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Seven Other Pitfalls to Watch Out For
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Watching for these six warning signs will help you avoid maybe two-thirds of potential accounting-related blowups. Unfortunately, though, there are many other ways that firms can embellish their financial results. When you're read­ing a IO-K or annual report, watch for the following pitfalls.

Gains from Stock Investments

It's reasonably common for large firms—especially in the technology sector—to make small investments in other companies. Occasionally, these investments "work out "well, the owner sells some of the shares, and records the capital gain as income. This is no different from the way you or I "would re­port a capital gain as income when we're doing our taxes every year, and it's perfectly legal and aboveboard.

An honest company breaks out these sales, however, and reports them below the "operating income" line on its income statement. The problem arises when companies try to boost their operating results—in other words, the performance of their core business—by shoehorning investment income Into other parts of their financial statements.

The most blatant means of using investment income to boost results is to include it as part of revenue, though this isn't very common. Companies can also record the income "above the line" so that it is included as part of operating income and thus boosts their operating margins. This is manifestly a no-no because accounting rules require any piece of one-time income to be separated from income that comes from normal operations. Finally, companies can hide investment gains in their expense accounts by using them to reduce operating expenses, which makes the firm look more efficient than it really is.

If the firm you're analyzing is using investment gains or asset sales to boost operating income or reduce expenses, you know you're dealing with a company that might be less than forthcoming in other areas as well.

Pension Pitfalls

Pensions can be a big ball-and-chain for companies "with many retirees be­cause if the assets in the pension plan don't increase quickly enough, the firm has to divert profits to prop up the pension. To fund pension payments to future retirees, companies shovel money into pension plans that then are invested in stocks, bonds, real estate, and so forth. If a company winds up with fewer pension assets than pension liabilities, it has an underfunded plan, and if the company has more than enough pension assets to meet its projected obligations to retirees, it has an overfunded plan. (More on overfunded plans in the next section of this chapter.)

To see whether the company has an over- or underfunded pension plan, go to the footnotes of a IO-K filing and look for the note labeled "pension and other postretirement benefits," "employee retirement benefits," or some vari­ation. Then look at the line labeled "projected benefit obligation." This is the first key number. It's the estimated amount the company will owe to employees after they retire, and it's based on assumptions about how long retirees "will live, the rate that salary levels at the company will grow over time, and the interest rate that the company uses to discount its future obligations to their present value. Compare this with the line labeled "fair value of plan as­sets at end of year," which is the second key number.

If the benefit obligation exceeds the plan assets, the company has an un­derfunded pension plan and is likely to have to shovel in more money in the future, reducing profits. This can be a huge number for a large company with many retirees—General Motors, for example, had pension obligations of $80 billion at year-end 2OO2 versus pension assets of $61 billion. One way or another, GM will need to make up the $19 billion difference. (As recently as 2OOO, GM had a Si.7 billion surplus in its pension plan. When Wall Street goes south, so do pension plans—but the obligation keeps growing as employees earn benefits.)

What did this mean for GM? In 2OO2, the firm chucked in a whopping $4. 9 billion to the plan. (You can see this in the pension footnote under "em­ployer contributions.") That's almost $5 billion in cold, hard cash that an un­wary shareholder might have been expecting to increase the firm's value, but which actually went straight to GM retirees.

So, always check out the pension footnote. There's a lot of accounting gobblcdygook there, but you can also find out "whether the firm you're looking at is going to wind up owing its retirees more money than it actually has. And if that's the case, they'll get the money before you will as a shareholder.

Pension Padding

Pensions can be a boon as well as a burden. When stocks and bonds do really well, as they did in the 1990s, pension plans go gangbusters. And if those annual returns exceed the annual pension costs, the excess can be counted as profit. Flowing gains from an overfunded pension plan through the income statement is a perfectly legal practice that pumped up earnings at General Electric for years and boosted earnings at many defense companies by 30 percent to 40 percent during the 1990s.

However, this pension-related income is a strange kind of profit. It's not available to pay out to shareholders—it belongs to the pension plan. And the only way to unlock that excess is to terminate the plan, which is highly unusual. But the excess does benefit shareholders: It should mean the company will have to contribute less to the pension plan in the future to keep it solvent. As a shareholder, you'd much rather have an overfunded pension plan than an underfunded one. But this income is completely dependent on the stock market, so it's not money you want to rely on in the future. You should subtract it from net income when trying to figure out just how profitable a company really is.

To find out how much profits decreased because of pension costs or increased because of pension gains, go to the line in the pension footnote labeled either "net penslon/postretirement expense," "net pension credit/loss," "net periodic pension cost," or some variation. Companies usually breakout the con­tribution of pension costs to profits for the trailing three years; therefore, you can see not only the absolute level of pension profit or loss, but also the trend. You won't see these numbers in the income statement—they get lumped in with other categories there.

Vanishing Cash Flow

There's one important caveat to the general rule that cash flow is a number to be trusted: You can't count on cash flow generated by employees exercising options. I mentioned this wrinkle in Chapter 5—the amount is labeled "tax benefits from employee stock plans," or "tax benefit of stock options exercised" on the statement of cash flows. Here's why you don't want to count on this cash flow.

When employees exercise their stock options, the amount of cash taxes that their employer has to pay declines. Let's say your employer gives you 100 options with an exercise price of $IO. A few years later, the stock is trading for $30, and you decide to cash in. You pay taxes on the $2,000 difference (the $30 market price less the $10 exercise price), and your employer gets to take a tax deduction of $2,000 against its corporate income because taxable employee compensation is tax deductible for employers. In other "words, your employer reduced its tax bill by $700—assuming a 35 percent tax rate—just because you exercised your 100 options.

As long as the firm's stock keeps going up and it keeps giving out options, this process continues. More options are exercised, tax deductions are taken, and the firm saves cash by lowering its tax bill. But what happens if the stock takes a tumble? Many people's options will be worthless—their exercise prices will be higher than the market price—and, consequently, fewer options will be exercised. Fewer options are now exercised, the company's tax deduction gets smaller, and it has to pay more taxes than before, which means lower cash flow.

Therefore, when the stock price declines, the firm generates less cash than it did when the stock was flying. Sun Microsystems, for example, reported about $2.1 billion in cash flow from operations in fiscal 2001, $816 million of which resulted from this lovely tax benefit. In other words, Sun would have generated 40 percent less cash in 2OOI if its employees hadn't exercised tons of options. But the next year, when Sun's shares plunged to below $5, this portion of cash flow dried up very fast as fewer options were exercised. In 2OO2, Sun's option-related tax benefits dropped by almost 90 percent, to only $98 million.

If you're analyzing a company with great cash flow that also has a high­flying stock, check to see how much of that cash flow growth is coming from options-related tax benefits. Unless you think you can predict the stock market, that's not cash you want to count on in years to come.

Overstuffed Warehouses

When inventories rise faster than sales, there's likely to be trouble on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that's usually more the exception than the rule.

When a company produces more than it's selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually—probably at a discount—or written off, which "would result in a big charge to earnings.

This is what happened in late 2OOO to virtually every company selling communications-related gear—inventories started to balloon as demand from telecom carriers started to slow. At the time, many analysts (including, I'm humbled to say, me) thought that the gear-makers had simply overestimated demand temporarily and that the situation would correct itself once telecom carriers used up the gear they'd already ordered. But it turned out that demand was not just pausing—it was falling off a cliff. Therefore, inventories continued to pile up until sales started to slow as "well, and companies such as Cisco had to write off billions in unsold goods.

Change Is Bad

Another way firms can make themselves look better is by changing any one of a number of assumptions in their financial statements. As a very general rule, you should look skeptically on any optional change—some accounting changes are mandated by rule makers—that improves reported results. Odds are good that the motivation for making the change wasn't altruistic.

One item that can be altered is a firm's depreciation expense. If a firm is assuming that an asset—such as a building or factory—will wear out in 10 years, it subtracts (or depreciates) one-tenth of the building's value from its earnings each year. As you can Imagine, the longer the depreciation period, the smaller the annual hit to earnings. Therefore, if a firm suddenly decides that an asset has a longer useful life and stretches out the depreciation period, it's essentially pushing costs out into the future and inflating current earnings.

Firms can also change their allowance for doubtful accounts. If the allowance for doubtful accounts doesn't increase at the same rate as accounts receivable, a firm is essentially saying that its new customers are much more creditworthy than the previous ones—"which is pretty unlikely. If the allowance actually declines as accounts receivable rise, the company is stretching the truth even further. In either case, if more customers wind up not paying than the firm estimated, the firm will have to take a charge to earnings at some point in the future, which means current results are overstated.

Firms can also change things as basic as how expenses are recorded and when revenue is recognized (one of those gray accounting areas). You'll generally find this kind of information in the "summary of significant accounting policies" section of the IO-K—and if a firm chooses to make changes that materially reduce expenses or increase revenue, watch out. Unless these moves were required by the accounting rule makers, the firm is probably trying to cover up deteriorating results.

To Expense or Not to Expense

Companies can also fiddle with their costs by capitalizing them. As I discussed in Chapter 4, the basis of accrual accounting is that benefits have to be matched with expenses on the income statement. Operating costs—such as office supplies, office rents, and so forth—are expensed because they produce a short-term benefit. (You pay the rent only one month or year at a time, and the benefit you receive expires at the end of that period unless you make another payment.) On the other hand, costs such as a new piece of machinery are capitalized —that is, their value is recorded as an asset that slowly declines in value over time—because they produce long-term benefits. (A machine that you buy today "will still be cranking out products three years from now, just at a lower rate because of wear and tear.)

The tricky part is that certain types of costs, such as marketing and some kinds of software development, can be treated either way. As you can imagine, a company that wants to inflate profits can easily do so by capitalizing $100 In marketing costs and spreading the expense out over several years, rather than expensing the entire SiOO in the current period. This is exactly what AOL did in the mid-1990s—the firm argued that the subscribers it was acquiring were likely to produce long-term benefits, so it should be allowed to capitalize its marketing costs. The SEC disagreed, and AOL had to reverse course.

Finding this kind of information will take some digging around in the footnotes of a company's IO-K form, but it's time well spent. Any time you see expenses being capitalized, ask some hard questions about just how long that "asset" will generate an economic benefit. Looking at the useful life assumption will generally do the trick—a building might be useful for 40 years, but a piece of office furniture or a chunk of software won't.

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