I’ll keep this non-technical in order to avoid losing most of my readers in the details. There have been entire textbooks written on all of the ways that accounting can be used to cover up and obfuscate what’s actually happening in a business. If you want a technical review, find one of those books. (My favourite is Financial Shenanigans.)
This topic is close to my CPA heart, and one of the reasons I think that a solid background in accounting is so important for any capital allocator (not just investors, but CEOs and CIOs as well.)
Here is where I see many investors — even sophisticated ones — get led astray. Taking the numbers you see in the financial statements at face value is a mistake.
I mentioned a couple of these factors previously when I talked about quality of earnings.
What are the basics? As a rule, you want to see accounting earnings reliably turned into cash over time. You want to understand the nature of the company’s business, how they contract sales, and what their revenue recognition policies are. You want to understand how they amortize their assets, both tangible and intangible. And you want to make sure that their “free cash flow” calculations properly designate between maintenance and growth capex, because these distinctions are not as clear as one would assume.
In my public accounting years, I worked on audits of some public companies and their subsidiaries. As a young and impressionable staff auditor, I was often surprised at the machinations happening behind the scenes to get earnings numbers to meet the expectations of “The Street.” I won’t go into detail, but suffice it to say, accounting is more of an art than a science, and there are a lot of levers that can be pulled to get that EPS number where it needs to be.
And so I tend to prefer companies with pretty simple business models. I shy away from serial acquirers, only because the accounting surrounding business combinations can be especially opaque. I prefer companies with less capital intensity, partially because they can’t try to get away with classifying maintenance capital costs as “growth” in order to inflate their free cash flow. I look for companies with long track records. The longer a business has been running, the more of a track record I have to see if things are getting fishy or the numbers are drifting out of whack.
Without a long track record through which to understand what the numbers should look like, one would need to develop a very good understanding of the underlying business in order to judge whether or not the numbers, as presented, are reasonable. This is difficult, time consuming work that most stock analysts aren’t actually doing.
Simplicity, in this sense, is a key element of the low-risk investing framework. Complexity too often entails hidden risks… the “unknown unknowns” that can demolish your best laid plans.
All of this to say that this is the part of the checklist that starts to get quite difficult for individual investors to navigate on their own. Even someone with strong accounting knowledge can miss important flags that may indicate things going awry. Worse, some outright frauds often can’t be caught until it’s too late. This is where an investor’s network and third-party research access can help uncover warning signs that might otherwise be missed.
While others might simplistically focus on headline numbers, fundamental investors know that the devil, as they say, so often lurks in the details.