Friday, July 18, 2014

Essential Lessons From Ben Graham

I recently read Joe Carlen's book called "The Einstein of Money", a book on Ben Graham. The book was half bibliographical while the other half tried to explain his investing philosophy. It was a great read and I would recommend the book. 

I found myself looking back at the notes I made when I read The Intelligent Investor after I read Carlen's book. I would like to share some of the notes I made in this post. 

Buffett was absolutely correct in claiming that the book was "by far the best book on investing ever written." The principles advocated by Graham remains relevant today even though the first edition of the book was written in 1949. Buffett's quote in the preface proves this point: "To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What is needed is a sound intelligent framework for making decisions and the ability to keep emotions from corroding that framework." (preface 4th edition revised, Graham 2003) Hence successful investing is about following a disciplined approach and controlling one's own emotion from getting too euphoric when the markets are rising and from getting to pessimistic when markets are falling. Investor may not realize this fact: an investor's worst enemy is himself/herself. Investors should note that no matter how intelligent or diligent they are, they will fall prey to their own emotions, which is often much harder to control and difficult to correct. Graham was correct when he stated, "the investor's chief problem - and even his worst enemy - is likely to be himself. (The fault dear investors is not in our stars - and not in our stocks - but in ourselves." (p.8) 

Buffett said that chapter 8 and 20 were his favorites. I would add chapter 1 to the list. Therefore I hope reader will enjoy my notes for these chapters. 

Chapter 1: Investment versus Speculation 
An investment operation is one which, upon thorough analysis, promises the safety of principal and an adequate return. Operations not meeting these requirements are speculative (p.18)
The quote above is one of Graham's best quote on investing. Many investment operations are essentially speculations because they do not require a thorough analysis of the underlying securities to ensure the safety of principal and an adequate return. Many investors believe the key to make money is to forecast what the stock market, or any other financial market, will do tomorrow. These forecasting approaches, while popular, are not the right method to make money in the long run. Without an examination of the underlying security, any fancy method, such as using complex formulas, that claims to have the ability to generate high returns should be taken with a grain of salt.  

What is "thorough analysis", "safety of principal" and "an adequate return"? Graham defined "thorough analysis" as "the study of facts in the light of established standards of safety and value." This simply implies the detailed study of the underlying security (stock or bond) with a close attention to the risks and facts relating to the intrinsic value of the security. His definition of "safety of principal" is "protection against loss under all normal or reasonably likely conditions or variations." Therefore, investors should ensure that all risks of the investment are analyzed and the price paid for the security is attractive versus potential risks that may result in a permanent loss of capital. Finally, his definition of "an adequate return is "any rate or amount of return, however low, which the investor is willing to accept provided he acts with reasonable intelligence." Thus, investors must make sure their investments can satisfied the minimum required returns in the long run.  

For defensive investors, Graham warned that going after "hot" issues is speculative. Since defensive investors want to achieve a satisfactory result without much effort, they need to keep their investment operation simple. Graham suggestion that they should (1) purchase shares of well-established companies (e.g. S&P500 companies) or well-established funds. He also suggested the use of "dollar cost averaging" in order to limit the number of shares/fund units when prices are high and increase the amount of shares/fund units bought when prices are low. 

For enterprising investors, there are three pitfalls Graham warned against:

  1. Trading in the market: He referred to this activity as "buying stocks when the market has been advancing or selling them after it has turned downwards." In today's terminology, this activity would be called "momentum chasing" or "trend following". Graham concluded that investors' overall of success in trading in the market is very low.
  2. Short-term selectivity: He defined this method as "buying stocks of companies which are reporting or expected to report increased earnings or for which some other favorable development is anticipated." Graham warned this approach is dangerous because (1) the prediction of near-term events could be wrong or (2) the current price may already fully reflect or "discount" good events like upcoming earnings. 
  3. Long-term selectivity: This approach is about picking companies with unusual high growth in the future or picking stocks that are expected to establish a high earnings power later. The biggest problem in this approach is the selection of the right stocks that will do well even if an investor has found the growth industry. 
Graham instead gave the following suggestion for enterprising investors: 
To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising and (2) not popular on Wall Street (p.31) 

My translation: (1) boring, but sound, investment approaches (like value investing) that are ignored because it is boring as watching paint dry (2) must go against the grain

Chapter 8: The Investor's and Market Fluctuations

This is an important chapter to understand and it took me years to understand the content because the principle espoused in this chapter is truly "unconventional" compared other finance theories.

Graham discussed the difference between the pricing and timing techniques. I explained these concepts in my prior post. The former is about trying to figure out the intrinsic value of the underlying business (pricing) and buy/sell dependent on the variance between price and value. The latter point is about timing the market or stock prices in order to profit from those forecasts. As stated above, Graham did not believe in market forecasting or timing because it is very competitive and no one seems to make right forecasts consistently over time. It is almost impossible to do that.

Graham advocated the pricing technique but many investors may not feel comfortable with the approach because of the wrong attitude towards price fluctuations. All investors should read the following paragraph carefully:
Imagine that in some private business you own a small share that cost you $1000. One of your partner, named Mr. Market is a very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise. Only in case you agree with him, or in case you want to trade with him... the rest of the time you will be wiser to form your own ideas of the value of your holdings on full reports from the company about its operations and financial position (p.204-205)
As I stated in my prior post on intelligent investing, investors should transact with Mr. Market only if it is favorable to do so. Most of the time, investors should ignore Mr. Market. He'll just come back with another quote tomorrow and never feel bad when you ignore him. When discussing Graham's Mr.Market analogy, Buffett said: "the market is there to serve you, not to instruct you." Far too often however, investors cannot resist looking at daily quotations and trying to make a few quick bucks by looking at price trends because they believe Mr. Market can give them good instructions. Instead of trying to profit from price fluctuations, investors should keep the following Graham quote in mind:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies. (P.205) 

Chapter 20: Margin of Safety as the Central Concept of Investment 
Confronted with a like challenge to distill the secret of sound investing in three words we venture the motto, MARGIN OF SAFETY (p.512) 
I completely agree with Graham that the margin of safety principle is paramount for successful investing. Buying stocks near intrinsic or underlying value does not allow wiggle room if the appraiser has made a mistake. Therefore, an investor must purchase the stock at much lower prices than the calculated intrinsic value

On the margin of safety principle, Graham explains:
The margin of safety idea becomes much more evident when we apply it to the field of undervalued securities. We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments.... If these [value stocks] are bought on bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results (p.517-518)  

Hence a margin of safety is needed to prevent negative outcomes of the future and  provide a safety cushion if the estimated intrinsic value is correct. The key here is buying dollar bills for 50 cents. 

Graham stated the importance of considering the price paid when assessing the margin of safety for any investment: 
The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price and nonexistent at some still higher price. (p.517) 

The margin of safety principle is also applicable to bonds. A bond must meet the minimum coverage ratios, even in recession years, in order to qualify as an investment. Graham utilize both pre-tax and after-tax earnings coverage ratios, unlike most professionals who prefer using EBITDA coverage ratios. If Graham was still alive today, I don't think he would change his methodology since EBITDA coverage ratios overstate the cash generation capability of the business by not considering capital expenditures.

Conclusion:
Investment is most intelligent when it is most businesslike (p.523) 
While most investors believe the most profitable method of investing is predicting future prices, it is not true. Trying to outsmart countless other geniuses who are trying to do the same will not yield handsome results. Instead, readers should realize that stocks are fractional ownership of businesses and investors should realize that the best results will be realized when they think like business owners. Hence I completely agree with Graham that "investment is most intelligent when it is most businesslike." Buffett also agree with Graham's conclusion and have referenced the same quote in many of his annual letters, including the most recent 2013 letter.

I hope this post was useful to readers. If you haven't read The Intelligent Investor yet, I hope this post has convinced you to at least try reading it.


-----

Appendix (More Quotes from The Intelligent Investor): 


We draw two morals for our readers: (1) obvious prospect for physical growth in a business do not translate into obvious profits for investors (2) the experts do not have dependable ways of selecting and concentrating on the most promising companies in the most promising industries.  (p.7) 
Comment: Be wary of investing in the next "hot" industry. Even if you can guess the industry, picking the winners is extremely hard. Although investors may hear success stories of Facebook, Twitter, Linkedin etc., there must have been over thousands of social media company that failed for each one that succeeded.

We hope to implement in the reader a tendency to measure or quantify. For 99 issues out of 100 we could say that at some price they are cheap enough to buy and at some other price they would be so dear that they should be sold. The habit of relating what is paid to what is offered is an invaluable trait in investment (p.8) 
 Comment: The attractiveness of a stock is always dependent on the current price. At some price, it is cheap enough to buy and at some other price, it is so expensive it should be sold.

Buying a neglected and therefore undervalued issue for profit generally proves a protracted and patience-trying experience.And selling short a too popular and therefore overvalued issue is apt to be a test not only of one's courage and stamina but also the depth of one's pocketbook. (p.32)
Comment:  Buying undervalued securities requires a boatload of patience. Shorting overvalued stocks not only requires patience but also it requires a large amount of capital. Investors often forget the latter point and lose money shorting stocks that eventually collapsed.

Nearly all bull market had a number of well-defined characteristics in common, such as (1) a historical high price level (2) high price/earnings ratios (3) low dividend yields against bond yields (4) much speculations on margin (5) many offering of new common-stock issues of poor quality (p.193)
Comment:  Goods indicators Graham wrote on identifying overvalued markets. Intelligent investors do not try to time the market top or bottom. Nonetheless, if the market is overvalued, they should reduce current positions and raise cash levels.

A stock does not become a sound investment merely because it can be bought close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficient financial position and the prospect that its earnings will at least be maintained over the years (p.200) 
Comment:  I believe many readers of the book overlooked the quote above and confused Graham's purchase of net-nets with his idea of buying a good business. In addition to selling near tangible asset value (tangible book), the companies under consideration should be selling at a low price in relation to its future earnings power, have a healthy balance sheet (low debt) and the earnings should remain stable.

The development of the stock market in recent decades has made the typical investor more dependent on the course of price quotations and less free than formerly to consider as a business owner (p.198)  
 Comment:  I believe this quote is more applicable to investors now than in 1972 when Graham wrote the 4th edition of the book. With the increased use of smartphones, investors have the convenience of checking prices no matter where they are. While technology has enriched our lives, I believe technology has also transformed many investors into speculators.

 The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding securities at suitable prices (p.205)
Comment:  Graham identifies the correct and incorrect method of thinking about market fluctuations.

Saturday, July 12, 2014

Kenny's Track Record of Value Investing (3-Years)

I began an investment account to practice my stock picking skills in August 2011. It has been an amazing experience and I learned a lot on the way. I fully understand why most successful investor say that experience is the most important asset to a money manager.

I have followed the markets since 2005 and picked stocks through the investopedia simulation. I also traded on my parent's account since 2006 but decided a long term investment approach is needed to build wealth. While trading can be profitable in the short-run (mostly due to good luck), it is not the right approach to consistently build long term wealth. That is why I decided to focus on value investing and to prove it is the best approach using my own hard earned money.

The reason I'm posting my track record is I want prove a point: value investing works if practiced correctly. What I mean correctly is that the investor should follow all principles stated in Graham's books, The Intelligent Investor and Security Analysis, very closely. Don't try fancy formulas, leverage or chase a quick return. Therefore, if you haven't read those books, I highly recommend them as summer reading! Lots of investor claim they read them but I doubt those claims. Several re-reads are needed to fully comprehend the knowledge presented in those books. For the record, I read The Intelligent Investor 5 times (1973 edition 3 times and 1949 edition 2 times) and Security Analysis (1940 and 1951 editions) twice. I plan to re-read them again.

Kenny's 3-year Return (Time Weighted Total Returns, the method advocated by GIPS) 


Some Items To Note:

  • Three year annualized return of 17.1% vs. 7.1% for TSX on a total return basis. Total 3 year return of 60.6% vs. 23% delivered by the TSX.
  • I used no fancy strategies, just plain old value investing (Graham/Buffett style).
  • No leverage to juice returns, no options or shorting. No micro-caps or small-caps because I wanted to operated in the mid/large cap universe (my circle of competence) 
  • Unlike most managers, I'm extremely concentrated. On average, I owned only 3 stocks most of the time (currently hold 3 as well). This is not ideal for a professional manager but I'll still own a very small number of stocks, say 10-20 stocks, if I manage other people's money. 
  • My monthly returns are sometimes volatile especially when I build a position (i.e. BBRY) on the way down. This is problem facing all value investors but eventually patience will pay off. 
  • I'm extremely patient, especially for a 22 year old investor! I held one stock since I bought it in September 2011. My shortest holding period, among the 8 stocks I held, is 6 months. 
One message I want to deliver, value investing works! 

Thursday, May 15, 2014

Financial Shenanigans: A Deep Look At The Tricks Company Can Play With Its Accounting


The following is a talk I will present to a introductory financial accounting class. This piece is dedicated to Ms. Hopwood-Jones. 

The source for this discussion comes from a book titled "Financial Shenanigans" by Howard M. Schilit. The discussion is aimed at explaining accounting tricks public companies use to inflate their financial numbers in order to meet the expectation of analysts. Management of public companies are often pressured by analysts and investors to "make the numbers" every quarter. Therefore, some may cheat to meet a net income target for a certain quarter. A little cheating during one quarter can snowball into a lot of cheating (i.e. Enron is a famous example). How does these corporate executives cook the books? One may think they are rocket scientists but with a little accounting knowledge you learned from Ms. Hopwood-Jones's class, you too can detect accounting frauds.

Earnings[1] (Income Statement) Manipulations:
Investors often scrutinize a public company's quarterly earnings report very carefully. They often cheer when a company can meet or beat the consensus earnings (net income) estimate. If a company failed to meet the consensus estimate, the share price often declines.  How do corporate executives create "fake" earnings? They often just play around with the fundamental income statement equation as listed below.

Revenue - Expenses = Net Income

Since net income is calculated by subtracting expenses from revenue, corporate management can manipulate net income by inflating revenues or making expenses disappear.

Trick #1: Recording Revenue Too Soon

A common trick is to record revenue early before it is actually earned. In accounting, the revenue recognition rule is used to determine if revenue is actually earned (see table 1 below for more details). 

A common trick is to recognize revenues that belong to a future accounting period. For example, if company A is a magazine publisher that collected $100 for a 4-year subscription fee from a customer, how much revenue can the company recognize in year 1? The answer is only $25 because the other $75 should go into "unearned/deferred revenue" (a liability account) since the $75 does not meet the GAAP revenue recognition rule. Nonetheless, corporate executives often trick their auditors by using fancy wording to convince auditors that these 4-year subscriptions are actually 1 year subscriptions.  Therefore, it is vital for investors to read the footnotes to financial statements. Read the footnotes carefully!

One interesting method to boost revenue is by billing the customer for work not completed yet. In the real world, most transactions are not black and white as you see in accounting textbooks and revenue is often recognized over several accounting periods (construction industry is the common example). Since revenue is a credit account, they need a debit account to balance the books. Since customers generally don't pay cash unless the required work is completed, a common account to debit is account receivables. Therefore, be wary of any abnormal increases in accounts receivables or any receivable accounts. Also, if the accounts receivable turnover ratio (revenue/accounts receivables) starts to slow while revenues are still growing, it is a red flag and the company is probably inflating revenue by borrowing future revenue.

Table 1: Revenue Recognition under IFRS and US GAAP[2]
IFRS Revenue Recognition Criteria
US GAAP Revenue Recognition Criteria
(1) The amount of revenue can be measured reliably
(1) There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end
(2)  It is probable that the economic benefits associated with the transaction will flow to the entity
(2) The product has been delivered or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risk and rewards have not actually passed to the buyer
(3)  The stage of completion of transaction at the balance sheet date can be measured reliably
(3) The price is determined or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency
(4)  The costs incurred for the transaction and the costs to complete the transaction can be measured reliably
(4) The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay
Source: IASB and FASB

As shown in table 1, a company cannot recognize revenue unless the risk and rewards (economic benefits) is transferred from the seller to the buyer. A trick used in the 1990s by Sunbeam is to use a technique called "bill and hold." In essence, Sunbeam bills the customers and recognizes revenue despite the products were held in Sunbeam's warehouses. Although this trick is difficult to detect, a closer look at the revenue recognition footnote can discover aggressive revenue recognition. Below is the paragraph disclosed in Sunbeam's annual report:

"In limited circumstances, at the customers' request the company may sell seasonal products on a bill-and-hold basis provided that goods are completed, packaged and ready for shipment, such goods are segregated and the risks of ownership and legal title have been passed to the customer." 
With the grills sitting at Sunbeam's warehouses, there is no doubt that the economic benefits have not been passed onto the buyers despite Sunbeam tried using the words "risk of ownership and legal title have been passed to the customer." Also, customers often do not request goods on a bill-and-hold basis. Always be suspicious when the words "bill-and-hold" comes up in the financial footnotes.

Finally, another trick is to inflate revenues is to extend generous terms to buyers despite low creditworthiness, which fails criteria (4) listed in table 1 since the probability of collection is low. An acceleration of revenue along with growth in accounts or note receivable is a red flag. Although not all red flags imply revenue manipulation, investors should be careful when these red flag appear. If the company is showing abnormal growth in accounts or note receivable while also disclosing that it is extending credit to customers with generous terms, watch out!

Trick # 2: Boosting Income Using One Time Items
One-time items, also known as "extraordinary items", are often used to boost net income. By definition one-time items should occur infrequently such as gain/loss from sale of equipment[3] or damage incurred from a natural disaster.
Corporate management often tell investors to ignore one-time items because they do not reflect the continuous business operations.  They tell investors to focus on normalized income, which is often called "operating income." You will often see a corporate income statement organized as follows:

Table 2: Sample Corporate Income Statement[4]
Revenue
XXX
     COGS
XXX
Gross Profit
XXX


Operating Expenses
XXX
Operating Income
XXX
     One-time Items
XXX
Earnings Before Tax
XXX
     Income Tax Expense
XXX
Net Income
XXX

Investors do pay more attention to operating income than the net income number. Therefore, management has the opportunity to inflate operating income by shifting positive benefits from one-time items above the operating income line and shifting normal expenses below the operating line. The former outcome can be achieved by shifting a gain from the sale of an asset above the operating income line as reduction to operating expenses. For example in 1999, IBM sold a business to AT&T but instead of disclosing the gain on the sale in the one-time items line on the income statement, IBM decided to book the $4.06 billion gain on sale as a contra expense. The effect of IBM's accounting decision significantly reduced operating expense by $4.06 billion (reducing the $18.8 billion operating expenses to only $14.7 billion!). Investors thought IBM found a magic way to reduce operating expenses and decided to give a higher valuation[5] for the stock only to find out later that those expense reductions didn't continue into future periods. Savvy investors reading the financial footnote would have noticed this trick because the company, by law, had to disclose how the sale of a business is accounted for. Companies often bury these unwanted disclosures deep in the footnotes since they know most investors never bother to read 100 pages of financial footnotes. However, it pays to goes through the footnotes of financial statements!

Another genius method is to create a continuous stream of income from the sale of an asset. Because income from a one-time sale is less impressive than a continuous stream of income, corporate management will aim to create a continuous stream of income from the sale of an asset. Let's use the traditional debits and credits to explain this trick. Assuming an asset owned by company I is valued at $1,000,000 (fair-value). Instead of selling it at $1,000,000, company I sells the asset to company M at only $800,000. However, company I requires company M to pay for future products at above market prices to make up for the $200,000 difference. Table 3 shows the correct way to account for this transaction while table 4 shows the inflated approach.

Table 3: Correct way to account the transaction by company I

Cash
$800,000

Receivable (from Company M)
$200,000

            Asset Sold (Book Value)[6]

$700,000
            Gain on Sale of Asset

$300,000

When the inflated prices are paid by company M in the future, the following should occur:
Cash
$200,000

            Receivable (from Company M)

$200,000

Table 4: How to Create A Revenue Stream From One-Time Sale
Cash
$800,000

            Asset Sold (Book Value)

$700,000
            Gain on Sale of Asset

$100,000

When the inflated prices are paid by company M in the future, company I records:
Cash
$200,000

            Revenue

$200,000

Magically, company I created $200,000 of revenue that should have been recorded as a gain on sale from a prior accounting period. To create a continuous revenue stream, the company could have recognized the $200,000 more slowly, such as $20,000 for 10 reporting periods.  

This example is actually real. Company I was Intel and company M was Marvell Technology and this transaction took place back in November 2006.  Again, the only way to have detected this fraud was to look in the footnotes when Marvell disclosed that it will pay above market prices for Intel's products in future periods. When analyzing any transaction, always try to understand the underlying economics and consider which accounts are affected. It's critical for investors to understand their debits and credits.

Trick #3: Shifting Current Expenses to a Later Period

Two examples will be illustrated for this trick. The first example is capitalizing expenses. In order to understand the nature of this action, let's review the fundamental accounting equation:

Assets = Liabilities + Shareholder's Equity[7]   (1)

Now we can expand equation (1) above by expanding the Shareholder's Equity section as follows:

Assets = Liabilities + Beginning Shareholder's Equity + Revenue - Expense (2)[8]

In order to decrease expenses, the asset side must increase in order for equation (2) to remain in balance. How can a company increase assets to reduce expenses? Let's step back and revisit the accounting rules for a fixed asset. When a fixed asset is purchased, is the entire amount expensed on the income statement? The answer is obviously "no" since that action would distort the trend in net income by having years with high net income when there are no purchases of fixed assets and years with low net income when there are purchases of fixed assets. Accounting rule states that a fixed assets must be capitalized (put on the balance sheet) and the cost of the asset is allocated, by reporting costs in the income statement, over its useful life. However, only assets that provide economic benefits for more than one accounting period can be capitalized. Normal operating expenses should be expensed on the income statement. Nonetheless, managers who wish to reduce expenses will often capitalize normal operating expenses in order to boost net income.

Let's use debits and credits to explain this trick. To account for $1 million of normal operating expenses, the following should be recorded:

Operating Expense
$1,000,000

            Cash/Accounts Payable

$1,000,000

To defer a portion of the $1 million expense, consider what happens if the $1 million is capitalized and recognized over 2 accounting period instead of 1.

Fixed Asset
$1,000,000

            Cash/Accounts Payable

$1,000,000

Depreciation Expense 
$500,000

            Accumulated Depreciation

$500,000

By recognizing the $1 million expense over 2 periods, net income is overstated in the 1st period by $500,000. Because the effect reverses in the 2nd period, a company that capitalize expenses is often forced to repeat the trick over and over again until it goes bust. This was the case with WorldCom in 2002.

Capitalizing expenses is a simple trick, but shrewd investors can detect this fraud by looking at the balance sheet instead of focusing exclusively on the income statement. If any fixed asset is growing out of control and there is no good explanation in the footnotes, management is probably capitalizing normal operating expenses. For those grade 12 students who understand the cash flow statement, another method to detect this fraud is look at free cash flow, which is defined as cash flow from operations minus purchases of fixed assets, a line located in the cash flow from investing section. If free cash flow declines rapidly, it is a red flag. 
Another method to defer expense is to recognize them more slowly. Recall that depreciation/amortization expense should be recognized by an amount equaling to [(cost-salvage)/useful life]  if the straight line method is used. The useful life number is often an estimate and accounting rules allow management to use its best estimate as a proxy. Therefore, management can record a lower expense by simply assuming a longer useful life of its asset. The only way to detect this fraud is to compare the useful life (estimated by cost/annual depreciation expense) one company compared to the industry average. If the assumed useful life of a particular asset is significantly higher than the industry average, the company is probably making an aggressive assumption regarding the useful life of its assets.

Trick #4: Hiding Expenses 
Similar to how a magician makes a rabbit disappear, corporate management often employ tricks to make expenses disappear. The most simple trick to hide expenses is simply failing to record accrued expenses. Let's apply what you learned in Ms. Hopwood-Jones class on accrued expenses in the following example: company X repaired a machine for company Y and bills company Y for $100. If company Y does not pay in the current accounting period, an accrued expenses must be recorded in Y's books.

Maintenance Expense
$100

            Accounts Payable 

$100

However, to avoid the recognition of an expense, company Y simply ignores this adjusting entry, which would boost income (by reducing expenses) for the current accounting period. Although outside investors cannot detect this fraud without looking at the internal books, the expense recognition footnote may provide clues about aggressive accounting for expenses.

Another method to hide expenses is making aggressive assumption on "soft expenses" like warranty expenses. Soft expenses often require the significant use of management's judgement in determining the amount booked in the financials. Let's illustrate with an example of warranty expense. Under GAAP,  the company must record a warranty expense for each accounting period using past experience as a proxy, similar to the accounting for bad debt.

To illustrate with an example of warranty accounting. Let's see the following entries:

Warranty Expense
$1,000

            Warranty Liability 

$1,000

Warranty Liability
$900

            Cash

$900

The first entry records the $1,000 expense incurred while the second entry books the $900 actual claim during the period. The figures should be similar for the two entries. Nevertheless, a company wishing to reduce current expenses may book a lower warranty expense, such as booking only $500 in the prior example instead of the $1,000 justified using past experience. The easiest method to hide expenses is to assume a lower expense figure for these "soft expenses" like warranty expense or bad debt expense.  

Trick #5: Shifting Future Expenses to an Earlier Period

This trick is to incur the pain today while lowering expenses in future periods. Table 5 shows a two-step process for expense recognition for balance sheet items. By accelerating the expense recognition process, a company can recognize future expenses upfront and incur zero expense in the future. Let's illustrate with an example of an inventory write-down.

Table 5: Cost Recognition under a two-step progress
Step 1: Asset
Step 2: Expense
Prepaid Insurance 
Insurance Expense
Inventory
COGS
Property, Plant & Equipment
Depreciation/Amortization Expense

Under GAAP, inventories on the balance sheet are accounted for using the LCM (lower of cost or market) approach. If the market value (market price less estimated costs incurred to sell) is lower than the book value on the balance sheet, the difference must be written down as an expense (often through COGS) on the income statement. However, the market value used in the write-down is estimated by management and they could use an unrealistically low number so the expense recognized is higher than it should be. By writing down inventories close to zero, similar to how Cisco wrote down $2.25 billion in 2001, companies can report very low COGS numbers in the future and inflate their profit margins significantly.

Another creative method to overload current expenses is to book a large "restructuring expense." This is a common trick used by companies during difficult times. By booking a large restructuring expense today, companies can release the excessive amount into net income through a reduction of operating expenses. Again, let's demonstrate with the use of debits and credits. Assuming company R decides to fire 100 workers and need to pay $10,000 to each worker as a severance expense, which will paid in a future period. The proper method to account for the transaction is shown below.

(1) Current period to recognize the expense:
Restructuring Expense (Wages)
$1,000,000

            Wage Payable

$1,000,000

(2) When Severance is paid at a later period:
Wage Payable
$1,000,000

            Cash

$1,000,000

However, because the $10,000 per worker is a "soft expense" estimated by management, there is a strong incentive to overestimate, such as using $20,000 per worker.

(1) Current period to recognize the expense:
Restructuring Expense (Wages)
$2,000,000

            Wage Payable

$2,000,000

(2) When Severance is paid at a later period and only $1,000,000 is paid:
Wage Payable
$2,000,000

            Cash

$1,000,000
            Wage Expense

$1,000,000

By booking an extra $1,000,000 of restructuring expense in the current period, the company can reduce wage expense by $1,000,000 in a future period when the restructuring liability is extinguished. This is a creative method but fails to conform to the basic matching rule under GAAP.

Conclusion:
Despite real world accounting is more complicated than what you learned in Ms. Hopwood-Jones's class, I believe everyone has the necessary tools to detect accounting frauds. As stated many times in this article, the key is to read the footnotes carefully so that you can detect aggressive accounting assumptions, whether it is related to revenue, expenses or one-time items.




[1] The word "earnings" is often used in place of "net income" when discussion financials of public traded companies (ones that trade on a public exchange such as the TSX or NYSE).
[2] When an accounting textbook uses the word "GAAP", it is referring to the old Canadian GAAP rules. IFRS, the international standard, replaced Canadian GAAP in 2011. Nonetheless, IFRS is quite different and US GAAP is closer to the old Canadian GAAP.
[3] Recall that a gain/loss is recorded from the sale of a fixed asset when the sale price is higher/lower than the net book value (historical cost - accumulated depreciation)
[4] When you read financial statements of public companies, the income statement is commonly called the "statement of operations" or "statement of earnings."
[5] Stocks valuation can be explained by the P/E ratio which is market price of stock divided by its earnings. Usually investors would use operating earnings (income) as the denominator as those earnings are continuous in nature. Therefore, IBM's action of moving a gain from sale of an asset above the operating income line inflates operating income and increase the "E" in the P/E ratio, result in a higher stock price.
[6] The net book value is credited for the sake of simplicity. In reality, the asset account (historical cost) is credited while the accumulated depreciation is debited.
[7] "Shareholder Equity" is the equivalent of "Owner's Equity" and it is used for the equity account of a public traded company
[8] Assuming no dividends (Owner's withdrawals) or share issuance (Owner's deposit)
[9] Salvage value is ignored because it usually a negligible amount