Earnings management and outright fraud are big concerns for investors (ask former Enron shareholders, who watched revenues grow 10 fold to over $100 billion in four short years, only to lost everything in a few weeks in 2001). Usually, the blame falls on the shoulders of management, who wields the power and desire to misrepresent the economic reality (through a variety of methods) in order to cash in on stock options and other compensation/bonuses tied to stock performance. However, it would be a grave miscalculation to assume that the CEO and the CFO are the only culprits; we are dependent upon the board of directors and auditors to verify management's accountability.
The structure of the corporation can tell you a lot, and potentially serve as a warning for an unwieldy management team with few checks and balances to monitor executive behavior. Here are three areas for investors to analyze outside of the four financial statements for potential red flags:
THE BOARD OF DIRECTORS
The board of directors should be comprised of outside and independent directors, meaning that family members, suppliers, and football players (O.J. Simpson used to be on the audit committee for a publicly traded company) should get the axe. When a company finds itself in trouble, you need someone who will understand the dilemma and stand up to say something, not sit back and pray it gets fixed because they are scared of damaging their relationship with the CEO. Great examples of inappropriate board members are former Citigroup (NYSE:C) CEO Sandy Weill and former ATT (NYSE:T) CEO Michael Armstrong, who both served on each other's board of directors during their tenures at their respective companies. During this time, Mr. Weill had an analyst "take another look at ATT" to boost a bum rating, which was followed by investment banking business with Citigroup for ATT (and eventually by $400 million in fines from regulators for Citi). Directors need to be able to say what needs to be heard, without fear of adverse consequences to their outside interests; they are elected to represent shareholders, and shouldn't have any connection to the company that may hamper their ability to do so.
For those of us without an accounting background, we can't reasonably expect to discover discrepancies in financial reporting like auditors, who have a thorough understanding of their practice; as such, we are dependent upon their opinion to some extent. A 1984 Supreme Court decision (U.S. v. Arthur Young) stated that the auditor's ultimate purpose is to "a corporation's creditor and stockholders," unfortunately, we aren't cutting the checks, and must remain vigilant of the auditor's ultimate incentive: profit from the hands of the corporation. In James Montier's "Value Investing: Tools and Techniques for Intelligent Investment", he discusses the self-serving bias, and how auditors incentives affect their conclusions on any given situation. In the study, 139 professional auditors were given five cases to examine, all of which were independent of each other. Half of the participants were told they were working for the company, while the other half were told that they represented an outside investor; in the end, those that were working for the company were 31% more likely to allow various accounting decisions (described as "dubious") than those who were representing the outside investor. This certainly shouldn't be surprising; it is the same exact agency problem that we see with credit rating agencies and the investment bank situation discussed above. The question for the individual investor is what should we do about it? One red flag to look for are changes in the auditor; Rite Aid (NYSE:RAD) and Adelphia Communications, both of which had accounting issues in the late 1990's, saw auditor changes (RAD's auditors resigned, while Adelphia fired their auditors) which should have concerned investors. Like most accounting red flags, this can only be identified by looking over multiple annual reports.
Accounting standards are reactive to new issues, not proactive. As an investor, it is important to see how accounting standards (or the lack their of) may misrepresent the economic reality for the company in question. A great example is expensing stock options, which was vehemently fought against by corporate America (especially tech start-ups). When the FASB was shot down in 1993, that didn't change the economic reality: stock options are a real expense, and dilutive to your ownership interest. This idea expands to footnotes as well, where companies might try to bury pertinent information (the infamous footnote 16 is how Jim Chanos first spotted Enron and profited from its collapse). It is important to maintain an understanding of accounting standards that affect your investments, and to interpret accounting changes that the company reports in their SEC filings; these changes and their implementation can provide telling information about the accounting practices of the company.
Spotting aggressive accounting is easier said than done for most individual investors. Fortunately, there are thousands of stocks in the markets around the world, and we don't need to understand or invest in all of them; simply avoiding stocks that don't pass the requirements as identified in these three categories would be an intelligent strategy for investors looking to avoid potential accounting fraud.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.