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.
Just remember…
“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)
Overview:
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?
Proxy:
- How many times did the audit committee meet? Do they have enough experience?
- So salaries correspond to company’s performance?
- Shareholder proposals being included
Prasad Capital 