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Subject: [CANSLIM] Accounting Know-how
Date: Mon, 1 Apr 2002 01:54:44 -0600
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A nicely done article from this weekend's Barron's on where to look and =
what to look for when performing due diligence.... reminds me of =
something a good friend of mine said recently..."The only thing I =
remember from those accounting courses you and I had to take was that =
everything we really needed to know was in the footnotes..."
- --Katherine
MONDAY, APRIL 01, 2002=20
Scrutinize This!
Accounting professor to investors: Put on your eyeshades and sharpen =
your pencils
By Jacqueline Doherty
Recent bankruptcies such as Enron and Global Crossing have made it clear =
that securities analysts need a deeper understanding of the financial =
health of many companies they cover. It is no longer enough simply to =
know a company's products and build a spreadsheet to model earnings. The =
best analysts, and for that matter, the best investors, need a firmer =
grounding in corporate accounting, and greater expertise in navigating =
the twists and turns of financial statements. At Morgan Stanley, their =
guide is Trevor Harris.
The New York-based brokerage first hired Harris, a professor of =
accounting at Columbia University, in 1997. His mission: to reconcile =
the differences in the accounting policies of many countries, so that =
the firm's analysts could compare industries on an "apples-to-apples" =
global basis.
=20
Harris, 47, remains on leave from Columbia, and now serves as head of =
Morgan Stanley's global valuation, accounting and tax policy team. His =
work with telecom analyst Simon Flannery resulted in a controversial =
report about Qwest Communications last summer that questioned the =
company's accounting. The concerns that Flannery raised have helped =
drive the shares to a current 8.22 from the mid-30s.
More recently, Harris and Christopher Stix, a Morgan Stanley technology =
analyst, gave their blessing to Cisco Systems' ledgers, after concluding =
the company had been conservative in increasing reserves by $2.2 billion =
to reflect the deteriorating value of its inventory and likely equipment =
returns.
Harris, who grew up in Zimbabwe and graduated from the University of =
Cape Town, in South Africa, took an indirect path to Wall Street. For =
one thing, he worked as an accountant, at a firm that later merged with =
Arthur Andersen. After earning his doctorate in accounting at the =
University of Washington, he became a professor at Columbia, ultimately =
chairing the university's accounting department. But he continued to =
keep one foot in the real world by consulting to companies and =
investors.
How should investors without accounting degrees tackle financial =
reports? It helps to remember that they're open to some interpretation. =
"We've created a perception that there is precision in numbers like =
earnings and free cash flow," Harris says. "But accounting is not that =
concrete. We have to make choices."
Harris argues that U.S. accounting has become too bound by rules and =
regulations, in part to protect accountants and their clients from =
litigation. As a result, the system has sacrificed the forest for the =
trees. "We lost sight of what we are really trying to do: paint a =
picture of a company's economics as best we can, knowing it's =
imperfect," he says.
Had accountants looked at the big picture, as Harris suggests they =
should have, surprises like Enron and Global Crossing might not have =
occurred. In the case of many telecom companies, for instance, =
accountants might have questioned why revenues continued to climb even =
after customers ran into trouble. Instead, it appears they merely signed =
off on the particulars of "fiber-swap" transactions, which allowed =
companies to book the sale of fiberoptic capacity as revenue, but =
capitalize the purchase of fiber -- that is, write down the value of the =
purchased asset over time -- instead of treating it as an immediate =
expense. As a result many companies enjoyed inflated earnings.
Harris urges investors to evaluate a company by first comparing reported =
earnings with cash flow. If earnings are rising but the company is not =
generating any cash, it might be using accounting to inflate profits. =
Like some telecoms, it may be capitalizing instead of expensing costs -- =
a dubious practice under certain circumstances.
When the sale of a product generates a receivable, as is the case in =
most corporate transactions, revenues increase without a boost to cash. =
The situation becomes problematic if and when customers don't pay their =
bills. That's why Harris pays particular attention to days' sales =
outstanding, the number of days it takes for a company to collect.
To calculate this number, divide revenues by receivables, and multiply =
the result by the number of days in a quarter. Then compare that results =
with the company's, and competitors' historic trends. If days' sales =
outstanding increase significantly, the company may be pushing products =
or services on customers who can't pay, or don't want the goods, which =
is what Sunbeam did several years ago. Companies that "stuff" their =
customers' inventories in such fashion have a tough time in future =
quarters.
Places to Poke
Harris recommends checking these items before investing.
. Statement of Cash Flows: Compare cash flows to earnings to =
see whether profits are being translated into cash. If not, question =
earnings.
=20
. Management Discussion and Analysis: Gives management's =
insight about past and future opportunities and potential pressure =
points.
=20
. Statement of Accounting Policies: Discloses what =
accounting methods were used for items such as revenue recognition and =
inventory valuations. By changing accounting methods, companies can =
artificially increase or decrease earnings.
=20
. Deferred Tax Note: Describes the difference between the =
value of assets and liabilities used when reporting taxes and the value =
used in preparing earnings. Shows how quickly companies are drawing down =
reserves.
=20
. "Other": When a company classifies something as "other," =
this usually refers to an item or adjustment on which management doesn't =
want investors to focus.
=20
=20
=20
=20
Yet, a spike in receivables doesn't always point to problems. IBM showed =
an increase in receivables in late 2000, but the shift occurred because =
the company saw great demand for a new product launched near the end of =
the quarter, Harris says. The key, again, is the rate at which =
receivables are collected.
Harris advises tracking a company's inventory levels, too. That's done =
by dividing inventory by the cost of goods sold, and then multiplying by =
the number of days in the quarter. If the result falls below that of =
previous quarters, or below competitors', the company might be =
manufacturing products more efficiently, which would lessen the need to =
keep excess inventory on hand. Conversely, when inventory levels rise =
without a commensurate increase in sales, a company might be tying up =
cash that could be used more productively elsewhere. Too, rising =
inventories can mean a product isn't selling well, or that a new product =
is being stockpiled prior to a launch. Nonetheless, question.
Depreciation is a non-cash item that's often ignored. Dividing capital =
expenditures by depreciation, says Harris, may offer clues as to whether =
a company is investing sufficiently in its business. Typically the ratio =
of capital spending to depreciation is 1-to-1.2. A lower number implies =
the company is cutting back on expenditures, perhaps to cut costs -- a =
development that may spell future trouble.
Annual and quarterly reports yield much useful information, not all of =
it in the income statement or on the balance sheet. Harris recommends a =
careful reading of management's discussion and analysis, which lays out =
the company's view of past accomplishments and shortfalls, and future =
opportunities, as well as potential problems. The section also notes =
corporate commitments, liquidity constraints, business risks and =
competition.
A company's statement of accounting policies likewise can be revealing, =
Harris says, especially when it highlights a change in accounting =
methods. If an airline changes its depreciation schedule, for instance, =
raising the depreciable life of its planes from 20 to 25 years, its =
costs will fall and earnings rise without any improvement in its =
operations.
Not surprisingly, Harris has many ideas about how to improve corporate =
accounting. Chief among them, he thinks companies should define more =
clearly operating and financing items on their income statements. =
Currently a vendor that loans customers money can classify income on =
such loans as revenue. Instead, it ought to be included under interest =
income, he says. And gains and losses on pension-plan investments should =
be disaggregated from operating items.
Some assets, liabilities, revenue and expenses in fact are listed as =
"other." But beware this category, Harris warns. "Other" may refer to =
items and adjustments that management would just as soon investors not =
see.
Although accounting is often difficult to decode, a knowledge of it =
essential to investing wisely. "It's the misunderstanding of accounting =
that leads to the misallocation of resources," Harris says.
=20
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<DIV>A nicely done article from this weekend's Barron's on =
where to=20
look and what to look for when performing due diligence.... reminds me =
of=20
something a good friend of mine said recently..."The only thing I =
remember from=20
those accounting courses you and I had to take was that everything we =
really=20
needed to know was in the footnotes..."</DIV>
<DIV> </DIV>
<DIV>--Katherine</DIV>
<DIV><BR><FONT size=3D-1><B><NOBR><B>MONDAY, APRIL 01, =
2002</B></NOBR></B></FONT>=20
</DIV>
<DIV>Scrutinize This!</DIV>
<DIV>Accounting professor to investors: Put on your eyeshades and =
sharpen your=20
pencils<IMG height=3D3 alt=3D"thin rule"=20
src=3D"http://online.wsj.com/media/B-thinblueline.gif" =
width=3D466><BR>By Jacqueline=20
Doherty</DIV>
<DIV><BR>
<P class=3Dtimes><B><FONT size=3D6>R</FONT></B>ecent bankruptcies such =
as Enron and=20
Global Crossing have made it clear that securities analysts need a =
deeper=20
understanding of the financial health of many companies they cover. It =
is no=20
longer enough simply to know a company's products and build a =
spreadsheet to=20
model earnings. The best analysts, and for that matter, the best =
investors, need=20
a firmer grounding in corporate accounting, and greater expertise in =
navigating=20
the twists and turns of financial statements. At <A class=3Dtimes=20
onmouseover=3D"window.status=3D(' Quotes & Research for =
MWD');return true"=20
onmouseout=3D"window.status=3D('');return true"=20
href=3D"http://online.wsj.com/mds/companyresearch-quote.cgi?route=3DBOEH&=
amp;template=3Dcompany-research&ambiguous-purchase-template=3Dcompany=
- -research-symbol-ambiguity&profile-name=3DPortfolio1&profile-vers=
ion=3D3.0&profile-type=3DPortfolio&profile-format-action=3Dinclud=
e&profile-read-action=3Dskip-read&profile-write-action=3Dskip-wri=
te&transform-value-quote-search=3Dmwd&transform-name-quote-search=
=3Dnvp-set-p-sym&nvp-companion-p-type=3Ddjn&q-match=3Dstem&se=
ction=3Dquote&profile-end=3DPortfolio&p-headline=3Dwsjie">Morgan =
Stanley</A>, their guide is Trevor Harris.</P>
<P class=3Dtimes>The New York-based brokerage first hired Harris, a =
professor of=20
accounting at Columbia University, in 1997. His mission: to reconcile =
the=20
differences in the accounting policies of many countries, so that the =
firm's=20
analysts could compare industries on an "apples-to-apples" global =
basis.</P>=20
<P class=3Dtimes>Harris, 47, remains on leave from Columbia, and now =
serves as=20
head of Morgan Stanley's global valuation, accounting and tax policy =
team. His=20
work with telecom analyst Simon Flannery resulted in a controversial =
report=20
about <A class=3Dtimes=20
onmouseover=3D"window.status=3D(' Quotes & Research for Q');return =
true"=20
onmouseout=3D"window.status=3D('');return true"=20
href=3D"http://online.wsj.com/mds/companyresearch-quote.cgi?route=3DBOEH&=
amp;template=3Dcompany-research&ambiguous-purchase-template=3Dcompany=
- -research-symbol-ambiguity&profile-name=3DPortfolio1&profile-vers=
ion=3D3.0&profile-type=3DPortfolio&profile-format-action=3Dinclud=
e&profile-read-action=3Dskip-read&profile-write-action=3Dskip-wri=
te&transform-value-quote-search=3Dq&transform-name-quote-search=3D=
nvp-set-p-sym&nvp-companion-p-type=3Ddjn&q-match=3Dstem&secti=
on=3Dquote&profile-end=3DPortfolio&p-headline=3Dwsjie">Qwest=20
Communications</A> last summer that questioned the company's accounting. =
The=20
concerns that Flannery raised have helped drive the shares to a current =
8.22=20
from the mid-30s.</P>
<P class=3Dtimes>More recently, Harris and Christopher Stix, a Morgan =
Stanley=20
technology analyst, gave their blessing to Cisco Systems' ledgers, after =
concluding the company had been conservative in increasing reserves by =
$2.2=20
billion to reflect the deteriorating value of its inventory and likely =
equipment=20
returns.</P>
<P class=3Dtimes>Harris, who grew up in Zimbabwe and graduated from the =
University=20
of Cape Town, in South Africa, took an indirect path to Wall Street. For =
one=20
thing, he worked as an accountant, at a firm that later merged with =
Arthur=20
Andersen. After earning his doctorate in accounting at the University of =
Washington, he became a professor at Columbia, ultimately chairing the=20
university's accounting department. But he continued to keep one foot in =
the=20
real world by consulting to companies and investors.</P>
<P class=3Dtimes>How should investors without accounting degrees tackle =
financial=20
reports? It helps to remember that they're open to some interpretation. =
"We've=20
created a perception that there is precision in numbers like earnings =
and free=20
cash flow," Harris says. "But accounting is not that concrete. We have =
to make=20
choices."</P>
<P class=3Dtimes>Harris argues that U.S. accounting has become too bound =
by rules=20
and regulations, in part to protect accountants and their clients from=20
litigation. As a result, the system has sacrificed the forest for the =
trees. "We=20
lost sight of what we are really trying to do: paint a picture of a =
company's=20
economics as best we can, knowing it's imperfect," he says.</P>
<P class=3Dtimes>Had accountants looked at the big picture, as Harris =
suggests=20
they should have, surprises like Enron and Global Crossing might not =
have=20
occurred. In the case of many telecom companies, for instance, =
accountants might=20
have questioned why revenues continued to climb even after customers ran =
into=20
trouble. Instead, it appears they merely signed off on the particulars =
of=20
"fiber-swap" transactions, which allowed companies to book the sale of=20
fiberoptic capacity as revenue, but capitalize the purchase of fiber -- =
that is,=20
write down the value of the purchased asset over time -- instead of =
treating it=20
as an immediate expense. As a result many companies enjoyed inflated=20
earnings.</P>
<P class=3Dtimes>Harris urges investors to evaluate a company by first =
comparing=20
reported earnings with cash flow. If earnings are rising but the company =
is not=20
generating any cash, it might be using accounting to inflate profits. =
Like some=20
telecoms, it may be capitalizing instead of expensing costs -- a dubious =
practice under certain circumstances.</P>
<P class=3Dtimes>When the sale of a product generates a receivable, as =
is the case=20
in most corporate transactions, revenues increase without a boost to =
cash. The=20
situation becomes problematic if and when customers don't pay their =
bills.=20
That's why Harris pays particular attention to days' sales outstanding, =
the=20
number of days it takes for a company to collect.</P>
<P class=3Dtimes>To calculate this number, divide revenues by =
receivables, and=20
multiply the result by the number of days in a quarter. Then compare =
that=20
results with the company's, and competitors' historic trends. If days' =
sales=20
outstanding increase significantly, the company may be pushing products =
or=20
services on customers who can't pay, or don't want the goods, which is =
what=20
Sunbeam did several years ago. Companies that "stuff" their customers'=20
inventories in such fashion have a tough time in future quarters.</P>
<TABLE cellSpacing=3D0 cellPadding=3D1 width=3D254 align=3Dright =
border=3D0>
<TBODY>
<TR>
<TD vAlign=3Dtop width=3D243 bgColor=3D#cccccc><!-- Start Nest -->
<TABLE cellSpacing=3D0 cellPadding=3D0 width=3D243 =
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<TBODY>
<TR vAlign=3Dtop>
<TD width=3D8 height=3D1 rowSpan=3D99><SPACER width=3D"8" =
type=3D"block"=20
height=3D"1"></TD>
<TD class=3DplnEleven style=3D"PADDING-BOTTOM: 5px; =
PADDING-TOP: 5px">
<P class=3DplnEleven align=3Dcenter><B>Places to =
Poke</B></P>
<P class=3DplnEleven><I>Harris recommends checking these =
items before=20
investing.</I></P><SPAN =
class=3DplnEleven>=95</SPAN> Statement of=20
Cash Flows: Compare cash flows to earnings to see whether =
profits=20
are being translated into cash. If not, question =
earnings.<SPAN=20
style=3D"FONT-SIZE: 5px"><BR> <BR></SPAN><SPAN=20
class=3DplnEleven>=95</SPAN> Management Discussion and =
Analysis:=20
Gives management's insight about past and future =
opportunities and=20
potential pressure points.<SPAN=20
style=3D"FONT-SIZE: 5px"><BR> <BR></SPAN><SPAN=20
class=3DplnEleven>=95</SPAN> Statement of Accounting =
Policies:=20
Discloses what accounting methods were used for items such =
as=20
revenue recognition and inventory valuations. By changing =
accounting=20
methods, companies can artificially increase or decrease=20
earnings.<SPAN style=3D"FONT-SIZE: =
5px"><BR> <BR></SPAN><SPAN=20
class=3DplnEleven>=95</SPAN> Deferred Tax Note: =
Describes the=20
difference between the value of assets and liabilities used =
when=20
reporting taxes and the value used in preparing earnings. =
Shows how=20
quickly companies are drawing down reserves.<SPAN=20
style=3D"FONT-SIZE: 5px"><BR> <BR></SPAN><SPAN=20
class=3DplnEleven>=95</SPAN> "Other": When a company =
classifies=20
something as "other," this usually refers to an item or =
adjustment=20
on which management doesn't want investors to focus.<SPAN=20
style=3D"FONT-SIZE: 5px"><BR> <BR></SPAN></TD>
<TD width=3D8 height=3D1 rowSpan=3D99><SPACER width=3D"8" =
type=3D"block"=20
height=3D"1"></TD></TR></TBODY></TABLE><!-- End Nest =
- --></TD>
<TD width=3D9><SPACER width=3D"9" type=3D"block" =
height=3D"5"></TD></TR>
<TR>
<TD width=3D252 colSpan=3D2 height=3D12><SPACER width=3D"252" =
type=3D"block"=20
height=3D"12"></TD></TR></TBODY></TABLE>
<P class=3Dtimes>Yet, a spike in receivables doesn't always point to =
problems. <A=20
class=3Dtimes=20
onmouseover=3D"window.status=3D(' Quotes & Research for =
IBM');return true"=20
onmouseout=3D"window.status=3D('');return true"=20
href=3D"http://online.wsj.com/mds/companyresearch-quote.cgi?route=3DBOEH&=
amp;template=3Dcompany-research&ambiguous-purchase-template=3Dcompany=
- -research-symbol-ambiguity&profile-name=3DPortfolio1&profile-vers=
ion=3D3.0&profile-type=3DPortfolio&profile-format-action=3Dinclud=
e&profile-read-action=3Dskip-read&profile-write-action=3Dskip-wri=
te&transform-value-quote-search=3Dibm&transform-name-quote-search=
=3Dnvp-set-p-sym&nvp-companion-p-type=3Ddjn&q-match=3Dstem&se=
ction=3Dquote&profile-end=3DPortfolio&p-headline=3Dwsjie">IBM</A>=
=20
showed an increase in receivables in late 2000, but the shift occurred =
because=20
the company saw great demand for a new product launched near the end of =
the=20
quarter, Harris says. The key, again, is the rate at which receivables =
are=20
collected.</P>
<P class=3Dtimes>Harris advises tracking a company's inventory levels, =
too. That's=20
done by dividing inventory by the cost of goods sold, and then =
multiplying by=20
the number of days in the quarter. If the result falls below that of =
previous=20
quarters, or below competitors', the company might be manufacturing =
products=20
more efficiently, which would lessen the need to keep excess inventory =
on hand.=20
Conversely, when inventory levels rise without a commensurate increase =
in sales,=20
a company might be tying up cash that could be used more productively =
elsewhere.=20
Too, rising inventories can mean a product isn't selling well, or that a =
new=20
product is being stockpiled prior to a launch. Nonetheless, =
question.</P>
<P class=3Dtimes>Depreciation is a non-cash item that's often ignored. =
Dividing=20
capital expenditures by depreciation, says Harris, may offer clues as to =
whether=20
a company is investing sufficiently in its business. Typically the ratio =
of=20
capital spending to depreciation is 1-to-1.2. A lower number implies the =
company=20
is cutting back on expenditures, perhaps to cut costs -- a development =
that may=20
spell future trouble.</P>
<P class=3Dtimes>Annual and quarterly reports yield much useful =
information, not=20
all of it in the income statement or on the balance sheet. Harris =
recommends a=20
careful reading of management's discussion and analysis, which lays out =
the=20
company's view of past accomplishments and shortfalls, and future =
opportunities,=20
as well as potential problems. The section also notes corporate =
commitments,=20
liquidity constraints, business risks and competition.</P>
<P class=3Dtimes>A company's statement of accounting policies likewise =
can be=20
revealing, Harris says, especially when it highlights a change in =
accounting=20
methods. If an airline changes its depreciation schedule, for instance, =
raising=20
the depreciable life of its planes from 20 to 25 years, its costs will =
fall and=20
earnings rise without any improvement in its operations.</P>
<P class=3Dtimes>Not surprisingly, Harris has many ideas about how to =
improve=20
corporate accounting. Chief among them, he thinks companies should =
define more=20
clearly operating and financing items on their income statements. =
Currently a=20
vendor that loans customers money can classify income on such loans as =
revenue.=20
Instead, it ought to be included under interest income, he says. And =
gains and=20
losses on pension-plan investments should be disaggregated from =
operating=20
items.</P>
<P class=3Dtimes>Some assets, liabilities, revenue and expenses in fact =
are listed=20
as "other." But beware this category, Harris warns. "Other" may refer to =
items=20
and adjustments that management would just as soon investors not =
see.</P>
<P class=3Dtimes>Although accounting is often difficult to decode, a =
knowledge of=20
it essential to investing wisely. "It's the misunderstanding of =
accounting that=20
leads to the misallocation of resources," Harris says.</P>
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