How Should Investors Deal with Accountin

慎思

How Should Investors Deal with Accounting Problems

By Michael Wu

The Enron collapse, and reports about Worldcom, Adelphia and other others have given rise to investor skepticism. Large American corporations and so called “blue chips” considered to be a safe haven by investors have left investors wondering who can be trusted, whether there is any use in employing financial analysis, and how they must deal with creative accounting.

Unfortunately, such accounting irregularities are not new in the financial statements of American public companies.  There will always be companies that will attempt to take advantage of the weaknesses of the accounting rules.  It is important to remember that the fraudulent companies are a minority in comparison to the majority of honest corporation that employs valid accounting principles. It is quite tempting to let oneself be swayed by the doom and gloom reports in the media; however a smart investors will obtain facts prior to jumping to conclusions.

There is useful information that one can obtain from financial statements. These comprise of income and cash flow statement and balance sheet.  For example, when quarter-end earnings are announced, most investors only pay attention to earnings and revenue.  However one can learn more about the operations of a company if the balance sheet and cash flow statements are examined.  For instance, even though revenue is reportedly increased, account receivables and inventories may give investors more useful information if these are examined.  If the increase in account receivables is much faster than the increase in revenue, this may indicate that the company is having a problem with sales and financial controlling. If this is the case, then investors should be careful even if earnings have increased.  This also applies to inventories.  When revenues and earnings increase with inventories increasing at a much faster rate, then the company might have a problem with production control and sales.  This could be a dangerous signal especially if there is a change in the environment of the industry.  Also on the balance sheet, the debt ratio may give an indication of potential problems.  For example, if the company has not made any proposal for expansion but the debt ratio increased substantially, this should flag the investors to take caution of their investments.

On the other hand, even though financial statements comply with the Generally Accepted Accounting Principles (GAAP), it does not necessarily mean that financial statements are problem free.  In fact, according to GAAP, many items in the financial statements are at the discretion of executives of public companies.  In other words, executives can manage earnings under the current accounting rules, i.e., adoption of less conservative accounting estimates and principles; one-time transactions that generate gains; actions that shift income from future periods to the present; under-reserving for future expenditures; early adoption of a new accounting standard; reduction of managed costs; capitalizing when expensing was done for similar items in previous periods; adoption of a new strategy, using historical information to make projections regarding this new strategy, writing off investments soon after they are made; etc. Most methods or actions are, in fact, acceptable to the accounting principles. However, earnings management may indicate potential accounting problems.  Investors should differentiate between normal practices and practices that leading to potential accounting problems.  If an accounting problem is found, investors should take caution.

While analyzing financial statements, investors should also pay a special attention to off-balance items, i.e. operating leases, pension plans, executive stock options, unconsolidated partnerships, pending litigation, inventory reserve account, account receivable allowance reserve account, etc.  According to the current accounting rules, these items can be excluded from balance sheet and only need to be disclosed in the footnote of the financial statements.  However, these items may increase the cost and the debt burden of the company, leading to lower earnings and higher debt ratio.  For example, the executive stock options may result in dilution effect on the existing shareholders if they are exercised and thus are real cost to the existing shareholders.  If the cost of the stock options is included in the earnings report, the result will be very different.  For instance, earning per share for Ebay would be reduced to a profit of $0.19 to a loss of $0.36 if the cost of stock option were included.  The stock option has become a notorious topic after the scandals at Enron and Worldcom.  Investors are looking for a new ruling on the change in the accounting treatment of executive stock options.  Analysis of various off-balance items will help investors better understand the earnings and debt structure of the company, and allow financial statements of different companies to be more comparable; thus leading to a better valuation of the company.

In fact, companies will often show some warning signals before accounting problems materialize.  Some warning signals include: (1) growing faster than the industry; (2) frequent business combination; (3) a history of using accounting methods to achieve earning targets; (4) rapid growth results in possible lack of controls; (5) management meets earnings expectations at the expense of other aspects of the business; (6) doing too well to believe.  Upon seeing any of these warning signals, investors pay special attention to financial statements and their footnotes, and refrain from making an assumption without a full analysis over a relatively long period of time.  Investors should pay attention to factors beyond the financial statements, such as the company’s competitors within its industry, economic environment, and ethics of corporate executives.  Only if a full analysis is conducted, can an investor unravel potential accounting problems.  In many situations, financial statements themselves may not disclose any problems.  However, if investors take into consideration external warning signals, they will likely avoid many big mistakes.

In conclusion, I believe that there is tremendous value in conducting a full financial analysis that takes into consideration of external warning signs.  If a problem is identified in the financial statements, investors should make a further investigation to differentiate the acceptable behaviors and potential problems.  It is also important to pay attention to off-balance sheet items.  If the quality of earnings is deteriorating and potential accounting problem is found, investors should become cautious about their investment decisions.  Indeed, it is very difficult to estimate the long-term impact of some factors which are often beyond the financial statements themselves.  As a result, investors should examine a company from a broad horizon beyond the financial statements.  This is the lesson we learned from recent accounting scandals.  

Author: Michael Wu is an investment advisor of HSBC Securities (Canada) Inc.  He holds a Canadian Investment Manager designation and an MBA from the University of Western Ontario and a PhD in Economics from Nankai University.  Tel: 416-756-2298; Cell: 416-274-8978.

General Disclaimer
This article is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment.  HSBC makes no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness.  This article contains the personal views of the author and does not necessarily reflect the position of HSBC Securities (Canada) Inc. It is not a comprehensive review of all developments and is not intended to provide specific advice.  Readers wishing to act on information contained in this article should seek specific advice from qualified advisors on particular matters of interest to them. HSBC Securities (Canada) Inc. is a wholly owned subsidiary of, but separate entity form, HSBC Bank Canada.  Member CIPF.