Bending The Numbers
Deceptive Accounting Practices
With earnings season coming around four times a year, and
the balance sheets of many companies always under heavy scrutiny by analysts
and investors, it pays to know some of the accounting tricks that some
companies use. Two of these tricks,
one-time charges and investment gains, pop up regularly on financial
statements. But while both are legitimate
accounting practices, they can be deceptive about how the company is truly
faring.
The vast majority of publicly traded companies use the
Generally Accepted Accounting Principles (GAAP) as a method of keeping their
books. While the GAAP is a standard,
formalized method that does a good job of making all companies tally their
balance sheets in the same way, it does allow for a little give and take with
some figures. Most notably, the methods
used to tally a company's total worth can vary slightly.
One-Time Charges
One-time charges are probably the most frequent balance
sheet loophole exploited by large companies.
Of course, this isn't to say a company taking a one-time charge is doing
anything wrong or even trying to deceive anyone. One-time charges are perfectly legitimate and are actually a
necessity in certain accounting situations.
But some companies do seem to take advantage of one-time charges far
more often than they should, and that abuse can mislead investors.
A one-time charge is an expense that a company has incurred
due to a its own mistake, merger, bad debt, major purchase, etc. The charge is one that should occur only
once as an isolated event outside of the business's normal operations, and not
every quarter or year -- hence the ‘one-time.'
Rather than put these charges in the main quarterly income
statement, they are given a separate designation. This allows the company to demonstrate its normal earnings growth
to investors, without the one-time charge adversely affecting the all-important
growth figures, or damaging the long-term earnings projections of the
company.
There are obvious reasons why so many companies would take
advantage of the one-time charge. Any
loss that can be removed from the income statement and assigned as a one-time
charge allows the company's overall earnings to appear to improve. Of course, not just any loss can be written
off. It truly has to be a one-time
event to qualify for the designation.
Unfortunately, some companies try to take advantage of this
method. Businesses that somehow seem to
take one-time charges year after year are probably covering up fundamental
problems within the company. Because
there is some gray area concerning what constitutes a one-time charge and what
does not, some companies stretch the truth in order to make their balance
sheets look better.
Anytime a one-time charge is taken by a business it should
be greeted with skepticism. If it is a
legitimate charge, it will truly only occur one time. If a company has a history of one-time charges on its record,
chances are that something is amiss.
Investors should be wary of these balance sheets that don't always tell
the full story.
Investment Gains
The other way some companies misrepresent their real value
on the balance sheets is through investment gains. While most companies of any significant size use part their
wealth to invest in other companies, the outcome of these investments is no
more assured than for any other investor.
During the dot.com boom of early last year, many companies were able to
significantly raise their overall returns on the balance sheet due to lucrative
investments.
Of course, the folly of projecting future earnings with the
income derived from investment gains became apparent when the Nasdaq plunged
more than 60% last year. Many companies
had invested heavily in technology and were hurt even worse than the main
indices. Just because a company has a
good management team or a best-selling product doesn't mean it will be able to
beat the Street. Investors should look
carefully to see how much of a company's earnings are derived from inconsistent
investment gains.
Unfortunately, some companies have even used investment
gains as a sort of last-ditch effort at improving their bottom line. A recent trend has seen some businesses use
speculative investing to try to meet earnings projections or make up for
failing units of their business.
While some of these companies do succeed in making big
returns by using this method, it is a particularly foolish practice in that it
puts capital needlessly at risk. Even
if a company does succeed in covering some losses with a successful speculative
investment, it is still misleading investors by essentially masking a lucky
streak in the guise of sustainable income.
The investment gain section of a financial statement should
be read with care, and an investor should not expect an unusually good return
to be duplicated in the future.
Diversified investments are a good way for a company to derive solid,
steady income, but wild speculation puts the company's money at risk and calls
the ability of the management into question.
Keep an eye out for balance sheets that seem too good to be
true. Oftentimes they are. By checking for both one-time charges and investment
gains, an investor can significantly reduce the chances of being burned by
shady accounting practices.