Management discretion can be a problem, a necessary but uncertainty-inducing element of financial statements and other corporate reporting.
In previous sections of chapter five of "Strategic Value Investing: Practical Techniques of Leading Value Investors," the authors took a value investor’s perspective on income statements, cash flow statements, balance sheets, ratios and integrated ratios.
Next, they turned to the accounting games some companies play when reporting on their performance or financial positions. As authors Stephen Horan, Robert R. Johnson and Thomas Robinson reported, “The amount of discretion that management has in how results are actually reported can have a significant impact on an evaluation of a company’s performance and financial position.”
There are accounting standards, of course, including the International Financial Reporting Standards and the U.S. Generally Accepted Accounting Standards. Still, accounting cannot avoid estimates and assumptions.
The authors offered the example of a company that buys a machine for its factory for $500,000 and assumes it will last five years under normal use (one shift per day, five days per week). In that scenario, the machine’s value would decrease $100,000 per year for five years. But the manager making the call might also argue the machine will last 10 years, for good or bad reasons.
Why do companies allow this kind of discretion? Because different companies (or even different factories in the same company) might use this type of machine differently. One might use it on two shifts, six days a week, while another only uses it only occasionally. They noted, “Discretion exists for management to choose assumptions that match its particular circumstances.”
With that in mind, the book lists several areas where we may find warning signs. They don’t necessarily indicate fraud or manipulation, but should be red flags for investors.
Aggressive revenue recognition
- The days sales ratio is increasing because accounts receivable is growing faster than sales. Has the company been recording revenues before they are earned, or has it relaxed its credit policies?
- Persistently negative operating cash flow, despite positive and growing net income. This might be expected with new companies, but among those that are more mature, “operating cash flow should catch up with net income.”
- Revenues are created by revaluing assets, rather than through sales.
Understating expenses
- The company uses longer depreciation and amortization periods than its peers. The authors wrote, “More aggressive accounting treatment than industry norms may be signals of potential problems.”
- Expenses are deferred to future periods. Look in the footnotes to find out why this is happening.
- Inventory is growing faster than revenues, as shown in the days inventory ratio. Is the company having trouble selling its inventory?
Overstating its financial position
- Enron was the poster child for this sort of manipulation because it used assets that were not recorded on the balance sheet—and had related obligations. The authors wrote, “By using special purpose entities, a company can keep assets and liabilities off the balance sheet and make its return on assets and debt ratios look discernibly better.”
Related party transactions
- Are there transactions involving management or family members? The authors wrote, “These transactions should be disclosed in the proxy statement. You should evaluate whether they are benefiting managers at the expense of shareholders.”
That concludes the section on potential accounting games, but the authors went on to recommend investors read every report issued by a company. More and better knowledge helps us spot and avoid dubious accounting practices. Reports worth reading include:
- Proxy statements.
- Prospectuses for new issues.
- Quarterly reports.
- Earnings releases.
- Securites and Exchange Commission filings.
Another excellent source of information is analyst conference calls (sometimes transcripts of these calls also are available). In these sessions, professional analysts “grill” management on the company’s performance. In addition to providing good information, they will also let you hear or see how open senior officers are in dealing with hard questions.
The proxy statement and other SEC filings will contain information about senior officers and how they are compensated (including pay and potential option grants). Does the management incentive system align with your interests as a shareholder? In particular, do the managers have what’s called “skin in the game,” which means they own a significant number of shares in the company and not just stock options?
Management information will be most helpful when analyzing a new company or when a new team takes over at an existing company. If it’s a new team or new company, check to see what happened at the companies they just left and what the individuals did at those companies.
Turning to stock options, the authors observed, “Stock options are also good, but to a limit: In the extreme, excessive stock options which do not cost management anything can encourage excessive risk taking.”
Conclusion
In this section of chapter five, the authors warned investors not to take everything they read in the financial statements at face value. Of necessity, management must have discretion about its estimates and assumptions, opening an opportunity for bad actors to take advantage of shareholders.
Being aware of these possibilities is the first line of defense; the second is to learn as much as possible about the companies and the executives who run them.
The authors wrapped up the full chapter with these words:
“Making a strategic value investment means buying good companies at good prices. A thorough understanding of the company’s past performance and current financial condition is necessary in order to determine if it is a good company. Analyzing the financial statements and related information will also help you understand what is beneath the surface—the main drivers of the company’s performance.”
Read more here:
- Ă‚ Strategic Value Investing: Company Analysis, Part 4
- Strategic Value Investing: Company Analysis, Part 3
- Strategic Value Investing: Company Analysis, Part 2
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