CFA Series - Avoiding Accounting Traps

Things you wished the CFA taught you in plain English 
After  spending one torturous year studying for my CFA level 1, I am going back to the pits of hell to attempt for my level 2 exams. The difficulty of the content is unquestioned, and the use of convoluted English in a roundabout matter probably contributed significantly to its high failure rate. To fulfill my objective to become a better investor and learner, I shall attempt to consolidate the fragmented parts of the curriculum into a series of simplified <CFA Series> blog posts.

In my onerous quest to attain the charter, I sometimes forget that the lessons gleaned from an applied CFA curriculum are equally important. The purpose of the CFA is to improve my skills as an investor, and one sure way to arrive at the truth is to reject the Null hypothesis and stay away from the obvious traps. Charlie Munger's famous quote <All I Want To Know Is Where I'm Going To Die So I'll Never Go There>  may be coined as an offhand joke, but the wisdom of this phrase to identify and avoid obvious pitfalls in investing deserves worthy mention. 

Warren Buffet shareholder letters contributed immensely in helping me to connect the dots between the walls of text in the CFA text, and the book <Financial Shenanigans – How to detect Accounting Gimmicks and Fraud in Financial Reports> is immensely invaluable in providing applied case studies in comprehensible English. Although this short blog-post could not cover all of the possible scenarios, it serves as a litmus test for red flags so that I will be able to stay away from the obvious traps and go for the easy and clear swings.

Survival Rules Never trust management words to smooth out accounting problems. If there is a cockroach there is probably a nest somewhere. High probability that corrected numbers and underlying business performance is worse than expected. Be wary of diwosifications and related party transactions to offload poor performing assets from the acquired to the acquirer. Never overlook culture of poor financial disclosure, unethical business practices, mistreatment of shareholder rights. When there is change, Ask Why and Why Now? Check out accounting assumptions in notes to financial statements and determine whether there is cover ups. Never blindly accept the accounting assumptions in note to financial statements Pay attention to incentive structure, strength of internal controls, company culture, for breeding grounds of bad behavior Look at past annual reports and see if there are certain patterns of behavior. Earnings manipulations may be reflected through unusual patterns in the balance sheet and cash flow statements. Ideally, buy acquisitions from founder led business that has a long-term orientation for the businesses. Be wary of LBO / Venture capital firms that are there to cash in for quick profits. Red flags include (Excess raising of capital through equity rather than debt for mature companies, paying themselves special dividends, Loading balance sheet with debt, acquisition heavy to inflate book value, cutting core capex/ R and D as discretionary expenses) Due to the dependence of accounting numbers for value investing, never be complacent and feel free to walk away if there is suspicion about the validity of the accounts.

Traps

Low quality / subjective assets Unusual build-up of inventory and receivables especially in cyclical business. Absense of quality assets such as cash and prime location buildings. Balance sheet contains mostly receivables, intangible assets and goodwill. Large proportion of assets that do not generate cash reliably.

Heavy acquisition companies Potential for accounting mischief from the acquired company before deal closure. Large amount of goodwill and high risk of overpaying. Acquired companies can use aggressive accounting to inflate its profits and numbers prior to the acquisition. Potential abuse of accumulation / release of restructuring reserves to manipulate appearance of financial performance.

Complicated capital structure in AR Heavy use of debt and quasi equity High leverage boosting ROE Use of Special purpose Entity and VIE to hide losses. Heavy use of convoluted legalese. High frequency of exceptional events, erratic and unexplained mark-ups and write-offs. High frequency of transactions that does not make economic sense

Fickle nature of business operations Complicated business, transactions and cash flows that you cannot explain easily. Once off transactions, consolidations / spinoffs , write-offs, magical disappearances of impaired assets, and restructuring charges distorting financial analysis. Frequent appearances should trigger a red flag Cyclical businesses. Small cap with no proven track record. Diwosifications. High concentration of operating cash flow on single tenants / clients.

Management Attitude Managers chasing headlines and acting as blatant stock price promoters Use of buzzwords such as China, India, strategic acquisitions, synergy FOMO and irrational basis for business acquisition. Heavy focus on meeting wall street expectations rather than economic benefit for operations / transactions. Beware of Private equity, LBO and managers whom are heavily rewarded with stock options as there is strong incentive to chase short term share performance Little or no ownership of actual stock, cashing out of stock at strategic moments.

Management Treatment of shareholders Diluted share voting rights leading to power consolidated at owners. Shareholder dilutive corporate actions.

Quality of earnings and cash flow Low quality of earnings with aggressive accounting. Cash flow classification tricks leading to low quality of operating cash flow / Free cash flow. Earnings and Operating cash flow showing huge divergence. High dividend payout without Free cash flow and Operating cash flow to support dividend policy Poor and declining operating cash flow, followed by dramatic improvement in operating cash flow Be wary of channel stuffing practices to spike up revenue (scuttlebutt analysis), transactions that lack economic substance, inflating revenue from underlying transactions.

Financial opacity (Banking / Insurance) Manipulation of loss reserve to inflate / smooth-en profitability Off balance sheet financing

Creative accounting Use of creative metrics as proxy for revenue, earnings and cash flow. Eyeballs, MAU/DAU, ARPU, subscriber numbers, Same store sales, bookings and backlog Use of EBITDA and ignoring capex nature of industry. Proforma earnings that does not reflect economic reality.