Many investors and creditors are discouraged from using financial statements and the related footnotes because of their complexity. And, indeed, a thorough knowledge of financial statements of a company of any size can required considerable time and effort. But it is possible to glean important information about a company's prospects by spending time looking for specific indications of potential problems or .
But suppose the financial statement is wrong? Some companies use creative accounting techniques to disguise damaging information, to provide a distorted picture of the financial health of the business, to smooth out erratic earnings, or to boost anemic or no earnings. Investors should have a healthy skepticism when reading and evaluating financial reports. Businesses are often clever in hiding these accounting tricks and gimmicks, so investors must be ever alert to the signs of outright financial shenanigans. Investors must attack financial statements and company information the way the fictional Sherlock Holmes approached murder cases.
According to Howard M. Schilit, "financial shenanigans are acts or omissions intended to hide or distort the real financial performance or financialconditions of an entity." Schilit provides seven shenanigans; the first five boost current year earnings, and the last two shifts current-year earnings to the future:
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2. The Specific Identification Method: You identify specific shares to be sold (before you sell or exchange them). You may choose the shares with the highest cost basis to reduce taxes on the transaction.
3. If You Don't Use One of the Above Methods, the IRS' "Default" Method (First-In, First-Out) is Applied: The IRS assumes you are selling the first shares you purchased, which may result in a higher tax liability than necessary if you purchased shares later at a higher price.
One of the most highly publicized statement on fraud auditing standards in recent years was published in early February of 1997. Statement on Auditing Standards No. 82, Consideration of Fraud in a Financial Statement Audit, provided guidance to the auditor in the detection of financial statement fraud. This statement, effective December 15, 1997, clarified the auditorís responsibility to detect fraud.
The statement is rather lengthy but it has an interesting discussion of what it calls risk factors (what we call ) that should be of interest to our readers. Although subsequent SAS No. 99 replaced SAS No. 82, the following section of SAS No. 82 is still of particular relevance:
Risk Factors relating to managementís characteristics and influence over the control environment. Examples include:
A motivation for management to engage in fraudulent financial reporting. Specific indicators might include:
Green Flags/ Yellow Flags
1. Start up Dividends. Kent Womack, Professor of Finance at Dartmouth University, believes that companies that start paying dividends (or resume paying them after a long pause) are great buys. Such stocks get an initial boost of about 3%, and then go on to outperform the market by more than 20% in the next three years. [Red flag: stocks whose dividends are eliminated tend to fall in price an average of 7% in the first two days, and then outperform the market by 15% the next three years.]
2. Price-to-earnings gauge. This ratio measures the relationship between the price of common stocks and their annual earnings per share by dividing the price of the common stocks in the S&P 500 index by the earnings per share of the stocks in the 500 index. The market is fairly valued when stock prices reflect reasonable expectations regarding earnings growth. When the price-earnings ratio is high--above 20 say--the market is expecting significant positive future earnings increase (a prediction that may not occur). When price-earnings ratios approach historic lows--under 10--the market may be too pessimistic about future earnings growth. Since 1950, stocks in the Standard &Poor's 500 index have traded an average of 14.3 times the previous 12 months' earnings per share. This ratio is provided weekly in Barron's. A ratio above 18 historically indicates that the market may be ready for a correction (green flag). Like all stock market predictors, the P/E gauge does not have a perfect record, especially in the short run. Extreme readings can be reached and maintained for long periods of time.
3. Fund Performance. According to D Enterprises, a Baton Rouge-based strategic planning and consulting firm, this area can be very elusive to the investor, because the fund's performance should not be looked at as the annual return that the fund realized. Performance should be compared to an appropriate benchmark for that fund. For example, benchmarks used could be the average performance of peer funds or the market index that this particular fund tries to outperform. Once you determine what benchmark the fund is using and if it seems appropriate, then you look to see if the fund outperformed the benchmark. An underperforming fund is not necessarily a bad thing. It could be that the fund manager's strategy is to reduce risk relative to the benchmarks, and thus, he expects the fund to perform below the comparative benchmark.
4. Rule of 23. This measure offers a simple method of evaluating whether or not the market is vulnerable. According to this rule, when the price-earnings (P/E) ratio of the Dow Jones Industrials plus the current rate of inflation total 23 or more, watch out (red flag). Prior to the October 1987 crash, the rate of inflation was 5% and the P/E ratio of the Dow Jones Industrials was 18.4. The P/E ratio of the DowJones is available daily in Investor's Business Daily and weekly in Barron's.
5. Presidential election cycle. An interesting indicator is based upon the presidential election cycle. Simply put, every four years, stock prices tend to perform much better in the last two years of an administration rather than in the first two years. This difference arises because the incumbent President in years three and four acts politically to ensure the party's return to power.
Yale Hirsch has extensively researched the cycle, with the results providing evidence of the validity of this indicator. The last two years, (election year and pre-election year) of the 41 administrations since 1832 produced a total net market gain of 557%, far in excess of the74% gain of the first two years of these administrations. Although the evidence is convincing, there have been misleading signals. For example, in 1985 and 1986, when stock prices should have been weak, they were up 27% and 17% respectively.
An update of the presidential election cycle is provided annually in Yale Hirsch's Stock Trader's Almanac (The Hirsch Organization, Inc., 184 Central Avenue, Old Tappan, NJ 07675). This publication contains a wealth of information useful to investors.
6. Real Estate Investment Trusts. During a down market, a person may consider investing in a Real Estate Investment Trust (REIT). According to Martin Cohen, Cohen & Steers Realty Shares, because REITs invest in properties--not manufacturers or producers--they are more dependent on real estate values than on the economy as a whole. That's why REITs tend to rise or remain stable in volatile market environments.
7. The January 20,
1997, Deloitte & Touche Review indicates that when invested solely in
equity securities, a mix of approximately 70% U.S. stocks and 30% foreign
stocks produces the best return with the least amount of risk. In the
past, individuals who invested 100% in U.S. stocks could have improved
their rate of return and lowered their risk by allocating a portion of their
portfolio to foreign equity securities.
9. Corporate Takeovers. In a recent study of 1,000 corporate takeovers, according to Bottom Line Personal, stock price increases for the first five years after the takeover were highest when takeovers were hostile and for cash...and lowest when friendly and for stock. In friendly for-stock situations, the price over the next five years typically increased less than at similar companies that had not made acquisitions. Bottom line: If you own shares in a company that is taken over for stock, consider selling after the takeover.
10. Mutual Fund Classifications. According to the September 1997 issue of the ABA Journal, in the Winter 1997 issue of The Journal of Portfolio Management, John J. Bowen Jr. and Meir Statman discuss ways that funds can be manipulated to boost ratings. "People know that a sure way to look tall is to stand next to short people, and mutual fund managers know that a sure way to a high standing is a short benchmark." As crucial as category assignments are to fund raisings, they can be highly capricious. The authors note that funds focused on various overseas stock markets are lumped into a single "international stock" category even though they have little in common. Likewise, stock/bond blend funds that diversify risks by having fixed ratios of assets in each market are in the same category as a fund whose manager can switch assets entirely from one market to another. Uncovering mismatched classifications is one thing, but circumventing fund managers' attempts to play the ratings game is even tougher Bowen and Statman say. It can be done, but "fund detectives will always be slower than fund managers,...[and] investors will know only later what fund managers know now."
11. For years experts have suggested a 60-40 mix of stocks and bonds, but this benchmark may no longer be the appropriate ratio. Jonathan Clements in the Wall Street Journal on 12/16/97 at page C-1 states that even if 60-40 is no longer the optimal mix, a stock-market investor should still own at least some bonds, argues John Bogle, chairman of Vanguard Group, the Malvern, Pa., mutual-fund company.
"They should have at least 5% or 10% in bonds," he says. "It's psychological comfort, and it reduces the volatility of your portfolio."
The same holds true for bond investors. "If you start with an all-bond portfolio and add a small amount of stock, you don't increase risk," notes Pittsburgh investment adviser Roger Gibson. "There's a small free lunch. An 80% bond and 20% stock portfolio will have a similar risk level to an all-bond portfolio, but with modest incremental returns."
12. Deloitte & Touche says that the goal of asset allocation is to maximize potential return based on the investor's acceptable level of risk. There is no one "correct" allocation for any particular situation. An investor should understand the principles of risk and return and the potential impact of the allocation strategy on his/her financial situation before determining the target asset allocation.
"An asset allocation strategy that has a long-term focus will help take the emotion out of investment decisions, especially during times of market volatility," notes Greg Sandor, Financial Counseling Services Group, Deloitte & Touche LLP.
13. Tracking your mutual fund basis.
The Taxpayer Relief Act of 1997 reduced the tax
rate on long-term capital gains, but increased the complexity of tracking and
computing an investor's cost basis in shares of mutual funds. Investors must
compute the cost basis in mutual fund shares in order to determine the
gain/loss from a sale, and the method used to compute basis can affect the
amount and type of gain/loss realized.
The tax rate differential between capital gains and ordinary income can exceed 19.6 percent for high-income taxpayers. The lowest capital gains tax rate is currently 15 percent (for taxpayers above the 15 percent federal tax bracket). Because of the tax rate differential, investors should maintain records of their mutual fund basis (rather than rely on reports provided by the mutual fund company).
Basis in Shares. The original basis in a mutual fund share is generally the purchase price, plus any fees paid in connection with buying or selling the share (front-or back-end load). Other items that increase basis include reinvested dividends (taxable and nontaxable), reinvested capital gains, and undistributed long-term capital gains. Among the items that reduce basis are nontaxable distributions and taxes paid by the mutual fund on undistributed long-term capital gains. Failure to consider reinvested dividends is a common mistake taxpayers make when computing basis in mutual fund shares sold-- a mistake that results in double taxation of dividends (as ordinary income and increased capital gain) from tracking your mutual fund basis, Deloitte & Touche Review, June 22, 1998, page 7.
14. The Auditors are always last to know.
It's clear that something's not quite right in
the world of accounting. "It used to be you'd see two, three, four, or five
accounting restatements in a year," says class-action attorney Bill Lerach of
Milberg Weiss Bershad Hynes & Lerach. "Now you see one almost every other
week." Part of the increase is due to tremendous competition among companies
to boost results and stock prices, Lerach says. More directly, he traces it to
the passage of new securities legislation in December 1995,which made it
harder to hold accountants culpable in securities-fraud cases notes
Herb Greenberg, Fortune, August 17, 1998, page 228.
15. John Dorfman in the July/August1998 issue of Bloomberg Personal Finance indicates that earnings can lie:
a. Watch the Inventories
b. Beware of Rising Receivables
c. Uncover Extraordinary Expenses
d. Investigate Asset Sales
e. Who's Skimping on Research?
f. Note Reduced Capital Spending
g. When Is Revenue Really Not?
h. Who's Playing Currency Roulette?
i. Look for Pension Shenanigans
j. Spot Out-of-Balance Growth
When interest rates go up, bond prices drop; and when interest rates drop, bond prices go up. To better illustrate, let's suppose you own a 10-year bond with a face value of $1,000 that pays 6 percent interest. If it was issued three years ago, the bond will mature in seven years. Let's suppose interest rates rise to 8 percent. It makes little sense for an investor to purchase your 3-year-old bond yielding 6 percent when the investor can buy a newly- issued bond at 8 percent.
If you were to sell your 6 percent bond, you would
probably sell it at less than its face value - at a discount.
Conversely, if interest rates declined to 4 percent, you could sell the
bond for more than its face value - at a premium. The reason: Investors
might be willing to pay more for the 6 percent yield when new issues offer a
yield of only 4 percent.
(Apostolou/ Crumbley) Keys to Understanding the Financial News, Barrons, 1994, 250 Wireless Blvd., Hauppauge, N.Y. 11788.
(Apostolou/ Apostolou) Keys to Investing in Common Stock, Barrons, 1995.
(Apostolou) Keys to Investing in Corporate Bonds, Barrons, 1990.
(Crumbley/ Smith) Keys to Personal Financial Planning, New York: Barrons, 1994.
(Apostolou) Keys to Conservative Investments, Barrons, 1996.
(Apostolou) Keys to Business and Personal Financial Statements, Barrons, 1991.
(Crumbley/ Friedman/ Anders) Barron's Guide To Tax Terms, Barron's Publishing, 1995.
(Apostolou) Keys to Investing in Options and Futures, Barrons, 1995.
(Crumbley/ Milam) Keys to Estate Planning and Trusts, Barrons, 1993.
(Crumbley/ Grossman) A Manager's Guide to Financial Analysis, 4th edition, American Management Association, 1992.
(Crumbley/ Engelage) How to Effectively Manage Corporate Cash, American Management Association, 1993.
(Evensky and Irwin) Wealth Management, Chicago, Irwin, 1997.
|Drudge Report||.............||Malpractice: Tax/
Send examples of financial tricks, gimmicks, and shenanigans to:
|Nick Apostolou||Larry Crumbley|
|Dept. of Accounting||or||Dept. of Accounting|
|Louisiana State University||Louisiana State University|
|Baton Rouge, LA. 70803||Baton Rouge, LA. 70803|
|Phone (225) 578-6211||Phone (225) 578-6231|
|Fax (225) 578-6201||Fax (225) 578-6201|
Last Updated: May 31, 2006