Earnings Management - Accounting Red Flags

By: Richard J. Wayman, CFA
Richard J. Wayman, CFA, is president of researchstock.com, an independent equity research firm that focuses on under-followed small cap stocks and has over twenty years of investment experience. Prior to cofounding researchstock.com, he was a buy-side analyst for Fifth Third Bank and a sell-side analyst for The Ohio Company. He is an active member of the Association for Investment Management and Research and is currently the president of the Columbus Society of Financial Analysts.

How can investors protect themselves from companies that spend more time managing earrings than managing their business? As shown by "Enrongate," it is very difficult to determine a company's real profitability even if a company complies with generally accepted accounting principles and with Securities and Exchange Commission regulations. At best it can be done in hindsight. The best protection for investors is knowledge, independent thinking and portfolio diversification.

Assuming a properly diversified portfolio, investors can further protect themselves by knowing where to look for signs of earnings manipulation. (We can't help you with the independent thinking bit.) Many companies exploit gaps in the generally accepted accounting principles (GAAP) and, although the specific techniques may be deemed acceptable under accounting and tax regulations, the results can be dire for shareholders if economic reality does not match the accounting.

What follows are five of the most abused techniques. Click on anyone to read an explanation.