No investor wants to see a press release announcing that a company she owns is restating its financial figures because of accounting issues. The mere mention of those words could send a stock tumbling, sometimes 20% or more.

That’s because some investors believe an accounting restatement means fraud has been committed. While some restatements are due to an error in the books or management fudging the numbers, many situations are more complex. Sometimes, it’s just a difference of opinions over vague accounting guidelines. Some accounting restatements end up taking everyone by surprise because there is a general absence of the typical financial statement red flags. While those warnings signs are important, advisors need to consider two other areas: fundamental warnings signs in the business, and management
motivation factors.

Red flags

Accounting red flags are typically the most difficult area for advisors and investors to monitor on an ongoing basis because it requires you to study financial statements in depth. Reading all the notes, comparing the accounting choices made to other companies, and questioning the overall feel of the financial statements is something most advisors don’t have the time to do.

Sino-Forest is a good example of a company that had red flags in its financial statements that could’ve been caught. In short, Sino-
Forest’s various financial statements did not look like they belonged to the same company. There was an overall feel that was not right, but it would’ve taken extensive accounting training to have identified any inconsistencies within the statements. The OSC ordered a trading halt in 2011 and Sino-
Forest filed for bankruptcy in 2012.

In contrast to accounting red flags, advisors have an easier time picking up on the warning signs of a business itself. For instance, we’ve spoken to many advisors who avoided Poseidon Concepts before its collapse due to accounting issues. That’s because those advisors thought the reported results were too good to be true, given their knowledge of the business and the low barriers to entry. As it turned out, in Feb. 2013, Poseidon had to restate a significant amount of its revenue due to uncollectable receivables (up to $102 million out of $126 million). The company also stated up to $106 million of the company’s $148 million in revenue for the nine months ending September 30, 2012 should not have been recorded as revenue.

Management motivation

Advisors should also consider management motivation as a potential factor that could lead to an accounting restatement.

Take the recent example of Penn West Exploration, which restated its results for prior years in September 2014. The company said that, in 2013, $71 million in operating expenses were improperly reclassified to property, plant and equipment as capital expenditures. And, in 2012, approximately $66 million in operating expenses were reclassified to property, plant and equipment as capital expenditures without adequate support. As a result, the property, plant and equipment balances in those years were overstated. Also, in both 2012 and 2013, the company says that $101 million in operating expenses were incorrectly reclassified as royalty expenses.

As a result, Penn West appeared to be operating more efficiently than perhaps it really was. Because Penn West’s prior results did not make it appear the company was operating on any exceptional basis relative to its peers, there was no business red flag for investors to pick up on.

As for any accounting red flags, it’s a matter of opinion on whether a company’s chosen accounting policies and the resulting figures fairly present the financial affairs and position of the company.

The accounting rules themselves are vague and open to interpretation. So, in the case of Penn West, determining whether an expenditure should be considered an expense or an asset is far from simple.

The accounting rules state: “An asset is recognized in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be
measured reliably.

“An asset is not recognized in the balance sheet when an expenditure has been incurred for which it is considered improbable that the economic benefits will flow to the entity beyond the current accounting period. Instead, such a transaction results in the recognition of an expense in the income statement.”

The terms “economic benefits” and “current accounting period” are not further defined by the rules. So, questioning executive motivations or bias is important in such situations. It’s worth analyzing the books to see whether, in your opinion, the previous numbers were too aggressive, or whether current numbers are too conservative.

Given the openness of the rules, and the wide latitude that management has to interpret them, the only tip-off for investors
that there may have been concerns over the numbers could have been the changeover that took place in the CFO office in May 2014.

Even in retrospect, it’s difficult to say that this management motivation factor is something that investors should’ve seen coming with Penn West. Catching something like that would require a level of skepticism, and a culture of second-guessing, that would drive an investor out of equities entirely.

While monitoring companies for accounting red flags and dubious business results pays off in the end, advisors cannot hold themselves reasonably responsible for catching any and all accounting restatements. The accounting rules themselves just don’t allow for that level of certainty.

Be aware that accounting restatements can occur due to vague rules.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, is MBA, CFA, CFE.

Originally published in Advisor's Edge Report

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