Spotting Accounting Chicanery

By Willam Trent, CFA of Stock Market Beat

Motley Fool tells investors to Steer Clear of Accounting Shenanigans. So far, so good. However, we found their advice on how to do so a bit lacking:

So what’s an investor to do? A lot, actually. For starters, look for small caps with conservative accounting practices, positive free cash flow, responsible management, and a history of underestimating and overdelivering on promises to shareholders.

If the average investor was able to discern conservative accounting from aggressive accounting, the advice would be wholly unnecessary. We at least give solid tips and case studies on aggressive accounting practices in our forensic accounting category. You can also check out sites like Financial Education to get some tips on basic accounting practices. “Free cash flow” has so many definitions that looking for it to be “positive” is nearly meaningless.

But the last bit may be the most useless. WorldCom and Enron had long histories of overdelivering on promises to shareholders because they were committing fraud. In fact, one earnings quality study showed that the strongest warning signal is when a company has beaten estimates by exactly one penny for a number of consecutive quarters.

The fact is, monitoring accounting practices is not easy, which is one reason many investors are better off indexing than trying to pick their own stocks. However, it isn’t all that hard either. For investors who are interested in learning more about it and spending some time reading the financial satements it can be a rewarding hobby.

The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

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