Paying for smaller companies with stock is inflationary, especially when the value is not there. It is a shell game and most of the corporations playing it ended up losing money and many even filed bankruptcy. It deceived investors, regulators, and ac- counting firms for years. If you notice a large volume of acquisi- tions on a financial report, the matter requires a closer look.
worthwhile. The second alternative is to organize or join an investment club. This is an organization of individuals, usually numbering between 10 and 20, who share research and meet regularly to dis- cuss stocks and other investments. Usually firmly based in the fundamentals, investment clubs have proven to be successful forums for individuals who are not comfortable investing without consultation with others.
Whether you work on your own or with pro- fessionals and fellow investors, you need to know what information is not shown on the financial statements. Some of the areas to remember are:
1. Current market value of assets. It is troubling that traditional accounting methods do not provide for accurate reporting of asset values. The bal- ance sheet is supposed to summarize a com- pany’s equity value, but so many of the accounts on the balance sheet are inaccurate. One of these is the capital assets section. Many of these assets may be valued far higher or lower than the net value reported. A good example is real estate holdings. Under the accounting rules, buildings
financial planner
an individual with experience and credentials to advise investors on how to pick stocks and other products. A quali- fied planner should hold the CFP designation.
Certified Financial Planner (CFP) a professional designation awarded to indi- viduals who hold a BA degree, com- plete an educa- tion program, pass a 10-hour exam, and com- plete three years of experience in the field.
investment club
an informal orga- nization of individ- uals who meet to share research chores, pool their money, and iden- tify profitable investments;
funds contributed by members are invested as a unit in the investments selected through the club members’
research.
To find a qualified professional financial planner, check the website for the Financial Planning Asso- ciation, at http://www.fpanet.org. Click “public / find a planner” to begin the process.
Valuable Resource
To find an investment club near you or to find out what is involved in forming your own club, vist the National Association of Investors Corporation (NAIC) website at http://www .betterinvesting.org.
Valuable Resource
are reported at their original purchase price; and that value de- clines each year because depreciation is claimed over time. This diminishing asset may, in fact, be increasing in market value and today’s true value is likely to be far higher than the reported value.
The unreliability of the asset account is disturbing by itself.
This also affects the book value of equity and as a result, the book value of stock. So, in essence, you are asked to decide whether today’s price per share of stock is reasonable, even though the financial information you have available is
outdated. The financial statement’s foot- notes may include an estimate of fair market value for real estate and other assets. If not, you may need to call the company and ask for more information.
2. Current amount of unrecorded liabilities. Just as the true value of assets is not reported on the balance sheet, many liabilities are sim- ply left off; they are explained somewhere in the footnotes. Two major areas may be lease commitments and pension liabilities. A lease commitment is the liability owed to lease equipment or real estate. It exists un- der a contract so it is an actual liability; but under the accounting rules, lease commit- ments are not always required to be listed.
Of even greater concern is the unre- corded pension liability—that is, the amount the company is committed to pay retired em- ployees, present and future, for their retire- ment benefits. In many corporations this is a huge liability and, were it recorded, the corporations would be bankrupt. General Motors, for example, owes more on its pen- sion liability than its net worth. This is a dis- turbing shortcoming in the accounting and reporting rules, and the information can only be found in the footnotes.
3. The potential liability known to the company from lawsuits. Companies may be advised
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lease
commitments liabilities under contract, often long-term, to pay rent for equip- ment, rights, or real estate. These liabilities are probably not recorded on the financial state- ment of a corpo- ration and can only be found in the footnotes.
pension liabilities the amount of money due to retired employees and accumulating in the accounts of current employ- ees and due in the future. Pension liabilities are often substantial, but are normally not recorded on the balance sheet and can be found only in the foot- notes to the finan- cial statements.
that lawsuits have been filed or are about to be filed against them. These may be individual or class action and, in many instances may end up costing the company millions or even billions of dollars. However, until a case is filed and either tried or settled, accounting rules do not require the company to list these as actual liabilities. Foot- notes will disclose any contingent liability of this type, but they are not highlighted in the financial statements.
4. Changes, if applicable, in accounting methods. While accounting rules are complex and often confusing, some significant decisions might have been made that affect what you see on the financial statement. These may include methods for valuing inventory, ac- counts receivable and bad debt estimates and reserves, and other accounting matters.
Trying to read the footnotes and understand (1) the nature of changes and (2) how they impact the profit or loss shown on the financial statement is not a simple matter.
5. Impact of accounting decisions as to the timing that revenues, costs, or expenses have been recorded. In addition to changes made in ac- counting methods, corporations may also have made decisions about the timing of reporting transactions. One of the more common practices in the widespread corporate scandals of the 1990s was the practice of prebooking revenues. Companies may simply make up the numbers, in which case it is outright fraud;
but the smarter ones try to document a justification under the GAAP rules. There are numerous ways to “create” a justification for inflating revenues. First, revenues can be recorded although services are not going to be provided until later. Second, record- ing might occur before goods are shipped or orders accepted by customers. Third, revenues are booked even when customers have not actually placed orders, thus they are only estimates of future orders. Fourth, a corporation may book sales to its own subsidiaries or partners to create a higher dollar value.
All of these practices are deceptive. Even if corporations can get au- ditors to approve their timing of revenues improperly, it eventually
contingent liability
a potential obliga- tion that may or may not become an actual liability in the future, such as pending law- suits filed against the company.
comes around and leads to future adjustments. The same kind of adjust- ments may occur with costs and expenses. For example, expenses can be reduced by capitalizing them and writing them off over several years.
This is not an especially imaginative technique, but it does increase re- ported profits this year. A more subtle approach is to change accounting methods so that some of this year’s expenses are moved to a previous year. It is more subtle because, to appreciate the impact of this more subtle tinkering, you need to look at a series of financial statements.
Many people simply ignore restated past statements, but this opens the possibilities up, especially for the creative accounting executive: In- creasing this year’s profits by moving expenses back in time to the previ- ous year.