In today's market, the pressure for firms to produce outstanding earnings year after year sometimes creates a temptation to "cook the books," as we have seen time and again over the last few years. 

The stock market fortunes of companies relate directly to their earnings, and if earnings aren't up-to-snuff-according to Wall Street's expectations-that can mean that companies can miss out on millions of dollars of new funding from investors and financial institutions, subject themselves to shareholders' lawsuits and even have entire boards of directors removed. 

Consequently, some firms try to artificially prop up their earnings. Unfortunately, that only lasts temporarily, and when the bottom finally falls out, it is usually the rand and file shareholders left holding vastly reduced or even worthless shares of stock in the company. 

So, how is an investor supposed to avoid investing in firms like Enron, WorldComm, or HealthSouth-all of which were Wall Street darlings at one time? If the high-priced Wall Street analysts couldn't figure out something was seriously wrong at these companies, how is the average investor supposed to do so? 

I wish I could give you an absolute fool-proof checklist, but I can't. Folks looking to defraud others can create accounting tricks faster than regulators can keep up. There are a handful of red flags, however, that can help you spot these tricksters' manipulations, before they take your hard-earned profits to their bank! 

You will need to become familiar with a company's financial statements in order to find these tricks. I know that many investors never read those seemingly complex statements, but as I tell investors at my workshops, if the company is good enough to put your money into, doesn't it make sense to know what it's all about?   

Don't panic about the prospect of delving into these reports; it really isn't all that difficult; in fact, we've already given you some help. In case you missed it, our June 12, 2007 of Financially Fit discussed the key points you need to know to understand financial statements. 

So, take out your favorite company's annual report and let's get started. Here are the most-favored accounting tricks, designed to make a company's fortunes look brighter: 

Revenue Recognition Discrepancies (what I call manipulation of sales). Generally Accepted Accounting Procedures (GAAP) require that revenue must first be earned before it can be recorded. This seems to be a problem with a lot of companies who frequently cheat, as follows: 

Channel stuffing - Encouraging customers to order unneeded products by offering longer payment terms (e.g., one-year instead of the usual 60 days), thereby booking sales before they are legitimately warranted and often disguising a decline in demand.  

Booking revenues too early - Often a problem in industries such as software, where service contracts and upgrades can stretch revenue out for years. 

Relaxing credit requirements to grow sales - Will often result in sales that eventually turn into bad debt.     

Then, there are the firms that just create fictitious revenue. It doesn't exist, but it sure looks good on the income statement! 

Expense Recognition Shenanigans. Just like with revenues, companies may also shift their current expenses to a later period, to prop up their immediate earnings. Or they may even shift future expenses to an earlier period-such as goodwill write-offs or restructuring expenses-to falsely expand future earnings. This might be the case if the company wanted to give the impression that business conditions were improving, when they were, in fact, declining. 

Non-Recurring Transactions. For years, most of these entries in a financial statement were actually legitimate-a company occasionally wrote-off bad debt, restructuring or M&A expenses. They are not recorded on the income statement, but are included in a separate line item charge.  The problem is, these charges have become the repository of unfavorable expenses or investments that went wrong, which really should be part of the income statement, visible to all investors. If you see these 'non-recurring' expenses recurring on a regular basis, it should raise a question in your mind. 

Off-Balance Sheet Items. Enron had more than 2,500 offshore accounts and around 850 special-purpose entities, which are often used to move revenues and expenses around, without the shareholders knowing. 

Those are the major categories of financial statement manipulation that can create absolute havoc when they come to light. But you don't have to be surprised at the last minute, when it's too late to cash out of these bad-news companies. Instead, watch for these red flags which will often precipitate the crashing and burning of Wall Street's darlings: 

Reduced Cash Flow. Look at the cash flow statement over time to verify how reliable the earnings are. If earnings are increasing, but cash flow from operations is declining, that may be an indication that earnings are being artificially manipulated.  

Sales and Net Income out of Sync. Compare the trend in sales with that of net income. They should be moving in tandem. If net income is growing phenomenally, like in the case of HealthSouth, who reported an-almost 500% increase in earnings from 1999 to 2001, while its revenues rose by only 5%, you should be alarmed. The SEC found out later that the company at booked some $1.4 billion in fraudulent profits. 

Underreported Bad Debt Reserves. If these accounts are not keeping up with the growth in account receivables, uncollectible accounts may be understated.  

Changing CPA Firms. Companies with financial problems, or who are trying to "pull one over" on their auditors, will frequently change accounting firms.  

Boards of Directors who may not have your interests at heart. Beware the boards with the following characteristics:  

·        The CEO appoints outside directors.

·        Outside directors have significant business dealings with company.

·        Outside directors who serve on many other boards.

·        A large proportion of "inside" directors.

·        High turnover. 

Management whose primary interest is lining their pockets. Be on the lookout for:  

·        A large portion of management compensation is based on bonuses, stock options, or other incentives that are tied to the company's stock price or aggressive earnings targets.

·        Announcements of extremely aggressive financial forecasts.

·        Failing to correct known reportable conditions on a timely basis.

·        High turnover of senior management, counsel, or board members. 

Any account that is growing out of proportion to its percentage of sales or total assets. Accountants use a technique, called "common-sizing" to determine if accounts are changing disproportionate to their historical levels. All that means is dividing income statement accounts by total sales, and balance sheet accounts by total assets, to arrive at that particular item's relationship to sales or total assets. If you do that over several time periods, you will have a good indication if the account is out-of-sync with the rest of the income statement or balance sheet. For example, inventory that zooms to 30% from 15% of total assets should raise a red flag in your mind. Likewise, net income that was 5% of sales last year and is now 30%, should make you ask yourself how that feat was accomplished.  

This is by no means an exhaustive study of creative accounting tricks, but if you practice reading a company's financial statements, over time you will become very familiar with its reporting strategy. And if you pay particular attention to the items we've covered here, then you will be able to immediately tell if something doesn't look right. Always remember-question any item that looks like it's too good to be true.  

You need to feel comfortable that a company is truthful with its shareholders and that you actually understand how it makes and spends its money. After all, it's your hard-earned money that you are investing. No one else is looking out for it, so you should!

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

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