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Six Red Flags
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As you've LIKELY figured out by now, picking great stocks is not a black- and-white process. Unfortunately, neither is accounting. There are literally dozens of techniques that are perfectly legal and aboveboard, but which have the effect of fooling an observer into thinking that a firm has posted true op­erational improvements when all it has really done Is moved some numbers around. You need to know how to identify what's known as aggressive accounting so you can avoid the companies that practice it.

Even worse than aggressive accounting, of course, is outright fraud—the hucksters of the "world are naturally attracted to the stock market because it's the perfect arena for profiting from the greed and carelessness of others. Knowing the signs of potential fraud can save you a lot of financial pain.

It's not that hard, either. Although you might need a CPA to understand exactly how an aggressive or fraudulent firm is exaggerating its results, you don't need to be an expert to recognize the warning signs of accounting chicanery. As long as you avoid the companies that bristle with red flags, you won't be caught owning them when the SEC starts investigating.

When you're giving a company the once-over, there are six major red flags to watch out for. Though some of these issues can pop up for innocent reasons, be sure you thoroughly investigate them before giving the firm a clean bill of health—or your money.

Declining Cash Flow

Even if accounting gobbledygook makes your head spin, there is one very simple thing you can do: Watch cash flow. Over time, increases in a com­pany's cash flow from operations should roughly track increases in net in­come. If you see cash from operations decline even as net income keeps marching upward—or if cash from operations increases much more slowly than net income—watch out. This usually means that the company is generating sales without necessarily collecting the cash, and that's a very good recipe for a blowup down the road.

My favorite example of this is former high-flyer Lucent. Between 1997 and 1999, Lucent's net income soared from $449 million, to just over $1 billion, to almost $3.5 billion—an incredible growth rate for such a large company. At the same time, however, cash flow from operations was plunging precipitously, from $2.1 billion in 1997 to $1.9 billion in 1998, to negative $276 million in 1999. Why? It's a long and sordid story, but it boiled down to three big reasons:

•  Lucent was extending credit to anyone who could spell photon, which
meant it was booking many sales without receiving the cash. (Think back
to our hot dog stand example in Chapter 4—as long as a firm ships a
product and has reasonable certainty that it will eventually collect the
cash, it can post the sale.) Accounts receivable (A/R) ballooned from 20
percent of sales to 27 percent of sales between 1997 and 1999, a clear sign
that the firm was having trouble collecting the money it was owed.

•  Lucent kept building more gear than it could ship, which sent inventories
upward. (Remember, manufacturing something and then storing it in a
warehouse uses cash.) This effect showed up in the "increase in invento­
ries" line item in the firm's statement of cash flows.

•  Lucent's pension plan was pumping up net income with noncash gains.

If you do nothing else, watch cash flow like a hawk.

Serial Chargers

Be "wary of firms that take frequent one-time charges and wrke-downs. This practice makes the historical financials muddier because every charge has a long explanation and usually has various components that affect different accounts—all of which need to be adjusted if you want to look at comparable year-to-year financial results.

More importantly, frequent charges are an open invitation to accounting hanky-panky because firms can bury bad decisions in a single restructuring charge. Usually, the rationale for a charge is pretty vague, which means there's a fair amount of leeway for management.

When a firm takes a big restructuring charge, it's essentially improving future results by pulling future expenses into the present. In other words, poor decisions that might need to be paid for in future quarters—an unsuccessful product that may need to be terminated or a bloated division that will need to pay severance payments to redundant employees—all get rolled into a single one-time charge in the current quarter, "which improves future results.

If you run across a firm that has frequent restructuring charges, don't ignore them, despite the firm's blandishments about what earnings would be after excluding the charge. After all, if a firm dug itself into a deep enough hole that it needs quarter after quarter of charges to make things right, those charges are a normal cost of improving the business.

Serial Acquirers

As I mentioned earlier in the book, firms that make numerous acquisitions can be problematic—their financials have been restated and rejiggered so many times that it's tough to know which end is up. Aside from muddying the waters, acquisitions increase the risk that the firm will report a nasty surprise some time in the future, because acquisitive firms that want to beat their competitors to the punch often don't spend as much time checking out their targets as they should.

The Chief Financial Officer or Auditors Leave the Company

Quis custodiet ipsos custodes? is Latin for "who watches the watchmen?" And when it comes to financial reporting, those watchmen are the chief financial officer (CFO) and the corporate auditors. If a CFO leaves the company for reasons that seem at all strange—or inexplicable—you should be on your guard. It's normal for CFOs to move around just like other executives, but if you see a CFO leave a company that's already under suspicion for accounting issues, you should think very hard about whether there might be more going on than meets the eye. The same applies to corporate auditors. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out. This one may not be a big deal by itself, but it's definitely something to watch "with firms that have al­ready displayed other warning signs.

The Bills Aren't Being Paid

There are few things Wall Street loves more than growth, and companies go to great lengths to keep their top line increasing as rapidly as possible. One of the sneakier ways for a company to pump up its growth rate is to loosen customers' credit terms, which induces them to buy more products or services. (Companies can also ship out more products than their customers ask for— known as "stuffing the channel"—but this is less common.)

The trick here is that even though the company has recorded a sale— which Increases revenues—the customer has not yet paid for the product. If enough customers don't pay—and those looser credit terms are probably at­tracting financially shakier customers—the pumped-up growth rate will eventually come back to bite the company in the form of a nasty write-down or charge against earnings.

You should track how fast A/R are increasing relative to sales—the two should roughly track each other. But if sales Increase by, for example, 15 percent, while A/R increases 25 percent, the company is booking sales faster than it's receiving cash from its customers. (Remember, A/R measures goods that are sold, but not yet paid for.) As a general rule, it's simply not possible for A/R to increase faster than sales for a long time—the company is paying out more money (as finished goods) than it's taking in (through cash payments).

On the credit front, watch the "allowance for doubtful accounts," "which is essentially the company's estimate of how much money it won't be able to collect from deadbeat customers. If this amount doesn't move up in sync with A/R, the company may be artificially boosting its results by being overly optimistic about how many of its new customers will pay their bills.

Changes in Credit Terms and Accounts Receivable

Finally, check the company's IO-Q filing for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped. (Look in the management's discussion and analysis section for the latter and in the accounting footnotes for the former.)

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