Public companies are under enormous pressure to consistently meet or beat Wall Street estimates. For that reason, many managers rely on accounting skills rather than sales savvy to meet expectations. That often means that things are not as good as they look. But for sharp investors, the tricks are easy to spot.
Here's what to look for.
Stuffing and Smoothing
Some companies will ship an enormous amount of product at the end of the quarter to their distributors, and/or offer sweet financing terms to customers in an effort to boost sales in a hurry. This is called "stuffing the channel." And it works great for companies that need to meet estimates in a given quarter. But over the long haul these shenanigans are usually detected when short-sellers or skeptical analysts check with retailers about the terms offered by certain manufacturers and distributors. Sunbeam, which is in reorganization under Chapter 11 of the Bankruptcy Code, was accused in 1998 of using this gimmick to mask true demand for its grills.
Incidentally, the reverse is also true. Sometimes, if management thinks the current quarter's in the bag, it will push off sales, or even tinker with other variable expenses like pension contributions. In some cases the company may delay certain shipments, or simply work out special arrangements with its distributors, so it can record sales in a later quarter. The practice is called "revenue smoothing." And various companies from
have been accused of it.
Expensing: The Passive Aggressive Types
A company must recognize expenses during the quarter in which they are incurred. That's pretty much common knowledge. But there is some give in this definition. How so? Let's say that XYZ company is carrying a great deal of soon-to-be obsolete equipment or inventory on its balance sheet. Come the fourth quarter, some companies will clean the decks and record a one-time charge, rather than wait until next year to expense the goods. The logic is that next year's earnings will be charge-free and appear pure as the driven snow.
Another very common tactic is for a company to purposely lump a bunch of one-time charges in with a lousy quarter. That can be done to muddy the waters and make it hard for outsiders to figure out how bad things really are.
Some companies recognize sales on receipt of goods. Others recognize revenue on a percentage-of-sales basis. For example, a plane manufacturer such as
or Airbus might recognize revenue as the plane is being built. In other words, when it attaches the fuselage and the wings, it might realize 50% of the value of the plane in its revenue line. And 70% when the wheels are on, and so on. This method of revenue recognition also has an enormous amount of gray area and is extremely subjective. The point is that you should always take with a grain of salt revenue projections from companies that recognize sales on a percentage-of-completion basis.
The good news is that there are ways to uncover potential problems and trickery before the rest of the world becomes aware of their existence. A good investor is like a detective. Start by taking a good, long look at each of the three major financial statements -- the income statement, the balance sheet, and the cash flow statement. Then:
- Check to see if the company's cash reserves are dwindling rapidly. This could indicate a solvency issue, particularly if the company doesn't have access to outside capital. And be particularly aware if cash flow starts to decline. This is a sign that the company is bleeding capital, whether it be from its investments, financing agreements or actual operations.
Check to see that growth in receivables and inventories are in line with sales growth. If inventories are piling up at a rapid rate, it may be a sign the company is sitting on a bunch of obsolete merchandise.
Also, take a look to see if the number of shares changes dramatically from one quarter to the next. If a company continues to issue new shares, it may indicate that it is running out of money, or that it's lining its officers' pockets with a bigger and bigger equity stake.
In short, most companies are on the up and up. And most auditors will not sign off on any trickery that subverts rules of generally accepted accounting principles. But unfortunately, these gimmicks are still being used every day by countless public companies. So it's up to you to know what to watch for.
As originally published, this story contained an error. Please see
Corrections and Clarifications.
In keeping with TSC's editorial policy, Glenn Curtis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Curtis welcomes your feedback and invites you to send it to