MBA in a Nutshell #24 - Accounting and Finance : Creative Accounting

This article highlights various approaches to accounting that can possibly lead to civil and criminal penalties. Because financial statements allow a degree of flexibility and discretion, highly skilled accountants with the right lawyer can this game while avoiding more serious consequences.

It is therefore up to the investor to be wary of creative accounting techniques :

a) Growth in accounts receivables exceed growth in sales 

This happens if you sell a sell a lot of products but keep extending credit terms so you never collect on the debts owed to you. This technique can boost revenue but minimize actual incoming cash flow. The final outcome is that the company eventually runs out of cash while looking profitable throughout this period.

b) Growth of inventories exceed growth of sale

This suggests that the company's products are crap and they are losing market share.

c) Ordinary expenses are included in restructuring charges and restructuring happens frequently

This can overstate future profits. As I am not an accountant, I'm not even sure how to detect this. I am guessing that reading footnotes on the restructuring is required to see this. This gets worse if the company is serially writing off something. In the book, Kodak tried to restructure in 6 out of 7 years.

Having worked for HP and facing restructuring throughout my entire stay there, this should be more common than expected. In fact, I can argue that in old HP, restructuring charges ought to be ordinary expenses.

d) In-process R&D charges are written off by the purchaser at the time of acquisition

As I am not an accountant, I thought this was fine. How much of R&D even results in a product that can be monetized by a company ? Why not just write it off so that investors will not have false hopes about the future. But this idea is also wrong, most decent companies have intangible assets and this has to be R&D spending that will be amortized over time.

As an investor, it is very tempting to build a checklist from the above-mentioned points to qualitatively suss out the weaker counters. Unfortunately, they hardly matter in REITs because there is little by way of product sales and R&D.

The problem in investing is that even if you can build a detailed checklist of accounting watch-outs, you will merely be left with a few obvious stocks to buy that every retail investor is hoarding like toilet paper right now. The outcome of rigorous screening is often the same as intuition.

As such, you need to be be careful of investment experts who talk about screen filters and qualitative checks but end up with a list of strong-sponsor REITs that yield less than 5%. Any uncle with some investing experience can create this list for you without a model or a checklist.