The Smart Investor's List: A Dozen Things You Need to Know to Watch Your Flank

We're back to the "fundamentals don't matter anymore" phase of the market. That's when, more than ever, you need to remember how deliberately some companies try to make their financial performance look better than it really is. (Yep, Martha, there he -- meaning me -- goes again!)

So when my colleague Jesse Eisinger sent around an email to TheStreet.com staff that had been collecting dust on his hard drive, my first reaction was, What a column! It was written by a former brokerage analyst (with several very well-known firms), and it was a list of his favorite red flags. I called the author, and he gave me permission to reprint it.

The only caveat (and you'll see why) is that I couldn't use his name. It's so good you should print it out and reread it from time to time just as a reminder. Without further babble, here it is.

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I look at your current subject, accounting wiggle room, with an unusual perspective. My career has included sell-side analyst positions, a long period as a journalist and my present role in investor relations (for a midsize company).

Herb's Latest: Join the discussion on TSC message boards.

Earnings-smoothing is alive and well despite Arthur Levitt's broadsides. Companies are so frightened of missing EPS consensus in any coming quarter (because of the market's fixation on "the number") that they may sacrifice the future. Rules I have learned:

Be suspicious of any company's results in quarters subsequent to a one-time accrual for merger or restructuring charges. You would be amazed at what qualifies as an expense that can be allocated to these accruals. No doubt that the Big Five let companies overstate precharge earnings over a protracted period.

Year-over-year comparisons are for the naive. Too bad so many corporate execs manage off of them. Worse, a majority of Wall Street analysts build their earnings models based on assumed year-over-year growth rates rather than coming to understand how sequential results create those numbers. I have seen middle managers awarded bonuses for producing good-looking year-over-year percentage growth when their units had flat performance or worse for the final six months of the fiscal year. Needless to say, continue that trend and next year is awful. Why shouldn't GAAP capture the sequential trend? There is zero analysis of sequential trend in SEC financial statements.

Watch out for earnings before interest, taxes, depreciation and amortization, or EBITDA. Companies can amortize a tremendous variety of true operating costs, especially regarding severance, legal and a wide variety of corporate-type expenses. If the latest exposure draft on accounting for business combinations is approved, financial statements will reveal how much amortization expense remains after goodwill. Might be shocking in some cases.

Segment reporting is screwball. The SEC thought it hit a home run with SFAS 131, a 1998 accounting rule requiring financial reporting by operating segment. But the standard for allocating corporate vs. segment costs is virtually nonexistent. In the limited data already filed, you can find many companies with huge swings in segment margins decided largely by how overhead costs are allocated. This is useful information?

It is too easy for companies to manage earnings by using nondisclosed acquisitions. A large enough company can make accretive acquisitions without disclosing them as long as the deals are not "significant." Surprisingly, an insignificant transaction may add one cent or more to quarterly EPS. Perfect way to tweak a quarter.

Also, companies tend to pick up a full quarter's results of an acquired business even though the deal is announced midquarter. Analysts are surprisingly naive about this practice. And I have encountered numerous instances where company execs lied about how much an acquisition contributed to a given quarter.

On the other hand, the balance sheet effect of an acquisition (under purchase accounting) is taken from the date the deal closes. Meaning there's a mismatch between cash flows and changes in assets that distorts the statement of cash flows. Many investors worship the statement of cash flows, but any sequential analysis is hugely problematic. For many companies, it is impossible for investors to calculate an accurate receivables turnover. Financial statements do not contain the necessary information about acquired company's balance sheets on date of acquisition and quarter end. Investors may either rely on what the company says on the conference call, or they can use the reported balance sheet data, which are misleading.

The balance sheet is distorted by the assumptions built into the revalued assets/liabilities of an acquired company. It is pretty common practice for companies to take highly conservative accruals at time of acquisition. That means they can use these large accruals to smooth future earnings.

Beware of large sequential declines in selling, general and administrative, or SG&A, expenses at the end of a company's fiscal year. Companies do not have to disclose whether they disgorged bonus accruals to make year-end expectations. In doing so, companies may be sabotaging future growth potential. Depriving employees of bonuses is a powerful turnover incentive.

I have seen companies defer marketing expenses in a given quarter to make earnings. I have seen companies take what amounts to one-time tax credits (unannounced) to make earnings. I have seen companies give away margin to obtain high-volume contracts to boost revenue growth, even at the expense of earnings. And in all of these cases, investors were not fooled and the execs were mystified ... and replaced.

Investors were fooled long enough to believe those companies did not see dark clouds on the horizon. GAAP do not ensure that companies must disclose in timely fashion all concerns likely to affect the performance of a stock.

Watch out for surprises in companies' accruals for worker compensation and health-care benefit expenses. Inflation has returned to health care. Betcha almost every small or midsize company in America is underaccrued. Might hit large companies, too, though their pools are large enough to allow for a greater margin for error.

It is interesting, on the other hand, to see Web-hype companies accorded the opportunity to spend madly in pursuit of growth. Those execs have their own key numbers they have to beat, but they don't have to worry about managing to maximize quarterly EPS. They have a tremendous competitive advantage in that respect. Balancing current outcome and future opportunity is the most difficult challenge of all growth companies.

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Which is why the pressure to fudge is so great.

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