on less than reliable accounting policies. Is this a fine point only? No; in fact, the corporate scandals that were practiced throughout the 1990s and pub- licized in 2001 and 2002 were invariably generated through accounting adjustments. It is unlikely that all instances of manipulation started out with inten- tional misrepresentations; such things tend to grow in small steps.
Motivation for these practices often was a cause. Corporate executives often are paid for keeping the stock price high and for delivering exceptional operating results. With incentive compensation (bonuses and stock options, for ex- ample) often in the multi-millions of dollars, some CEOs and CFOs gave in to temptation and made decisions to alter the books. For a while, the board of directors, Wall Street analysts, and auditors were all happy, because the results were excellent.
Even the Dow Jones Corporation liked Enron enough to add the company to its prestigious aver- ages before the whole deception came to light.
This demonstrates how easily even the experts in the industry can be fooled. If nothing else, every investor should be aware of the flaws in GAAP and of how easily the numbers can be manipulated within the rules.
The inaccuracy of reporting, even after the well-known corporate frauds that came to light a few years ago, remains a serious problem for every investor. To manage the problem of inaccuracy, follow these guidelines:
1. Rely on the fundamentals. The basic rule of thumb is to keep your eye on the financial results. Do not give in to the temptation to make trading decisions based on price movements or on rumor and short-term news. The financial results are the most trustwor- thy source for making investment decisions. Knowing that the numbers can be manipulated and misrepresented remains a chronic problem; but identifying the proper trend analysis tools
depreciation a noncash ex- pense reflecting periodic value of capital assets. All capital assets (except land) are fully depreciated over a period of years, involving regular annual allowances (straight-line de- preciation) or larger write-offs in the earlier years and lower write- offs later (acceler- ated depreciation).
All capital assets except land are depreciated over several years.
write-off the process of reducing an asset’s value and converting it to an expense. This occurs when an asset becomes valueless or, in the case of capital assets, through recording of peri- odic depreciation.
will help you to identify suspicious trends and to make decisions cautiously—or avoid companies with puzzling numbers.
2. Look for consistency in the long term. It is long-term results that demonstrate whether a corporation is able to manage its operat- ing results and markets. Manipulation occurs only for a few years and, eventually, any artificially inflated results have to be ab- sorbed. So when you see trends that are new and have not been established for many years, they cannot be used as reliably as trends lasting many years.
3. Be suspicious of rapid and exceptional growth. Many of the prob- lems coming out of the years of corporate fraud were sudden and dramatic. Any fundamental investor should be suspicious when growth is unusually rapid and sustained. It simply is unlikely for growth to occur that way. Growth tends to occur consistently and gradually over many years. So a short burst of high earnings may be the result of liberal accounting policies, exaggerated accruals, and even outright fraud. With new federal laws designed to make such fraud more difficult, it is less likely. But it is virtually certain that fraud will not disappear altogether. Investors should remain suspicious when reported results look too good to be true.
4. Be suspicious of high fundamental volatility. It is very troubling to fundamental analysts when year-to-year results are volatile. It makes any type of long-term prediction difficult. Volatile finan- cial results can also be a sign of excessive accounting tinkering.
There are varying degrees of policy within companies. Some or- ganizations have a very liberal interpretation of accounting rules, and the result often is a high volume of nonrecurring charges, ad- justments, and restatements of past results. The more of this you see, the more suspicious you should be.
5. Remember, prices do not rise forever. Even the most dedicated fun- damental investor is susceptible to temptation. When a stock’s price climbs dramatically, many people want to buy shares and cash in on the trend; this is speculative and you must remember that the highest level of buying occurs at the highest price. A stock’s price is not going to rise forever. Everyone knows this, but during the past decade it was easy to overlook the obvious truth.
Thousands of investors lost millions of dollars putting too much
T h e B a s i c R e p o r t i n g P r o b l e m : I n a c c u r a c y 105
value in the short-term trends of dot.com companies such as Ama- zon, Yahoo!, eBay, and others. Thousands more lost money in WorldCom, Enron, Tyco, and even Xerox, all of which were scruti- nized due to questionable accounting practices. Stay with the funda- mentals, follow the trends, and be suspicious when things change.
More than anything else, remember that short-term trends—
especially on the technical side—are not reliable as indicators, and should not be used to determine when to buy, hold, or sell.