After writing yesterday’s issue on the Enron Saga, I realized it might be helpful if I shared some of the red flags that can alert investors to corporate fraud. So I’ve put together a list of ten different possible pitfalls – what they mean, and how to spot them. Armed with this list, you’ll be much better prepared to pick the right investments.

It’s important to do your own due diligence on your investments – because ultimately, only you are responsible for your success or failure. And I know today’s issue is a little long – but I urge you to read it all the way to the end. It just might save you a bundle by helping you avoid losses down the road.

The good news is that you don’t need an advanced accounting degree to master some of the basics of financial analysis. It is very productive to (1) know how manipulation takes place, (2) identify the trends showing that something manipulative is going on, and (3) understand the questions to ask.

Ten important red flags to watch out for:

1. Unusual accounts receivables growth. If accounts receivables grow at a faster pace than the company’s sales, it can indicate that the company is making bad sales to companies unable or unwilling to pay, which could result in bad debt down the road. It may also indicate that the company is booking revenues before the proper time, which is one of the most common practices within the universe of manipulation. Future sales are simply recognized early, inflating earnings. The tell-tale sign, of course, is accounts receivable growth in excess of reported revenue levels. Studying the dollar amounts is not adequate to spot this. Instead, compare the rate of growth in year-to-year revenues and receivables.

2. Unusual deferrals on the balance sheet. If you spot an item under the assets section called “prepaid assets” or “deferred assets,” take a closer look. This could be a sign that the company has created artificial revenues with a simple journal entry: crediting revenues and setting up a prepaid or deferred asset. An explanation could justify this, but it has to make sense. For example, an entry could be justified with this explanation: “Setting up revenues under contract with a major customer as earned in the current year but scheduled to be paid over a five-year period per contract.” As long as this explanation can be documented, it should be accepted. However, to represent earned income in the current year, there must be a delivery of the goods or services in the current year. Also look for more dubious explanations, remembering that if it doesn’t make sense, it is probably not for real. For example, “Setting up deferral in anticipation of current-period earnings not yet booked and long-term in nature, pending completion of international provision agreement with subsidiaries and with major customers.” What does this mean? The company has made no effort to prove that these revenues are for real, so they probably are not. Booking current year revenues for long-term deferral occurs, but it is unusual.

3. Falsifying actual revenue earned. The previous kinds of revenue reporting are often based on actual revenue to be earned in the future. It manipulates the facts by showing the revenue before it is actually earned. However, another kind of manipulation involves simply making up revenue and reporting it. For example, a company may receive loan proceeds and, instead of reporting these proceeds as a liability, set it up as cash revenue. A similar problem arises when a company sells investments and instead of reporting net investment income, the full value of the sale is reported as current income. For example, in 1989, Cineplex Odeon reported revenue from selling off a production company. This transformed what would have been a $14.5 million loss for the year into a $48 million reported net income. Treating the sale as revenue was deceptive because it was actually a nonrecurring capital gain. The reported sale distorted the true picture and violated the accounting standards for this kind of transaction.

4. Capitalizing current year expenses. Another favorite way to manipulate earnings is by capitalizing some current year expenses. This sets up a prepaid or deferred asset instead of reporting the expense itself, boosting current year earnings. The idea is to write off these prepaid expenses over several years, but once a company starts artificially increasing net earnings, it tends to only get worse over time. It is not normal to set up expenses and amortize them over many years; some exceptions include payment of a three-year insurance premium and amortizing it over the following 36 months, and similar, easily explained cases. But when the prepaid amount is quite high and remains unexplained or explained poorly, it could be a form of manipulation.

5. Sugar bowling. This is the practice of deferring some revenue until future years. When a company has an unusually successful year, it may “sugar bowl” some of those earnings to offset lower results in the future. This is also called “cookie jar” accounting, and as cute as it sounds, it remains a form of manipulation. The fact that the adjustment sets up a reserve to be used in the future is seen by some as a more benign form of manipulation. But remember, if a company thinks it is acceptable to underreport revenues this year, it can use the same rationale to over-report revenues in the future. You deserve accurate reports, whether exceptionally optimistic or pessimistic; that is the only way you can truly judge a company.

6. Reporting expenses early. Just as higher-than-expected revenue can be sugar bowled to be used later, the same problem occurs when a company reports current year expenses in advance. And not only is the result the same, but the net income ratio also stays the same because both revenue and expenses are raised. A skilled CFO can make this happen and control the trend, at least for one or two years. The giveaway is found in the liability section as a “special charge” booked in the current year. So the journal entry increases expenses and sets up the special charge. When you see this odd credit next to liabilities and in the same year, both revenue and expense levels have grown considerably (but net profit percentage remains the same), it could mean that expenses have been booked early.

7. Off-balance sheet subsidiaries. This is a particularly troubling type of manipulation because it is difficult to find. Because a subsidiary is set up off the balance sheet, it may be completely undisclosed or left to the fine print of the footnotes. Off-balance sheet subsidiaries can be used for all kinds of manipulation, and this technique was one of the favorite creative accounting methods used by Enron. For example, a company can loan money to its subsidiary and, without exchanging any funds, set up the obligation through journal entries. Then annual journal entries are made each year to report interest income by the parent company. Even though no cash has exchanged funds, this boosts net income through a series of sham transactions. A similar use of off-balance sheet subsidiaries is to assign some portion of current expenses to the subsidiary, which reports a large net loss. Meanwhile, the parent company can control the level of net earnings reported. It is completely false and misleading, but the results look spectacular.

8. Converting reserves into income. Companies set up reserves for many reasons. These include reserves for bad debts, which reduces the current asset value of accounts receivable, and reserves for absorption of merger and acquisition profit or loss. Companies carrying large credit-balance reserves can manipulate current year outcome by simply reclassifying all or part of the reserve balance to income. Explanations may be full of double-talk. For example: “Release of a portion of the deferred credit related to acquisition from the past period, to reflect accelerated marketing activity and to more accurately estimate the timing and recapture rate of the company’s investment.” Huh? Accounting explanations like these are popular, especially when manipulation has taken place.

9. Extending the rate of write-offs to a longer time period. Companies set up assets and amortize or depreciate them over a period of years. The intended purpose is to accurately report expenses or costs in the proper year. For example, a capital asset with a recovery period of 15 years is depreciated over 15 years, and if a company acquires another and agrees to a covenant not to compete, that asset (although intangible) may have a specified number of years of value. If a merger specifies this and the company agrees to the covenant for a five-year period, its assigned value may be set up as an asset and written off over five years. But net earnings are raised if and when the company decides to amortize an intangible asset over 10 years instead of over five. This is difficult to spot, because even the footnotes might not disclose the change. But watching the trend in amortization, you can spot the change and then start to ask questions.

10. Odd changes in accounting policies. Finally, companies can adjust reported net earnings simply by changing accounting policies. These tend to be quite complex and difficult to understand, but the details are going to be found in the footnotes. For example, a company may change the way it values inventory, which in turn could have a big effect on calculation of the cost of goods sold and gross profit. If you see a sudden big change in gross profit, that is your red flag. But companies can also adopt different methods for recognizing revenues, meaning that they may book more income earlier (as long as this is rationalized in an accounting opinion somewhere in GAAP).

The key to finding manipulation is analysis. Here are some good starting points:

1. Always study the trend. Eventually, all forms of manipulation are going to show up in an odd adjustment in the long-term trend, on the balance sheet, the income statement, or both.

2. If it doesn’t make sense, ask questions. Call or e-mail a company’s investor relations department and ask specific questions regarding footnotes, trends, or dubious changes in the financial statements.

3. If explanations don’t make sense, stay away. None of this is so complicated that it cannot be explained in non-accounting terms. Obfuscation is one of the unavoidable symptoms of manipulation. In other words, if an investor relations representative seems like they’re tap-dancing around the truth, then you have every reason to avoid the stock.

The Bottom Line

Stock prices over the long term move in the same direction as financial performance.

The best performing stocks are those whose sales and income grow year after year.

Companies with great stories and prospects may appear compelling, but unless the company delivers sales and profits, the long-term prospects for the stock will be poor.

Companies’ financial reporting might be manipulated to show improved short-term performance.

It is important to review key financial metrics including revenues, earnings, cash flow from operations, and profit margin trends.

All listed companies report on an accrual accounting basis. This makes each period’s reported sales, costs, earnings, and net income accurate, but it also invites manipulation.

Overstated revenue, changes in inventory valuation or capitalizing of general expenses are several ways companies can manipulate results.

Watch cash flow by tracking both the current ratio and the debt ratio. If the current ratio is artificially maintained by transferring higher borrowings into current asset accounts, that is a red flag.