Ignore This Red Flag at Your Own Risk

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"Aggressive" can be an inspiring word in investing, one that could point to positive returns over time. A company's management could be aggressively embarking on growth initiatives, for example. Investors could find themselves full of admiration for a company's aggressive competitive moves to fend off or even vault ahead of its rivals.

When "aggressive" is paired with the word "accounting," though, investors should look out and think twice.

The power of pattern recognition
Enron is probably the most well-known example of accounting fraud, but accounting problems, irregularities, and even fraud aren't as uncommon as we may think.


Accounting methods have occasionally come into the public eye, even long after the late 1990s dot-com bubble's bursting raised awareness of the dangers associated with aggressive and "creative" accounting. Remember all those financial restatements?

Lately, there's been a resurgence in accounting-related controversies. Groupon burst right out of the IPO gate with accounting issues that raised eyebrows. Green Mountain Coffee Roasters (NAS: GMCR) is still under investigation by the Securities & Exchange Commission for questionable revenue accounting.

GMI Ratings, the leading provider of research on environmental, social, governance, and accounting-related risks affecting the performance of public companies, released a report (link opens PDF file) last week diving deep into the pitfalls of improper expense recognition in corporate accounting.

GMI Ratings assigns Accounting & Governance Risk, or AGR, ratings to the companies in its database, setting its algorithms to conduct pattern recognition of factors that over the course of 13 years have indicated fraud. Although GMI Ratings doesn't claim its results are correct in all cases, the red-flagged companies bear watching, since in quite a few cases companies that have scored low on its AGR have been more likely to suffer from regulatory scrutiny and have also showed stock underperformance to boot.

Massaging the numbers
GMI Ratings gave several case studies of well-known companies that have raised the SEC's attention due to the expense recognition issue. Let's refresh our memories with two examples from the report.

In July 2010, Dell (NAS: DELL) was accused of having various disclosure and accounting violations from 2001 through 2006. Although its accounting made it appear that Dell was lowering its operating expenses, in fact the company was offsetting its costs with rebates from Intel.

In June 2010, Diebold was charged with having conducted earnings management fraud from 2002 through 2007. It participated in a litany of shady manipulations of its numbers, including delaying and capitalizing expenses, manipulating finished goods inventory and putting off expenses to spread them over several reporting periods, and writing up the value of its used ATM inventory. 

Many investors in our current marketplace are fairly short term and fairly speculative in nature, so memories are brief. Those of us who are long-term investors shouldn't forget corporate managements' urges to make their numbers look better than they truly are, nor should we ignore warnings about possible serious problems on the horizon.

Companies on GMI Ratings' current watchlist for "Aggressive" or "Very Aggressive" AGR ratings due to expense recognition issues include Cisco (NAS: CSCO) , Abbott Labs (NYS: ABT) , and General Electric (NYS: GE) .

Spreading the word
Granted, most of us individual investors aren't formally trained in accounting. However, it's not impossible to spot trouble. In 2010 my colleague Matthew Argersinger outlined ways to identify bad companies, and recommended one go-to tome: Dr. Howard Schilit's Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports. Matthew also outlined some basic takeaways for ferreting out problems, including red flags in revenue recognition.

Meanwhile, we should do exactly what speculators and traders tend not to do: Keep a close eye on the news about companies we own and always question whether we truly believe managements are serving shareholders' interests and not just their own. We should also take data and warnings from organizations like GMI Ratings seriously.

There's a lot more to investing than a ticker symbol and a company's daily stock price. Fortunately, given the communications tools we have today and organizations and individuals that track issues like these and disseminate their findings further than ever before, investors have more information on hand than ever before. That's good for long-term investing.

It might be good for corporations, too, in the sense that it might begin to dissuade the use of accounting funny business. When it comes to financial reporting, let's not look for aggression; let's demand the truth.

The Fool'spremium report on Green Mountain Coffee Roasterscan shed some light on the company's prospects.Get your copy today.

Check back atFool.comfor more of Alyce Lomax's columns on environmental, social, and governance issues.

The article Ignore This Red Flag at Your Own Risk originally appeared on Fool.com.

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