Many people assume diversification is good because it minimizes risks…
A couple of weeks ago, I had the pleasure of finishing the book, “Sound Investing” by Kate Mooney and Kerry Marrer. It’s an excellent book for those learning to improve their fundamental analysis, but more importantly, it’s a fantastic book for everyone to detect potential accounting frauds. We do want to avoid buying stocks like Enron, don’t we? I will mention a couple of points that you can keep a heads up on before purchasing your next stock, but if you do want the comprehensive guide in detecting accounting frauds, I highly recommend buying this book. You can purchase it at Amazon by clicking here.
So without further ado, here are five points for you to be aware of:
1. Revenue Recognition Methods Can Be Manipulated
Companies may use tricks to recognize revenue even when it isn’t appropriate to. For example, a method of revenue recognition is the percentage-of-completion method, whereby revenue is recognized based on how much is already completed instead of waiting for the finished product / payment transfer. Some industries might find it appropriate to use this method. I will borrow an example from the book to illustrate this percentage-of-completion method manipulation.
A contractor agrees to receive $5,000,000 to construct a building, which will take 3 years to complete. Total costs are estimated to be $4,000,000. In year 1, total costs incurred is $1,000,000. Revenue recognized would be 1M/4M * 5M = $1,250,000. However, the contractor can easily load up $500,000 more raw materials at the end of the year to increase the total costs incurred. Even though the raw materials have not been used, the contractor will recognize revenue as 1.5M/4M * 5M = $1,875,000 instead for year one.
Also, it is very important to see when numbers are estimations only. The costs here are estimated to be $4M. Had management lowered cost estimates, the revenue recognized would be much higher, but future revenue may suffer when the more accurate cost estimates surface.
2. Be Aware Of Fraudulent Revenue Recognition
The book lists several ways companies can create fraudulent revenue recognition. One susceptible way is round-tripping, whereby two companies buy each other’s assets on an agreed price – but these assets are pretty much identical, hence artificially increasing both parties’ revenue. The SEC bans such practices, but it is a possibility that companies may engage in such behavior. If they do, stay away from these companies!
3. Unrecorded Liabilities
There are certain criteria to be met for a liability to be mandatorily recorded, otherwise the company can avoid listing them as liabilities, improving key ratios such as those pertaining to liquidity; however, these unrecorded debt obligations are usually disclosed in notes. It’s very important to read these notes because some of these liabilities may be long term contracts. Some companies may create deals that avoid being listed as liabilities.
For a serious real life example (again borrowing from the book), Ford had a contract to buy palladium, which its price fell more than 50% in 2001, and the need for palladium was reduced due to technological advancement, causing Ford to record a $953 million loss on the contract. This contract wasn’t recorded as a liability previously.
4. Ratios Are Your Friends
Ratios are one of the best ways to detect for scams and frauds. There are many ratios which you can use to analyze (read more about them in the book), and one such ratio is comparing revenue over net income and seeing whether there are major fluctuations year by year. If the trend isn’t consistent, you have to ask yourself why this may be the case. A general decline in percentage may mean the company isn’t managing its expenses well. A sharp rise in percentage may mean the company is engaging in fraudulent activities, recognizing revenue where it’s not supposed to.
To ensure your analysis is correct, compare with similar companies in the same industry and see if they are experiencing the same trend. If they are, something could be happening to the industry itself. If it’s just the company itself, you will need to dig deeper into the notes and seek for understanding.
5. Change in Auditors
A change in auditors may or may not be a warning. Of the latter, it is acceptable for an auditor to be dismissed if two companies with two different auditors merge together.
On the contrary, when a change in auditor coincides with a filing of internal control weakness, this should raise some alarming bells. Or, if the auditor suggests that they cannot rely on management’s representations, it could imply that they are questioning the integrity of the management and therefore the reliability of management numbers. Lastly, scope limitations coinciding with a change in auditors may signal problems with the company as well. An auditor may need to expand their investigations, only for the company to switch auditors to prevent these extra investigations. This again should raise doubts for you.
Hopefully I’ve raised your interest in buying the book (honestly, it’s a great book if you’re into this kind of stuff) and more importantly, raised your awareness on what to be concerned about along with how to detect fraudulent activities. Ratios and identifying trends are important for detection and therefore, it only makes sense to buy companies with lots of years’ of public data. This is why new companies, especially IPO, should be avoided, because you don’t have enough financial information to make good judgments. IPOs are often just based on sentiments and marketing, and usually the data pre-IPO are decorated so that investors are willing to pay more for the stock, and so you are often speculating that sentiment will carry the newly IPO stock to higher prices, which is a larger risk than you should be taking.
Some other things to be aware of. Look for consistency in ratios. If growth suddenly increases or decreases spectacularly, it may require digging deeper into the numbers. The most crucial information are often buried in the notes and footnotes, so read them. Read the Management Discussion and Analysis. Also, is a deal too complicated? If so, ask yourself why and if it was necessary.
That’s why I believe Warren Buffett and many other highly esteemed investors agree that while quantitative information is important, we also need to consider qualitative factors such as the trustworthiness of managers. The more honest they are, the more likely the numbers are straightforward, unbiased, and unaltered.
Again you can buy “Sound Investing” here.
What are some other tricks you use to determine whether a company’s stock is worthwhile buying? Please share below.