Having lived in Houston, Texas, the Enron scandal remains on my mind. My father-in-law held Enron bonds and a friend of mine who worked there lost his job the day the company closed. I interviewed with Enron for a job and—fortunately, in hindsight—I was not extended an offer of employment.

While it was the biggest offender, Enron isn’t the only company to have committed accounting fraud or engaged in questionable accounting practices. Accounting issues can call a company’s numbers into question. Whenever underlying financial data cannot be trusted, neither can valuations, growth rates or indicators of quality.

Fortunately, most companies don’t engage in fraud. Absolute numbers and percentages are two different things. Even a very small percentage of the nearly 5,700 exchange-listed companies engaging in deceptive practices can still be enough to cause losses in shareholders’ and bondholders’ portfolios.

There are steps you can take to reduce the odds of investing in a company with questionable accounting practices. One way is to use the M-Score. The M-Score is a model designed to detect manipulation in financial statements.

Investment editor Cynthia McLaughlin spoke to the M-Score’s creator, Indiana University accounting professor Messod D. “Daniel” Beneish. Beneish shares the components behind his model and explains what it is designed to look for.

Among the things he suggests watching for is receivables growing faster than revenues. Receivables are balances due from customers. When they rise faster than revenues, it could be a sign of customers being slower to pay or it could be the company attempting to artificially boost sales. Channel-stuffing, which involves moving out product to hit a quarterly or annual sales goal, is a practice that has been repeated over time.

It’s not the first time we’ve addressed the topic of detecting accounting fraud.

In the June 2018 AAII Journal (“Tricking Investors With Merger-Related Accounting Shenanigans”), author Howard Schilit wrote about how corporate managers go about boosting performance or hiding past mistakes. At the top of his list of earnings manipulation shenanigans was “recording revenue too soon.” The second was “recording bogus revenue.”

Michelle Leder, who runs Footnoted.com, discussed what to look for in U.S. Securities and Exchange Commission (SEC) filings in the June 2011 AAII Journal (“Using SEC Filings to Identify Risk Factors”). She told me there are two ways companies can manipulate the numbers: overstate revenues or understate expenses. (Notice that revenue was mentioned by all three.)

One of the things Leder keeps an eye out for is “significant changes in the accounting policy.” She also suggests watching out for a lot of third-party transactions. Leder is a proponent of reading the disclosures and footnotes in SEC filings.

When reviewing quarterly earnings, I like to look through the financial statements to see if there are any changes in the quarterly numbers relative to the same period one year ago that jump out. There isn’t one thing that I look for, as it could involve inventory, payables or something else. But if I see a change that wasn’t addressed at the beginning of the press release, I’ll go back through the entire release, the earnings conference call and even the latest SEC filing to see if there is an answer. Typically, it’s not something to be concerned about, but the one time there could be a red flag, I’ll be glad that I caught it.

In addition to our Beneish interview, we have a second interview in this month’s issue. Dan Villalon of AQR Capital Management spoke to us about combining the factors of value and momentum in a portfolio. I specifically reached out to AQR because its research has been among the sources that influenced how I approach investing. It is a firm that utilizes evidence-based quantitative approaches and has been a big proponent of factor-based strategies. 

Those of you who are concerned about taxes in retirement will want to read William Reichenstein’s article. Reichenstein is a longtime contributor to the AAII Journal. His latest, co-authored with William Meyer, focuses on the importance of considering marginal tax rates when taking withdrawals. The marginal tax rates used in the article are the tax rates on a dollar of ordinary income adjusted for Social Security and Medicare thresholds. Failure to take this into consideration can cause you to unintentionally cross thresholds and effectively pay more than you would have with proper planning.

Wishing you prosperity and good health,