I have taken a break in the last week from searching for investments and done something equally rewarding, and that is improving my knowledge. I chose to look at how companies manipulate their financial statements in order to deceive shareholders.
The book I read on this subject is called The Financial Numbers Game: Detecting Creative Accounting Practices
It is commonly known that net income is open to abuse and should be investigated by investors before considering a purchase. They usually look to the cash flow statement as it is deemed to be untouchable. However this is not entirely correct, as the famous example of Enron in 2001 showed.
You can read a copy of Enron’s last Annual Report here. This was before they went bankrupt and unveiled one of the largest cases of fraud in history. After reading the Financial Numbers Game, it doesn’t take long looking over their financial statements to smell a rat. While it wouldn’t prove fraud it would be enough to send any value investor running for the hills. Let’s look at it a little closer and what we can learn from it.
Enron’s 2000 results
Let’s ignore the fact that Enron’s profit margins were minuscule and shareholders were being massively diluted (this should be enough for any value investor to reject the company) and let’s pretend that we’re interested in this company. The first thing I usually look at is the cash flow statement and see how much of those profits are coming through as free cash flow. A quick glance (page 36) shows no warning signs and plenty of cash flow. Or does it?
There are three main things to look out for in detecting cash flow manipulation.
1. The first is expenses that are being inappropriately capitalised, hence aren’t included as costs but instead appear as capital expenses on the cash flow statements, creating an asset which is amortised in the future. This is easily rectified by an investor by calculating free cash flow.
2. The second is tax. Tax paid on sales of investments will usually be included in operating cash flow but it should not as it’s a non-recurring tax expense. Also, companies can receive tax relief from a complicated rule concerning share options. This is also included in operating cash flow but should be removed to get a real sense of the earning power of the company.
3. The third is investments held ‘for trading’. The purchase and sale of investments held for trading is included in operating cash flows and under normal calculations of free cash flow will be included in this also.
Enron’s investments for trading
A closer look at Enron’s operating cash flow shows large inflows from sales of ‘merchant assets’ i.e. investments held for trading. If we exclude all cash changes related to merchant assets for the years 1998 to 2000, cash flow greatly reduces, and if we then take off capital expenditures it’s negative.
Related Party Transactions
Another useful thing to do is search for ‘related party’ in the annual report. This will soon yield results that show it is in fact the related party that is buying all these ‘merchant assets’ from Enron, and moreover the managing partner is an officer at Enron. The related party itself was initially set up by Enron itself, with it’s stock. It then bought investments from Enron. This smells like an arrangement to get things off the balance sheet.
And that’s all it should take. A red flag like this should be enough to put anyone off an investment in this company. It is clearly not generating any actual cash from it’s investments and has created another third party to ‘hedge’.
Enron fraud
As it turns out, what had happened was Enron has used it’s own stock as collateral in this third party to make loans to buy these ‘merchant assets’ from itself and boost its operating cash flow. What they were selling was worth nowhere near what they paid for it but that didn’t matter, this was simply a way to hide debt off the balance sheet.
Here it was simple to smell the rat because I already knew there was something fishy to find, looking at other companies will be more difficult. But just remember, before assuming operating cash flow show the earnings are real, check the three things listed above. If you found this useful then I suggest reading the book as it contains a far more detailed and thorough discussion of accounting tricks.
Investing Sidekick
Founder of Investing Sidekick. Works as a research analyst and is an avid value investor, always searching for undervalued shares.