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Watch out for sales growing slower
than accounts receivable or
inventory. Look at the balance sheet
to see if there are falling reserves
for bad debt, or an increase in
deferred revenue.
If cash flow from operations is
increasing or decreasing at a
different rate than net income, this
may be an indication that net income
is being manipulated.
Fuzzy accounting didn’t begin
with Enron or WorldCom. From 1998 to
2000, 464 corporations re-stated
their financial statements with the
SEC, wiping out a combined $31.2
billion earnings in 2000 alone.
Kroger, the country’s largest
grocery chain, disclosed that the
manager’s of their Ralph’s chain had
padded $14 million to sales, moving
money from the company’s general
fund.
Other companies have done
“channel stuffing”, getting
customers to receive goods that
would not have to be paid (or could
be returned) until the following
year, and claiming the sale and
profit now.
Why do these companies use
accounting tricks to nudge earnings
a penny or two to meet Wall Street’s
estimates?
The trend to tie executive’s pay
to how well the company’s profits
perform as well as how well the
stock performs, puts many managers
under pressure to play games with
the numbers.
The top reason management is
concerned with the stock price, is
because their stock options will be
worthless if the price falls. Their
jobs may also be on the line, since
key board members generally hold
large blocks of stock, and don’t
like watching their fortunes melt
away.
How badly can the market react to
a company missing its earnings
estimate?
On July 2, 2002, First Horizon
Pharmaceutical, which had been
trading above $20 for the past 12
months, warned that it would make
less the 2 cents per share (instead
of the anticipated 8 cents) for the
quarter. The stock had closed at
$18.24, then based on the earnings
news, opened the next morning at
$5.96, and then immediately dropping
down to $4.46.
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