Waving a Warning Flag on the Proposed CIT IPO - TheStreet

Recently,

I outlined how companies use accounting tricks when acquiring other companies by "priming the pump for future, overstated earnings."

Enough of generic descriptions of accounting games, though. I'll highlight three of the red flags that I look for when reviewing the financials of companies involved in acquisitions, using a real-life example:

CIT Group

(proposed symbol CIT:NYSE), a subsidiary of

Tyco

(TYC)

, coming to you Monday as a very large, very important $5 billion IPO.

Here's what I look for in the financials of companies involved in acquisitions:

Red Flag No. 1: Expense-Packing

In the preacquisition phase, inscrutable acquirers will pack as much expense as possible onto the acquired company's books. This provides a nice lift to earnings immediately after the acquisition. Per the 10-Qs, CIT's income early last year, for the five months immediately before the acquisition by Tyco, was $81 million. For the four months immediately after the acquisition, that number was $252 million.

Red Flag No. 2: Balance Sheet Earnings

This issue is a bit esoteric and hard to explain, but I'll give it a shot: Writedowns taken before an acquisition act as "reserves" and can be turned on, at management's discretion, to pump earnings in future periods. These reserves are typically housed on the balance sheet under "other accrued liabilities and payables."

Look for sizable declines in this category as an indication that the company is producing earnings off the balance sheet. (Adjusting an accrued liability lower equals income.) At CIT, accrued liabilities fell dramatically, per governmental filings, by $713 million for the first 10 months after it was acquired by Tyco (from June 2, 2001, to March 31, 2002).

Find out more about this flag -- and another one -- by clicking here for a free trial to RealMoney. Will CIT be a success? Once you sign up, you can learn Arne's conclusions here -- as well as access all of our premium content.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to

arne@alsincapital.com.

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