Aggressive Accounting: Bad for Company Health

1
Aggressive Accounting Bad for Company Health?

• Article by David W. Tice, CFA
• Presented by Charlsie Estess
• October 2, 2007

2
Tices Caution to Analysts

• Aggressive corporate accounting practices cause a
  deterioration in the quality of reported
  earnings.
• To avoid pitfalls associated associated with
  such, analysts should identify warning signs such
  as financial confusion, aggressive revenue
  recognition, growth through acquisitions, cutting
  discretionary expenses, and accounting problems.
• Analysts Resist misconceptions about evaluating
  companies and take a skeptical approach to
  interpreting contained in or omitted from
  earnings reports and financial statements.

3
What to Look For

• EPS versus Sales Growth Is EPS growth matched
  by sales growth?
• Gross Margin versus EPS Is gross margin growth
  increasing at the same rate as EPS?
• Cash flows versus EPS Identify cash flow
  changes relative to what is happening with EPS
  growth.
• Charge-offs Evaluate how frequently and for
  what reasons charge-offs occur.

4
What to look for

• Return on Capital Is the company earning a
  reasonable return on invested capital?
• Flexibility of GAAP Do financial statement
  footnotes suggest that accounting matches
  economic common sense?
• Extrapolation of Trends Assess the current
  environment and determine how likely it is to
  affect the company.
• Contrarian Thinking Analysts are encouraged to
  challenge optimistic assumptions of management
  and bankers.

5
Sources of Trouble

• Financial Confusion frequent acquisitions and
  charge-offs disguise unsustainable growth rates.
  Seek to find sustainable EPS growth.
• Aggressive Revenue Recognition, such as deferred
  revenue, nearly always foreshadows problems.
• Unsustainable Growth through Acquisitions often
  leads to consolidation difficulties, unmanageable
  debt levels, lower returns on capital, and
  write-offs.

6
Sources of Trouble

• Cutting Discretionary Expenditures may improve
  earnings in the short term, but these actions
  could weaken future earnings performance.
• Specific Accounting Problems Some accounting
  practices allow for the distortion of economic
  reality.
• Wall Street Misconceptions look beyond Wall
  Streets individual company bull premise to
  financial statements.

7
In Summary

• Company managements may use aggressive or even
  misleading accounting practices to tell analysts
  the story they wish to hear. As Arthur Levitt
  warned Too many corporate managers, auditors,
  and analysts are participants in a game of nods
  and winks. The cautious analyst will delve
  beneath these accounting games to find the true
  story of a companys health.