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A Modest List of Financial Analysis 'Red Flags'

My blog 'readership' (shame on me for using such a stuffy term!) primarily consists of preparers, auditors and journalists. But, for those intrepid analysts who actually do read my blog, this week I have something especially for you! I humbly offer you a list of red flags for you to think about adding to your own personal collection.

But first, permit me this minor rant.

I have given some thought as to why analysts may be somewhat indifferent to my commentary – or more importantly, why very few submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one's core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

My objective in pointing this out is to make the point that it is a grave mistake for policy makers to believe that analysts are interested in accounting rules that make the world a better place. Just like most everyone else, financial analysts are focused like laser beams on creating value for themselves. The policy implication is that, instead of pining for more comment letters from investors, the FASB and SEC (and IASB) should acknowledge the free rider problem in their 'due process' deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense a la Justice Louis Brandeis' sunlight being the best disinfectant rule of thumb, and policymakers should have the gumption to act accordingly. Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.  

Now, on to the red flags.

#5 – Younger companies meeting growth projections for the umpteenth time in a row. I am suspicious when a relatively young company has consistently generated above average returns even while its product portfolio is clearly maturing, and its industry has become more competitive. It is often the case that management seeks to extend its recent record of rapid growth in sales and profitability by unconventional means, because it has not been able to identify investment opportunities within its historical core competency (generally, some form of cost reduction or product differentiation strategy). That's when the earnings games begin: aggressive estimates, drawing down 'earnings banks', selling assets for accounting gains, taking on excess leverage, or entering into byzantine financial transactions.

The Apollo Group, which I wrote about regarding the SEC's investigation into its revenue recognition policies, seems to fit the profile. It entered the for-profit college degree business when it was still young, and appears to have established the model for later entrants to emulate. Moreover, one of its more distinctive products, online classes, seems to be becoming commoditized as non-for-profits have undertaken changes in their "business models" to better respond to the needs of part-time and geographically distant students.

#4 – Management has adopted a minimalist approach to disclosure. My suspicions, and my hackles, are raised by multibillion dollar companies claiming that they have only one reportable segment. Some might say that that management, by evading segment disclosure, is fighting the good fight so as to prevent actionable information from falling into the hands of competitors. But, something is rotten in Denmark when companies alter their internal communications for the apparent purpose of floating a disingenuous tale that their "chief operating decision maker" is willingly in the dark when it comes to significant components of its operations.

When ITT Educational Services Inc. reports having an executive officer of its "online division," yet implicitly claims that it has no obligation to provide disaggregated information on that part of their business (either in MD&A, or the financial statement notes), I become suspicious. Although Apollo does provide some segment disclosures, its annual report is notably silent on the effects of online courses on recent earnings trends. (Some unsolicited advice to both companies: I respectfully suggest that they read the SEC's enforcement release regarding Sony's MD&A deficiencies and take heed. All it could take is one impairment charge or restructuring to put the Enforcement Division on their tails for similar omissions.)

I also blanch at boilerplate MD&As, particularly when no overview section is provided, the summaries of critical accounting policies are rote recitations of standard GAAP, and mechanical recitations of numbers masquerade as "analysis."

Here's a portion of Apollo's MD&A that caught my attention, and which I did not to mention in my earlier post. To set the stage, you should know that Apollo reported gross student accounts receivable of $380 million less an allowance for doubtful accounts of $110 million. Total revenues reported were $3,974 million.

"For the purpose of sensitivity, a one percent change in our allowance for doubtful accounts as a percentage of gross student receivables as of August 31, 2009 would have resulted in a pre-tax change in income of $3.8 million. Additionally, if our bad debt expense were to change by one percent of total net revenue for the fiscal year ended August 31, 2009, we would have recorded a pre-tax change in income of approximately $39.7 million."

Even ignoring the wow factor of Apollo's gigunda allowance for doubtful accounts, SEC rules imply that a sensitivity analysis should flex base estimates by a minimum of 10% (see Regulation S-K, Item 305, on sensitivity analysis for "market risk sensitive instruments) to be reasonably indicative of the underlying risks being modeled; Apollo's is only 3.5% (= 3.8/110); by comparison, a grudging token.

On the other hand, Apollo does report that if their allowance were an additional 1% of revenues, net income would be reduced by a much more significant sum. However, that statistic hardly qualifies as a "sensitivity analysis." That's because cash flows underlying revenues can come from either tuition payments made in advance (a very substantial amount in Apollo's case), or from payments made in arrears. Multiplying a non-collection rate, however determined, by cash flows that have already been collected makes no sense.

Finally, another pet peeve of mine is when there are no substantial differences between this year's and last year's MD&A, except for different numbers inserted between the words.

#3 – Management is obsessed with earnings reports. Beware of companies whose management appears to be fixated on reported earnings, usually to the detriment of attending to real drivers of value. Indicators include the aggressive use of "non-GAAP measures of performance," "special items" or "non-recurring charges." Watch out as well for highly decentralized operations where division managers' compensation packages are heavily weighted toward the attainment of reported earnings or those non-GAAP measures of performance.

Here are two examples of apparently obsessed managers. The older example is one that I have written about in the past. GE, under Jack Welch's leadership, had acquired Kidder-Peabody in the mid-1980s.  It was ultimately determined that much of the earnings that Kidder had reported were bogus.  As a consequence, GE was would announce within two days that it would take a non-cash write-off of $350 million.  Here is how Jack, "there was only one way – the straight way," Welch described the ensuing meeting with senior management in his memoir, Straight from the Gut:

"The response of our business leaders to the crisis was typical of the GE culture [my emphasis].  Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap.  Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise.  Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people." [p. 225]

I doubt if, in this post-Enron and S-OX 404 environment, a CEO today would so openly express such a blatant disregard for reporting to investors, but I also doubt if things have changed much at many companies – especially those where the CEO and board chair are one and the same, stock options to the CEO have the potential to dwarf the other compensation components, and the audit committee lacks gumption and sophistication.

A more current example is Overstock.com, which Floyd Norris very colorfully described in his NYT blog. In brief, their CEO fired the company's newly-appointed auditor before it could even render its first opinion on the company's annual financial statements. The auditor's crime, it appears, was to have changed course on the treatment of a non-recurring gain: whether it should be reported as income in the current year, or should have been pushed back to a prior year. In other words, no cash flow effect, and no discernable consequences on future operations. I would not be surprised if the accounting treatment directly affected the CEO's 2009 cash bonus, or tips the company toward the wrong side of a loan covenant.

#3 – Restructuring and/or impairment charges. Years ago, it was often the case that a company's stock price would rise after it recognized a "big bath" charge to the current period's earnings. The conventional wisdom was that accounting recognition signaled either that management was now ready to part with the lagging portion of a company, so as to re-direct its attention and talents to the potential 'stars'; and/or the earnings charge itself should be ignored, because it related to past events of no relevance to an assessment of the company's future earnings potential.

My take, however, is that the events leading ultimately to the big bath on the financial statements didn't happen overnight, even though the accounting for those events sure makes it look like the world was destroyed in one fell swoop. Management may want you to believe that the balance sheet cleanup will put the company back on the old path, but the problem is that the old path of reported earnings wasn't itself real. Restructuring charges and impairments mean that expenses of prior years' earnings were very likely overstated relative to economic earnings, even if all was strictly according to the letter of GAAP. When I had students, I counseled that if one cared to extrapolate historic earnings trends, one should make a pro forma haircut of prior years' earnings for a reasonable share of the current period's restructuring and impairment charges.

#2 – Management has the M & A bug. Business combinations accounting has forever been a fertile ground for earnings management. Take Tyco. According to SEC documents, from 1996 to 2002 it acquired more than 700 companies. First, beware of a growth-at-any-cost corporate culture and the likely ineffectiveness of both operational and financial reporting controls to efficiently absorb all of those changes. Second, the SEC claimed that Tyco used just about every business combinations accounting trick in the book to juice earnings. Granted, the rules of the game have been changed somewhat by FAS 141R, the newest business combinations standard, but opportunities to juice earnings and to create 'earnings banks' still abound by understating assets acquired and overstating liabilities assumed.

#1 – An SEC investigation.  The SEC's investigation of Apollo may only have as its initial focus one particular area of revenue recognition. But, where there is smoke, there could be a forest fire. The SEC may find grounds to challenge Apollo's entire revenue recognition policy. Or, with their subpoena powers wielded broadly, the SEC could stumble onto other questionable areas as well. Is Apollo willfully hiding lackluster performance of, say, its online programs a la Sony; or is it juicing consolidated earnings with questionable accounting for recent acquisitions? Who knows?

For that matter, will Apollo's public company competitors (like ITT) get caught up in the SEC's web? Who knows?

A Final Caveat

Numerous commentators and researchers before me have discovered some pretty powerful systems for extracting negative indications of financial health from accounting data. I am in no way trying to replicate that work, nor am I suggesting that the red flags I have proffered are the product of a similarly rigorous and systematic approach, or the state of the art. My goal has been only for each reader to think just once, "I hadn't thought of that one; it could make sense."

 

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Posted on December 28, 2009 at 01:08 AM in Financial Analysis | Permalink

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Comments

From relevance to specific standards, to impact on Big Picture standard-setting, I think your rant is worthwhile and highly topical reading, in that using 'analysts' as a proxy for the common 'investor' or 'user' is not a slam dunk, for the reasons you cite. Other challenges in use of such a proxy include judging 'understandability' of a particular standard and its output, and judging different points of view on what information is 'relevant' and 'reliable' and the tradeoffs therein.

Posted by: Edith Orenstein | December 28, 2009 at 08:23 AM

Careful, Tom. If you mention OSTK to prominently, you get on the "Sith Lord helpers list." ;)

Good post, and a helpful reminder to investors like me.

Posted by: David Merkel | December 28, 2009 at 09:33 AM

TS, my comments on your rant:
5. Absolutely. Any company which knocks out 20-25% a year increases in earnings, sales, EPS, etc., five or more years in a row, goes to the top of the "possibly cooked books list".
4. Agreed, except for the critical accounting summaries. I think they should be eliminated. If you want to read accounting policies, go to the footnotes.
3. Agreed. For decades I have believed GE's financials were works of fiction.
3. Agreed. (Three twice?.
2. I still remember Charlie Bludhorn. Lots of mergers are a big red flag.
1. Here I am cautious. Anything can spur an SEC investigation, including the SEC's looking to divert attention from some other entity. Really. Where are the SEC investigations of: Citigroup, AIG, Goldman, etc.? I won't hold my breath.

Good show

Posted by: Independent Accountant | December 28, 2009 at 06:00 PM

Excellent article! Many more similar articles are urgently needed. The average investor is clueless when it comes to accounting issues and based on current trends, the need will continue to grow exponentially.

In contrast to prior years, foreign investors have grown more concerned about our accounting standards and their application than the other way around as was previously the case.

Posted by: Tony Frank | December 28, 2009 at 08:32 PM

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I have started a lot of projects in the past and many of them either aren’t standing anymore or are owned by other parties. In terms of them becoming huge and garnering me millions of dollars they all would be considered failures, but in terms of walking away and learning something I don’t think I would consider any of them to be a failure. I think that everyone that reads this site has a passion for starting a pet project and I’m sure many of you have done a couple in the past, the problem seems to be that many times we just can’t let go because we don’t want “failures” being associated with us.

On the other end of the spectrum we have projects that we don’t follow through on, but that is for another article.

Why is it really that hard to let go? For it’s hard because I know what is needed to get the project to where I would be happy with it and all I need to do is go on and do that stuff. However, I find something else to do, but tell myself that I can still make the project a success. If I really wanted to make it a success then I would have stuck with it. There is a huge difference between wanting something and wanting something. Just because you tell yourself you want it doesn’t prove anything. Just like relationships, it’s your actions that need to do the talking.

With a success-to-failure ratio like the one I have why even bother starting these pet projects? It’s that whole “if you have an itch, scratch it” kind of thing. My life is about learning and I can’t learn by simply reading and sitting around. I have to learn by doing and that is what every one of these projects does for me. They teach me new things that I would never have gained by just reading someone else’s observations. It’s not like starting another blog or simple website is going to put me in financial ruin so there really is nothing holding me back.

You may think that your failures become part of your reputation however and if you want to start future projects with partners people may be a bit hesitant to join up with you due to what they know about your past. In this case, hopefully you do have successes on your record that stand head and shoulders above any failures you may have endured.

To move forward eventually you have to let certain projects die. If you don’t have the time or resources to get around to them letting them die frees up not only your time, but your thoughts for future projects. There is nothing worse than trying to work on a project and you have the nagging voice in your head telling you that your former project needs some maintenance. How many projects are started in this community with a flourish and then slowly die to the point where they get maybe an update a month. There is no point in that, just let it die.

At least you gave it a shot. Move on and give the next project a try because you know that is the one that is going to succeed.

Far better it is to dare mighty things, to win glorious triumphs even though checkered by failure, than to rank with those poor spirits who neither enjoy nor suffer much because they live in the gray twilight that knows neither victory nor defeat.

Theodore Roosevelt

Success is the ability to go from one failure to another with no loss of enthusiasm.

Thomas Edison

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Mental Math and Good Spending Choices 14comments

March 31, 2010 @ 2:00 pm - Written by Trent
Categories: Getting Started
Bookmarks: del.icio.us, reddit

Earlier today, I linked to an article at Free Money Finance that included a quote from Mary Hunt:

Get into the habit of quickly calculating the annualized cost of things and you’ll achieve an effective way to get mindless spending under control.

After reading this, a reader wrote in to me and said:

I can see how a tip like that could be useful, but I’m really awful at mental math and it seems unreasonable to futz around with a calcluator to do the math. How do you do this kind of math?

First of all, I’ll admit that I’m good at mental math. It was something I practiced a lot when I was very young and I can still do things like add a series of numbers or multiply two multi-digit numbers in my head. Thus, I usually do the math in a strange fashion in my head that really is hard to explain or make rational to others.

Instead, I asked a few people on Facebook and Twitter how they did this kind of math and they all responded with more or less the same technique.

First, they figured up how much a week of such purchases costs. If you do this thing once a week, it’s easy. If you do it more than once, double it or triple it – whatever’s appropriate. If you’re unsure about the pennies, round to the nearest dollar. So, if you get a coffee and a bagel for $5.46 three times a week, round the amount to the nearest dollar (down to $5) and multiply that amount by three, giving you $15.

Next, add two zeros on the end. That’s easy enough. If your current amount is $15, your new number is $1,500.

Finally, divide that number in half. If you can’t do it quickly, feel free to adjust the number from the second step. So, for example, if you have a hard time dividing $1,500 in half (it’s $750), just add $1 to the original $15 and divide that resulting number in half – $1,600 divided in half is $800. I suggest adjusting up if you rounded down in step one or adjusting down if you rounded up in step one.

That’s it – you have a very quick thumbnail of how much this expense costs you over the course of a year.

What if the expense is monthly? Slap a zero on the end and you’re getting close, but it’s a bit higher than that, too.

The thing to keep in mind is that this is a rough estimation, just to let you know the approximate amount you’ll be spending on this routine if you keep it up. Being able to come up with a rough estimate quickly is key. This way, you can do the math in your head while standing in line, giving you time to rethink the whole thing.

What’s the real benefit for doing this? If you do this type of calculation, you can quickly put your impulse spending in context. $750 a year spent on bagels and coffee could be half of an extra house payment. Paying off the house sooner makes it easier and more attainable for you to jump into the career you’ve been dreaming of for years. It might also open the door to having a child sooner than you think.

If you decide to go ahead with the purchase after doing this calculation and weighing the options, that’s great – you’ve weighed the options and chosen the option that provides the most value to you. However, denying yourself that opportunity often puts a big restriction on your big dreams.

Yep, a bit of mental math can make all the difference.

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Comments

#1 jim @ 2:16 pm March 31st, 2010

If you’re serious about getting your finances in order, then messing with a calculator shouldn’t be something that gets in your way. Using tricks to approximate is good, but the key is doing it. If you’re going to let the use of a calculator or lack of math practice be your crutch, then you have bigger problems.

#2 Chapeau @ 2:29 pm March 31st, 2010

One of my favorite bits of mental math is “how many hours do I have to work to pay for this?” I have a second job. After taxes, I earn about $7/hour at that job. So your bagel and coffee would “cost” me about 45 minutes at the second job. So not worth it. I’d much rather be out digging in the yard. That snack/piece of clothing/pair of shoes is a lot less desirable if I know it’s going to cost me 2 Saturdays doing what I enjoy.
That math, since it’s a job I don’t really love, earning just above minimum wage, is also more convincing than the math with the full-time job. If I only have to work 15 minutes to buy something, it’s not quite as undesirable. But it still works. Telling my husband that the “great buy” he found will mean I’m away from home for 2 more nights a week really puts it in perspective for him (and me).
On the other hand, don’t do the math to figure out how many hours you’ll have to work for something you just bought. Do it before you buy.

#3 Nicole @ 2:51 pm March 31st, 2010

Nice!

I like leaving 20% tips because there’s fewer math steps involved. (Just have to chop off 2 zeros and multiply by two rather than chopping off the two zeroes, remembering that number, dividing it by two and adding to the number you remembered). I like lazy mental math.

Chapeau– since the 2nd job is your marginal job, you’re actually doing the economically “right” calculation. A lot of people use their average wage to do these, but if you only make $7 for each additional hour, that’s the marginal wage, which is the right comparison.

I never did understand the people who spent money on the overpriced vending machines or fastfood during break at the minimum wage job I had in high school– that was like a full hour of work going down the drain.

#4 David @ 3:54 pm March 31st, 2010

Suggest always rounding up rather than down to nearest dollar. If you round down $5.46 * 3 and call it $15 a week, $750 a year, you are deluding yourself because the true figure is $851.76 annually. Of course, even if you round up and call it $16 a week, $800 a year, you are still underestimating, because $5.46 * 3 is $16.38, not $16, and there are 52 weeks in a year, not 50. But perhaps you don’t buy coffee and bagels on your annual vacation.

Another compelling argument in favour of rounding up, not down, is that prices almost invariably go up, not down. Furthermore, if you get into the habit of rounding up then you increase your chance of ending the year under budget, not over it.

Numbers in this post calculated in my head. If they are wrong, go ahead and embarrass me.

#5 Jeannette @ 4:11 pm March 31st, 2010

Chapeau,
You bring up one of the most viable methods to really understand what something “costs” on a visceral (as well as financial) level.

If more of us actually computed, as you advised– before buying, what something costs us in terms of time, etc. we’d probably spend a lot less.

Instead, I think a lot more folks rationalize the cost of something by how much “pleasure” or usage they’ll get out of something. Sometimes, that is truly a legit way to evaluate cost. Sometimes, not so much.

It’s a lot easier to say “no” to purchases when you are say, saving up so you can leave a lousy job…but often people overspend when they are miserable, rather than belt tightening so they might be able to take a less lucrative but less soul-leeching job.

It reminds me of people who have high-income jobs but travel all the time and are away from their families and very isolated and disconnected. Their families may have lots of nice stuff, but most kids would rather have their parents around and actively present in their lives. Same for a partner/spouse.

#6 Ruby Leigh @ 4:44 pm March 31st, 2010

Hi – I will be printing this article for an Extra Credit assignment in my Math Class. I teach Basic Math to adults. I hope that’s okay with you.

#7 et @ 6:33 pm March 31st, 2010

And be sure your base price estimate includes tax and the tip where applicable. I’ve gotten caught too many times at the end of a vacation needing more cash than estimated because I didn’t include the added tips. Rounding up more generously would also cover some of the added maintenance/ care/utility costs on certain purchases.

#8 Corey @ 6:34 pm March 31st, 2010

@Nicole (#3), you said: “I like leaving 20% tips because there’s fewer math steps involved. (Just have to chop off 2 zeros and multiply by two….)”

Well, I hope you really only chop of one zero. Otherwise, there are probably a lot of waiters and waitresses out there who were not too pleased with their 2% tips. ;)

#9 Nicole @ 8:40 pm March 31st, 2010

Corey yeah yeah.

In my defense, I was chopping off two zeroes off of numbers in the CPS while I was writing that post (since they report hourly wage without the decimal)… but yes. Good catch. Just keeping you on your toes. ;)

#10 Bill @ 8:49 pm March 31st, 2010

I try to think of the cost of something in before tax dollars. In the 25% tax bracket, I need to earn $1.33 for every dollar I spend. So I need to earn $2.00 to buy a $1.50 coke from the machine. However I need to earn $667 to buy a $500 laptop.

#11 Jules @ 1:51 am April 1st, 2010

This is what summers spent adding 4236 + 8972 and multiplying and long division lead up to: doing quick mental math.

#12 David/yourfinances101 @ 2:49 am April 1st, 2010

I think that’s an even quicker process than mine. I usually mulitply times four for the monthly amount, then multiply times ten and times two and add those together for the annual amount.

Getting proficient in at least a little “mental math” goes a long way to understanding your finances in the “big picture”.

#13 J @ 7:10 am April 1st, 2010

The “annualized cost” is something I especially like to apply to things with contracts or monthly fees. Like cell phones with data plans. I just can’t justify the $800-1000 per year on that.

#14 Moby Homemaker @ 7:30 am April 1st, 2010

Really good post!!!
I get a rounded monthly figure…then multiply by 12–to get the annual expense.
I’m sure there’s an easier and better way–but it seems to work for me.

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