs, because PBGC doesn’t return the $s even when the plan comes back into compliance. Also, when cos. add cash to their pension-land, it’s tax-deductible and again, depending on the expected return, this cash infusion adds to their net income.
Five Common Ingredients in Frauds:
- Taxes: depending on how far they can lower the taxes they show to the IRS, this can be a signal that something’s off in GAAP #s (ala Sunbeam)
- Derivatives: if you can’t understand them, just keep away
- “Others”: are all the bad numbers ending up in “others” line item?
- Legal Issues: post-Enron, disclosure has improved, so worth taking a look at this section
- Segment Breakdown: Tells you if more of the earnings are coming from an area that you wouldn’t expect (or, easy to manipulate)
10-Q Checklist (beyond items listed above):
- Net Income vs. PF #s
- Difference in press release vs. 10-Q
- Stock option expensing, when applicable
- What is kept off the B/S? Any other commitment/contingency?
10-K Checklist (beyond items listed above):
- How is the debt being handled?
- How many times did the audit committee meet? Do they have enough experience?
- So salaries correspond to company’s performance?
- Shareholder proposals being included