How to Spot the Next Enron Before It Happens

The Weekend Edition is pulled from the daily Stansberry Digest.

Accounting isn't a sexy subject...

It's dry. Some would say it's flat-out boring. More than a few high school or college students have dozed off during their introductory accounting classes. I get it.

But here's the thing...

Accounting is incredibly important for investors. You'll never be a great investor without at least a basic understanding of it.

You can tell yourself that you can rely on your broker and the so-called "financial professionals" on Wall Street to make sense of all the numbers for you. But that's a big mistake. They have enormous financial interests to work against you and lead you astray.

It's like when you take your car to the mechanic... You're a lot less likely to get ripped off if you know something about how your engine works.

I have bachelor's and master's degrees in accounting. I'm a former certified public accountant who worked for one of the "Big Four" auditing firms. I was also the vice president of finance at a large, publicly traded software company for many years.

You don't need an advanced degree in accounting like me. But you do need to understand the basics – like you do with your car's engine. I'll share those with you today...

I'll explain the source of the confusion with accounting and why even experienced Wall Street investors get fooled. Then, I'll detail how I would fix these problems... and offer a way for average investors to overcome them.

If business was a game, accountants would be the scorekeepers...

Accountants measure businesses' performance. They keep the score and help separate the winners from the losers. Think how tough it would be to win in business if you never knew the score.

They don't try to predict the future. They just tell management (and you) where the business is today and where it has been.

They do this by regularly publishing a complete set of financial statements. These statements include...

  • A balance sheet (sometimes called a statement of financial position).
  • An income statement (also called a profit and loss statement).
  • A statement of cash flows.

Most investors go wrong by focusing too much on just one of these statements – the income statement. In fact, Wall Street spends most of its time focusing on just two lines on the income statement – revenue and earnings per share ("EPS").

To be a good investor, you can't focus on just one statement. You need to look at all three of the statements above.

So let's take a quick look at the purpose of each financial statement...

A balance sheet shows you the assets a company owns. And it shows you how much of those assets are owned by creditors versus stockholders. The value of the assets always equals the total amount owed to creditors plus the total of stockholders' equity. They are always in balance, hence the name.

Think of the balance sheet as a photograph... It captures a picture of a business at a certain point in time. Just like looking at a photograph of a person, you can quickly tell whether a business is healthy or sick by looking at its balance sheet. You can see if it's overleveraged (if its liabilities are far greater than its equity). You can see if it has liquidity problems (if it has enough cash and short-term assets to cover its short-term debt).

The balance sheet is great. But remember, it's just a snapshot. It doesn't tell you where the company came from... or give any clues as to where it is headed.

That's where the income statement and cash flow statements come in... Think of them as movies rather than photographs. They show you how a business performed over a period of time (typically the last quarter or year).

Astute readers might be asking, "Why do I need two movies?"

Because each movie shows you what happened to the business from different perspectives. It's like giving two people a video camera to film a business. Each will capture different things about the business from different perspectives. In the end, you'll get two completely different movies.

The cash flow statement views the business from the perspective of cash. It answers the question, "What happened to my cash over the last year?" The income statement views the business from the perspective of owners. It answers the question for shareholders, "What happened to my equity over the last year?"

Both views are valuable. Here's what's important...

If you only focus on one of these statements, you won't get the full picture of what happened...

The difference between the income and the cash flow statements can be summed up by the difference between the two accepted methods of accounting – the cash method and the accrual method.

The cash method is much easier to understand. Sales are recorded when cash is received, and expenses are recorded when cash is paid. If every transaction in a business were recorded on the cash basis, you wouldn't need an income statement. The income statement would equal the cash flow statement. The world would need far fewer accountants.

But the cash method has big problems. It can give you funny results.

For example, let's assume you own a consulting business. You worked on a big project that took a little more than 12 months to complete. At the outset, you and the customer agreed that if you did a great job, they would pay you $1 million. If you did an OK job, they would only owe you $700,000. And if you did a lousy job, you'd only get paid for your costs.

Let's say you didn't finish all of your work by the end of the year. But you paid $300,000 out of your pocket for expenses throughout the year on things like employee salaries, travel, and rent. A few days into the following year, you finished the project. The customer informs you that you did a great job and happily pays you $1 million in cash.

Here's where the accountants come in...

Under the cash method of accounting, the only thing you would have recorded in Year 1 was the $300,000 in cash payments you made. In Year 2, you would have only recorded the receipt of $1 million in cash. You end up with a "loss" in Year 1 of $300,000 and a "profit" in Year 2 of $1 million.

Does that seem right?

The accrual method of accounting was created to fix the distortions that can be caused by pure cash accounting. It was designed to match sales with their related expenses. So instead of recording sales when cash is received or expenses when paid, they are recorded when they are earned or incurred.

The true profit of the big consulting project was obviously $700,000 ($1 million of sales minus the $300,000 of expenses). So the profit should be allocated between the two years based on how it was earned. Since almost all of the work was done in Year 1, that's when you should have recorded the profits. Under the accrual method, all of the revenue and expenses are recorded in Year 1.

That's a huge difference. The rules that govern when revenue and expenses get recorded under the accrual method are known as generally accepted accounting principles, or simply "GAAP." The creation of the accrual method to fix the deficiencies of the cash method spawned the enormous global accounting industry.

Despite the benefits of the accrual system, many Stansberry analysts – including myself – focus mainly on the cash flow statement. We look at a few years' worth of cash flows because of the distortions that cash accounting sometimes causes.

You see, the accrual method has its flaws, too... many flaws. And these flaws are often worse than the flaws that can be seen in the cash method.

There are big problems with accrual accounting...

As my colleague Bryan Beach explained last Saturday, the income statement is full of accounting estimates. The statement of cash flows is not. As we like to say, cash can't be faked. But companies can easily manipulate their earnings.

The biggest accounting blow-ups have come from illegal earnings manipulation – like Enron and WorldCom. Most of the largest cases of fraud come from management overstating earnings by using estimates that were later found to be flat-out wrong.

The problem is that it's very difficult to spot these types of frauds under today's accounting rules. You have to be in the business of looking for fraud to find it. (That's what forensic accountants do.)

And it isn't just bad management estimates that can throw off investors. As Bryan noted, many companies make adjustments to their bottom-line GAAP earnings when reporting their numbers. Wall Street often only looks at these "non-GAAP" – or so-called "adjusted earnings" – numbers. These non-GAAP adjustments aren't audited. And no consistent rules govern what kind of adjustments should be allowed.

All of this leaves investors with so many numbers, estimates, and inconsistencies that they don't know what's important and what's not. It's not surprising that so many people don't bother to dig in. They don't even know where to start.

Here's how I would "fix" the accounting rules...

First, I'd require companies to report how much of their sales and expenses are estimates. That would tell you much more about the quality of the company's sales and earnings.

Let's go back to our example above...

Imagine management didn't know the customer was going to pay them $1 million when they were preparing their financial statements at the end of the first year. There was an equally likely chance they would get paid the smaller amounts for doing an OK or lousy job. So they had to guess.

My rules would require the company to report how much of their sales were estimates (the entire $1 million in this case). That would tell you if management could be fudging the numbers by a large amount. Knowing that information could potentially change your investment decision.

Second, I'd require companies to report their statement of cash flows in the same format as the income statement. This might seem like a technical detail... but it would make a huge difference. You would be able to see how much cash they received from customers... and how much they paid for sales and marketing expenses, research and development, and all other expenses. Today, companies have the option of presenting a more detailed cash flow statement like this, but no one does it... The way companies report their cash earnings now is convoluted and doesn't help investors much.

Third, I'd require companies to break out their capital expenditures by maintenance capital versus growth capital. Capital expenditures ("capex") are things like purchase of land, buildings, equipment, furniture, and software. Maintenance capex would cover investments to replace existing assets. Growth capex would reflect purchases of new assets to expand the business. To properly evaluate a business, investors need to know this...

Today, they're all lumped together. Investors can't easily tell if a company is using loads of cash just to maintain its asset base or if it's investing in the future.

Fourth, I'd standardize the types of non-GAAP adjustments companies can make to their earnings. These types of adjustments need to be consistently applied. They aren't today... Management has a lot of leeway in deciding what adjustments can be made. And I would require them to be audited.

But changing the accounting rules isn't realistic in the short term...

It takes years to make accounting rule changes. New rules are set by an independent accounting authority. But they have to go through a long political process where the companies that implement them get to voice their opinions and often oppose them. So better rules that would help investors often get shot down.

In the meantime, analyzing financial statements will continue to be a difficult job... even for experienced accountants and investors. And as I said before, you shouldn't rely on others to analyze or interpret them for you unless they are truly independent financial analysts like Stansberry Research.

Until changes are made to the accounting rules, investors have another option...

Joel Litman – a former Ivy League professor and now president and CEO of investment-services company Valens Research – has long known of the problems in today's accrual accounting.

Joel and his team of more than 100 accountants and researchers have identified more than 130 inconsistencies within GAAP and its international counterpart, the International Financial Reporting Standards ("IFRS"). These inconsistencies cause earnings, balance sheets, and other key financial metrics to be distorted across companies in the same industries and from year to year within single companies.

His team "fixes" the inconsistencies and problems of today's accrual accounting and corrects financial statements – line by line – under his proprietary "Uniform Accounting" standard.

It's a powerful system for determining the true earnings and profitability of some of the best- and least-known stocks in America. It's a tedious process. But it's worth it. His work is read every month by more than 180 of the top 300 investors in the world.

And now, for the first time, Joel is making his system available to individual investors. He calls it his "Investment Truth Detector"... It's a powerful tool for discerning the real value of nearly any stock on the market. Joel's system will tell you immediately if a stock has been unfairly sold off... or if investors have bid up its price beyond reason.

Earlier this week, Stansberry Research founder Porter Stansberry joined Joel as he walked through a live demonstration of his system. But if you missed it, you're in luck... For a limited time, you can watch a replay of this special online event. Get started right here

Good investing,

Mike DiBiase

Editor's note: For a decade, many of the world's biggest money managers have used Professor Joel Litman's remarkable system to figure out a company's "true" earnings numbers before they buy or sell. Now, Joel is bringing his approach to the masses... And he just prepared a special presentation to reveal all the details. Watch it right here